Treasury Releases Blue Book Detailing Tax Proposals in White House Budget

Treasury Releases Blue Book Detailing Tax Proposals in White House Budget

The Treasury Department on February 3 released its Blue Book, an explanation of the revenue proposals in the Bush administration's fiscal 2004 budget.

Document Type: Treasury Reports

Tax Analysts Document Number: Doc 2003-3041 (156 original pages) [PDF]

Tax Analysts Electronic Citation: 2003 TNT 23-11

Citations: (3 Feb 2003)

GENERAL EXPLANATIONS OF THE ADMINISTRATION'S FISCAL YEAR
2004 REVENUE PROPOSALS

=============== SUMMARY ===============

The Treasury Department on February 3 released its Blue Book, an explanation of the revenue proposals in the Bush administration's fiscal 2004 budget.

Proposals include President Bush's economic growth package; tax incentives affecting charitable giving, education, the environment, energy conservation, and health care; improvements to tax administration; adjustments to unemployment insurance; simplification of the code; extension of several expiring provisions; and a response to the World Trade Organization's decision on the U.S. foreign sales corporation-extraterritorial income regime.

=============== FULL TEXT ===============

Department of the Treasury
February 2003

GENERAL EXPLANATIONS OF THE ADMINISTRATION'S FISCAL YEAR 2004
REVENUE PROPOSALS

INTRODUCTION

ADMINISTRATION PROPOSALS

ECONOMIC GROWTH PACKAGE

RATIONALE

Accelerate 10-percent individual income tax rate bracket
expansion
Accelerate reduction in individual income tax rates
Accelerate 15-percent individual income tax rate bracket
expansion for married taxpayers filing joint returns
Accelerate increase in standard deduction for married
taxpayers filing joint returns
Accelerate increase in child tax credit
Eliminate the double taxation of corporate earnings small
business
Provide minimum tax relief to individuals

TAX INCENTIVES

PROVIDE INCENTIVES FOR CHARITABLE GIVING

Provide charitable contribution deduction for non-
itemizers
Permit tax-free withdrawals from IRAs for charitable
contributions
Expand and increase the enhanced charitable deduction
for contributions of food inventory
Reform excise tax based on investment income of private
foundations
Modify tax on unrelated business taxable income of
charitable remainder trusts
Modify basis adjustment to stock of S corporations
contributing appreciated property
Repeal the $150 million limitation on qualified
501(c)(3) bonds
Repeal restrictions on the use of qualified 501(c)(3)
bonds for residential rental property

STRENGTHEN AND REFORM EDUCATION

Provide refundable tax credit for certain costs of
attending a different school for pupils assigned to
failing public schools
Extend, increase and expand the above-the-line deduction
for qualified out-of-pocket classroom expenses

INVEST IN HEALTH CARE

Provide refundable tax credit for the purchase of health
insurance
Provide an above-the-line deduction for long-term care
insurance premiums
Allow up to $500 in unused benefits in a health flexible
spending arrangement to be carried forward to the next
year
Provide additional choice with regard to unused benefits
in a health flexible spending arrangement
Permanently extend and reform Archer Medical Savings
Accounts
Provide an additional personal exemption to home
caregivers of family members
Allow the orphan drug tax credit for certain pre-
designation expenses

ENCOURAGE TELECOMMUTING

Exclude from income the value of employer-provided
computers, software and peripherals

INCREASE HOUSING OPPORTUNITIES

Provide tax credit for developers of affordable single-
family housing

ENCOURAGE SAVING

Establish Individual Development Accounts (IDAs)

PROTECT THE ENVIRONMENT

Permanently extend expensing of brownfields remediation
costs
Exclude 50 percent of gains from the sale of property
for conservation purposes

INCREASE ENERGY PRODUCTION AND PROMOTE ENERGY CONSERVATION

Extend and modify the tax credit for producing
electricity from certain sources
Provide tax credit for residential solar energy
systems
Modify treatment of nuclear decommissioning funds
Provide tax credit for purchase of certain hybrid and
fuel cell vehicles
Provide tax credit for energy produced from landfill
gas
Provide tax credit for combined heat and power
property
Provide excise tax exemption (credit) for ethanol

TAX ADMINISTRATION AND UNEMPLOYMENT INSURANCE

IMPROVE TAX ADMINISTRATION

Modify the IRS Restructuring and Reform Act of 1998
(RRA98)
Make Section 1203 of the IRS Restructuring and Reform
Act of 1998 more effective and fair
Curb the use of frivolous submissions and filings made
to impede or delay tax administration
Authorize partial-liability installment agreements
Allow for the termination of installment agreements
for failure to file returns and for failure to make
tax deposits
Consolidate judicial review of collection due process
cases in the United States Tax Court
Eliminate the monetary threshold for counsel review of
offers in compromise
Initiate IRS Cost Saving Measures
Allow the Financial Management Service to retain
transaction fees from levied amounts
Extend the due date for electronically filed returns
Repeal section 132 of the Revenue Act of 1978 and amend
the tax code to authorize the Secretary of the Treasury to
issue rules to address inappropriate nonqualified deferred
compensation arrangements
Permit private collection agencies to engage in
specific, limited activities to support IRS collection
efforts
Combat abusive tax avoidance transactions
Limit related party interest deductions

REFORM UNEMPLOYMENT INSURANCE

Reform unemployment insurance administrative financing

SIMPLIFY THE TAX LAWS

Establish uniform definition of a qualifying child
Simplify adoption tax provisions
Expand tax-free savings opportunities
Consolidate employer-based savings accounts

EXPIRING PROVISIONS

PERMANENTLY EXTEND EXPIRING PROVISIONS

Permanently extend provisions expiring in 2010
Permanently extend the research and experimentation
(R&E) tax credit
Repeal the disallowance of certain deductions of mutual
life insurance companies
Permanently extend and expand disclosure of tax return
information for administration of student loans

TEMPORARILY EXTEND EXPIRING PROVISIONS

Extend and modify the work opportunity tax credit and
the welfare-to-work tax credit
Extend minimum tax relief for individuals
Extend the District of Columbia (DC) Enterprise Zone
Extend the first-time homebuyer credit for the District
of Columbia
Extend authority to issue Qualified Zone Academy
Bond
Extend deduction for corporate donations of computer
technology
Extend the waiver of the Alternative Minimum Tax
limitation on NOL use
Extend IRS user fees
Extend provisions permitting disclosure of return
information relating to terrorist activity

RESPOND TO FOREIGN SALES CORPORATION/EXTRATERRITORIAL INCOME
DECISIONS
REVENUE ESTIMATES TABLE

GENERAL EXPLANATIONS OF THE ADMINISTRATION'S
FISCAL YEAR 2004 REVENUE PROPOSALS

Introduction

[1] This report summarizes the revenue proposals in the Administration's Fiscal Year 2004 Budget. These proposals include the economic growth package of proposals, which is designed to reinvigorate the economic recovery, create jobs, and enhance long- term economic growth. The other proposals, also intended to strengthen the American economy, affect a wide range of areas including encouraging saving, strengthening education, investing in health care, increasing housing opportunities, protecting the environment, encouraging telecommuting, and providing incentives for charitable giving, as well as simplifying the tax laws and improving tax administration. To maintain their favorable effects and provide greater certainty for economic and financial planning, the proposals extend several tax provisions that expire in 2003 and 2004 and permanently extend the tax cuts enacted in the Economic Growth and Tax Relief Reconciliation Act of 2001 as well as the Research and Experimentation tax credit.

[2] As announced in last year's Budget, the Administration is pursuing a tax simplification project which is focusing on immediately achievable reforms of the current tax system. Several proposals in this year's Budget result from this project. They include the proposals relating to: creating a uniform definition of a qualifying child, eliminating the phase-out of adoption tax benefits, repealing the restrictions on the use of qualified 501(c)(3) bonds in refinancing taxable debt and working capital debt and in providing residential rental housing, simplifying use of the orphan drug tax credit for pre-designation costs, exclusion from income of the value of employer-provided computers, consolidating IRAs into Lifetime Savings Accounts and Retirement Savings Accounts (LSAs/RSAs), consolidating defined contribution retirement plans into Employer Retirement Savings Accounts (ERSAs), allowing section 179 expensing elections to be made or revoked on amended returns, and conforming and simplifying the Work Opportunity Tax Credit and the Welfare to Work Tax Credit. Additional tax simplification proposals are under development by the Treasury's Office of Tax Policy and will be released during the coming year.

ADMINISTRATION PROPOSALS
ECONOMIC GROWTH PACKAGE

Rationale¹

[3] In 2001, the Administration worked with Congress to reduce income taxes for everyone who pays them - more than 100 million individuals, families, and sole proprietors received tax relief. Tax relief began immediately in July 2001 through reductions in tax rates and through advancing the benefits of a new, lower rate, 10-percent tax bracket by sending checks of up to $600 per taxpayer. Additional tax relief was received when taxpayers filed their 2001 tax returns in 2002, and further rate reductions took effect in 2002. However, the 2001 Act also delayed significant tax relief until 2004, 2006, and later years.

[4] The economy has shown great resilience over the past two years in the face of sharp declines in the stock market since March 2000, the terrorist attacks of September 11, 2001, and an ongoing war against terrorism. The U.S. economy continues to recover and long-run fundamentals are solid, with low inflation and strong productivity growth. Despite the strong underlying fundamentals, the recovery is slow. Businesses are expanding production only slowly and too few jobs are being created. Many employers lack the confidence to invest and hire additional workers.

[5] The President's proposed Economic Growth Package responds to the slow current economic recovery and builds a foundation for strong economic growth in the future. The greatest strengths of this economy now and in the future are the productivity and entrepreneurial spirit of Americans. High tax rates discourage individuals from investing in themselves through training and education since their higher earnings bear higher taxes. High tax rates discourage entrepreneurship, because the successful small business owner keeps less of any additional amount that is earned. High tax rates slow the economy, and a slowly growing economy produces fewer jobs for individuals wanting to work.

[6] The Economic Growth Package provides immediate acceleration of significant tax relief enacted in 2001 that is scheduled, under current law, to phase-in on a delayed basis. The proposal moves to this year the expansion of the 10-percent tax bracket, scheduled under current law for 2008, as well as marginal tax rate reductions, scheduled under current law to take place in 2004 and 2006. It further reduces taxes by putting marriage penalty relief provisions, scheduled under current law to take place between 2005 and 2009, in place for 2003. The Growth Package also provides for the immediate acceleration of the Child Tax Credit, scheduled under current law to take place between 2005 and 2010. The proposal also provides for temporary alternative minimum tax (AMT) relief to ensure that additional taxpayers do not become subject to the complicated rules of the AMT merely because of the legislated tax relief provided.

[7] Increases in the level of investment are essential to ensuring future increases in productivity, the key to an increasing standard of living for Americans. Higher levels of investment bring higher wages as each worker can produce more with better and more efficient plant, equipment, and technology. The Economic Growth Package provides a significant reduction in the cost of undertaking new investment by eliminating the double tax on corporate earnings. Under current law, income earned by a corporation is first taxed at the corporate level and then taxed a second time when distributed to shareholders as dividends. Corporate earnings that are retained are also subject to a second tax when shareholders sell their stock and the appreciation representing these retained earnings is taxed again. Double taxation can result in rates of tax as high as 60 percent, far in excess of rates of tax imposed on other income.

[8] Under the proposal, corporate income would be subject to only one level of tax. Dividends paid out of income that was fully taxed at the corporate level would be excluded from tax at the shareholder level. Similarly, if a company retained earnings out of income that was fully taxed at the corporate level, shareholders would be permitted to increase their basis in their shares to reflect the previously taxed retained earnings of the firm. The basis increase would eliminate any capital gains tax liability arising directly from retentions of previously taxed earnings.

[9] Elimination of the double tax on corporate earnings can result in significant efficiency gains for the economy and reduce the cost to corporations of undertaking new investment. Elimination of the double tax reduces other tax-induced distortions in the economy. Because, under current law, interest payments on debt are deductible but payments of dividends on equity are not, corporations rely too much on debt to finance their investment. An excessive use of debt finance can make corporations more vulnerable during economic downturns to financial distress and may lead to bankruptcy. The bias in the current system against paying dividends can result in a reduced pressure on corporate managers to make the most efficient use of retained earnings, because corporate investments funded by retained earnings may receive less scrutiny than investments funded by new, outside sources of capital.

[10] The proposal provides further support for investment by significantly expanding the amount of investment that may be immediately deducted by a small business. The increased cash flow and reduced effective costs for making new investments allows small businesses to expand and create new employment opportunities.

[11] The components of the President's Economic Growth Package work together to enhance growth in the near-term and in the long- term. The components of the Economic Growth Package are described in more detail in this section.

ACCELERATE 10-PERCENT INDIVIDUAL INCOME TAX RATE BRACKET EXPANSION

Current Law

[12] The Economic Growth and Tax Relief Reconciliation Act of 2001 split the prior law 15-percent individual income tax rate bracket into two tax rate brackets of 10 and 15 percent. The 10- percent tax rate bracket applies to the first $6,000 of taxable income for single taxpayers and married taxpayers filing separate returns (increasing to $7,000 for taxable years 2008 and later), the first $10,000 of taxable income for heads of household, and the first $12,000 of taxable income for married taxpayers filing joint returns (increasing to $14,000 for taxable years 2008 and later). The income thresholds for the new tax rate brackets will be adjusted annually for inflation, effective for taxable years beginning after 2008. Taxable income above these thresholds that was taxed at the 15- percent rate under prior law will continue to be taxed at the 15- percent tax rate.

[13] Under current law, the 10-percent tax rate bracket would be eliminated when tax rates return to their pre-EGTRRA levels after taxable year 2010.

Proposal

[14] The Administration proposes to accelerate to 2003 the expansion of the 10-percent bracket scheduled for 2008. Effective for taxable years beginning after December 31, 2002, the 10-percent tax rate bracket would apply to the first $7,000 of taxable income for single taxpayers and married taxpayers filing separate returns, the first $10,000 of taxable income for heads of household, and the first $14,000 of taxable income for married taxpayers filing joint returns. The income thresholds for the 10-percent tax rate brackets would be adjusted annually for inflation, effective for taxable years beginning after December 31, 2002. The 10-percent tax rate bracket would remain in effect for taxable years beginning after 2010 as a result of the Administration's separate proposal to permanently extend the EGTRRA provisions.

Revenue Estimate

Fiscal Years

2003 2004 2005 2006 2007 2008 2004-2008 2004-2013
($'s in millions)

-978 -7,782 -6,112 -6,117 -6,495 -4,275 -30,781 -47,194

ACCELERATE REDUCTION IN INDIVIDUAL INCOME TAX RATES

Current Law

[15] The Economic Growth and Tax Relief Reconciliation Act of 2001 lowered the tax rates in the four tax rate brackets higher than 15 percent from 28, 31, 36, and 39.6 percent to 25, 28, 33, and 35 percent. The reduced tax rates are phased in over a period of six years in four steps, beginning with taxable year 2001, according to the following schedule:

Taxable 28% rate is 31% rate is 36% rate is 39.6% rate
Year reduced to: reduced to: reduced to: is reduced to:

2001 27.5% 30.5% 35.5% 39.1%
2002 - 2003 27% 30% 35% 38.6%
2004 - 2005 26% 29% 34% 37.6%
2006 - 2010 25% 28% 33% 35%

[16] The width of each of these tax brackets is adjusted annually to reflect inflation during the preceding year.

[17] Under current law, these rates return to their pre-EGTRRA levels after taxable year 2010.

Proposal

[18] The income tax rate reduction scheduled for 2004 and 2006 would be accelerated to 2003. Effective for taxable years beginning after December 31, 2002, the 27-percent rate would be reduced to 25 percent; the 30-percent rate would be reduced to 28 percent; the 35- percent rate would be reduced to 33 percent; and the 38.6-percent rate would be reduced to 35 percent. The lower rates would remain in effect for taxable years beginning after December 31, 2010 as a result of the Administration's separate proposal to permanently extend all provisions of EGTRRA.

Revenue Estimate

Fiscal Years

2003 2004 2005 2006 2007 2008 2004-2008 2004-2013
($'s in millions)

-5,808 -35,693 -17,470 -4,939 0 0 -58,102 -58,102

ACCELERATE 15-PERCENT INDIVIDUAL INCOME TAX RATE BRACKET EXPANSION FOR MARRIED TAXPAYERS FILING JOINT RETURNS

Current Law

[19] A married couple has a marriage penalty if they owe more income tax filing a joint return than the couple would pay if they were unmarried and each filed a separate return. Marriage penalties often arise because the size of the rate brackets for joint filers is less than twice the size for single filers or head of household filers. In 2003, the maximum taxable income in the 15-percent tax rate bracket is 167 percent of the corresponding amount for an unmarried individual filing a single return.

[20] The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) increases the size of the 15-percent tax rate bracket for married taxpayers filing joint returns over a four-year period, beginning after December 31, 2004. The increase is as follows: the maximum taxable income in the 15-percent tax rate bracket for married taxpayers filing joint returns increases to 180 percent of the corresponding amount for single taxpayers in taxable year 2005, 187 percent in taxable year 2006, 193 percent in taxable year 2007, and 200 percent in taxable years 2008, 2009, and 2010.

Proposal

[21] The maximum taxable amount in the 15-percent tax rate bracket for married taxpayers filing joint returns would be increased to 200 percent of the corresponding amount for single taxpayers, effective for taxable years beginning after December 31, 2002. The Administration is also proposing to permanently extend the EGTRRA provisions in 2010. Thus, the expanded 15-percent tax rate bracket for married taxpayers would also apply to taxable years beginning after December 31, 2010.

Revenue Estimate

Fiscal Years

2003 2004 2005 2006 2007 2008 2004-2008 2004-2013
($'s in millions)

-2,042 -19,889 -10,171 -4,718 -1,785 -463 -37,026 37,026

ACCELERATE INCREASE IN STANDARD DEDUCTION FOR MARRIED TAXPAYERS FILING JOINT RETURNS

Current Law

[22] A couple has a marriage penalty if they owe more income tax filing a joint return than the couple would pay if they were unmarried and each filed a separate return. Marriage penalties often arise because the standard deduction for joint filers is less than twice the corresponding amounts for single filers or head of household filers. In 2003, the basic standard deduction amount for a married couple filing a joint return is 167 percent of the corresponding amount for an unmarried individual filing a single return.

[23] The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) increases the standard deduction for married couples filing joint returns to double the standard deduction for single taxpayers over a five-year period, beginning after December 31, 2004. The standard deduction for married taxpayers filing joint returns increases to 174 percent of the standard deduction for single taxpayers in taxable year 2005, 184 percent in taxable year 2006, 187 percent in taxable year 2007, 190 percent in taxable year 2008, and 200 percent in taxable years 2009 and 2010.

Proposal

[24] The standard deduction for married taxpayers filing joint returns would be increased to 200 percent of the standard deduction for single taxpayers, effective for taxable years beginning after December 31, 2002. The Administration is also proposing to permanently extend the EGTRRA provisions expiring in 2010. Thus, the increase in the standard deduction for married taxpayers would also apply to taxable years beginning after December 31, 2010.

Revenue Estimate

Fiscal Years

2003 2004 2005 2006 2007 2008 2004-2008 2004-2013
($'s in millions)

-735 -7,245 -4,509 -2,924 -1,811 -1,272 -17,761 18,185

ACCELERATE INCREASE IN CHILD TAX CREDIT

Current Law

[25] Taxpayers may be eligible for a tax credit of up to $600 for each qualifying child under the age of 17. The credit increases to $700 for taxable years 2005 through 2008, $800 for taxable year 2009, and $1,000 for taxable year 2010. The credit declines to $500 in taxable year 2011. The credit is reduced by $50 for each $1,000 (or fraction thereof) by which the taxpayer's modified adjusted gross income exceeds $110,000 ($75,000 if the taxpayer is not married and $55,000 if the taxpayer is married but filing a separate return). The credit amounts and income thresholds are not adjusted for inflation. For taxable years before January 1, 2011, the credit offsets both the regular and the alternative minimum tax.

[26] The child tax credit is refundable to the extent of 10 percent of the taxpayer's earned income in excess of $10,500. The percentage increases to 15 percent for taxable years 2005 through 2010. The $10,500 earned income threshold is indexed annually for inflation. Families with three or more children are allowed a refundable credit for the amount by which their social security payroll taxes exceed the refundable portion of their earned income tax credit, if that amount is greater than the refundable credit based on their earned income in excess of $10,500. For taxable years beginning after December 31, 2010, the credit is nonrefundable unless the taxpayer has three or more children and social security taxes in excess of the refundable portion of the earned income tax credit.

Proposal

[27] The amount of the child tax credit would be increased by $400 to $1,000 per child. The proposal would be effective for taxable years beginning after December 31, 2002.

[28] In 2003, the increased amount of the child tax credit (up to $400) would be paid in advance beginning in July 2003 on the basis of information on the taxpayer's 2002 tax return filed in 2003. Advance payments would be made in a manner similar to the distribution of advance payment checks in 2001.

[29] The Administration is also proposing to permanently extend the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) provisions expiring in 2010. Thus in taxable years beginning after December 31, 2010, the credit would be $1,000, would offset the alternative minimum tax, and would be partially refundable for families with one or two children.

Revenue Estimate²

Fiscal Years

2003 2004 2005 2006 2007 2008 2004-2008 2004-2013
($'s in millions)

-13,827 -6,134 -15,518 -12,806 -12,727 -12,644 -59,829 -78,545

ELIMINATE THE DOUBLE TAXATION OF CORPORATE EARNINGS

Current Law

[30] Income earned by a corporation is taxed at the corporate level, generally at the rate of 35 percent. If the corporation distributes earnings to shareholders in the form of dividends, the income generally is taxed a second time at the shareholder level (at rates as high as 38.6 percent). If a corporation instead retains its earnings, the value of corporate stock will reflect the retained earnings. When shareholders sell their stock, that additional value will be taxed as capital gains (generally at a maximum rate of 20 percent for long-term capital gains). The combined rate of tax on corporate income can be as high as 60 percent, far in excess of rates of tax imposed on other types of income.

Reasons for Change

[31] The double taxation of corporate profits creates significant economic distortions.

First, double taxation creates a bias in favor of debt as compared to equity, because payments of interest by the corporation are deductible while returns on equity in the form of dividends and retained earnings are not. Excessive debt increases the risks of bankruptcy during economic downturns.
Second, double taxation of corporate profits creates a bias in favor of unincorporated entities (such as partnerships and limited liability companies), which are not subject to the double tax.
Third, because dividends are taxed at a higher rate than are capital gains, double taxation of corporate profits encourages a corporation to retain its earnings rather than distribute them in the form of dividends. This lessens the pressure on corporate managers to undertake only the most productive investments because corporate investments funded by retained earnings may receive less scrutiny than investments funded by outside equity or debt financing.
Fourth, double taxation encourages corporations to engage in transactions such as share repurchases rather than to pay dividends because share repurchases permit the corporation to distribute earnings at reduced capital gains tax rates.
Fifth, double taxation increases incentives for corporations to engage in transactions for the sole purpose of minimizing their tax liability.

[32] By eliminating double taxation, the proposal will reduce tax- induced distortions that, in the current tax system, encourage firms to use debt rather than equity finance and to adopt noncorporate rather than corporate structures. Because shareholders will be exempt from tax only on distributions of previously taxed corporate income, the proposal will reduce incentives for certain types of corporate tax planning. In addition, the proposal will enhance corporate governance by eliminating the current bias against the payment of dividends. Dividends can provide evidence of a corporation's underlying financial health and enable investors to evaluate more readily a corporation's financial condition. This, in turn, increases the accountability of corporate management to its investors.

Proposal

Overview

[33] The proposal would integrate the corporate and individual income taxes so that corporate earnings generally will be taxed once and only once. Under the proposal, public and private corporations would be permitted to distribute nontaxable dividends to their shareholders to the extent that those dividends are paid out of income previously taxed at the corporate level. The proposal generally would be effective for distributions made on or after January 1, 2003, with respect to corporate earnings after 2000.

[34] To calculate the amount that can be distributed to its shareholders without further tax, a corporation will compute an excludable dividend amount (EDA) for each year. The EDA reflects income of the corporation that has been fully taxed. Thus, for example, a corporation with $100 of income that pays $35 of U.S. income taxes will have an EDA of $65 that can be distributed as excludable dividends.

[35] If an amount would be a dividend under current law, it will be treated as an excludable dividend to the extent of EDA. Excludable dividends will not be taxed to shareholders. If a corporation's distributions during a calendar year exceed its EDA, only a proportionate amount of each distribution will be treated as an excludable dividend. Ordering rules are provided below for distributions that exceed EDA.

[36] The capital gains tax on the sale of stock will be retained. Without further change, this would create an incentive for corporations to distribute previously taxed income as excludable dividends rather than retaining earnings for future investment. This is because excludable dividends would not be taxed to the shareholders but capital gains that represent retained earnings would be taxed to the shareholders when they sell their shares.

[37] To ensure that distributions and retentions of previously taxed earnings are treated similarly, shareholders will be permitted to increase their basis in their shares to reflect that the retained earnings have already been taxed at the corporate level. As an alternative to distributing excludable dividends, corporations generally may allocate throughout the year all or a portion of the EDA to provide these basis increases. The basis increases will not be taxable. The effect of the basis increases will be to reduce the capital gains realized when shareholders sell their stock to the extent that the sales price reflects the corporation's retained, previously taxed earnings.

Technical Explanation

Corporate Level

A. In General

[38] Corporations will continue to calculate their income under current law rules and will pay tax according to the existing graduated rate schedule. The corporate alternative minimum tax (AMT) will continue to apply.

[39] The rules for computing earnings and profits will be retained. The rules for treating corporate level transactions, such as acquisitive and divisive reorganizations, liquidations, and taxable acquisitions will generally be the same as under current law. Corporations may continue to file consolidated returns as under current law. The consolidated return regulations will be amended to reflect the dividend exclusion.

B. The Excludable Dividend Amount

[40] Corporations will be able to determine with certainty on January 1 the amount of their EDA for the year.

[41] To compute EDA, the corporation will first convert U.S. income taxes shown on its U.S. income tax return filed during the prior year into an equivalent amount of income taxed at a 35 percent rate. The formula divides U.S. income taxes shown on the return by the maximum statutory corporate tax rate (currently 35 percent) and then subtracts the U.S. income taxes shown on the return. For purposes of the computation, U.S. income taxes includes U.S. income taxes on foreign source income that have been offset by foreign tax credits. It also includes AMT.

[42] Although the graduated rates of tax on corporate income set forth in section 11(b) will still apply, taxes will be grossed-up for purposes of calculating the EDA as if all income were subject to U.S. tax at a 35 percent rate. Similarly, taxes paid at the AMT rate will be grossed-up at a 35 percent rate. Because the proposal treats AMT as U.S. income taxes, it will not treat as U.S. income taxes the portion of regular taxes that are offset by the AMT credit allowed under section 53.

[43] These steps in calculating EDA are illustrated as follows:

U.S. income taxes - U.S. income taxes
___________________
.35

[44] The calculation of EDA then adds excludable dividends received in the prior year by the corporation as a shareholder and retained earnings basis adjustments (as described below) for the prior year made with respect to stock owned by the corporation. For example, an excludable dividend received by a corporation on March 31, 2004, will be included in its EDA for 2005. These additions to EDA will ensure that multiple levels of corporate ownership do not result in more than one level of tax on income that has been previously taxed at the corporate level.

[45] For purposes of computing a corporation's EDA for a particular calendar year, U.S. income taxes means U.S. income taxes (other than estimated taxes) shown on returns filed by the corporation in the previous calendar year. Thus, for example, U.S. income taxes shown on a return filed on September 15, 2005, will be used to compute EDA for 2006. In addition, U.S. income taxes include U.S. income taxes paid pursuant to an assessment of deficiency in that year and will be reduced, but not below zero, by refunds of income taxes paid during that year. Refunds of income taxes and payments of additional income taxes that are attributable to a taxable year the return for which was filed prior to January 1, 2002, will not be included in the computation of the EDA.

[46] To the extent the EDA for a particular calendar year exceeds the current and accumulated earnings and profits, the excess will be added to the EDA for the following calendar year. Otherwise, any remaining EDA not distributed or added to shareholder basis will expire.

C. Retained Earnings Basis Adjustments

[47] As an alternative to distributing excludable dividends, corporations will be permitted to allocate throughout the year all or a portion of their EDA to increase their shareholders= basis in their stock.

[48] The sum of excludable dividends and basis increases cannot exceed the lesser of EDA or current and accumulated earnings and profits. As described below, all dividend distributions during the year will be treated as excludable dividends to the extent of EDA. Consequently, basis increases will be permitted only to the extent that the total dividend distributions during the year do not exceed EDA. If the corporation's earnings and profits is less than EDA, then basis increases are limited to the excess of earnings and profits over excludable dividends.

[49] The basis increases will not be taxable. Basis increases will reduce the EDA and earnings and profits.

[50] Basis increases must be allocated in the same manner as a distribution would be allocated. Basis increases may not be allocated, however, to stock that is preferred and limited as to dividends. Regulations may address other situations where a corporation has multiple classes of stock.

[51] Allocated basis increases reflecting retained earnings are referred to as REBAs. A corporation will maintain records of the total REBAs made with respect to its stock in prior years. The cumulative amount of REBAs for all years is referred to as the CREBA.

[52] From time to time, a corporation's EDA for a calendar year may be less than the distributions it intends to make. Instead of treating distributions in excess of EDA as taxable dividends, as described below, the proposal treats those distributions as effectively reversing basis adjustments that were allocated in prior years. These distributions reduce CREBA. This flexibility reflects the fact that, even though a corporation's taxable income may fluctuate, it may maintain a stable dividend payout.

D. Distributions

[53] For a distribution to be an excludable dividend, it must be a dividend under current law, i.e., out of earnings and profits.

[54] If a distribution is a dividend under current law, it will be treated as an excludable dividend to the extent of EDA. Distributions that are excludable dividends reduce EDA and earnings and profits.

[55] If dividend distributions are less than EDA, a corporation may permit its shareholders to increase their basis in their stock as discussed above.

[56] If a corporation's distributions during a calendar year exceed its EDA, only a proportionate amount will be treated as an excludable dividend.

[57] Distributions that are not excludable dividends generally will be treated as:

first a return of basis and then capital gain to the extent of the CREBA,
then a taxable dividend to the extent of the corporation's earnings and profits,
then a return of capital to the extent of the shareholder's remaining basis, and
then capital gain.

[58] The distinction between a redemption distribution that is treated as a dividend and a redemption that is treated as a sale or exchange of stock will remain as under current law. The proposal, however, may modify the attribution rules (particularly as they relate to options) for purposes of determining whether a redemption distribution is treated as a dividend.

[59] A redemption that is treated as a sale or exchange of stock will reduce pro rata the redeeming corporation's current year EDA and CREBA. For example, if a corporation redeems two percent of its stock, the corporation will reduce its current year EDA and CREBA by two percent.

[60] The rules under sections 304, 305, and 306 will be retained. To the extent that those rules characterize transactions as distributions to which sections 301 and 316 apply, EDA will be reduced accordingly.

E. Refunds of Taxes

[61] The rules governing refunds of taxes will be revised to ensure that EDA for a year in which shareholders have already derived a benefit is not affected. In general, if a refund is due in a particular calendar year, the refund will be paid to the extent the corporation has paid U.S. income taxes shown on a final return previously filed in that calendar year. If any refund remains unpaid, the corporation may recompute its EDA for the current year as if the refund reduced the U.S. incomes taxes previously used to compute the current year's EDA. This permits an additional refund to be paid currently. The recomputed EDA will be used to determine the character of distributions made, and the amount of basis adjustments permitted to be allocated, during the entire year. Any refund that is not paid currently will be credited against future tax liability.

[62] Refunds attributable to a taxable year the return for which was filed prior to January 1, 2002, will be paid as under current law.

F. Carryback of Net Operating Losses

[63] The rules governing the carryback of net operating losses will be revised to ensure that EDA for a year in which shareholders have already derived a benefit is not affected. Accordingly, under the proposal, net operating losses of corporations may be carried back one year. For example, a net operating loss attributable to a taxable year ending during 2003 may be carried back one year to the taxable year ending in 2002. If a net operating loss is carried back, however, the EDA for the current year must be recomputed. That recomputed EDA will be used to determine the character of distributions made, and the amount of basis adjustments allocated, during the entire year.

[64] The proposal will not affect the carryback period for net operating losses that are carried back to a taxable year the return for which was filed prior to January 1, 2003.

G. Reorganizations and Liquidations

[65] The proposal retains current law rules that treat a qualifying corporate reorganization and certain corporate liquidations as tax- free at the shareholder level and at the corporate level. Under current law, the acquired corporation's tax attributes, including its asset basis, carry over to the acquiror. These rules will be amended to provide for the carryover of the acquired corporation's EDA and CREBA.

[66] The proposal retains current law rules governing tax-free spin- offs. Under the proposal, rules will be provided to divide the CREBA, if any, of the distributing and controlled corporations between the distributing and controlled corporations based on the relative fair market values of their assets and to ensure that duplicate CREBA is eliminated.

H. Consolidated Returns

[67] The Secretary of the Treasury will amend the consolidated return regulations to effect the provisions of the proposal. For example, regulations might provide that, in a consolidated group, EDA will be calculated on a consolidated group basis based on U.S. income taxes of the group, and then apportioned among the entities that were members of the group during the taxable year based on each member's separate taxable income. No EDA will be allocated to members that generated a loss during the taxable year. The stock basis adjustment rules of the current consolidated return regulations, rather than the rules described above, will control for members of a consolidated group.

I. Limits on Tax Motivated Acquisitions

[68] Section 269 will apply, as under current law, to discourage tax motivated acquisitions, including acquisitions undertaken for the purpose of obtaining an EDA or a CREBA. Because EDA generally expires at the end of each year, the proposal does not include section 382- type rules.

J. Accumulated Earnings Tax and Personal Holding Company Tax

[69] The accumulated earnings tax and personal holding company tax will be repealed because they are of diminished importance in a system that does not impose a shareholder level of tax on dividends. Their repeal will simplify compliance with the tax laws.

K. Foreign Corporations

[70] U.S. income taxes on income of a foreign corporation that is effectively connected with a U.S. trade or business will be treated as U.S. income taxes for purposes of the EDA computation. Branch profits taxes will not be treated as U.S. income taxes for purposes of computing EDA, and any branch profits taxes paid will reduce a foreign corporation's EDA. A foreign corporation's EDA will be increased by any excludable dividends received by it as a shareholder as well as distributions from CREBA of the distributing corporation, reduced by any applicable U.S. withholding taxes. U.S. withholding taxes imposed on a foreign corporation will not be treated as U.S. income taxes for purposes of the EDA computation.

[71] Consistent with the general rule, distributions from a foreign corporation first will be attributable to EDA and then CREBA. Shareholders receiving distributions of those amounts will not be entitled to receive foreign tax credits for foreign taxes paid or accrued with respect to those amounts.

L. S Corporations

[72] The S corporation rules will be retained under the proposal with certain modifications. Under current law, the income of S corporations is subject to an entity level tax only in limited circumstances. To the extent an S corporation pays income tax at the corporate level, the S corporation will compute EDA based on that tax and the income subject to that tax will not be taxed again at the shareholder level.

[73] In addition, under the proposal, distributions first will be treated as excludable dividends to the extent that the corporation's EDA does not exceed its earnings and profits and then will be from CREBA. After these distributions, the remainder will be characterized as under current law.

M. Regulated Investment Companies (RICs) and Real Estate Investment Trusts (REITs)

[74] Under the proposal, a RIC or a REIT that has excludable dividend income will generally pass through this income as excludable to its shareholders. In addition, RICs and REITS will be able to pass through REBAs as basis adjustments.

[75] Under current law, RICs and REITs are entitled to a deduction for the dividends they distribute to their shareholders. Under the proposal, RICs and REITs will not be allowed a deduction for distributions that are designated as excludable or from CREBA. For purposes of the distribution requirements of RICs and REITs, excludable dividends will be treated in the same manner as tax-exempt interest.

N. Insurance Companies

[76] Insurance companies are allowed to deduct benefits paid on insurance contracts (death benefits, annuity payments, payments for property and casualty losses) plus an estimate of benefits to be paid in the future (i.e., amounts added annually to reserves held by the company to fund future benefit payments). Under current law, to prevent a double benefit with respect to exempt income, insurance companies are required to allocate exempt earnings on a pro rata basis between the insurance company's general earnings and those amounts set aside to pay benefits. Any earnings otherwise exempt that are allocated to pay benefits are treated as not exempt from tax. These allocations are made by means of certain proration rules. These rules set forth computations that produce the percentage of exempt income to be allocated to the company and the percentage to be treated as held to pay policy benefits.

[77] Under the proposal, all excludable dividends will be subject to proration. The basis increase attributable to REBAs will be adjusted to take into account these proration rules. In addition, all excludable dividends and REBAs attributable to assets held in a separate account funding variable life insurance and annuity contracts will be allocated to the separate account.

O. Cooperatives

[78] Cooperatives will compute EDA in the same manner as a C corporation and will be permitted to distribute excludable dividends or to allocate REBAs to the extent of EDA.

Shareholder Level

A. Distributions

1. In General

[79] Under the proposal, shareholders generally will exclude from gross income dividends that are characterized as excludable dividends. Each year, shareholders will receive a Form 1099 from the corporation setting forth which portions of their distributions are excludable dividends, taxable dividends, or returns of capital. In addition, the statement will show the amount by which shareholders are entitled to increase their basis in their stock as a result of REBAs.

2. Special Rules for Dividend Exclusion and REBAs

[80] Under current section 246(c), corporate shareholders must hold their stock for more than 45 days (and for more than 90 days in the case of preferred stock) during the 90-day period (and the 180- day period in the case of preferred stock) beginning 45 days (and 90 days in the case of preferred stock) before the ex-dividend date to be eligible to claim a dividends received deduction. A rule similar to section 246(c), with the same holding period requirements, will apply to excludable dividends received and REBAs allocated to both corporate and noncorporate shareholders.

[81] Under current law, section 1059 requires stock basis reductions for certain dividends received by corporate shareholders. Under the proposal, section 1059 will be extended to apply to excludable dividends received and REBAs allocated to both corporate and noncorporate shareholders. For purposes of the section 246(c) and 1059 rules, a shareholder who acquires stock from a decedent will treat its holding period with respect to that stock as beginning on the date used for purposes of determining the fair market value of the stock for estate tax purposes.

[82] Under current section 852(b)(4), if a shareholder of a RIC receives an exempt-interest dividend in respect of a share held by the shareholder for 6 months or less, any loss on the sale of the share is disallowed to the extent of the exempt-interest dividend. Similar rules will be provided if a shareholder of a RIC receives a distribution that is designated as an excludable dividend or is entitled to make a REBA.

B. Capital Gains

[83] Shareholders will be taxed on sales of their stock, as under current law. REBAs should largely prevent shareholders from being taxed on the portion of appreciation in the value of their shares that is attributable to previously taxed income that the corporation has chosen to retain rather than pay out as dividends. The capital loss limitation will remain as under current law.

C. Redemptions

[84] In general, a redemption of stock is characterized as either a distribution under section 301 or a sale or exchange of stock as under current law.

D. Corporate Shareholders

[85] Under the proposal, an excludable dividend received by a U.S. corporation will not be taxable. Excludable dividends received by a corporation will increase the recipient corporation's EDA and will, therefore, remain excludable when distributed by the recipient corporation.

[86] Under current law, a corporation that receives a dividend from another corporation is entitled to a dividends received deduction. Under the proposal, the 100 percent deduction for dividends received from a corporation 80 percent or more of which is owned by another corporation will be retained. The 70 and 80 percent deductions for dividends received, however, will only be available for distributions of pre-2001 earnings and profits that are distributed before January 1, 2006, with respect to stock issued before February 3, 2003.

E. Shareholder Level Debt

[87] Section 246A, which prohibits the dividends received deduction for debt-financed portfolio stock, will be modified to require that otherwise excludable dividends received by corporations be included in income if attributable to debt-financed stock. Additionally, because under section 163(d) excludable dividends will not be treated as investment income, excludable dividends will not increase the amount deductible as investment interest.

F. Shareholder AMT

[88] The proposal does not affect the alternative minimum tax. Excludable dividends will not be an AMT adjustment or preference. In addition, excludable dividends will not be a preference for adjusted current earnings for corporate AMT.

G. Foreign Shareholders

[89] In the case of foreign shareholders, the withholding tax on dividends will be retained for distributions out of earnings and profits, whether or not excludable, and will apply to distributions from CREBA. U.S. withholding tax will not apply to REBAs.

[90] REBAs allocable to stock held by a foreign shareholder will not increase the basis of the foreign shareholder's stock. Any distributions to a foreign shareholder from CREBA will not decrease the foreign shareholder's stock basis.

[91] If the foreign shareholder is a corporation, distributions of excludable dividends, reduced by any applicable U.S. withholding taxes, will increase the EDA of the foreign shareholder. REBAs will not increase the EDA of a foreign corporate shareholder. Distributions from the distributing corporation's CREBA to foreign corporate shareholders will be treated in the same manner as an excludable dividend received.

H. Pension Plans, 401(k) Plans, and Individual Retirement Accounts (Retirement Plans)

[92] In a Retirement Plan, all investment income, including all dividend income, is effectively free from tax. The proposal's treatment of Retirement Plans will not change current law.

[93] Generally, under current law, amounts contributed to a Retirement Plan are not subject to tax when contributed. Income of the Retirement Plan is not subject to tax when earned. Instead, contributions and earnings are subject to tax when distributed. In contrast, contributions to a Roth-IRA are made with after-tax dollars. However, both the after-tax contributions and income earned on those contributions are free from tax when distributed.

[94] All investment income, including dividend income, earned by a Roth-IRA is free from tax. The tax treatment of other retirement plans is economically equivalent to Roth-IRA treatment. A plan with tax-free contributions and no tax until withdrawal produces the same after-tax benefit for an individual as a plan with after-tax contributions and tax-free investment returns.

[95] Because all investment income is effectively free from tax in Retirement Plans, investments in these plans will remain tax advantaged relative to investments outside of these plans.

I. Employee Stock Ownership Plans (ESOPs)

[96] Under current law, a corporation is entitled to a deduction for certain dividends paid with respect to shares held by an ESOP sponsored by the corporation or another corporation in the same controlled group. Under the proposal, an otherwise excludable dividend will be taxable if a deduction is allowed in respect of such dividend. The amount of the dividend, however, will not reduce a distributing corporation's EDA. If both a deduction and an exclusion for a dividend were permitted, then the amounts paid would not be taxed at either the corporate or the shareholder level.

[97] In addition, REBAs will not be permitted to be made to the basis of shares held by an ESOP. The corporation will be permitted a deduction for distributions from CREBA in respect of shares held by an ESOP. Correspondingly, such distributions will not decrease the basis of such shares and, instead, will be taxable if paid in cash. Finally, such amounts will not reduce a distributing corporation's CREBA.

J. Private Foundations

[98] Under current law, private foundations are subject to tax on net investment income. Under the proposal, excludable dividends and distributions from CREBA will not be included in the calculation of net investment income for this purpose.

K. Treatment of Owner of Rights to Acquire Stock

[99] Under the proposal, the Secretary may promulgate regulations treating the holder of a right to acquire stock as a shareholder as necessary to prevent the creation of stock losses or reduction of stock gains.

Reporting and Recordkeeping

[100] Forms 1099 will be revised to provide information to shareholders to indicate the amounts of excludable dividends, taxable dividends, and returns of capital. The revised form will also indicate the amounts of REBAs so that shareholders can adjust their basis.

[101] A corporation will calculate the EDA and the CREBA and will report those amounts to the IRS annually on its income tax return.

Revenue Estimate

Fiscal Years

2003 2004 2005 2006 2007 2008 2004-08 2004-13
$'s in millions

-2,665 -24,224 -25,962 -31,501 -33,996 -36,983 -152,666 -385,429

INCREASE EXPENSING FOR SMALL BUSINESS

Current Law

[102] Section 179 provides that, in place of depreciation, certain taxpayers may elect to deduct up to $25,000 of the cost of qualifying property placed in service each year. In general, qualifying property is defined as depreciable tangible personal property that is purchased for use in the active conduct of a trade or business. Off- the-shelf computer software generally does not qualify for the Section 179 deduction because it is intangible property. The $25,000 amount is reduced (but not below zero) by the amount by which the cost of qualifying property exceeds $200,000. More generous incentives are provided for investment in the New York Liberty Zone or in an empowerment zone or renewal community. An election for the Section 179 deduction must generally be made on the taxpayer's initial tax return to which the election applies. The election can be revoked only with the consent of the Commissioner.

Reasons for Change

[103] Expensing encourages investment by lowering the after-tax cost of capital purchases, relative to claiming regular depreciation deductions. Expensing is also simpler than claiming regular depreciation deductions, which is particularly helpful for small businesses. Raising the amount of total investment at which the phase-out begins would increase the number of taxpayers eligible for Section 179 expensing.

[104] The exclusion of off-the-shelf computer software from Section 179 is confusing to many taxpayers and puts purchased software at a disadvantage relative to developed software (for which development costs can generally be expensed as incurred).

[105] Small business taxpayers may not always be aware of the advantages or disadvantages of Section 179 expensing.³ For example, a taxpayer may want to make an election on an amended return if the taxpayer was not aware of the Section 179 election or if changes on an amended return make the taxpayer eligible for the election. Alternatively, a taxpayer may want to revoke a previous Section 179 election if the taxpayer determines that it was not to the taxpayer's advantage. However, a taxpayer is precluded from revoking a Section 179 election on an amended return without incurring the expense and uncertainty of requesting the consent of the Commissioner.

Proposal

[106] The proposal would increase the maximum amount of qualified property that a taxpayer may deduct under Section 179 to $75,000. The proposal would raise the amount of total qualifying investment at which the phase-out begins to $325,000 per year and include off-the- shelf computer software as qualifying property. Both the deduction limit and phase-out threshold would be indexed annually for inflation. Additionally, the Administration proposes to allow expensing elections to be made or revoked on amended returns.

[107] The proposal would be effective for taxable years beginning on or after January 1, 2003.

Revenue Estimate

Fiscal Years

2003 2004 2005 2006 2007 2008 2004-08 2004-13
($'s in millions)

-1,023 -1652 -1,776 -1,912 -1,601 -1,431 -8,372 -14,583

PROVIDE MINIMUM TAX RELIEF TO INDIVIDUALS

Current Law

[108] The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) increased the alternative minimum tax (AMT) exemption for taxable years 2001 through 2004 from $33,750 to $35,750 for single and head of household filers, from $45,000 to $49,000 for married taxpayers filing joint returns, and from $22,500 to $24,500 for married taxpayers filing separate returns. The income levels at which the exemptions begin to phase out, the AMT tax rates of 26 percent and 28 percent, and the income level at which the tax rate increases to 28 percent were not altered by EGTRRA. After taxable year 2004, the exemption levels revert to their pre-EGTRRA levels.

Proposal

[109] The Administration proposes to increase the AMT exemption amount in taxable years 2003 and 2004 by $4,000 for single taxpayers and married taxpayers filing separate returns and by $8,000 for married taxpayers filing joint returns, and to maintain those higher exemption levels through taxable year 2005. Under the proposal, the AMT exemption would be $39,750 for single and head of household filers, $57,000 for married taxpayers filing joint returns, and $28,500 for married taxpayers filing separate returns.

Revenue Estimate

Fiscal Years

2003 2004 2005 2006 2007 2008 2004-2008 2004-2013
($'s in millions)

-3,141 -8,534 -10,353 -6,931 0 0 -25,818 -25,818

TAX INCENTIVES

Provide Incentives for Charitable Giving

PROVIDE CHARITABLE CONTRIBUTION DEDUCTION FOR NON-ITEMIZERS

Current Law

[110] Individual taxpayers who itemize their deductions may claim a deduction for contributions made to qualified charitable organizations. Total deductible contributions may not exceed 50 percent of the taxpayer's adjusted gross income (AGI), and lower deductibility limits apply in the case of contributions of appreciated property and contributions to certain private foundations. Under current law, taxpayers who elect the standard deduction ("non-itemizers") may not claim a deduction for charitable contributions.

Reasons for Change

[111] Approximately two-thirds of tax filers are non-itemizers, and thus are not allowed to claim tax deductions for their charitable contributions. Allowing non-itemizers to deduct their charitable contributions would help increase support for charitable organizations by rewarding and encouraging giving by all taxpayers.

Proposal

[112] Taxpayers who do not itemize would be allowed to deduct cash contributions to qualified charitable organizations in addition to claiming the standard deduction, effective for tax years beginning after December 31, 2002. Taxpayers would be allowed to deduct aggregate contributions that exceed $250 ($500 for married taxpayers filing joint returns) up to a maximum deduction of $250 ($500 for married taxpayers filing joint returns). The deduction floors and limits would be indexed for inflation after 2003.⁴ Deductible contributions would be subject to existing rules governing itemized charitable contributions, such as the substantiation requirements and the percentage-of-AGI limitations. The non-itemizer deduction would not be a preference item for alternative minimum tax purposes, and would not affect the calculation of AGI.

Revenue Estimate

Fiscal Years

2003 2004 2005 2006 2007 2008 2004-2008 2004-2013
($'s in millions)

-199 -1,358 -1,067 -1,128 1,177 -1,214 -5,944 -12,571

PERMIT TAX-FREE WITHDRAWALS FROM IRAS FOR CHARITABLE CONTRIBUTIONS

Current Law

[113] Eligible individuals may make deductible contributions to a traditional individual retirement arrangement (traditional IRA). Other individuals with taxable income may make nondeductible contributions to a traditional IRA. Earnings and pre-tax contributions in a traditional IRA are includible in income when withdrawn. Withdrawals made before age 59 1/2 are subject to an additional 10-percent excise tax, unless an exception applies.

[114] Individuals with adjusted gross incomes (AGI) below certain levels may make nondeductible contributions to a Roth IRA. Amounts withdrawn from a Roth IRA as a qualified distribution are not includible in income. A qualified distribution is a distribution made (1) after 5 years and (2) after the holder has attained age 59 1/2, died, or become disabled or is made for first-time homebuyer expenses of up to $10,000. Distributions from a Roth IRA that are not qualified distributions are includible in income to the extent the distributions are attributable to earnings, and are also subject to the 10-percent early withdrawal tax (unless an exception applies).

[115] Individuals who itemize their deductions may claim a deduction for contributions made to qualified charitable organizations. Total deductible contributions may not exceed 50 percent of the taxpayer's AGI, and lower deductibility limits apply in the case of contributions of appreciated property and contributions to certain private foundations. Excess amounts may be carried forward and deducted in future years. In addition, the total of most categories of itemized deductions, including charitable contributions, is reduced by 3 percent of AGI in excess of a certain threshold ($137,300 for most filers in 2002).

Reasons for Change

[116] Under current law, a taxpayer who wishes to donate otherwise taxable IRA assets to charity must first include the taxable amounts in income and then claim a deduction for charitable contributions. Because not all taxpayers can deduct the full amount of their charitable contributions, current law effectively discourages some taxpayers from contributing their IRA assets to charity. Allowing taxpayers to exclude from income direct transfers from IRAs to qualified charities will stimulate additional charitable giving by simplifying the required tax calculations and eliminating the current-law tax disincentives.

Proposal

[117] Individuals would be allowed to exclude from gross income (and thus from AGI for all purposes under the Code) distributions made after age 65 from a traditional or Roth IRA directly to a qualified charitable organization. The exclusion would not apply to indirect gifts through a split interest entity such as a charitable remainder trust or pooled income fund, or through the purchase of a charitable gift annuity. The exclusion would be available without regard to the percentage of AGI limits that apply to deductible contributions. An amount transferred directly to a charitable organization would be counted as a distribution for purposes of the required minimum distribution rules. The exclusion for transfers to charitable organizations would apply only to the extent the individual does not receive any benefit in exchange for the transfer. No charitable deduction would be allowed with respect to any amount that is excludable from income under this provision. If an amount transferred from the IRA would otherwise be nontaxable, such as a qualified distribution from a Roth IRA or the return of nondeductible contributions from a traditional IRA, the normal charitable contribution deduction rules would apply.

[118] The proposal would be effective for distributions after December 31, 2002.

Revenue Estimate

Fiscal Years

2003 2004 2005 2006 2007 2008 2004-2008 2004-2013
($'s in millions)

-66 -437 -361 -376 -382 -388 -1,944 -4,076

EXPAND AND INCREASE THE ENHANCED CHARITABLE DEDUCTION FOR CONTRIBUTIONS OF FOOD INVENTORY

Current Law

[119] A taxpayer's deduction for charitable contributions of inventory property generally is limited to the taxpayer's basis (typically, cost) in the inventory. However, for certain contributions of inventory, C corporations may claim an enhanced deduction equal to the lesser of (1) the taxpayer's basis in the contributed property, plus one-half of the gain that would have been realized had the property been sold or (2) two times basis. To be eligible for the enhanced deduction, the inventory must be contributed to a charitable organization (other than a private nonoperating foundation), and the donee must (1) use the property consistent with the donee's exempt purpose solely for the care of the ill, the needy, or infants, (2) not transfer the property in exchange for money, other property, or services, and (3) provide the taxpayer a written statement that the donee's use of the property will be consistent with these requirements. To claim the enhanced deduction, the taxpayer must establish that the fair market value of the donated item exceeds basis.

Reasons for Change

[120] The lack of incentives for businesses other than C corporations (including many farmers and small businesses) to donate food inventory to charity reduces the ability of charities to combat hunger. Increasing the amount of the enhanced deduction for contributions of food inventory, making it available to any taxpayer engaged in a trade or business, and clarifying the method of determining fair market value in the case of surplus food will increase donations of food inventory.

Proposal

[121] Eligibility for the enhanced deduction for donations of food inventory would be expanded to include businesses other than C corporations. The amount of the enhanced deduction for donations of food inventory would be increased to the lesser of: (1) fair market value, or (2) two times basis. To ensure consistent treatment of all businesses claiming an enhanced deduction for donations of food inventory, the enhanced deduction for qualified food donations by S corporations and non-corporate taxpayers would be limited to 10 percent of net income from the associated trade or business. A special provision would allow taxpayers with a zero or low basis in the qualified food donation (e.g., taxpayers that use the cash method of accounting for purchases and sales, and taxpayers that are not required to capitalize indirect costs) to assume a basis equal to 25 percent of fair market value. The enhanced deduction would be available only for donations of "apparently wholesome food" (food intended for human consumption that meets all quality and labeling standards imposed by Federal, State, and local laws and regulations, even though the food may not be readily marketable due to appearance, age, freshness, grade, size, surplus, or other conditions). The fair market value of "apparently wholesome food" that cannot or will not be sold solely due to internal standards of the taxpayer or lack of market, would be determined by taking into account the price at which the same or substantially the same food items (taking into account both type and quality) are sold by the taxpayer at the time of the contribution or, if not so sold at such time, in the recent past.

[122] These proposed changes in the enhanced deduction for donations of food inventory would be effective for taxable years beginning after December 31, 2002.