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Congressional Testimony
September 7, 2000, Thursday
SECTION: CAPITOL HILL HEARING TESTIMONY
LENGTH: 13040 words
COMMITTEE:
HOUSE SMALL BUSINESS
SUBCOMMITTEE:
TAX, FINANCE, AND EXPORTS
HEADLINE: TESTIMONY IMPACT OF
COMPLEX TAX SYSTEM ON SMALL BUSINESS
TESTIMONY-BY:
PAMELA OLSON , TAX SECTION OF THE
AFFILIATION: AMERICAN
BAR ASSOCIATION
BODY:
September 7, 2000 Prepared
Testimony of Pamela Olson Tax Section of the American Bar Association House
Committee on Small Business "The Impact of The Complexity Of The Tax Code On
Small Business: What Can Be Done About It?" Mr. Chairman and Members of the
Subcommittee: My name is Pamela F. Olson. I appear before you today in my
capacity as Chair of the American Bar Association Section of Taxation. This
testimony is presented on behalf of the Section of Taxation. It has not been
approved by the House of Delegates or the Board of Governors of the American Bar
Association and, accordingly, should not be construed as representing the policy
of the Association. The Section appreciates the opportunity to appear before the
Subcommittee today to discuss simplification. On behalf of the Section, I want
to thank the Chairman and the Members of this Subcommittee for their focus on
eliminating complexity in the Internal Revenue Code (the "Code"). The ABA and
its Tax Section have long been forceful advocates for simplification of the
Internal Revenue Code. In resolutions proposed by the Tax Section and passed by
the full ABA in 1976 and 1985, the ABA went on record urging tax law simplicity,
a broad tax base and lower tax rates. We have reiterated this position in
testimony before the House Ways and Means and Senate Finance Committees on
numerous occasions. Over a year ago, the Section of Taxation testified before
the House Ways and Means Oversight Subcommittee and the Senate Finance Committee
on simplification of the Internal Revenue Code. Our testimony included a number
of recommendations important to the small business community. On February 25,
2000, the Section of Taxation, the AICPA Tax Division, and Tax Executives
Institute released identical simplification proposals. We are pleased the
Subcommittee has chosen to address this issue. In recent years, the Code has
become more and more complex, as Congress and various administrations have
sought to address difficult issues, target various tax incentives and raise
revenue without explicit rate increases. As the complexity of the Code has
increased, so has the complexity of the regulations that the Internal Revenue
Service (the "IRS") and Treasury have issued interpreting the Code. Moreover,
the sheer volume of tax law changes has made learning and understanding these
new provisions difficult for taxpayers, tax practitioners and IRS personnel
alike. The volume of changes, especially recent changes affecting average
taxpayers, has created the impression of instability and unmanageable tax
complexity. This takes a tremendous toll on taxpayer confidence. Our tax system
relies heavily on the willingness of the average taxpayer voluntarily to comply
with his or her tax obligations. Members of the Tax Section can attest to the
widespread disaffection among taxpayers with the current Code. The willingness
and ability of taxpayers to keep up with the pace and complexity of changes is
now under serious stress. We do not claim to have all the answers. The Tax
Section will continue to point out opportunities to achieve simplification
whenever possible, including several ideas that we will discuss later in this
testimony. However, it is also necessary that we point out that simplification
necessitates hard choices and a willingness to embrace proposals that are often
dull and without passionate political constituencies. Simplification also
requires that easy, politically popular, proposals be avoided if they would add
significant new complexity. Simplification - and preventing greater complexity -
may not garner political capital or headlines, but it is crucial. SPECIFIC
PROPOSALS The Code is replete with numerous provisions, the complexity of which
are much greater than the perceived abuse to which the provision was directed or
the benefit that was deemed gained by its addition. Furthermore, the Code
contains many provisions that at the time of enactment may well have been
desirable, but with the passage of time or the enactment of other changes, have
truly become "deadwood." Despite the lack of utility of such provisions (whether
in a relative or absolute sense), analysis of the effect of such provisions may
nevertheless be required either in the preparation of the tax return or in the
consummation of a proposed transaction. Thus, the elimination of such provisions
would greatly simplify the law. The following are examples of provisions, that
when analyzed do not justify their continuation in the law. Obviously, these are
but a few examples, and an extensive analysis of the Code would undoubtedly
uncover many more. We have separated our recommendations into categories for
small business, alternative minimum tax, administrative, and individual items.
1. Small Business Tax Provisions. a. Permit Accrual Method Taxpayers to Use the
Installment Method. Following a proposal set forth in President Clinton's Fiscal
Year 2000 Budget Proposal, Congress repealed the installment method of tax
accounting for accrual method taxpayers in the Tax Relief Act of 1999 (Title V,
Subtitle C, Section 536), enacted as part of the "Ticket to Work and Work
Incentives Improvement Act of 1999" (H.R. 1180). The repeal of installment sales
treatment for accrual method taxpayers adversely affects businesses attempting
to sell business assets because they are taxed immediately even when payments
are received years later. Immediate taxation of business sellers, and its
chilling effect on the marketplace, simply does not represent sound tax policy.
For these and other reasons that we have previously outlined, we respectfully
request that Congress reenact prior law which, for over eighty years, has
permitted accrual method taxpayers to sell business assets for installment
payments and report the gain in the year cash is actually received. In response
to concerns expressed about the repeal of the installment method, the Treasury
Department issued Revenue Procedure 2000-22, 2000-20 I.R.B. 1008, permitting
businesses with gross receipts of $1 million or less to use the cash method of
accounting. Although we applaud the Treasury Department for taking this step, we
do not believe it resolves the concerns caused by the repeal of installment
sales reporting and we do not believe $1 million in gross receipts provides
sufficient relief from the complexity the accrual method of accounting creates.
b. Expand the Use of the Cash Method of Accounting. Current law requires
businesses that purchase, sell, or produce merchandise to apply the inventory
accounting rules and use the accrual method of accounting. Although taxpayers
and the IRS have spent considerable resources contesting whether particular
items constitute merchandise, the issue has never been consistently resolved.
The result is some businesses cannot easily determine if they have merchandise
inventory that requires them to use the accrual method of accounting. Additional
issues continue to arise as taxpayers provide new products and services.
Considerable simplification could be achieved by amending sections 446 and 448
to allow small businesses to elect to use the cash method of accounting even
when the purchase, production, or sale of merchandise is an income-producing
factor. We suggest that utilization of the $5 million gross receipts test
already included in section 448 to identify small businesses eligible for this
election would provide simplification for more taxpayers, minimize the confusion
likely to result from different dollar thresholds, and reduce controversy that
is similarly likely to result from applying different dollar thresholds for
different types of businesses. A gross receipts threshold at least equal to the
threshold provided for service businesses in section 448 is appropriate because
the profit margin often is lower for businesses selling merchandise than for
businesses providing services. c. Inventory Accounting. Further simplification
could be achieved by amending section 471 to allow small businesses with gross
receipts of $5 million or less to elect not to maintain inventories even if the
purchase, production, or sale of merchandise is an income-producing factor.
Although allowing a small business to deduct in the current year the cost of
goods to be sold in a future year would result in some mismatch of income and
expense, we believe the mismatch would be minimal for the simple reason that
small businesses generally cannot afford to maintain large quantities of
inventories. Although we expect there will be concern expressed over the
possibilities for abuse such a proposal entails, we do not believe this should
be a significant concern because we do not believe it will result in small
businesses purchasing additional inventory to manipulate taxable income.
Inventory purchases entail carrying costs and risks of ownership. The result is
that small businesses seeking to manipulate taxable income would incur in excess
of $1.00 in costs to save 35 cents in tax. We do not believe most small
businesses will adopt such a course of conduct. In addition, case law provides
that sham inventory purchases or purchases not for use in the ordinary course of
a taxpayer's business are to be disregarded. Thus, the courts have made it clear
that the IRS can address abusive situations. If small businesses are allowed to
elect not to maintain inventories, such businesses should also be permitted to
elect to deduct materials and supplies as purchased to avoid the complexity and
controversy likely to result from assertions that amounts previously viewed as
merchandise must be capitalized as materials and supplies under section 1.162-3
of the regulations. While small businesses that predominantly provide services
have been involved in many of the litigated cases regarding the definition of
merchandise, other small businesses with gross receipts of $5 million or less
that do not primarily perform services may have relatively more significant
inventory levels. Our proposal would allow these small businesses to elect not
to maintain inventories as well. We believe this approach achieves maximum
simplification. Should the Committee find this approach unacceptable, a
different test should be developed to determine whether inventories must be
maintained by taxpayers with gross receipts of $5 million or less. For example,
rather than requiring inventories only if gross receipts exceed $5 million,
inventories could be required if the taxpayer's total purchases of merchandise,
materials, and supplies during the year exceeded a stated percentage, perhaps
twenty percent, of its total gross receipts. Alternatively, inventories could be
required if the taxpayer either (i) keeps a record of consumption or (ii) takes
physical inventories. These alternatives, while more complicated than a $5
million gross receipts test, would nevertheless represent substantial
simplification for many taxpayers. d. Simplify the Minimum Distribution
Requirements. The tax rules concerning retirement plan distributions (especially
the minimum distribution requirements of section 401(a)(9)) are among the most
complex in the Code and present numerous traps for the unwary. To avoid a
possible 50-percent penalty where a distribution is less than the required
minimum, all but the most sophisticated taxpayers must seek professional help to
navigate the maze of complicated rules (involving, among other things, the
potential for requiring an annual recalculation of the minimum distribution,
based on a taxpayer's changing life expectancy from year to year). Further, an
evergrowing percentage of Americans are now in or approaching their retirement
years, and untold millions of IRA and 401(k) accounts (in addition to
traditional pension accounts) will become subject to these rules. Simplification
is badly needed. Although the minimum distribution rules are intended to
preclude the unreasonable deferral of benefits, they are not truly needed
inasmuch as benefits deferred are subject to income taxation upon eventual
distribution and may be subject to estate taxation on a participant's death.
Thus, the provisions of section 401(a)(9), other than those dealing with the
required start date for distributions, should be replaced with the incidental
death benefit rule in effect prior to the enactment of ERISA. e. Eliminate the
Half-Year Age Conventions. Section 401(a)(9) provides that retirement plan
benefits must commence, with respect to certain employees, by April 1 of the
calendar year following the calendar year in which the employee attains 701/2.
Section 401(k) states that plan benefits may not be distributed before certain
stated events occur, including attainment of age 591/2. Further, section 72(t)
provides that premature distributions from a qualified retirement plan,
including most in-service distributions occurring before an employee attains age
591/2, are subject to an additional ten percent tax. The half-year age
conventions complicate retirement plan operation because they require employers
to track dates other than birth dates. Changing the age requirements to 70 from
70-1/2 and to 59 from 59-1/2 would have a significant simplifying effect. f.
Repeal or Modify the Top Heavy Rules. Congress enacted section 416 to limit the
ability of a plan sponsor to maintain a qualified retirement plan benefiting
primarily the highly paid. Section 416 is both administratively complex and
difficult to understand. Furthermore, current law includes (i) limitations on
the compensation with respect to which qualified retirement plan benefits can be
provided, (ii) overall limitations on qualified retirement plan benefits, and
(iii) non-discrimination rules that limit the ability of sponsors to adopt
benefit formulas favoring the highly paid. Given the other limitations in the
Code, section 416 adds an unnecessary layer of complexity to employee plan
administration. If section 416 is retained, the rule attributing to a
participant stock owned by a member of the participant s family for purposes of
determining whether or not the participant is a key employee should be
eliminated. This change would be consistent with the recent repeal of the family
aggregation rules under sections 401(a)(17) and 414(q). g. Replace the
Affiliated Service Group and Employee Leasing Rules. Sections 414(b) and 414(c)
treat businesses under common control as a single employer for purposes of
determining whether a retirement plan maintained by one or more of these
businesses qualifies under section 401. Two other Code provisions also adopt an
aggregation concept. Specifically, section 414(m) generally treats all employees
of members of an affiliated service group as though they were employed by a
single employer, and section 414(n) states that, under certain circumstances, a
so-called leased employee will be deemed to be employed by the person for whom
the employee performs services. No regulations have been finalized under these
provisions. They are difficult to comprehend and to apply. Sections 414(m) and
414(n) should be replaced with provisions explicitly describing and limiting the
circumstances under which employees of businesses that are not under common
control must be taken into account for purposes of determining the qualified
status of a sponsor's retirement plan, and the discretion granted under section
414(o) to develop different rules should be repealed. h. Worker Classification.
Determining whether a worker is an employee or independent contractor is a
particularly complex undertaking because it is based on a twenty-factor common
law test. The factors are subjective, given to varying interpretations, and
there is precious little guidance on how or whether to weigh them. In addition,
the factors are not applicable in all work situations, and do not always provide
a meaningful indication of whether the worker is an employee or independent
contractor. Moreover, the factors do not take into consideration the
differential in bargaining power between the parties. The consequences of
misclassification are significant for both the worker and service recipient,
including loss of social security and benefit plan coverage, retroactive tax
assessments, imposition of penalties, disqualification of benefit plans, and
loss of deductions. Legislative safe harbors provide relief only for employment
taxes. The current complex and highly uncertain determination should be replaced
with an objective test that applies for federal income tax and ERISA purposes.
Alternatively, changes could be made to reduce differences between the tax
treatment of employees and independent contractors. Judicial review by the
United States Tax Court of worker classification disputes should be available to
both workers and employers. i. Provide Clear Rules Governing the Capitalization
and Expensing of Costs and Recovery of Capitalized Costs. Although the IRS
clearly stated that the Supreme Court's decision in INDOPCO v. Commissioner, 503
U.S. 79 (1992), did not change fundamental legal principles for determining
whether a particular expense may be deducted or must be capitalized,
nonetheless, since INDOPCO, whether an expense must be capitalized has become
the most contested audit issue for businesses. A future benefit test derived
from the INDOPCO decision has been used by the IRS to support capitalization of
numerous expenditures, many of which have long been viewed as clearly
deductible. Almost any ongoing business expenditure arguably has some future
benefit. The distinction between an "incidental" future benefit, which would not
bar deduction of the expenditure, and a "more than incidental" future benefit,
which might require capitalization, generally is neither apparent nor easy to
establish to the satisfaction of parties with differing objectives. In addition,
the administrative burden associated with maintaining the records necessary to
permit the capitalization of regular and recurring expenditures is significant.
It is imperative that this enormous drain on both Government and taxpayer time
and resources be alleviated by developing objective, administrable tests. For
example, repair allowance percentages such as those previously provided under
the Class Life Asset Depreciation Range (CLADR) System would significantly
reduce controversy regarding capitalization of repair expenditures. See Rev.
Proc. 83-35, 1983- 1 C.B. 745 (CLADR repair allowance percentages); see also
I.R.C. - 263(d) (repair allowance percentage for railroad rolling stock). j.
Modify the Uniform Capitalization Rules. The uniform capitalization ("UNICAP")
rules in section 263A are extraordinarily complex. Compliance with the UNICAP
rules consumes significant taxpayer resources; yet, for many taxpayers, the
UNICAP rules do not result in capitalization of any significant amounts not
capitalized under prior law. Modification of the UNICAP rules to limit their
application to categories of expenditures not addressed comprehensively under
prior law (e.g., self-constructed assets) or to large taxpayers would reduce
complexity for many taxpayers. k. Simplify S Corporation Qualification Criteria.
The definition of an "S corporation" contained in section 1361 establishes a
number of qualification criteria. To qualify, the corporation may have only one
class of stock and no more than seventy-five shareholders. Complex rules provide
that the shareholders must be entirely composed of qualified individuals or
entities. On account of state statutory changes and the check- the-box
regulations, S corporations are disadvantaged relative to other limited
liability entities, which qualify for a single level of Federal income taxation
without the restrictions. The repeal of many of the restrictions would simplify
the law and prevent inadvertent disqualifications of S corporation elections. l.
Modify the S Corporation Election Requirement. Section 1362(a)(2) requires all
shareholders to consent to an S corporation election, as well as that the
election be made on or before the fifteenth day of the third month of the
taxable year. There are also election deadlines for qualified subchapter S
subsidiaries and qualified subchapter S trusts, which add complexity. Late
elections are common occurrences because taxpayers are unaware of or simply miss
the election deadline. Section 1362(b)(5) permits the IRS to treat a late
election as timely if the IRS finds reasonable cause for the late election. This
provision has saved hundreds of taxpayers from the consequences of a procedural
mistake; it has also generated considerable administrative work for the IRS as
is evidenced by the hundreds of rulings granting relief. The election deadline
was intended to prevent taxpayers from waiting until income and expenses for the
taxable year were known before deciding whether to make an S corporation
election. The differences that exist between the taxation of S and C
corporations are so significant, however, that it is unlikely a taxpayer s
decision over whether to make an S corporation election would be determined by
the events during a single taxable year. Even if that were the case, it is
difficult to understand the compelling policy reason to require taxpayers to
guess at their financial operations for the year in determining whether to make
an S corporation election at the beginning of the year rather than making an
informed decision. The ability to pass through losses has been substantially
restricted by various provisions of the Code. Thus, concerns about passing
through losses are likely more theoretical than real. In addition, as a
practical matter, taxpayers cannot wait until the end of the taxable year to
make a decision because the need to make estimated tax payments compels a
decision before the date the first estimated tax payment is due. Thus, the
separate filing of the election itself is a mere procedural requirement leading
to frequent procedural foot faults, but little else. The most obvious time for
the filing of an election is with a filing that is otherwise required.
Significant simplification could be achieved by requiring the election to be
made on the corporation's timely filed (including extensions) Federal income tax
return for the year of the election. The same rule should apply to the qualified
subchapter S subsidiary and qualified subchapter S trust elections. m. Repeal or
Simplify the Personal Holding Company Rules. The personal holding company rules
were enacted in 1934 to tax the so-called "incorporated pocketbook." With
differentials in the corporate and individual tax rates, individuals could, for
example, place their investments in a corporation and substantially lower the
Federal income tax paid on income generated by those investments, especially if
the income was held in the corporation and reinvested for a long period of time.
The personal holding company provisions attack this plan by imposing a surtax on
certain types of passive income earned by closely held corporations that is not
distributed (and thus taxed) annually. Over time, the personal holding company
rules have been broadened to include many closely held corporations, both large
and small, with passive income (whether or not such corporations are, in effect,
"incorporated pocketbooks") and, thus, may create a trap for the unwary. In
addition, the rules have become very complex and difficult for the IRS to
administer and for taxpayers to comply with, and sometimes require taxpayers to
rearrange asset ownership to comply with the rules. With maximum corporate and
individual rates coming closer together and the repeal of the General Utilities
doctrine, it is questionable whether the personal holding company rules should
remain in the Code at all. Regardless of this debate, however, the rules should
be significantly simplified to eliminate the substantial burden they impose on
closely held corporations. n. Repeal the Collapsible Corporation Provision. The
repeal of the General Utilities doctrine in 1986 rendered section 341 redundant.
By definition, a collapsible corporation is a corporation formed or availed of
with a view to a sale of stock, or liquidation, before a substantial amount of
the corporate gain has been recognized. Since 1986, a corporation cannot sell
its assets and liquidate without recognition of gain at the corporate level;
likewise, the shareholders of a corporation cannot sell their stock in a manner
that would allow the purchaser to obtain a step-up in basis of the assets,
without full recognition of gain at the corporate level. Because it was the
potential for escaping corporate taxation that gave rise to section 341, it is
now deadwood and should be repealed. Repeal of section 341 would result in the
interment of the longest sentence in the Code - section 341(e). o. Simplify the
Attribution Rules. The attribution rules throughout the Code contain myriad
distinctions, many of which may have been reasonably fashioned in light of the
particular concern the underlying provision initially addressed. It is not
clear, however, that the reasons originally leading to the differences justify
the complexity the current attribution rules create. The attribution rules
should be reexamined in light of the underlying concerns to harmonize and, if
possible, standardize the rules. Even without reexamination, the attribution
rules could be simplified by providing consistently either an "equal to"
standard or a "greater than" standard for application of the ownership
percentages. p. Simplify the Loss Limitation Rules. The Code contains multiple
rules limiting the ability of a taxpayer claim to use losses including: (i)
section 465, which limits the deductibility of losses of individuals and certain
C corporations to the amount at risk - that is, generally, the amount of the
investment that could be lost plus the taxpayer's personal liability for
additional losses; (ii) section 469, which limits losses incurred in "passive
activities"; (iii) section 704(d), which limits a partner's distributive share
of a partnership's losses to the partner's basis in the partnership interest;
and (iv) section 1366(d), which limits an S corporation shareholder's loss in
similar fashion. There are numerous limitations and qualifications layered on
each of these rules and definitions, and sections 465 and 469, in particular,
are extremely complicated and difficult to comprehend. Section 465 originally
applied only to certain types of activities deemed especially prone to abuse,
such as the production and distribution of films and video tapes, but, in 1978,
it was extended to virtually all other income-producing activities. Since the
enactment of section 469, section 465 has become superfluous because there are
very few situations in which a deduction would be denied because of the
applicability of section 465 that would not also be denied because of the
applicability of section 469. Substantial simplification could be achieved by
combining, rationalizing and harmonizing the loss limitation provisions. q.
Simplify Section 355. Section 355 permits a corporation or an affiliated group
of corporations to divide on a tax-free basis into two or more separate entities
with separate businesses. Under section 355(b)(2)(A), which currently provides
an attribution or "lookthrough" rule for groups of corporations that operate
active businesses under a holding company, "substantially all" of the assets of
the holding company must consist of stock of active controlled subsidiaries. As
a result, holding companies that, for very sound business reasons, own assets
other than the stock of active controlled subsidiaries are required to undertake
one or more preliminary (and costly) reorganizations solely for the purpose of
complying with this provision. Substantial simplification could be achieved by
treating members of an affiliated group as a single corporation for purposes of
the active trade or business requirement. r. Simplify the Consolidated Return
Rules. Affiliated groups of corporations can elect to file a single consolidated
income tax return. The dominant theory governing the development of the
consolidated return regulations is that the consolidated group should be treated
as a single entity. As evidenced by the hundreds of pages of regulations and
excruciating detail, this seemingly simple concept has evolved into one of the
most complex and burdensome areas of the tax law. The consolidated return rules,
are laced with numerous traps for the unwary and are virtually incomprehensible
to experienced tax practitioners unless they spend an entire career practicing
in the consolidated return area. With the advent of single-member limited
liability companies ("LLCs") and the check-the-box regulations, many taxpayers
may be able to avoid or ameliorate the complexity of the consolidated return
rules. For taxpayers that desire or are required to use a C corporation,
however, the consolidated return rules still present a major source of
complexity. Accordingly, simplification of the consolidated return rules would
be a major step towards the ultimate goal of simplifying the tax laws. For
example, in the small business context, all wholly owned subsidiaries could be
treated as flow- through entities. s. Simplify the PFIC Rules. In 1997, the
passive foreign investment company ("PFIC") rules were greatly simplified by the
elimination of the controlled foreign corporation-PFIC overlap and by allowing
for a mark-to- market election for marketable stock. A great deal of
complication remains, however, and further simplification is necessary. We
recommend, for example, that Congress eliminate the application of the PFIC
rules to smaller investments in foreign companies whose stock is not marketable.
t. Simplify the Foreign Tax Credit Rules. The core purpose of the foreign tax
credit ("FTC"), which has been part of the Code for more than eighty years, is
to prevent double taxation of income by both the United States and a foreign
country. The FTC rules are complex in large measure, but not exclusively,
because the global economy is complex. The section 904(d)(1) basket regime,
which includes nine separate baskets for allocating income and credits and is
intended to prevent inappropriate averaging of high-and-low-tax earnings, is
especially complicated to apply, particularly for small businesses. The FTC
rules may never be truly simple, but actions can be taken to temper the
extraordinary complexity of the current regime. At a minimum, Congress should
(i) consolidate the separate baskets for businesses that are either starting up
abroad or that have only small investments abroad; and (ii) eliminate the
alternative minimum tax credit limitations on the use of the FTC. In addition,
Congress should consider accelerating the effective date of the "look-through"
rules for dividends from so-called 10/50 companies. The Tax Reform Act of 1986
created a separate FTC limitation for foreign affiliates that are owned between
ten and fifty percent by a U.S. shareholder. The requirement for separate
baskets for dividends from each 10/50 company was among the most complicated
provisions of the 1986 Act, and in 1998, Congress acted to afford taxpayers an
election to use a "look- through" rule for dividends (similar to the one
provided for controlled foreign corporations under section 904(d)(3)). The
implementation of the rule was delayed, however, until 2002. In addition
taxpayers must maintain a separate "super" FTC basket for dividends received
after 2002 that are attributable to pre- 2003 earnings and profits. The current
application of both a single basket approach for pre-2003 earnings and a
look-through approach for post-2002 earnings results in unnecessary complexity.
Congress should eliminate the "super" basket and accelerate the effective date
of the look-through rule. u. Simplify Application of Subpart F. In general, ten
percent or greater U.S. shareholders of a controlled foreign corporation ("CFC")
are required to include in current income certain income of the CFC (referred to
as "Subpart F" income). The Subpart F rules are an exception to the Code's
general rule of deferral and were initially enacted in 1962 to tax passive
income or income that is readily moveable from one taxing jurisdiction to
another to, for example, take advantage of low rates of tax. Congress
subsequently expanded the Subpart F rules to capture more and more categories of
active operating income. Nevertheless, taxation of CFC income may be deferred
under various "same-country" exceptions to the Subpart F provisions. U.S.-based
companies incur substantial administrative and transaction costs in navigating
the maze of the Subpart F rules to minimize their tax liability. The Subpart F
rules sorely need to be updated to deal with today's global environment in which
companies are centralizing their services, distribution, and invoicing (and
often manufacturing operations). We recognize that the Treasury Department is
preparing a study on the policy goals and administration of the Subpart F
regime, which we eagerly await. Whatever effect this study may eventually have,
substantial simplification could be achieved now through the following basic
measures: 1.Except smaller taxpayers or smaller foreign investments from the
Subpart F rules; 2.Exclude foreign base company sales and services income from
current taxation; and 3.Treat countries of the European Union as a single
country for purposes of the same-country exception. v. Repeal Section
514(c)(9)(E). In general, income of a tax exempt organization from debt financed
property is treated as unrelated business taxable income. Debt financed property
is defined in section 514 as income producing property subject to "acquisition
indebtedness," which generally does not include debt incurred to acquire or
improve real property. Section 514(c)(9)(E) (the "fractions rule") provides, in
general, that debt of a partnership will not be treated as acquisition
indebtedness if the allocation of income and loss items to a tax exempt partner
cannot result in the share of the overall taxable income of that organization
for any year exceeding the smallest share of loss that will ever be allocated to
that organization. This provision was enacted to prevent disproportionate
allocations of income to tax exempt partners and disproportionate allocations of
loss items to taxable partners. The provision has become a trap for the unwary
as well as a tremendous source of planning complexity even for those familiar
with it. Anecdotal evidence suggests that few practitioners understand the
provision completely, and almost no IRS agents or auditors raise it as an issue
on audits. Instead, because of its daunting complexity, it has become a barrier
to legitimate investment in real estate by exempt organizations. At the same
time, other provisions in the tax law (such as the requirement of substantial
economic effect under section 704(b)) substantially limit the ability to shift
tax benefits among partners. Therefore, section 514(c)(9)(E) could be repealed
without substantial risk of abuse. 2. Alternative Minimum Tax. a. Repeal the
Individual AMT. The individual AMT no longer serves the purpose for which it was
enacted, produces enormous complexity, and has unintended consequences for many
taxpayers including many small business owners. Originally enacted in 1969 to
address concerns that persons with significant economic income were paying
little or no Federal taxes because of investments in tax shelters, the AMT today
has little effect on its original target and increasingly affects an unintended
class of taxpayers - the middle class - not engaged in tax-shelter or deferral
strategies. The AMT's failure to achieve its original purpose is attributable to
the numerous changes to the Internal Revenue Code since 1969 specifically
limiting tax- shelter deductions and credits. Studies indicate that, by 2007,
almost ninety-five percent of the revenue from AMT preferences and adjustments
will be derived from four items that are "personal" in nature and not the
product of tax planning strategies - the personal exemption, the standard
deduction, state and local taxes, and miscellaneous itemized deductions.
Further, the interaction of the AMT with a number of recently enacted credits
intended to benefit families and further education means that even individuals
who ultimately have no AMT liability will suffer because the AMT reduces the
benefits conferred by those credits. The AMT is too complex and imposes too
great a compliance burden. Significant simplification would be achieved by its
repeal. Alternatively, if repeal is not feasible, some simplification could be
achieved by (i) excluding taxpayers with average adjusted gross income below a
certain threshold from the AMT system, (ii) examining each preference and
adjustment item separately to determine whether it should be retained in the AMT
system, although, in our view, proper analysis of each item of adjustment and
preference would result in the AMT system being repealed, (iii) repealing two
preference items that present glaring problems - the denial for AMT purposes of
any deduction for miscellaneous itemized deductions and the adjustment for ISO
stock, which inappropriately taxes a portion of the gain at a rate in excess of
the maximum twenty percent that Congress intended be applied to long-term
capital gains, or (iv) indexing the rate brackets and the exemption amount. b.
Repeal the Corporate Minimum Tax As Well. The corporate AMT suffers from the
same infirmities as the individual AMT. It requires corporations to keep at
least two sets of books for tax purposes; imposes myriad other burdens on
taxpayers (especially those with significant depreciable assets); and has the
perverse effect of taxing struggling or cyclical companies at a time when they
can least afford it. If repeal of the corporate AMT leaves specific concerns
unaddressed, those concerns should be addressed directly by amending the Code
provisions causing the concerns, not by preserving a system requiring all
taxpayers to compute their tax liability twice. 3. Administrative Provisions. a.
Deposit Penalty. The failure to timely deposit taxes is subject to penalty,
pursuant to section 6656, in amounts ranging from two percent to fifteen percent
of the underdeposit, depending on the lateness of the deposit. The deposit rules
are unnecessarily complex and adversely affect small businesses as they move
from one payroll deposit category to another. For example, professional
corporations for which the payroll deposit is normally less than $100,000 per
pay period and are permitted at least semi-weekly deposits (i.e., a three-day
deposit rule) may be adversely affected. In order to pay out all, or almost all,
of the corporation's income, such corporations frequently make bonus payments on
the last day of the taxable year (often December 31). The amount of the bonus
payment for each employee, a prerequisite to determining the appropriate
withholding tax, cannot be ascertained until the annual books are closed. The
books cannot be closed until receipts and expenses for the last day of the
taxable year are recorded. Financial intermediaries generally require at least
one day's advance notice to make electronic federal withholding tax deposits.
Banks and taxpayer businesses are frequently shorthanded at year end and find it
difficult to determine the amount of the Federal tax deposit due until after the
financial intermediaries' cutoff time to make withholding tax deposits on the
next business day. This is particularly true for taxpayers in the western U.S.
time zones. A two percent penalty is excessive for a deposit that is only one
day late, particularly if the depositor is normally a semi-weekly depositor but
is required to make a one-day deposit. Congress recently recognized that the
changing of deposit requirement time frames is a complexity that causes great
confusion and that waiver of the penalty should be permitted for the first
change period. See I.R.C. - 6656(c)(2)(B). While this amendment helps, it does
not fully address the problem. The current provision requires an administrative
waiver request that may be expensive and time consuming and applies only to the
first instance of a problem that is likely to occur annually. Section 6302 (or
the regulations) should be modified to require next day electronic depositing
only in those instances in which next day depositing (i.e., a deposit of
$100,000 or more) is required of that taxpayer with respect to ten percent or
more of its deposits. Alternatively, taxpayers could be given a minimum of two
days to make deposits of $250,000 or less. b. Information Returns. Sections 6041
and 6041A generally require reporting of all payments made in connection with a
trade or business that exceed $600 per year. The $600 per year threshold has
never been adjusted for inflation. Section 6045(f) now requires reporting of
gross payments to attorneys (including law firms and professional corporations)
even if the payment is less than $600 if the portion constituting the legal fee
is unknown. The IRS cannot process many Form 1099 information returns from
non-financial institutions and as a result such returns do not provide truly
useable information. Anecdotal evidence suggests the IRS may not use the
information on these information returns in examinations of the taxpayers and
that these information returns cannot be reconciled to tax returns. The
reporting threshold should be increased to $5,000 (which harmonizes with section
6041A(b)) and adjusted for inflation in full $1,000 increments. c. Penalty
Reform. The Tax Section believes that reform of the penalty and interest
provisions is appropriate. There are many cases in which the application of
penalty and interest provisions takes on greater significance to taxpayers than
the original tax liability itself. The Tax Section is concerned that these
provisions often catch individuals unaware, and that the system lacks adequate
flexibility to achieve equitable results. d. Extenders. Uncertainty in the tax
law breeds complexity. The constant need to extend certain Code provisions (such
as AMT relief for individuals, the research and experimentation tax credit, and
the work opportunity tax credit) adds confusion to the law. In many cases,
temporary extension undermine the policy reasons for enacting the incentives in
the first place because the provisions are intended to encourage particular
activities but uncertainty surrounding whether the provisions will be extended
leaves taxpayers unable to plan for those activities. The on-again, off- again
nature of these provisions, coupled in some cases with retroactive enactment
(which often necessitates the filing of an amended return), contributes mightily
to the complexity of the law. These provisions should be enacted on a permanent
basis. e. Rationalize Estimated Tax Safe Harbors. Section 6654 imposes an
interest charge on underpayments by individuals of estimated income taxes, which
generally are paid by self-employed individuals. This interest charge generally
does not apply if the individual made estimated tax payments equal to the lesser
of (i) ninety percent of the tax actually due for the year or (ii) one hundred
percent of the tax due for the immediately prior year. The criteria for the
prior year safe harbor have been adjusted regularly by the Congress during the
past decade. Between 1998 and 20002, for individuals with adjusted gross income
exceeding $150,000, the prior year safe harbor percentage increases and
decreases from year to year over a range from 105 to 112 percent. The purpose of
these increases and decreases is to shift revenues from year to year within the
five and ten year budget windows used for estimating the revenue effects of tax
legislation. Congress should determine an appropriate safe harbor percentage
(perhaps 100%) and apply that amount for all years. Consideration should also be
given to simplifying estimated taxes (for example, by the enactment of a
meaningful safe harbor) for all corporations. 4. Individual Tax Provisions. In
previous testimony before the House Ways and Means Oversight Subcommittee and
the Senate Finance Committee on simplification of the Internal Revenue Code and
in the identical simplification proposal released by the Section of Taxation,
the AICPA Tax Division, and the Tax Executives Institute on February 25, 2000,
the Tax Section discussed a number of simplification proposals for individual
taxpayers. Some individual simplification proposals that are particularly
relevant to small businesses and their owners are discussed below. a. Repeal the
Two Percent Floor on Miscellaneous Itemized Deductions. The two percent floor on
miscellaneous itemized deductions contained in section 67 was enacted as a
simplification measure intended to relieve taxpayers of recordkeeping burdens
and the IRS of the burden of auditing deductions insignificant in amount.
Experience indicates that taxpayers continue to keep records of such expenses to
determine deductible amounts in excess of two percent of adjusted gross income.
Moreover, the existence of the limitation and the need to identify the
deductions to which it applies introduces needless computational and substantive
complexity to the preparation of tax returns. b. Simplify the Capital Gains
Provisions. The capital gains regime applicable to individuals is excessively
complex. The system imposes difficult record-keeping burdens on taxpayers. The
significant differences in capital gain rates encourage taxpayers to engage in
transactions such as investments in derivatives or short sales to qualify for
the lower capital gains rates. A special rule permits taxpayers holding property
acquired before 2001 to elect to have the property treated as if it had been
sold on the first business day after January 1, 2001, thereby becoming eligible
for a special eighteen percent rate if it is held for another five years.
Determining whether to make this election will require taxpayers to make
economic assumptions and complete difficult present value calculations. While
each item of fine-tuning in this area may be defensible in isolation, the
cumulative effect has been to create a structure that is incomprehensible to
taxpayers and to the people who prepare their tax returns. The taxation of
capital gains would be simplified by establishing a single preferential rate and
a single long-term holding period for all types of capital assets.
Alternatively, to assure that any benefit is extended to all taxpayers
regardless of their tax brackets, the concept of a special capital gain rate
might be replaced by an exclusion for a percentage of long-term capital gains.
c. Eliminate Elections. Many provisions allow taxpayers to elect special
treatment. While some elections are necessary and appropriate (e.g., election to
be treated as an S corporation), elections and safe harbors, even those enacted
in the name of simplification, often increase complexity. The availability of an
election frequently requires taxpayers to make multiple computations to
determine the best approach, thereby adding significant complexity. For example,
the various elections available under recently enacted section 6015 with respect
to innocent spouse relief increase planning and procedural complexity
significantly. Likewise, some recent proposals for eliminating or reducing the
so-called marriage penalty would effectively require married couples to compute
their income twice to determine which approach yields a lower tax payment. In
lieu of providing multiple approaches to the same goal, Congress should develop
a single legislative solution to address a specific problem, and should make
such a solution as simple and fair as possible. d. Increase the Estate and Gift
Tax Unified Credit. The Code requires the estates of decedents with gross
estates in excess of the exclusion amount ($675,000 in 2000 and 2001) to file
estate tax returns. In 1997, Congress put in place a gradual phase-up of the
exclusion amount to $1 million in 2006, which will eliminate the filing
requirements for a substantial number of estates otherwise required to file
returns and reduce to zero the tax owed by many of those estates. An additional
increase in the unified credit (beyond $1 million) would further relieve an
additional significant number of decedents' estates from the burden of filing
returns and paying estate tax without a significant decrease in Federal revenue.
More importantly, such a change would relieve many such individuals during their
lifetimes of the burden of estate planning oriented almost
entirely toward minimizing their estate tax liability, rather
than family and business succession considerations. e. Repeal of the
Estate Tax The manner in which a repeal of the estate
tax is accomplished and the replacement regime adopted may reduce the
simplification resulting from the repeal. Under the Death
Tax Elimination Act, H.R. 8, recently passed by the House and
Senate, the estate tax would not fully phase out until 2010.
Some delay in effective date or a limited phase-out period is helpful in the
estate tax context to enable state legislatures to make any necessary changes in
state death taxes. During any phase-out period, however, taxpayers must take
into account in their estate planning the potential effects of two different tax
regimes. Thus, shortening the more than nine-year phase-out period in the Death
Tax Elimination Act would reduce complexity. f. Reexamination of Sections 2032A
and 2057. Section 2032A (enacted in 1976) provides special valuation rules for
farms and other real property used in a trade or business. Section 2057 (enacted
in 1997) provides a deduction for a limited amount of the value of a closely
held business. The maximum reduction in the value of a decedent's estate from
use of section 2032A is $750,000; the maximum deduction under section 2057 is
$675,000 (not taking into account the interaction with the unified credit). The
limited dollar benefits provided by these sections, which are limited to a
select group of taxpayers, should be contrasted with the substantial complexity
they produce. In addition to their statutory and administrative complexity,
these provisions encourage extensive tax planning and invite manipulation of
ownership interests and asset use. We appreciate your interest in these matters.
The Section would be pleased to work with the Committee and its staff on these
important issues, as well as other tax issues of significance to small
businesses.
LOAD-DATE: September 8, 2000, Friday
