Meaning of "reckless" in 6694(b)

The $5,000 per position penalty of 6694(b)applies if the return preparer is "reckless"

There is a great deal of judicial authority on the term "reckless" as equivalent the term "willfulness" in determining the trusft fund penalty under section 6672. Much of the concept of "reckless disregard" from judicial precedent helps define the term "reckless" under section 6694(b).

I have selected just one case, below, to make the point. The courts say that when a person responsible for the payroll taxes has a "reckless disregard" for the payment of the payroll taxes, that person meets the "willfulness" requirement of the 6672 statute. I have had cases where the IRS has made that argument. The "failure to take steps" to make sure that payroll taxes is being paid is really a "due diligence" standard. That the my main point. If a return preparer has not made any effort to determine if, for example, an expense or deduction meets the necessary requirements of a tax regulation or other published authority, that is a lack of due diligence and therefore is likely to be treated as "reckless" within the meaning of section 6694(b).

Keep in mind that the IRS examiners should be expected to be aggressive. An aggressive IRS examiner could easily say that the failure to monitor substantiation is "reckless." The biggest trap for the unwary tax return preparer is when the return preparer relies on every number provided by a client without verifying the quality of the data and the technical requirements for that data. Although the final regulations say you do not have to audit your client, you run the risk of draconian penalties when you do not use your maximum due dilligence to qualify the data for substantiation and technical support.




89-2 USTC ¶9581] J. Allen Dougherty, Plaintiff v. The United States, Defendant


In order for a "responsible person" to be liable under section 6672 he must have acted "willfully" in failing to collect, truthfully account for or pay over the delinquent and unpaid Federal employment taxes. Willfulness for purposes of this statute has been defined as "a deliberate choice voluntarily, consciously, and intentionally made to pay other creditors instead of paying the Government." White v. United States [67-1 USTC ¶9250 ], 178 Ct. Cl. 765, 778, 779, 372 F.2d 513, 521 (1967). Mere knowledge of a past delinquency does not impose strict liability on a responsible officer for delinquencies during his tenure. Godfrey, 748 F.2d at 1578. In addition, negligence in determining a tax delinquency is insufficient to constitute willfulness. Bauer, 211 Ct. Cl. at 289, 543 F.2d at 150; see also Bolding, 215 Ct. Cl. at 163, 565 F.2d at 672.

The "Reckless Disregard" Standard of Willfulness

"Willful conduct may also include a reckless disregard of an 'obvious and known risk . . . that taxes might not be remitted'." Godfrey, 748 F.2d at 1577 (citations omitted). "[I]f a responsible officer knows that the corporation has recently committed such a delinquency and knows that since then its affairs have continued to deteriorate, he runs the risk of being held liable if he fails to take any steps either to ascertain, before signing checks, what the state of the tax withholding account is, or to institute effective financial controls to guard against non-payment." Wright v. United States [87-1 USTC ¶9130 ], 809 F.2d 425, 428 (7th Cir. 1987) (citations omitted); see also United States v. Leuschner [64-2 USTC ¶9742 ], 336 F.2d 246, 248 (9th Cir. 1964). However, "merely because a corporate officer has check-signing responsibilities and his corporation is in financial trouble, it does not follow that he can be held liable for any and all failures to pay withholding taxes." Wright, 809 F.2d at 428. Even considering plaintiff's version of events, the record establishes that plaintiff acted willfully in that, during the tax quarters at issue, he recklessly disregarded his duty to collect and pay over VELCO's Federal employment taxes and ignored the risks that VELCO's Federal employment taxes would not be paid. Wright [87-1 USTC ¶9130 ], 809 F.2d 425.

In Wright v. United States [87-1 USTC ¶9130 ], 809 F.2d 425, 427-428 (7th Cir. 1987), the Seventh Circuit, found that the plaintiff in that case had acted willfully under section 6672 by acting with recklessness. The Wright court distinguished its case from Godfrey:

We emphasize that merely because a corporate officer has check-signing responsibilities and his corporation is in financial trouble, it does not follow that he can be held liable for any and all failures to pay withholding taxes. Nor have we any quarrel with Godfrey v. United States [84-2 USTC ¶9974 ], 748 F.2d 1568 (Fed. Cir. 1984), which held that mere knowledge of a past delinquency does not impose strict liability on a responsible officer for delinquencies during his tenure. But if a responsible officer knows that the corporation has recently committed such a delinquency and knows that since then its affairs have continued to deteriorate, he runs the risk of being held liable if he fails to take any step either to ascertain, before signing checks, what the state of the tax withholding account is, or to institute effective financial controls to guard against nonpayment. See Hornsby v. IRS, supra; United States v. Leuschner [64-2 USTC ¶9742 ], 336 F.2d 246, 248 (9th Cir. 1964). Wright did neither of these things.
Id. at 428.

Negligence equals section 6694(b) penalty

The taxpayer in the Coleman case, below, was filed on January 29, 2009. This case illustrates some common tax return issues that you will see. The taxpayer was hit with the 20% negligence penalty. My point in presenting this case is that IF this person’s tax return was prepared by a professional tax return preparer, it is my opinion that the 6694(b) $5,000 penalty for being “reckless” would apply.
The taxpayer was not liable on a mortgage on her mother's residence was not entitled to deduct mortgage interest on the property until the individual inherited it following her mother's death. Prior to her mother's death, the individual was neither the equitable nor the beneficial owner of the property. The taxpayer did not occupy the property or have the unilateral right to make improvements to it, did not bear any risk of loss, and had no duty to maintain, insure or pay taxes, assessments or charges with respect to the property. Accordingly, the taxpayer could only deduct the portion of the mortgage interest paid after she inherited the property. An individual who was not liable on a mortgage on her mother's residence was not entitled to deduct mortgage interest on the property until the individual inherited it following her mother's death. Prior to her mother's death, the individual was neither the equitable nor the beneficial owner of the property. The individual did not occupy the property or have the unilateral right to make improvements to it, did not bear any risk of loss, and had no duty to maintain, insure or pay taxes, assessments or charges with respect to the property. Accordingly, the individual could only deduct the portion of the mortgage interest paid after she inherited the property. The taxpayer was not entitled to a theft loss deduction for property stolen from a church at which she served as the pastor. The individual did not establish that she owned the property that was stolen and that she personally sustained the loss. The taxpayer was allowed only a limited charitable contribution deduction for amounts she either donated to, or expended on behalf of, a church at which she served as the pastor. The individual was denied a charitable contribution deduction for amounts under $250 for which she lacked substantiation, and for amounts in excess of $250 or for which she did not obtain the required contemporaneous written acknowledgment from the organization
The Coleman case deals with the 163 mortgage deduction, the 165 theft deduction and the section 170 deduction. These are all common issues. When you read this case think about whether you would have checked the guidance of the applicable statutes and regulations. Without doing that you would, in my opinion, flunk the “reasonable basis” standard for disclosed positions in order to avoid the 6694 penalty. If an IRS examiner were looking to assess the 6694(b) penalty, the total penalties in this case would be $15,000.


[T.C. Summary Opinion 2009-16]
Lisa R. Coleman v. Commissioner.

Docket No. 12085-07S 16591-07S . Filed January 29, 2009.

DEAN, Special Trial Judge: These consolidated cases were heard pursuant to the provisions of section 7463 of the Internal Revenue Code (Code) in effect when the petitions were filed. Pursuant to section 7463(b), the decisions to be entered are not reviewable by any other court, and this opinion shall not be treated as precedent for any other case. Unless otherwise indicated, subsequent section references are to the Code in effect for the years in issue, and all Rule references are to the Tax Court Rules of Practice and Procedure.

For 2004 and 2005 respondent determined deficiencies in petitioner's Federal income taxes of $3,090 and $3,409 and accuracy-related penalties under section 6662(a) of $618 and $681.80, respectively. Respondent disallowed petitioner's claimed deductions for "Schedule A taxes" of $3,370 and her $19,441 charitable contribution deduction for 2004. 1 For 2005 respondent disallowed petitioner's claimed $5,993 theft loss deduction, her $11,396 mortgage interest deduction, and $10,561 of her claimed $11,061 charitable contribution deduction.

For 2004 and 2005 respondent concedes that petitioner is entitled to deductions for charitable contributions of $1,239.26 2 and $3,014 3 and "Schedule A taxes" of $3,370 and $3,582, respectively.

The issues remaining for decision are whether petitioner is: (1) Entitled to claim charitable contribution deductions in excess of those respondent allowed; (2) entitled to claim a mortgage interest deduction of $11,396 for 2005; (3) entitled to claim a theft loss deduction of $5,933 for 2005; and (4) liable for the accuracy-related penalty for each year.


Background

Some of the facts have been stipulated and are so found. The stipulation of facts and the exhibits received into evidence are incorporated herein by reference. When the petitions were filed, petitioner resided in California.



Charitable Contributions
During the years at issue, petitioner was employed as a law enforcement technician with the Los Angeles County Sheriff's Department. She also served as the pastor of Bethel, which is a member church of Mount Sinai Holy Church of America, Inc. Petitioner made expenditures on behalf of Bethel by cash or check For example, petitioner purchased a 15-passenger van for use by Bethel so that she could pick up church members for Sunday school and morning worship. The van bears Bethel's name and is parked on Bethel's premises, but it is titled in petitioner's name. In addition, petitioner purchased a "250 foot black rod [sic] iron fence" that runs the perimeter of Bethel's property.

On petitioner's Schedules A, Itemized Deductions, attached to her Forms 1040, U.S. Individual Income Tax Return, petitioner claimed deductions for charitable contributions of $19,441 and $11,061 for 2004 and 2005, respectively. As reflected on petitioner's 2004 Schedule A, her charitable contribution deduction consisted of gifts by cash or check of $18,379, gifts other than by cash or check of $500, and a $562 carryover from 2003. As reflected on petitioner's 2005 Schedule A, her charitable contribution deduction consisted of gifts by cash or check of $10,561 and gifts other than by cash or check of $500. In the notices of deficiency for 2004 and 2005, respondent disallowed "Cash Contributions" of $19,441 and $10,561, respectively. Respondent disallowed petitioner's claimed "Cash Contributions" because petitioner "did not verify that the amounts shown were contributions, and paid; [therefore,] the amounts are not deductible."



Mortgage Interest Deduction
On April 25, 2006, letters of administration were filed naming petitioner as the legal representative of her mother's estate. Petitioner's mother, Lula Mae Coleman, died intestate on August 15, 2005. In 2005 petitioner made some payments to the entities holding mortgages on her parent's home at "319 E Newfield St". Petitioner, however, has lived in her home at "E 90th" for over 11 years and resided at her "E. 90th" home during 2005. On petitioner's 2005 Schedule A, she claimed an $11,396 mortgage interest deduction for the interest paid with respect to the mortgages on her parent's home at "319 E Newfield St". Respondent disallowed petitioner's claimed mortgage interest deduction because she did not establish that the amount was her interest expense and that she paid it.



Theft Loss Deduction
On October 27, 2005, petitioner filed an incident report for a burglary at Bethel. On the incident report, the police officer recorded petitioner's statement that two computers, including monitors and printers, worth $2,000 were stolen. Petitioner also submitted a "Supplementary Loss Report", on which she claimed a total additional loss of $10,740. Petitioner claimed that the additional loss items consisted of musical equipment, chaffing dishes, roasters, a "T.V.", computer equipment, food, clothes, toys, and cases of paper.

On petitioner's 2005 Schedule A, petitioner described the event as a "HOME BURGLARY" in which various household items with a basis of $19,145 and a $10,148 fair market value were stolen. Petitioner claimed a $5,933 "TOTAL" theft loss that respondent disallowed because she did not establish that a theft occurred and that she sustained a loss.


Discussion




I. Burden of Proof
The Commissioner's determinations in a notice of deficiency are presumed correct, and the taxpayer bears the burden to prove that the determinations are in error. See Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933). But the burden of proof on factual issues that affect the taxpayer's tax liability may be shifted to the Commissioner where the taxpayer introduces credible evidence with respect to the issue and the taxpayer has satisfied certain conditions. See sec. 7491(a)(1). Petitioner has not alleged that section 7491(a) applies, and she has neither complied with the substantiation requirements nor maintained all required records. See sec. 7491(a)(2)(A) and (B). Accordingly, the burden of proof remains on her.



II. Charitable Contribution Deductions
Petitioner testified that Bethel was in need of repairs when she "received" it and that she "put a lot of money into the church because I think that that's my responsibility as the pastor of the church to make sure that the church is functioning and in decent order." According to petitioner, she had to rent equipment, charge things to her Home Depot account, and hire men to perform repairs. "[She] had to pay that on behalf of the church because the church did not have a fund in order to do that. That's where [her] contributions came from."

Unreimbursed expenditures made incident to the rendition of services to a qualifying charitable organization may constitute a deductible contribution. Rockefeller v. Commissioner, 76 T.C. 178, 183 (1981), affd. 676 F.2d 35 (2d Cir. 1982); McCollum v. Commissioner, T.C. Memo. 1978-435; Miller v. Commissioner, T.C. Memo. 1975-279; sec. 1.170A-1(g), Income Tax Regs. But deductions for charitable contributions are allowed "only if verified under regulations prescribed by the Secretary." Sec. 170(a).

A. Monetary Contributions of Less Than $250

In pertinent part, section 1.170A-13(f)(1), Income Tax Regs., provides that separate contributions of less than $250 are not subject to the "contemporaneous written acknowledgment" requirement of section 170(f)(8) regardless of whether the sum of the contributions to an organization equals $250 or more. Rather, monetary charitable contributions of less than $250 must be substantiated by a canceled check; a receipt from the organization that shows the name of the donee, the date of the contribution, and the amount thereof; or "other reliable written records" that show the name of the donee, the date of the contribution, and the amount thereof. Sec. 1.170A-13(a)(1), Income Tax Regs. A letter or other communication from the organization that acknowledges the receipt of a contribution and that shows the date and amount thereof constitutes a receipt. Id.

Sec. 1.170A-13(a)(2), Income Tax Regs., provides that the reliability of "other reliable written records" is determined on the basis of all of the facts and circumstances. Factors indicative of reliability include but are not limited to: (1) The contemporaneousness of the writing evidencing the contribution; (2) the regularity of the taxpayer's recordkeeping procedures, e.g., a contemporaneous diary entry stating the amount and date of the contribution and the name of the organization that is made by a taxpayer who regularly makes such diary entries; and (3) in the case of a de minimis contribution, any written or other evidence from the organization evidencing the contribution that would not otherwise constitute a receipt (including a "token" traditionally associated with the organization and regularly given by the organization to persons making cash donations). Id.

Petitioner has submitted into evidence a log of the 2004 and 2005 disputed monetary contributions of less than $250 and copies of the following canceled checks:



Check

Date No. Payee Amount Description

12/03
1 8632 Cash $20.00 Donation

Sparkletts
1/04 8645 Water 15.25 Water

1/04 8650 Sam's Club 170.51 Supplies

Mr.
2/04 8684 Barrueta 55.00 Repair-elec

3/04 8705 OfficeMax 25.00 Supplies

U.S.
4/04 8740 Postmaster 34.00 Postage

Sparkletts
5/04 8749 Water 104.00 Water

4/04 8756 OfficeMax 66.00 Supplies

6/04 8764 OfficeMax 67.00 Supplies

6/04 8774 Gas Co. 30.00 Utilities

Sparkletts
6/04 8781 Water 10.00 Water

6/04 8787 Sam's Club 100.03 Supplies

Sparkletts
8/04 8833 Water 128.00 Water

9/04 8850 Sam's Club 161.55 Supplies

U.S.
11/04 8870 Postmaster 34.00 Postage

Bishop
4/05 9034 Batten 2 100.00 Donation

Pastor
4/05 9187 Johnson 2 50.00 Donation

Total 1,170.34

1 This contribution was made in 2003 and thus is not
deductible as a charitable contribution for 2004. See
sec. 170(a)(1). Respondent's disallowance thereof is
sustained.

2 Respondent disallowed the deductions for these
contributions, reasoning that the payments fail the "to or
for the use of" the organization requirement, see
sec. 170(c), since the checks were deposited into the
individuals' personal banking accounts rather than an
account of a charitable organization. Since petitioner has
not proven that the payments were "to or for the use of" a
charitable organization rather than for the personal use
of the individuals, respondent's disallowance thereof is
sustained. See Davis v. United States, 495 U.S. 472,
478-486 (1990).


Petitioner's log also lists the following cash contributions of less than $250 for 2004, which respondent disputes:



Payment
Date method Recipient Amount Description

2/04 Cash Los Angeles Mission $35.55 Gift

8/04 Cash Los Angeles Mission 26.55 Gift

10/04 Cash Los Angeles Mission 45.00 Gift

12/04 Cash Los Angeles Mission 37.17 Gift

8/04 Cash March of Dimes 50.00 Gift

Neighborhood curb
11/04 Cash painting 10.00 Gift

3/04 Cash Easter Seals 75.00 Gift

United Negro College
6/04 Cash Fund 100.00 Gift

United Negro College
8/04 Cash Fund 150.00 Gift

Total 529.27


Petitioner has not provided receipts substantiating the foregoing charitable contributions. Petitioner's entitlement to her charitable contribution deductions therefore hinges on the canceled checks or her "other reliable written record".

The Court finds that neither the notations on the canceled checks nor the payees of the canceled checks prove that petitioner paid the expenses on Bethel's behalf. Indeed, the subject matter of the canceled checks indicates that the expenditures might be nondeductible personal expenses. See sec. 262(a).

With respect to the log, it is dated "11/22/06" and appears to have been created by petitioner's return preparer, Mr. Applewhite. Thus, petitioner has failed to establish the contemporaneous nature of the log, and she has not established that she regularly and contemporaneously recorded her contributions in the log. See sec. 1.170A-13(a)(2)(i)(A) and (B), Income Tax Regs. The Court accords little probative weight to the log.

Without other reliable evidence to substantiate her deductions for charitable contributions of less than $250 for 2004 and 2005, the Court finds that petitioner is not entitled to claim her deductions. In addition, the Court will not apply the Cohan rule to estimate a deductible amount. See Cohan v. Commissioner, 39 F.2d 540 (2d Cir. 1930); see also Bond v. Commissioner, 100 T.C. 32, 41 (1993) ("the reporting requirements [of section 1.170A-13, Income Tax Regs.,] are directory and not mandatory."); Vanicek v. Commissioner, 85 T.C. 731, 742-743 (1985) (an estimate must have a reasonable evidentiary basis). Without reliable evidence upon which to base an estimate, an allowance here would amount to "unguided largesse." Williams v. United States, 245 F.2d 559, 560 (5th Cir. 1957). Accordingly, respondent's determinations are sustained.

B. Donations of Money or Property of $250 or More

As is relevant here, section 170(f)(8) provides that no deduction is allowed for all or part of any charitable contribution of $250 or more unless the contribution is substantiated by a contemporaneous written acknowledgment from the organization. See also sec. 1.170A-13(f)(1), Income Tax Regs. A written acknowledgment is contemporaneous if it is obtained by the taxpayer on or before the earlier of the date the taxpayer files the original return for the taxable year of the contribution or the due date (including extensions) for filing the original return for the year. Sec. 170(f)(8)(C); sec. 1.170A-13(f)(3), Income Tax Regs. The written acknowledgment must state the amount of cash and a description (but not necessarily the value) of any property other than cash that the taxpayer donated and whether the organization provided any consideration to the taxpayer in exchange for the donation. Sec. 170(f)(8)(B)(i) and (ii); sec. 1.170A-13(f)(2)(i) and (ii), Income Tax Regs.

To substantiate the following disputed 2004 deductions for charitable contributions of $250 or more, petitioner has submitted into evidence a log of her contributions and certain letters:



Payment
Date method Recipient Amount Description

"various"
2004 Cash Bethel $18,293.71 Gift

"various"
2004 Cash Bethel 4,091.20 Van payments

2004 Cash Bethel 794.39 Van insurance

7 bags
Dorothy Brown clothing, TV,
4/04 Property School 500.00 household items

10 bags
Dorothy Brown clothing, TV,
7/04 Property School 500.00 household items

Total 24,179.30


To substantiate the following disputed 2005 deductions for charitable contributions of $250 or more, petitioner has submitted into evidence a log of her contributions, copies of canceled checks, certain letters, and photographs:



Payment
Date method Recipient Amount Description

Check No.
9/05 9141 Mr. Degado $1000.00 Repair-church

Check No. Bishop
10/05 9151 Batten 300.00 Donation

Wrought
"various" iron black
2005 Cash Bethel 9,000.00 fence

"various" Tractor
2005 Cash Bethel 1,000.00 mower

"various" Van
2005 Cash Bethel 3,854.68 payments

Van
2005 Bethel 1,124.63 insurance

7 bags
clothing, TV,
Dorothy household
4/05 Property Brown School 500.00 items

Total 16,779.31


Although petitioner's log shows a $13,038 charitable contribution for 2004, petitioner has provided three letters purporting to substantiate cash contributions of $18,293.71 to Bethel during 2004. 4 A letter from Bishop Coward, dated June 3, 2008, alleges that petitioner paid $18,293.71 in 2004 for "major repair work on the property". A letter from Pastor Kincy, dated January 14, 2005, alleges that petitioner made a "contribution of $18,293.71" in 2004. 5 A letter from Secretary Jackson, dated December 4, 2006, alleges the same.

Aside from other defects, 6 the three letters and the log fail to satisfy the requirement that the organization provide a statement as to whether or not the organization provided any goods or services in consideration for the donation. See sec. 170(f)(8)(B)(ii); sec. 1.170A-13(f)(2)(ii), Income Tax Regs. Therefore, petitioner's $18,293.71 charitable contribution deduction is not allowable. See Kendrix v. Commissioner, T.C. Memo. 2006-9 (disallowing the taxpayer's charitable contribution deductions because the requirements of section 170(f)(8)(B)(ii) were not satisfied since the "receipts" did not state whether the church provided any goods or services in consideration for the contributions); Castleton v. Commissioner, T.C. Memo. 2005-58, affd. 188 Fed. Appx. 561 (9th Cir. 2006).

Petitioner cannot deduct the $1,000 charitable contribution for a tractor lawnmower that she allegedly donated to Bethel because neither the log nor the letter, dated February 5, 2007, evidencing the contribution satisfies the contemporaneous acknowledgment requirements of section 1.170A-13(f)(2) and (3), Income Tax Regs.

Petitioner cannot deduct the $300 payment to Bishop Batten because neither the log nor the canceled check evidencing the payment satisfies the acknowledgment requirements of section 1.170A-13(f)(2) and (3), Income Tax Regs. In addition, since the check was deposited into Bishop Batten's personal bank account rather than an account of a charitable organization, petitioner has not proven that the payment was "to or for the use of" a charitable organization rather than for the personal use of the individual. See sec. 170(c); Davis v. United States, 495 U.S. 472, 478-486 (1990).

Petitioner cannot deduct the items donated to the Dorothy Brown School because the log evidencing the contribution does not satisfy the contemporaneous acknowledgment requirements of section 1.170A-13(f)(2) and (3), Income Tax Regs.

Petitioner submitted no other records and did not present testimony from any other representative of Bethel to substantiate her $18,293.71 cash contributions, her donation of the tractor lawnmower, or her $300 payment to Bishop Batten. Similarly, petitioner provided no other evidence to substantiate her charitable contributions to the Dorothy Brown School. Accordingly, the Court will not apply the Cohan rule to estimate a deductible amount. See Williams v. United States, 245 F.2d at 560; Vanicek v. Commissioner 85 T.C. at 742-743; see also Cohan v. Commissioner, 39 F.2d at 543-544; Bond v. Commissioner, 100 T.C. at 41. Respondent's determinations are sustained.

Petitioner has provided a "receipt", a letter from Bethel, canceled checks, the log, and photographs of the old and new fence to substantiate payments of $10,100 to a Mr. Degado for her purchase of the black wrought iron fence. The so-called receipt is dated September 16, 2005, and purports to be from Juan Degado. The receipt was not issued by Mr. Degado. The receipt was created on June 2, 2008, by the new owner of the fencing business based upon information supplied by petitioner and, allegedly, by one of the workers who installed the fence. 7 The Court, therefore, accords little weight to the receipt.

The letter from Bethel concerning the fence is dated October 1, 2005, and is signed by "Elder L.C. Kincy, Pastor [and] Sis Angelique Jackson, Secretary". The letter acknowledges a $9,000 donation for a "250 foot black rod [sic] iron fence". The letter, however, fails to satisfy the requirement that the organization provide a statement as to whether the organization provided any goods or services in consideration for the donation. See sec. 170(f)(8)(B)(ii); sec. 1.170A-13(f)(2)(ii), Income Tax Regs.

The canceled checks consist of a $1,000 payment to Mr. Degado that was drawn on petitioner's personal account on September 16, 2005, and a $3,000 payment to Mr. Degado that contained the notation "Iron Gates". 8 The canceled checks, however, are not written acknowledgments from the organization. See sec. 170(f)(8).

Taken together, the canceled checks, the letter, the log, and the photographs corroborate petitioner's claim that she expended some money to purchase the fence on Bethel's behalf. Although petitioner has not complied with the substantiation requirements of section 170(f)(8) and the regulations thereunder, the Court is satisfied that petitioner made some payments on behalf of Bethel --but not $10,100. Putting aside the evidentiary issues, the receipt indicates that petitioner made three payments of $3,000, a $1,000 payment, and a $100 payment. The record establishes that petitioner has not provided any other evidence establishing payments over $1,000 9 to Mr. Degado in 2005. Thus, petitioner has not proven that she paid the remaining $9,100 in 2005. 10 Accordingly, the Court finds that petitioner is entitled to a $1,000 charitable contribution deduction for the fence for 2005. See Cohan v. Commissioner, supra at 544 (estimates of a taxpayer's deductions bear heavily against the taxpayer whose inexactitude is of his or her own making); see also Bond v. Commissioner, supra at 41.

Petitioner cannot deduct the "Van Payments" as charitable contributions since she continues to own the property. The "contributions", therefore, consist of less than petitioner's entire interest in the property and are not deductible. 11 See sec. 170(f)(3); sec. 1.170A-7(a)(1), Income Tax Regs.; cf. Logan v. Commissioner, T.C. Memo. 1994-445 (classifying the donee's "rent-free" use of the taxpayer's real property as a mere right to use property and disallowing a deduction for its fair rental value as a charitable contribution under section 170(f)(3)). Respondent's determination is sustained.

Petitioner cannot deduct the insurance premium payments for the van as charitable contributions. Petitioner has not shown that Bethel was the sole beneficiary of the policy. See Orr v. United States, 343 F.2d 553 (5th Cir. 1965). In addition, neither petitioner's log nor the letter from the insurance agent dated June 2, 2008, satisfies the contemporaneous acknowledgment requirements of section 1.170A-13(f)(2) and (3), Income Tax Regs. Respondent's determination is sustained. 12



III. Mortgage Interest Deduction
Section 163(a) allows a deduction for interest paid or accrued within the taxable year on indebtedness. The "indebtedness" for purposes of section 163 must, in general, be an obligation of the taxpayer and not an obligation of another. Golder v. Commissioner, 604 F.2d 34, 35 (9th Cir. 1979), affg. T.C. Memo. 1976-150; Smith v. Commissioner, 84 T.C. 889, 897 (1985), affd. without published opinion 805 F.2d 1073 (D.C. Cir. 1986).

Petitioner was not directly liable on the mortgages for which she claimed a mortgage interest deduction. But petitioner argues that she is entitled to a deduction for mortgage interest that she paid in 2005 pursuant to section 1.163-1(b), Income Tax Regs., which provides in pertinent part: "Interest paid by the taxpayer on a mortgage upon real estate of which he is the legal or equitable owner, even though the taxpayer is not directly liable upon the bond or note secured by such mortgage, may be deducted as interest on his indebtedness."

Petitioner claims that she has both a vested and an equitable interest in her mother's property at "319 E Newfield St". Petitioner testified that she started making the mortgage payments in February when her mother became ill and was no longer able to work.

State law determines the nature of property rights, while Federal law determines the appropriate Federal income tax treatment of those rights. See United States v. Natl. Bank of Commerce, 472 U.S. 713, 722 (1985); Aquilino v. United States, 363 U.S. 509, 513 (1960). Thus, whatever rights or interests petitioner held in the property is determined pursuant to California law.

As is relevant here, title to the property of a decedent's estate vests, subject to administration, in his or her heirs immediately upon death under California law. Cal. Prob. Code sec. 7000; Olson v. Toy, 54 Cal. Rptr. 2d 29, 33 (Ct. App. 1996); Bethel v. Kerksey (In re Estate of Williams), 140 Cal. Rptr. 593, 597 (Ct. App. 1977) ("when there is an intestate succession, there is an automatic vesting of title in the intestate heirs subject to administration"); see also Cal. Prob. Code secs. 6400, 6401, and 6402. Such vesting is not contingent on any assent, acceptance, or election by the heirs. Taylor v. Crippled Children's Socy. (In re Estate of Taylor), 108 Cal. Rptr. 778, 781 (Ct. App. 1973) (citing Martin v. McGrath (In re Meyer's Estate), 238 P.2d 597, 605 (Cal. Dist. Ct. App. 1951)).

The Court considers several factors when determining whether a taxpayer is an equitable or beneficial owner of the property (and thus entitled to mortgage interest deductions). See Blanche v. Commissioner, T.C. Memo. 2001-63, affd. 33 Fed. Appx. 704 (5th Cir. 2002). As is relevant here, the factors include: (1) Whether the taxpayer had a right to possess the property and to enjoy the use, rents, or profits thereof; (2) whether the taxpayer had a duty to maintain the property; (3) whether the taxpayer was responsible for insuring the property; (4) whether the taxpayer bore the risk of loss of the property; (5) whether the taxpayer was obligated to pay taxes, assessments, and charges against the property; and (6) whether the taxpayer had the right to improve the property without the owner's consent. Id.

Several of these factors weigh against petitioner for the period before her mother's death on August 15, 2005. Specifically, there is no indication that petitioner bore the risk of loss or that she was responsible for maintaining the property, insuring the property, or paying any taxes, assessments, or charges; and there is no indication that she had the right to make improvements. Thus, the Court finds that petitioner was not an equitable or beneficial owner of the property before her mother's death on August 15, 2005. Petitioner is not entitled to mortgage interest deductions for payments she made before August 15, 2005, because she was not directly liable on the notes securing the mortgages and she has failed to prove that she was the legal, equitable, or beneficial owner of the property before August 15, 2005. 13

The property's legal title, however, passed, in part, to petitioner on August 15, 2005. Petitioner is entitled to mortgage interest deductions for payments she made from August 15, 2005, subject to the substantiation requirement of section 6001. See Zards v. Commissioner, T.C. Memo. 1995-497 (only mortgage interest paid for the period after the taxpayer becomes the legal or equitable owner of the property is deductible by the taxpayer).

Petitioner provided copies of Forms 1098, Mortgage Interest Statement, to substantiate her mortgage interest deductions. The Forms 1098 show interest payments in 2005 of: (1) $7,857.64 to Countrywide Home Loans (Countrywide); (2) $2,128.85 to POPA Federal Credit Union (POPA); and (3) $825.49 to "Vodofsky". In addition, petitioner provided two canceled checks issued in September 2005: One to Countrywide for $907.89 and one to POPA for $245.50. Petitioner also entered into evidence bank statements from September to December 2005. For September petitioner handwrote on the statement "HP" next to drafts in the sum of $1,040.47. For October petitioner handwrote on the statement "2nd" with respect to a "Transfer to Coleman Lula M * * * Loan 19" for $245.40. For November petitioner handwrote on the statement "2nd" with respect to a "Transfer to COLEMAN LULA M * * * Loan 19" for $245.40 and "HP" for a withdrawal to "MRS ASSOCIATES" for $841.75. For December petitioner handwrote on the statement "2nd" with respect to a "Transfer to COLEMAN LULA M * * * Loan 19" for $245.40 and "HP" with respect to withdrawals to Countrywide in the sum of $1,827.78 and "MORTGAGE JIT PMT" for $1,728.43.

It is unclear from the record that the September drafts and the payment to "MRS ASSOCIATES" were in fact mortgage payments. In addition, it is unclear from the record whether the "Mortgage JIT PMT" relates to the three mortgages for which interest deductions were claimed rather than to petitioner's home at the "E. 90th" address (for which no Form 1098 was entered into evidence). Petitioner testified that she makes four mortgage payments: One to Countrywide, one to Washington Mutual, one to "Vodofsky", and one to POPA. According to petitioner, the "[Mortgage JIT PMT] could be to any one of the other three."

From the evidence, the Court finds that petitioner is not entitled to mortgage interest deductions for the "Vodofsky" mortgage because she has not established that she made interest payments from August 15 to December 2005. See secs. 163(a), (h), 461. With respect to the Countrywide mortgage, petitioner has established that she made interest payments in September and December 2005, but she failed to establish that she made interest payments in August, October, and November 2005. Consequently, the Court finds that petitioner is entitled to deductions for mortgage interest paid to Countrywide in September and December 2005. See secs. 163(a), (h), 461. With respect to the POPA mortgage, petitioner has established that she made interest payments from September to December 2005. Accordingly, the Court finds that petitioner is entitled to deductions for mortgage interest paid to POPA from September to December 2005.



IV. Theft Loss Deduction
In general, section 165(a) and (c)(3) allows an individual a deduction for any theft sustained during the taxable year and not compensated for by insurance or otherwise. Among other requirements, petitioner must establish that she personally sustained the theft loss. See Draper v. Commissioner, 15 T.C. 135, 135-136 (1950) (only the owner of the misappropriated property is entitled to a theft loss deduction because the loss is personal to the owner); Malik v. Commissioner, T.C. Memo. 1995-204 (taxpayer could not claim a theft loss deduction because he was not the victim of the theft).

The police officer's incident report states that the location of the theft was Bethel. The officer's narrative explains that "unknown person(s) broke into * * * the interior of [Bethel]" and stole 2 computers, including monitors and printers, worth $2,000 that were located in an office in the "northwest corner of [Bethel]."

On her Form 4684, Casualties and Thefts Loss, petitioner described the theft event as a "HOME BURGLARY" and described the misappropriated property as "VARIOUS HOUSEHOLD ITEMS" worth $10,148.

Petitioner testified that the items were taken from Bethel, not from her residence. Petitioner explained that she uses "many different things down at [Bethel], but they [are] my personal items". Petitioner also testified that she did not have anything to prove that she owned the items. According to petitioner, she had to take the loss because Bethel did not have insurance.

Petitioner has failed to prove that she owned the misappropriated property. See also Urban Redev. Corp. v. Commissioner, 294 F.2d 328, 332 (4th Cir. 1961) (the Court may reject a taxpayer's uncorroborated, self-serving testimony), affg. 34 T.C. 845 (1960); Tokarski v. Commissioner, 87 T.C. 74, 77 (1986) (same). Because petitioner has failed to establish that she personally sustained a theft loss, respondent's disallowance of the theft loss is sustained. See Draper v. Commissioner, supra at 135-136; Malik v. Commissioner, supra; see also INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992) (stating that deductions are strictly a matter of legislative grace, and taxpayers bear the burden of proving that they are entitled to claim the deduction).



V. Accuracy-Related Penalty
Initially, the Commissioner has the burden of production with respect to any penalty, addition to tax, or additional amount. Sec. 7491(c). The Commissioner satisfies this burden of production by coming forward with sufficient evidence that indicates that it is appropriate to impose the penalty. See Higbee v. Commissioner, 116 T.C. 438, 446 (2001). Once the Commissioner satisfies this burden of production, the taxpayer must persuade the Court that the Commissioner's determination is in error by supplying sufficient evidence of reasonable cause, substantial authority, or a similar provision. Id.

In pertinent part, section 6662(a) and (b)(1) and (2) imposes an accuracy-related penalty equal to 20 percent of the underpayment that is attributable to negligence or disregard of rules or regulations or a substantial understatement of income tax. 14 Section 6662(c) defines the term "negligence" to include "any failure to make a reasonable attempt to comply with the provisions of this title," and the term "disregard" to include "any careless, reckless, or intentional disregard." Negligence also includes any failure by the taxpayer to keep adequate books and records or to substantiate items properly. Sec. 1.6662-3(b)(1), Income Tax Regs.

Section 6664(c)(1) provides an exception to the section 6662(a) penalty: no penalty is imposed with respect to any portion of an underpayment if it is shown that there was reasonable cause therefor and the taxpayer acted in good faith. Section 1.6664-4(b)(1), Income Tax Regs., incorporates a facts and circumstances test to determine whether the taxpayer acted with reasonable cause and in good faith. The most important factor is the extent of the taxpayer's effort to assess his proper tax liability. Id. "Circumstances that may indicate reasonable cause and good faith include an honest misunderstanding of fact or law that is reasonable in light of * * * the experience, knowledge and education of the taxpayer." Id.

The Court finds that respondent has met his burden of production and that petitioner was negligent. Petitioner did not properly substantiate her deductions as required by the Code and the regulations. Petitioner did not establish a defense for her noncompliance with the Code's requirements. Respondent's determinations are sustained.

Other arguments made by the parties and not discussed herein were considered and rejected as irrelevant, without merit, and/or moot.

To reflect the foregoing,

Decisions will be entered under Rule 155.

1 Petitioner's $19,441 charitable contribution deduction included a $562 carryover from 2003. Petitioner neither argued nor established that she had a $562 carryover from 2003. Petitioner is deemed to have conceded the issue. See Money v. Commissioner, 89 T.C. 46, 48 (1987); see also Stutsman v. Commissioner, T.C. Memo. 1961-109 (and cases cited therein).

2 The $1,239.26 figure consists of amounts evidenced by: (1) Copies of checks numbered 8652, 8653, 8662, 8674, and 8720 payable to Bethel Pentecostal Church (Bethel) that total $395.25; (2) copies of checks numbered 8713 and 8823 payable to "Bishop Martin" and "Sister Cascada" that total $125; and (3) copies of checks numbered 8686, 8712, 8851, 8794, 8790, 8776, and 8793 payable to various persons who performed services for the church that total $719.01.

3 The $3,014 figure consists of amounts evidenced by: (1) Copies of checks numbered 8950, 9016, 9043, 9044, 9046, 9068, 9084, 9144, 9168, and 9177 payable to Bethel that total $280; (2) copies of checks numbered 8981, 8990, 9145, 9146, 9149, 9150, and 9167 payable to various charities that total $1,200; (3) copies of checks numbered 8996 and 9119 payable to various persons who provided services for Bethel that total $200; (4) copies of checks numbered 9032 and 3215 payable to "Bishop T. Martin" and "Thomas Martin" that total $834; and (5) $500 that was allowed by respondent's revenue agent during the examination of petitioner's return.

4 The log and the letters fail to differentiate between contributions that were below $250 and those of $250 or more in the $18,293.71 sum that petitioner alleges that she paid at various intervals during 2004. The Court notes that such cash contributions would not be deductible even under the less stringent standard of sec. 1.170A-13(a)(1), Income Tax Regs., because the letters do not show the dates of the "various" contributions or the amounts thereof.

5 Petitioner testified that the title "Elder L.C. Kincy" is the name that she uses in her pastorage.

6 Specifically, the defects include: (1) Petitioner's log is not a written acknowledgment from the organization; (2) petitioner's log, the Bishop Coward letter, and the Secretary Jackson letter were not contemporaneous; and (3) the Pastor Kincy letter acknowledging petitioner's own charitable contributions is suspect in that it purports to be written by an individual other than petitioner. Thus, the Court accords little weight to the Pastor Kincy letter.

7 Petitioner did not call the worker as a witness to corroborate her charitable contribution.

8 The $3,000 check was signed by petitioner on Sept. 9, 2005, and was drawn on an account titled in her mother's name.

Cal. Prob. Code sec. 7000 (West 1991) provides that title to a decedent's property passes on the decedent's death to the decedent's heirs as prescribed by the laws governing intestate succession. As of Aug. 15, 2005, title to the account passed to petitioner's father and certain heirs (including petitioner). See Cal. Prob. Code secs. 6400, 6401, and 6402 (West Supp. 2008), 7000; see also United States v. Natl. Bank of Commerce, 472 U.S. 713, 722 (1985) (State law determines the nature of property rights).

Federal law determines the appropriate Federal income tax treatment of petitioner's $3,000 purported contribution. United States v. Natl. Bank of Commerce, supra at 722. An estate is a separate taxable entity. See sec. 641; Herter v. Commissioner, T.C. Memo. 1961-19. Generally, estates are allowed deductions for charitable contributions if the contributions are paid out of the estate's gross income and are made "pursuant to the terms of the governing instrument". Sec. 642(c)(1). Because petitioner is not the taxpayer who made the contribution, she is not entitled to claim a deduction for the contribution. See Mellott v. United States, 257 F.2d 798 (3d Cir. 1958); United States v. Norton, 250 F.2d 902, 905 (5th Cir. 1958); see also Stussy v. Commissioner, T.C. Memo. 1997-293.

9 See supra note 8.

10 Petitioner entered into evidence a bank statement for the period Jan. 1 to 31, 2006, showing a $3,000 payment by "Draft 009207" that bears petitioner's handwritten notation "Iron Gates". Putting aside the hearsay matter, the Court notes that the payment was "Effective" on Jan. 12, 2006, and posted on Jan. 13, 2006. Thus, it appears that petitioner would be entitled to this $3,000 deduction, if at all, in 2006, not 2005. See secs. 446(a), 461(a).

11 In addition, petitioner has not proven that the limited exceptions of sec. 170(f)(3) apply. See also sec. 1.170A-7(a) and (b), Income Tax Regs.

12 There is no evidence in the record as to the number of miles petitioner drove in her charitable endeavors that would allow a charitable contribution deduction based either on petitioner's out-of-pocket expenses or on the standard mileage deduction. See sec. 170(i); sec. 1.170A-1(g), Income Tax Regs.

13 If a taxpayer pays mortgage interest accrued before the date he became the legal or equitable owner of the mortgaged property, the amount must be capitalized as part of his cost of the property. See Koehler v. Commissioner, T.C. Memo. 1978-381 (and cases cited therein).

14 Because the Court finds that petitioner was negligent or disregarded rules or regulations, the Court need not discuss whether there is a substantial understatement of income tax. See sec. 6662(b); Fields v. Commissioner, T.C. Memo. 2008-207.

Correction to 6694 Final Regulations

Some of the changes involve important issues. I have the full text of the corrections to the 6694 final regulations uploaded below in this blog. But, to add some interest to this blog, I will discuss one of the corrections, as follows:

§1.6694-1(b)(2) <>If there is a signing tax return preparer within the meaning of §301.7701-15(b)(1) of this chapter within a firm, the signing tax return preparer generally will be considered the person who is primarily responsible for all of the positions on the return or claim for refund giving rise to an understatement unless, based upon credible information from any source, it is concluded that the signing tax return preparer is not primarily responsible for the position(s) on the return or claim for refund giving rise to an understatement.

There has to be a lot of tension between the signing tax return preparer and other people within the firm who input on each position. In most cases, there will be or should be a return reviewer. If I were the signing return preparer, I would not want the 6694 penalty risk and if I were the reviewer, I would want the risk. The penalties are huge and they will come.

I have been working on a simple theft loss issue for the 2008 tax year from a victim of the Madoff embezzlement. It is not a simple issue. The regulations are complex and narrowly drafted and there is a lot of judicial authority that deals with the issue. I will draft an opinion on whether the investor can tax a section 165(e) theft loss in the 2008 tax year. But assuming that I am a reviewer or a signing tax return preparer in your firm, which one, under the facts, is the prepson who is "primarily responsible" for the position in the return. I feel your pain - that is not an easy determination and is likely to be an issue that should be resolved within the firm. It is my personal opinion that the person making the final decision in the firm should ordinarly be the person "primarily responsible" except in cases where one member of the firm prepares the technical position relied upon by the reviewer. This is an interesting topic and comment is invited. If you rely on a tax attorney or some other outside tax expert, then the person writing the position becomes the return preparer, and at the same time, that reduces the risk of the 6662 penalty on the client if the position is wro


T.D. 9436, Correction

January 29, 2009

Code Sec. 6060

Code Sec. 6107

Code Sec. 6109

Code Sec. 6694

Code Sec. 6695

Code Sec. 6696

Code Sec. 7701

Tax return preparers : Definitions : Penalties : Standards : Calculation : Disclosure requirements : T.D. 9436, correction .



DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Parts 1, 20, 25, 26, 31, 40, 41, 44, 53, 54, 55, 56, 156, 157, and 301

[ TD 9436 ]

RIN 1545-BG83

Tax Return Preparer Penalties Under Sections 6694 and 6695; Correction

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Correcting amendment.

SUMMARY: This document contains corrections to final regulations ( TD 9436 ) that were published in the Federal Register on Monday, December 22, 2008 (73 FR 78430) implementing amendments to the tax return preparer penalties under sections 6694 and 6695 of the Internal Revenue Code and related provisions under sections 6060 , 6107, 6109, 6696, and 7701(a)(36) reflecting amendments to the Code made by section 8246 of the Small Business and Work Opportunity Tax Act of 2007 and section 506 of the Tax Extenders and Alternative Minimum Tax Relief Act of 2008. The final regulations affect tax return preparers and provide guidance regarding the amended provisions.

DATES: This correction is effective January 29, 2009, and is applicable on December 22, 2008.

FOR FURTHER INFORMATION CONTACT: Michael E. Hara, (202) 622-4910, and Matthew S. Cooper, (202) 622-4940 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:



Background

The final regulations that are the subject of this document are under sections 6060 , 6107, 6109, 6694, 6695, 6696, and 7701 of the Internal Revenue Code.



Need for Correction

As published, final regulations ( TD 9436 ) contains errors that may prove to be misleading and are in need of clarification.



List of Subjects



26 CFR Part 1

Income taxes, Reporting and recordkeeping requirements.



26 CFR Part 20

Generation-skipping transfer taxes, Reporting and recordkeeping requirements.



26 CFR Part 25

Gift taxes, Reporting and recordkeeping requirements.



26 CFR Part 26

Generation-skipping transfer taxes, Reporting and recordkeeping requirements.



26 CFR Part 31

Employment taxes, Income taxes, Penalties, Pensions, Railroad retirement, Reporting and recordkeeping requirements, Social security, Unemployment compensation.



26 CFR Part 40

Excise taxes, Reporting and recordkeeping requirements.



26 CFR Part 41

Excise taxes, Motor vehicles, Reporting and recordkeeping requirements.



26 CFR Part 44

Excise taxes, Gambling, Reporting and recordkeeping requirements.



26 CFR Part 53

Excise taxes, Foundations, Investments, Lobbying, Reporting and recordkeeping requirements.



26 CFR Part 54

Excise taxes, Pensions, Reporting and recordkeeping requirements.



26 CFR Part 55

Excise taxes, Investments, Reporting and recordkeeping requirements.



26 CFR Part 56

Excise taxes, Lobbying, Nonprofit organizations, Reporting and recordkeeping requirements.



26 CFR Part 156

Excise taxes, Reporting and recordkeeping requirements.



26 CFR Part 157

Excise taxes, Reporting and recordkeeping requirements.



26 CFR Part 301

Employment taxes, Estate taxes, Excise taxes, Gift taxes, Income taxes, Penalties, Reporting and recordkeeping requirements.



Correction of Publication

Accordingly, 26 CFR parts 1, 20, 25, 26, 31, 40, 41, 44, 53, 54, 55, 56, 156, 157, and 301 are corrected by making the following correcting amendments:



PART 1 --INCOME TAXES

Paragraph 1. The authority citation for part 1 continues to read in part as follows:

Authority: 26 U.S.C. 7805 * * *

Par. 2. Section 1.6107-1 is amended by revising paragraphs (d) (1) and (2) to read as follows:



§1.6107-1 Tax return preparer must furnish copy of return or claim for refund to taxpayer and must retain a copy or record.

* * * * *

(d) * * *

(1) For the civil penalty for failure to furnish a copy of the return or claim for refund to the taxpayers (or nontaxable entity) as required under paragraph (a) of this section, see section 6695(a) and §1.6695-1(a) .

(2) For the civil penalty for failure to retain a copy of the return or claim for refund, or to retain a record as required under paragraph (b) of this section, see section 6695(d) and §1.6695-1(d) .

* * * * *

Par. 3. Section 1.6694-1 is amended as follows:

1. The first sentence of paragraph (b)(2) is revised.

2. The second sentence of paragraph (f)(4) Example 1 . is revised.

3. The eighth sentence of paragraph (f)(4) Example 2 . is revised.



§1.6694-1 Section 6694 penalties applicable to tax return preparers.

* * * * *

(b) * * *

(2) * * * If there is a signing tax return preparer within the meaning of §301.7701-15(b)(1) of this chapter within a firm, the signing tax return preparer generally will be considered the person who is primarily responsible for all of the positions on the return or claim for refund giving rise to an understatement unless, based upon credible information from any source, it is concluded that the signing tax return preparer is not primarily responsible for the position(s) on the return or claim for refund giving rise to an understatement. * * *

* * * * *

(f) * * *

(4) * * *

Example 1 . * * * Of this amount, $20,000 relates to research and consultation regarding a transaction that is later reported on a return, and $1,000 is for the activities relating to the preparation of the return. * * *

Example 2 . * * * Because K's signature as the signing tax return preparer is on the return, the IRS advises K that K may be subject to the section 6694(a) penalty. * * *

* * * * *

Par. 4. Section 1.6694-2 is amended by revising the last sentence of each paragraph (d)(1), (d)(2), and (d)(3)(ii) to read as follows:



§1.6694-2 Penalty for understatement due to an unreasonable position.

* * * * *

(d) * * *

(1) * * * For an exception to the section 6694(a) penalty for reasonable cause and good faith, see paragraph (e) of this section.

(2) * * * For purposes of determining whether the tax return preparer has a reasonable basis for a position, a tax return preparer may rely in good faith without verification upon information furnished by the taxpayer and information and advice furnished by another advisor, another tax return preparer, or other party (including another advisor or tax return preparer at the tax return preparer's firm), as provided in §§1.6694-1(e) and 1.6694-2(e)(5).

(3) * * *

(ii) * * * In addition, disclosure of a position is adequate in the case of a nonsigning tax return preparer if, with respect to that position, the tax return preparer complies with the provisions of paragraph (d)(3)(ii)(A) or (B) of this section, whichever is applicable.

* * * * *

Par. 5. Section 1.6694-3 is amended by revising the first two sentences of paragraph (c)(2) to read as follows:



§1.6694-3 Penalty for understatement due to willful, reckless, or intentional conduct.

* * * * *

(c) * * *

(2) A tax return preparer is not considered to have recklessly or intentionally disregarded a rule or regulation if the position contrary to the rule or regulation has a reasonable basis as defined in §1.6694-2(d)(2) and is adequately disclosed in accordance with §§1.6694-2(d)(3)(i)(A) or (C) or 1.6694-2(d)(3)(ii). In the case of a position contrary to a regulation, the position must represent a good faith challenge to the validity of the regulation and, when disclosed in accordance with §§1.6694-2(d)(3)(i)(A) or (C) or 1.6694-2(d)(3)(ii), the tax return preparer must identify the regulation being challenged. * * *

* * * * *

Par. 6. Section 1.6695-1 is amended by revising paragraph (a)(2)(ii) to read as follows:



§1.6695-1 Other assessable penalties with respect to the preparation of tax returns for other persons.

(a) * * *

(2) * * *

(ii) In order faithfully to carry out their official duties, have so arranged their affairs that they have less than full knowledge of the property that they hold or of the debts for which they are responsible, if information is deleted from the copy in order to preserve or maintain this arrangement.

* * * * *

Par. 7. Section 1.6696-1 is amended by revising the introductory text of paragraph (g)(1)(i) to read as follows:



§1.6696-1 Claims for credit or refund by tax return preparers or appraisers.

* * * * *

(g) Time for filing claim . (1)(i) Except as provided in section 6694(c)(1) and §1.6694-4(a)(4)(ii) and (5), and in section 6694(d) and §1.6694-1(d) :

* * * * *



PART 20 --ESTATE TAX; ESTATES OF DECEDENTS DYING AFTER AUGUST 16, 1954

Par. 8. The authority citation for part 20 is amended by revising an entry for Section 20.6109-1 and removing an entry for Section 20.6695-2 in numerical order to read as follows:

Authority: 26 U.S.C. 7805 * * *

Section 20.6109-1 also issued under 26 U.S.C. 6109(a). * * *

Par. 9. Section 20.6694-1 is amended by revising paragraph (a) to read as follows:



§20.6694-1 Section 6694 penalties applicable to tax return preparer.

(a) In general . For general definitions regarding section 6694 penalties applicable to preparers of estate tax returns or claims for refund, see §1.6694-1 of this chapter.

* * * * *



PART 25 --GIFT TAX; GIFTS MADE AFTER DECEMBER 31, 1954

Par. 10. The authority citation for part 25 is amended by revising an entry for Section 25.6109-1 and removing an entry for Section 25.6695-2 in numerical order to read as follows:

Authority: 26 U.S.C. 7805 * * *

Section 25.6109-1 also issued under 26 U.S.C. 6109(a). * * *

Par. 11. Section 25.6694-1 is amended by revising paragraph (a) to read as follows:



§25.6694-1 Section 6694 penalties applicable to tax return preparer.

(a) In general . For general definitions regarding section 6694 penalties applicable to preparers of gift tax returns or claims for refund, see §1.6694-1 of this chapter.

* * * * *



PART 26 --GENERATION-SKIPPING TRANSFER TAX REGULATIONS UNDER THE TAX REFORM ACT OF 1986

Par. 12. The authority citation for part 26 is amended by revising an entry for Section 26.6109-1 and removing an entry for Section 26.6695-2 in numerical order to read as follows:

Authority: 26 U.S.C. 7805 * * *

Section 26.6109-1 also issued under 26 U.S.C. 6109(a). * * *

Par. 13. Section 26.6694-1 is amended by revising paragraph (a) to read as follows:



§26.6694-1 Section 6694 penalties applicable to tax return preparer.

(a) In general . For general definitions regarding section 6694 penalties applicable to preparers of generation-skipping transfer tax returns or claims for refund, see §1.6694-1 of this chapter.

* * * * *



PART 31 --EMPLOYMENT TAXES AND COLLECTION OF INCOME TAX AT THE SOURCE

Par. 14. The authority citation for part 31 is amended by removing an entry for Section 31.6695-2 in numerical order to read as follows:

Authority: 26 U.S.C. 7805 * * *

Par. 15. Section 31.6694-1 is amended by revising paragraph (a) to read as follows:



§31.6694-1 Section 6694 penalties applicable to tax return preparer.

(a) In general . For general definitions regarding section 6694 penalties applicable to preparers of employment tax returns or claims for refund of employment tax under chapters 21 through 25 of subtitle C of the Internal Revenue Code, see §1.6694-1 of this chapter.

* * * * *

Par. 16. Section 31.6694-3 is amended by revising paragraph (a) to read as follows:



§31.6694-3 Penalty for understatement due to willful, reckless, or intentional conduct .

(a) In general . A person who is a tax return preparer of any return or claim for refund of employment tax under chapters 21 through 25 of subtitle C of the Internal Revenue Code (Code) shall be subject to penalties under section 6694(b) of the Code in the manner stated in §1.6694-3 of this chapter.

* * * * *



PART 40 --EXCISE TAX PROCEDURAL REGULATIONS

Par. 17. The authority citation for part 40 is amended by revising an entry for Section 40.6109-1 and removing an entry for Section 40.6695-2 in numerical order to read as follows:

Authority: 26 U.S.C. 7805 * * *

Section 40.6109-1 also issued under 26 U.S.C. 6109(a). * * *

Par. 18. Section 40.6060-1 is amended by revising paragraph (a) to read as follows:



§40.6060-1 Reporting requirements for tax return preparers.

(a) In general . A person that employs one or more tax return preparers to prepare a return or claim for refund of any tax to which this part 40 applies other than for the person, at any time during a return period, shall satisfy the recordkeeping and inspection requirements in the manner stated in §1.6060-1 of this chapter.

* * * * *

Par. 19. Section 40.6107-1 is amended by revising paragraph (a) to read as follows:



§40.6107-1 Tax return preparer must furnish copy of return to taxpayer and must retain a copy or record .

(a) In general . A person who is a signing tax return preparer of any return or claim for refund of any tax to which this part 40 applies shall furnish a completed copy of the return or claim for refund to the taxpayer and retain a completed copy or record in the manner stated in §1.6107-1 of this chapter.

* * * * *

Par. 20. Section 40.6109-1 is amended by revising paragraph (a) to read as follows:



§40.6109-1 Tax return preparers furnishing identifying numbers for returns or claims for refund .

(a) In general . Each return or claim for refund of any tax to which this part 40 applies prepared by one or more signing tax return preparers must include the identifying number of the preparer required by §1.6695-1(b) of this chapter to sign the return or claim for refund in the manner stated in §1.6109-2 of this chapter.

* * * * *

Par. 21. Section 40.6694-1 is amended by revising paragraph (a) to read as follows:



§40.6694-1 Section 6694 penalties applicable to tax return preparer.

(a) In general . For general definitions regarding section 6694 penalties applicable to preparers of returns or claims for refund of any tax to which this part 40 applies, see §1.6694-1 of this chapter.

* * * * *

Par. 22. Section 40.6694-2 is amended by revising paragraph (a) to read as follows:



§40.6694-2 Penalties for understatement due to an unreasonable position .

(a) In general . A person who is a tax return preparer of any return or claim for refund of any tax to which this part 40 applies shall be subject to penalties under section 6694(a) in the manner stated in §1.6694-2 of this chapter.

* * * * *

Par. 23. Section 40.6694-3 is amended by revising paragraph (a) to read as follows:



§40.6694-3 Penalties for understatement due to willful, reckless, or intentional conduct .

(a) In general . A person who is a tax return preparer of any return or claim for refund of any tax to which this part 40 applies shall be subject to penalties under section 6694(b) in the manner stated in §1.6694-3 of this chapter.

* * * * *

Par. 24. Section 40.6694-4 is amended by revising paragraph (a) to read as follows:



§40.6694-4 Extension of period of collection when tax return preparer pays 15 percent of a penalty for understatement of taxpayer's liability and certain other procedural matters .

(a) In general . For rules relating to the extension of period of collection when a tax return preparer who prepared a return or claim for refund of any tax to which this part 40 applies pays 15 percent of a penalty for understatement of taxpayer's liability and procedural matters relating to the investigation, assessment and collection of the penalties under section 6694(a) and (b), the rules under §1.6694-4 of this chapter will apply.

* * * * *

Par. 25. Section 40.6695-1 is amended by revising paragraph (a) to read as follows:



§40.6695-1 Other assessable penalties with respect to the preparation of tax returns for other persons .

(a) In general . A person who is a tax return preparer of any return or claim for refund of any tax to which this part 40 applies shall be subject to penalties for failure to furnish a copy to the taxpayer under section 6695(a) of the Internal Revenue Code (Code), failure to sign the return under section 6695(b) of the Code, failure to furnish an identification number under section 6695(c) of the Code, failure to retain a copy or list under section 6695(d) of the Code, failure to file a correct information return under section 6695(e) of the Code, and negotiation of a check under section 6695(f) of the Code, in the manner stated in §6695 -1 of this chapter.

* * * * *

Par. 26. Section 40.6696-1 is amended by revising paragraph (a) to read as follows:



§40.6696-1 Claims for credit or refund by tax return preparers .

(a) In general . The rules under §1.6696-1 of this chapter will apply for claims for credit or refund by a tax return preparer who prepared a return or claim for refund of any tax to which this part 40 applies.

* * * * *



PART 41 --EXCISE TAX ON USE OF CERTAIN HIGHWAY MOTOR VEHICLES

Par. 27. The authority citation for part 41 is amended by removing an entry for Section 41.6695-2 in numerical order to read as follows:

Authority: 26 U.S.C. 7805 * * *

Par. 28. Section 41.6695-1 is amended by revising paragraph (a) to read as follows:



§41.6695-1 Other assessable penalties with respect to the preparation of tax returns for other persons .

(a) In general . A person who is a tax return preparer of any return or claim for refund of excise tax under section 4481 of the Internal Revenue Code (Code) shall be subject to penalties for failure to furnish a copy to the taxpayer under section 6695(a) of the Code, failure to sign a return under section 6695(b) of the Code, failure to furnish an identification number under section 6695(c) of the Code, failure to retain a copy or list under section 6695(d) of the Code, failure to file a correct information return under section 6695(e) of the Code, and negotiation of a check under section 6695(f) of the Code, in the manner stated in §6695 -1 of this chapter.

* * * * *



PART 44 --TAXES ON WAGERING; EFFECTIVE JANUARY 1, 1955

Par. 29. The authority citation for part 44 is amended by revising an entry for Section 44.6109-1 and removing an entry for Section 44.6695-2 in numerical order to read as follows:

Authority: 26 U.S.C. 7805 * * *

Section 44.6109-1 also issued under 26 U.S.C. 6109(a). * * *

Par. 30. Section 44.6695-1 is amended by revising paragraph (a) to read as follows:



§44.6695-1 Other assessable penalties with respect to the preparation of tax returns for other persons .

(a) In general . A person who is a tax return preparer of any return or claim for refund of tax on wagers under sections 4401 or 4411 of the Internal Revenue Code (Code) shall be subject to penalties for failure to furnish a copy to the taxpayer under section 6695(a) of the Code, failure to sign the return under section 6695(b) of the Code, failure to furnish an identification number under section 6695(c) of the Code, failure to retain a copy or list under section 6695(d) of the Code, failure to file a correct information return under section 6695(e) of the Code, and negotiation of a check under section 6695(f) of the Code, in the manner stated in §6695 -1 of this chapter.

* * * * *



PART 53 --FOUNDATION AND SIMILAR EXCISE TAXES

Par. 31. The authority citation for part 53 is amended by revising an entry for Section 53.6109-1 and removing an entry for Section 53.6695-2 in numerical order to read as follows:

Authority: 26 U.S.C. 7805 * * *

Section 53.6109-1 also issued under 26 U.S.C. 6109(a). * * *



PART 54 --PENSION EXCISE TAXES

Par. 32. The authority citation for part 54 is amended by revising an entry for Section 54.6109-1 and removing an entry for Section 54.6695-2 in numerical order to read as follows:

Authority: 26 U.S.C. 7805 * * *

Section 54.6109-1 also issued under 26 U.S.C. 6109(a). * * *

Par. 33. In FR Doc. E8-29750 appearing on page 78430 in the Federal Register of Monday, December 22, 2008, the following correction is made:



Section 54.6694-3 [Corrected]

On page 78458, in the third column, in paragraph 107, the instruction "Section 56.6694-3 is added to read as follows:" is removed and the language "Section 54.6694-3 is added to read as follows:" is added in its place.



PART 55 --EXCISE TAX ON REAL ESTATE INVESTMENT TRUSTS AND REGULATED INVESTMENT COMPANIES

Par. 34. The authority citation for part 55 is amended by revising an entry for Section 55.6109-1 and removing an entry for Section 55.6695-2 in numerical order to read as follows:

Authority: 26 U.S.C. 7805 * * *

Section 55.6109-1 also issued under 26 U.S.C. 6109(a). * * *



PART 56 --PUBLIC CHARITY EXCISE TAXES

Par. 35. The authority citation for part 56 is amended by revising an entry for Section 56.6109-1 and removing an entry for Section 56.6695-2 in numerical order to read as follows:

Authority: 26 U.S.C. 7805 * * *

Section 56.6109-1 also issued under 26 U.S.C. 6109(a). * * *



PART 156 --EXCISE TAX ON GREENMAIL

Par. 36. The authority citation for part 156 is amended by revising an entry for Section 156.6109-1 and removing an entry for Section 156.6695-2 in numerical order to read as follows:

Authority: 26 U.S.C. 7805 * * *

Section 156.6109-1 also issued under 26 U.S.C. 6109(a). * * *



PART 157 --EXCISE TAX ON STRUCTURED SETTLEMENT FACTORING TRANSACTIONS

Par. 37. The authority citation for part 157 is amended by revising an entry for Section 157.6109-1 and removing an entry for Section 157.6695-2 in numerical order to read as follows:

Authority: 26 U.S.C. 7805 * * *

Section 157.6109-1 also issued under 26 U.S.C. 6109(a). * * *



PART 301 --PROCEDURE AND ADMINISTRATION

Par. 38. The authority citation for part 301 continues to read in part as follows:

Authority: 26 U.S.C. 7805 * * *

Par. 39. Section 301.7701-15 is amended by revising paragraph (f)(1)(xi)(B) to read as follows:



§301.7701-15 Tax return preparer .

* * * * *

(f) * * *

(1) * * *

(xi) * * *

(B) A waiver of restriction on assessment after initiation of an audit of the taxpayer or another taxpayer if a determination in the audit of the other taxpayer affects, directly or indirectly, the liability of the taxpayer for tax.

* * * * *


LaNita Van Dyke



Chief, Publications and Regulations Branch



Legal Processing Division



Associate Chief Counsel



(Procedure and Administration)

Interesting case - a "must read"

I have put up the this case previously, but have uploaded the Cruz case again for a number of reasons, although it is a very strnge case with a very strange analysis and result. You should read it carefully.

First, think about the $5,000 6694(b) penalties that could be assessed agains the return preparer and the firm.

Second, it references the duty of the return preparer to know the tax statutes and regulations. Believe it!

Third, it is apparent that the Court appears to treat negligence as intentional. But if the Court can do that in this case, then there is a very possible that in another case the Court could find return preparer fraud. Where there are multiple errors, as in the present case, it is logical for the Court or the IRS to consider whether the errors are intentional.

Fourth, the Court gives guidance on procedures that should be followed in every tax preparation firm. The issue of appropriate practices of a return preparer firm is going to be a huge issue going forward in dealing with the "firm" reasonabl practices due to the fact that the firm is subject to the 6694 penalties. The following is a quote from the case:

Defendants' Practices


24. Prior to 2005, NBC's tax preparation services worked as follows: Clients were seen by appointment and first met with a staff member would interview the client and input the data into tax preparation software on a computer to generate a tax return. The initial interviewers were given no formal tax training or education. Cruz would review the tax return with the client, input any additional data needed, and sign the return as the preparer. Cruz's review was not a line-by-line audit of the draft tax return. Nevertheless Cruz maintained the ability to change any of the information previously entered by the interviewer.

25. NBC did not maintain any sort of general quality control procedure after tax returns were prepared and did not maintain receipts or other substantiation for the returns it prepared for its clients. No written record was made of the information provided by the taxpayer.

26. It was common for at least some of the information provided by the client to the interviewer to be provided orally, that is, without documentary support.

27. In the discretion of the interviewer or Cruz, the orally provided information would either be accepted or supporting documentation was requested.

28. In some instances NBC refused to prepare a return or enter an item thereon absent substantiation by supporting documents.

29. As of September of 2004, NBC did not have any procedures for documenting client verification of the information on the tax returns that might have occurred. That is, the client would not sign any acknowledgment that the return was accurate or that the client has indeed provided the information that ultimately appeared on the return. Nor did NBC have any procedure for documenting any inquiry made by the interviewer or Cruz with respect to supporting documentation or predicate facts necessary to support any particular deduction.

30. During the years at issue, tax years 2003-2006, there was no requirement for the tax return preparer to audit clients' tax returns or maintain the clients' supporting documentation.


The #30 item has some relevance to the requirement in the final regulations that there is a reference to items that the return preparer should be aware of situations of facts that require further inquiry or investigation.


United States of America, Plaintiff v. Abelardo Ernest Cruz, Nations Business Center, Inc., Nations Tax Service, Inc., Ruth Real, and Ruth Real and Associates, Inc., Defendants. U.S. District Court, So. Dist. Fla.; 07-61003-CIV-ZLOCH, December 30, 2008.







ORDER


ZLOCH, District Judge: THIS MATTER is before the Court upon Plaintiff's Complaint (DE 1) filed herein. A nine day non-jury trial was held commencing Wednesday, September 3, 2008. The Court has carefully reviewed the entire court file herein and is otherwise fully advised in the premises.




I. Background


Defendants are tax return preparers in the Miami area. In the early 1990s, during the course of the Internal Revenue Service's normal audit practice, Defendants, especially Abelardo Ernest Cruz (hereinafter "Cruz"), came under suspicion for several questionable practices. In 1995 and again in 1998, certain returns prepared by Cruz were selected for audit, and certain items were disallowed. Preparer penalties were imposed on Cruz for the positions taken on the returns. A formal investigation into returns prepared by Defendants was initiated in 2003 and was ongoing as of the date of trial. This investigation uncovered voluminous problems on returns prepared by Defendants, including improper deductions and exclusions and improper treatment of income. Ultimately the IRS referred the matter to the United States Department of Justice, who initiated this action.

The subject of the investigation and trial in this action were returns prepared by Defendants for tax years 2003 through 2006. In total 149 returns were audited, the great majority of which had deductions and exclusions from income disallowed. The Government initiated this action seeking injunctive relief against Defendants, proceeding under three sections of the Internal Revenue Code: 26 U.S.C. §§7407, 7408, & 7402 (2006). The Government seeks a permanent injunction barring Defendants from preparing tax returns or assisting in their preparation. The relevant statutes empower the Court to grant a range of relief from enjoining prohibited conduct to barring all tax preparation services, to entering any order necessary to aid in the proper administration of the internal revenue laws.

As more fully explained below, the Court finds that Defendants have engaged in conduct that impeded the proper enforcement and administration of the internal revenue laws. Specifically, they have knowingly taken unreasonable positions on tax returns, have knowingly aided in the preparation of returns with material misstatements on them resulting in an understatement of tax liability, and have misrepresented their ability to practice before the IRS. Thus, injunctive relief is proper. However, Defendants have demonstrated that they have worked diligently to eradicate past unlawful behavior and implemented procedures designed to minimize or eliminate these types of mistakes in their tax preparation practice. A balance of the hardships and consideration of the public interest favors keeping Defendants in business while enjoining the offending conduct. It is also sufficient to prevent further unlawful conduct. These conclusions are based on the type and rate of errors uncovered by the Government's investigation, as well as Defendants' efforts to eliminate the same.

After full presentation of the evidence by both sides and observing the demeanor of the witnesses, pursuant to Federal Rule of Civil Procedure 52 the Court hereby makes the following findings of fact and conclusions of law:




II. Findings of Fact





A. Background


1. Defendant Abelardo Ernest Cruz (hereinafter "Cruz") works as a tax return preparer in the area of Miami, Florida. Cruz is the primary manager and operator of Defendant Nations Business Center, Inc. (hereinafter "NBC") and Defendant Nations Tax Service, Inc. (hereinafter "NTS"). While both entities are owned by Cruz's wife Annmarie Biondolillo, she does not have an active role in the businesses.

2. NBC was established by Cruz in the early 1990s and continues to operate to this day. NTS was established by Cruz in late 2004 or early 2005 and likewise continues to operate.

3. In 1993, Cruz entered a plea of nolo contendere to a felony charge in Florida state court. The circumstances giving rise to the plea arose in 1988. Cruz was incarcerated for six months in 1993 following the plea.

4. Upon his release from jail, Cruz began re-building his tax preparation business.

5. NBC was formed with the funds of Cruz's then-estranged wife.

6. The tax return preparation business of NBC grew steadily from 1995 through 1998.

7. NBC operated primarily as a tax preparation service through 2004. When NTS was formed, NBC began to phase out its tax preparation practice and NTS became Cruz's main tax preparation service entity. Since that time, NBC has been primarily engaged in the business of accounting and payroll processing for business clients.

8. Defendant Ruth Real (hereinafter "Real") is also a tax return preparer in the Miami area. She owns and operates Defendant Ruth Real & Associates, Inc., a tax preparation service serving about thirty (30) clients.

9. In addition, Real works as an employee of both NBC and NTS. She prepares tax returns for clients of all three businesses, and she purports to represent clients of NBC, NTS, and Ruth Real & Associates, Inc. in audits of their tax returns by the Internal Revenue Service.




B. Previous audits and penalties


10. In or about 1995, Internal Revenue Agent Alice Denny (hereinafter "Denny") audited several tax returns prepared by NBC for tax years 1993 and 1994 that claimed a credit for payment of fuel taxes. Denny disallowed the fuel tax credits and proposed a preparer penalty against Cruz for each return.

11. At the same time, Internal Revenue Agent Joanne Leavitt (hereinafter "Leavitt") audited several tax returns prepared by NBC that claimed a credit for fuel taxes. Leavitt also disallowed the credits and asserted preparer penalties against Cruz.

12. In total there were about fourteen penalties proposed against Cruz.

13. Cruz believed the fuel tax credits were properly taken, or at least were not unreasonable positions, and filed the necessary paperwork to take his proposed penalties to the IRS appeals office.

14. The IRS and Cruz settled the matter at appeals. Seven preparer penalties were conceded by Cruz and the remaining seven were dropped.

15. The settlement was reached based upon the parties' assessment of the hazards of litigation before the United States Tax Court.

16. In 1996 and 1998, the IRS again reviewed additional samples of returns prepared by NBC. It found that Cruz incorrectly placed Schedule C income on the front of Form 1040 and incorrectly placed income subject to self-employment tax on Schedule E. Both actions resulted in an understatement of tax liability.

17. On May 7, 1998, the IRS revoked Cruz's eligibility to represent taxpayers in audits or appeals. See Government Exhibit 46.

18. This censure was based on several instances of "disreputable conduct," including Cruz's plea of nolo contendere, see ¶ 3, a determination by a bankruptcy court that Cruz embezzled over $680,000, and the preparer penalties previously discussed.

19. Cruz was also barred from participating in the IRS's efiling program due to the criminal conviction following his nolo contendere plea.

20. During the five year period of time from 1998 through 2002, NBC prepared over 10,000 income tax returns. Cruz signed each return as the preparer.

21. Five preparer penalties were assessed against Cruz for mistakes contained in five of the 10,000 returns.

22. No further preparer penalties were assessed against Cruz.

23. No preparer penalty has ever been assessed against Ruth Real.




C. Defendants' Practices


24. Prior to 2005, NBC's tax preparation services worked as follows: Clients were seen by appointment and first met with a staff member would interview the client and input the data into tax preparation software on a computer to generate a tax return. The initial interviewers were given no formal tax training or education. Cruz would review the tax return with the client, input any additional data needed, and sign the return as the preparer. Cruz's review was not a line-by-line audit of the draft tax return. Nevertheless Cruz maintained the ability to change any of the information previously entered by the interviewer.

25. NBC did not maintain any sort of general quality control procedure after tax returns were prepared and did not maintain receipts or other substantiation for the returns it prepared for its clients. No written record was made of the information provided by the taxpayer.

26. It was common for at least some of the information provided by the client to the interviewer to be provided orally, that is, without documentary support.

27. In the discretion of the interviewer or Cruz, the orally provided information would either be accepted or supporting documentation was requested.

28. In some instances NBC refused to prepare a return or enter an item thereon absent substantiation by supporting documents.

29. As of September of 2004, NBC did not have any procedures for documenting client verification of the information on the tax returns that might have occurred. That is, the client would not sign any acknowledgment that the return was accurate or that the client has indeed provided the information that ultimately appeared on the return. Nor did NBC have any procedure for documenting any inquiry made by the interviewer or Cruz with respect to supporting documentation or predicate facts necessary to support any particular deduction.

30. During the years at issue, tax years 2003-2006, there was no requirement for the tax return preparer to audit clients' tax returns or maintain the clients' supporting documentation.




D. Facts Preceding the Investigation


31. Denny was promoted to Return Preparer Coordinator for South Florida. When promoted, there were ongoing audits of returns prepared by NBC, and they were referred to Denny. In 2003, Denny named Cruz and NBC in a referral letter sent to the IRS's Lead Development Center ("LDC"), a group that reviews recurring problems to determine whether further action against a preparer is warranted.

32. Denny's referral letter reflects that the request for authority to investigate Cruz and NBC was partly based upon the seven income tax returns prepared approximately ten years earlier in 1993 and 1994 claiming a fuel tax credit and resulting in seven sustained preparer penalties. Gov. Ex. 92.

33. The referral letter also noted that the percentage of returns Cruz prepared that receive tax refunds was well above the national average of returns to receive refunds.

34. Though Denny drafted the referral letter in 2003, it contains statistics purporting to be for 2004.

35. Denny's referral letter stated that Cruz was a convicted felon. It also claimed, erroneously, that Cruz had a grand theft conviction for making unauthorized charges on his father's credit card.

36. In the fall of 2004, the LDC authorized Denny to commence an investigation of Cruz and NBC.

37. Leavitt was tasked with leading the investigation.

38. Leavitt met with Cruz in September of 2004. NTS was not established as of this meeting. Cf. supra, ¶ 2.

39. At the meeting, Leavitt told Cruz she was conducting an investigation; they discussed Cruz's business practices, his tax knowledge, and other matters relevant to her investigation. Leavitt requested NBC's entire client list. Gov. Ex. 43.

40. Cruz provided all of the information requested. When Cruz asked for details about the investigation, Leavitt would not provide him with any information.

41. Following this first meeting, Leavitt began her investigation. See infra, ¶¶ 49, et seq. below.

42. Leavitt met with Cruz again in the Fall of 2006. Gov. Ex. 66. At this time, based in part on the original returns selected for audit, Leavitt identified several types of repetitive problems on the returns prepared by NBC/NTS. Prior to this second meeting, Leavitt informed Cruz of the Internal Revenue Code sections that she considered to be problem areas on the returns prepared by NBC/NTS.

43. At the second meeting Cruz provided Leavitt with various materials in an attempt to show NBC/NTS's compliance with respect to these Code sections. Gov. Ex. 67.

44. Following the second meeting Cruz again provided additional materials to Leavitt in an attempt to show his compliance with the Code sections identified to be problem areas. Gov. Ex. 68.

45. Leavitt considered all the materials that Cruz presented in her analysis.

46. During the course of the investigation, Leavitt also met with Real in the same manner that she met with Cruz. Gov. Ex. 69. During this meeting, numerous issues were discussed, and Leavitt requested a list of clients that Real serviced through Ruth Real & Associates.

47. Pursuant to 26 U.S.C. §6107(b), tax return preparers are required to either keep copies of the returns that they prepared in the last three years or to keep a client list with certain required information.

48. Real was unable to provide Leavitt with either copies of the returns or a client list with the required information because the computer containing this information had crashed. See Gov. Ex. 80.




E. The Investigation


49. As referenced in Paragraphs 39 and 40 above, after their initial meeting in September of 2004, Cruz provided Leavitt with NBC's client list.

50. Leavitt randomly selected twenty-five returns.

51. Of these returns, she excluded four because the taxpayers lived outside of Florida and could not be readily audited. Of the remaining twenty-one, Leavitt identified thirteen that had large or questionable deductions or exclusions. She kept these to be audited and returned the balance to NBC.

52. Leavitt then selected seventeen more returns using the IRS's DIF program.

53. DIF is a computer program that identifies returns with large or unusual items probable to be questioned during an audit.

54. The total thirty returns selected for audit were assigned to approximately thirty Revenue Agents and Tax Compliance Officers be audited.

55. As the investigation continued over the course of the next several years, Leavitt selected additional returns for audit.

56. Ultimately, 149 income tax returns prepared by NBC and NTS during 2003, 2004, 2005, and 2006 were audited.

57. There were over forty IRS employees conducting the audits. Leavitt remained in charge of the investigation.




F. Audit Results


58. During the course of the investigation numerous repetitive problems were identified on the audited returns.

59. These repetitive problems included improper and unsubstantiated deductions taken pursuant to §179, failure to apply limits on the deduction of vehicles pursuant to §280F, double counting of deductions, improper treatment of closing costs for the purchase of property, overstated Schedule C expenses, fabricated casualty losses, and others.

60. Section 179 allows a taxpayer to deduct the expense of certain depreciable business assets in a single taxable year, but §280F places a limit on the amount that may be deducted under §179 for passenger automobiles.

61. The Government presented numerous examples of tax returns where NBC/NTS did not correctly take §179 deductions. E.g., Gov. Ex. 1, p. US10403 (Lopez tax return) (Gov. Ex. 94, ¶ 73); id. p. US10924 (Pineda tax return) (Gov. Ex. 94, ¶ 87); id. p. US10566 (Sandra Cruz tax return); id. p. US10726 (Delgado tax return); Gov. Ex. 94, ¶¶ 67, 99, and 108.

62. Any basis in a vehicle not deducted under §179 is to be depreciated over five years. 26 U.S.C. §168(e)(3)(B)(i).

63. In certain instances NBC/NTS impermissibly depreciated vehicles over three years instead of five. E.g., Gov. Ex. 1, p. US10287 (Hernandez tax return); id. p. US10566 (Sandra Cruz tax return) (Gov. Ex. 94, ¶ 27).

64. NBC/NTS prepared a large number of returns with improper § 179 deductions for truck purchases and truck overhauls.

65. These included numerous §179 deductions that were unsubstantiated. In some cases the returns claimed a large § 179 deduction for the purchase of a truck in one year and also a large §179 deduction for an overhaul of the truck in the following year, or the returns claimed deductions for major overhauls in back to back years. E.g., Gov. Ex. 94, ¶¶ 13, 29, 37, 38, 57, 61(b), 93, and 105.

66. NBC/NTS also claimed deductions twice on the same return in some instances. E.g., Gov. Ex. 1, p. US10827 (Covington/Affordable Borders, Inc. tax return) (Gov. Ex. 94, ¶ 25).

67. NBC/NTS also impermissibly deducted closing costs for the purchase of real property. Gov. Ex. 94, ¶ 9 (Amado tax return); id. ¶ 95 (Robaina tax return).

68. Closing costs should not be deducted as expenses but added to the taxpayer's basis in the property. IRS Pub. 530, p. 9 (2007).

69. On some returns, NBC/NTS also deducted amounts paid for the repayment of loan principle. E.g., Gov. Ex. 94, ¶ 40(b) (William Forde PA tax return). There is no deduction allowed for repayment of principle on a loan.

70. NBC/NTS also prepared corporate returns that claimed deductions for an officer's compensation but then failed to include that officer's compensation as income on the officer's personal returns. E.g., Gov. Ex. 94, ¶ 44.

71. NBC/NTS improperly reported a corporate officer's compensation on at least one individual tax return that listed it in a manner that avoided the requirement for the corporation to pay employment taxes on the income. E.g., Gov. Ex. 94, ¶ 51.

72. NBC/NTS also improperly deducted an automobile expense on at least one corporate return when the automobile was owned by the shareholder and not the corporation. E.g., Gov. Ex. 94, ¶ 83(b).

73. NBC/NTS also prepared at least one return that did not report any salary paid to a corporate officer but did report distribution income. E.g., Gov. Ex. 94, ¶ 101. It is improper for an officer of a closely held corporation to receive only distributions and no salary. Rev. Rul. 74-44 1974-1 C.B. 287.

74. NBC/NTS prepared returns that impermissibly claimed a deduction for a leasehold improvement on returns that also claimed a deduction for mortgage interest. See, e.g., Gov. Ex. 16 (Gopalgi tax return, Schedule C, line 13 and Schedule A, line 10); Gov. Ex. 24 (Negret tax return, Schedule C, line 13 and Schedule A, line 10).

75. To claim a deduction for money expended on an improvement to leased real property, the real property must be a nonresidential leasehold estate. 26 U.S.C. §168(i)(8)(A).

76. The deductions for mortgage interest on the returns noted in ¶ 74 made it clear that the real property for which the leasehold improvement deduction was claimed was not leasehold property, because mortgage interest can only be deducted for residential real property. 26 U.S.C. §163(h).

77. The actions recounted in Paragraphs 61, 63, 65, 66, 67, 69, 70, 71, 72, 73, and 74 resulted in an understatement of the taxpayers' tax liabilities and a loss to the United States Treasury.




G. Non-audit Investigation Facts


78. On July 18, 2007, the Government issued a press release that recited the positions taken its Complaint filed herein. Def. Ex. 12. The release did not make light of the Government's understanding of Defendants' practices.

79. In or about January 2008, Leavitt sent letters to 80 of the clients of NBC/NTS who were being audited in this investigation stating that the Department of Justice was seeking to enjoin Defendants from preparing tax returns and providing any sort of tax representation or advice. See, e.g., Def. Ex. 35.

80. In general, the letters stated the nature of items on the sample of returns that were disallowed by the IRS and asked the taxpayers if they told Cruz or the staff at NTS the information for the item that the IRS had disallowed on the taxpayer's return in particular.

81. Eight taxpayers replied to the letter.

82. Leavitt called the other taxpayers on the telephone, and another 7 agreed to talk to her.




H. National Statistics Published by the IRS


83. IRS-published statistics reflect that for tax year 2004, the average recommended additional tax resulting from audits of tax returns with Schedule C total gross receipts between $25,000 and $100,000 was $6,629 when the audit was conducted by a Revenue Agent. Def. Ex. 27.

84. IRS-published statistics reflect that for tax year 2004, the average recommended additional tax resulting from audits of tax returns with Schedule C total gross receipts between $25,000 and $100,000 was $12,323 when the audit was conducted by a Tax Examiner. Id.

85. IRS-published statistics reflect that for tax year 2004, the average recommended additional tax resulting from audits of tax returns with Schedule C total gross receipts between $25,000 and $100,000 was $1,994 when conducted through the mail, known as a correspondence audit. Id.

86. IRS-published statistics reflect that for tax year 2004, the average recommended additional tax resulting from audits of tax returns with Schedule C total gross receipts over $100,000 was $20,956 when conducted by a Revenue Agent. Def. Ex. 27.

87. IRS-published statistics reflect that for tax year 2004, the average recommended additional tax resulting from audits of tax returns with Schedule C total gross receipts over $100,000 was $55,330 when conducted by a Tax Examiner. Id.

88. IRS-published statistics reflect that for tax year 2004, the average recommended additional tax resulting from audits of tax returns with Schedule C total gross receipts over $100,000 was $2,892 when conducted as a correspondence audit. Id.

89. IRS-published statistics reflect that for tax year 2005, the average recommended additional tax resulting from audits of tax returns with Schedule C total gross receipts between $25,000 and $100,000 was $9,713 when conducted by a Revenue Agent. Def. Ex. 28.

90. IRS-published statistics reflect that for tax year 2005, the average recommended additional tax resulting from audits of tax returns with Schedule C total gross receipts between $25,000 and $100,000 was $5,801 when conducted by a Tax Compliance Officer. Id.

91. IRS-published statistics reflect that for tax year 2005, the average recommended additional tax resulting from audits of tax returns with Schedule C total gross receipts between $25,000 and $100,000 was $7,443 when conducted as a correspondence audit. Id.

92. IRS-published statistics reflect that for tax year 2005, the average recommended additional tax resulting from audits of tax returns with Schedule C total gross receipts over $100,000 was $37,024 when conducted by a Revenue Agent. Id.

93. IRS-published statistics reflect that for tax year 2005, the average recommended additional tax resulting from audits of tax returns with Schedule C total gross receipts over $100,000 was $4,641 when conducted by a Tax Examiner. Id.

94. IRS-published statistics reflect that for tax year 2005, the average recommended additional tax resulting from audits of tax returns with Schedule C total gross receipts over $100,000 was $21,032 when conducted as a correspondence audit. Id.

95. IRS-published statistics reflect that for tax year 2004, the average recommended additional tax resulting from audits of all non-business returns, except 1040A, with total positive income 1 between $50,000 and $100,000 was $7,975 when conducted by a Revenue Agent. Def. Ex. 27.

96. IRS-published statistics reflect that for tax year 2004, the average recommended additional tax resulting from audits of all non-business returns, except 1040A, with total positive income between $50,000 and $100,000 was $5,823 when conducted by a Tax Examiner. Id.

97. IRS-published statistics reflect that for tax year 2004, the average recommended additional tax resulting from audits of all non-business returns, except 1040A, with total positive income between $50,000 and $100,000 was $2,299 when the audit was conducted as a correspondence audit. Id.

98. IRS-published statistics reflect that for tax year 2005, the average recommended additional tax resulting from audits of all non-business returns, except 1040A, with total positive income between $50,000 and $100,000 was $11,098 when conducted by a Revenue Agent. Def. Ex. 28.

99. IRS-published statistics reflect that for tax year 2005, the average recommended additional tax resulting from audits of all non-business returns, except 1040A, with total positive income between $50,000 and $100,000 was $7,286 when conducted by a Tax Examiner. Id.

100. IRS-published statistics reflect that for tax year 2005, the average recommended additional tax resulting from audits of all non-business returns, except 1040A, with total positive income between $50,000 and $100,000 was $1,902 when conducted as a correspondence audit. Id.




I. 2003 audit results


101. The Government's investigation consisted of audits of a sample of 149 returns prepared by Defendants. See ¶¶ 49-56.

102. The sample of 149 returns in the Government's investigation included 46 prepared by NBC/NTS for tax year 2003. Def. Ex. 23.

103. These returns represent 1% of the approximate 4,600 returns that Defendants prepared for that year.

104. Only returns with large or unusual items and/or high DIF scores were selected for audit.

105. The average loss established by the 46 returns audited for tax year 2003 is $7,658.83. Def. Ex. 23.

106. This number is reasonably close to the average recommended additional tax figures published by the IRS for subsequent years. See Def. Exs. 27 & 28.

107. Of the 46 returns audited for tax year 2003, 10 are reflected as cases were the taxpayer failed to appear and the additional tax was assessed. Def. Ex. 23.

108. Two of the remaining 36 audits resulted in no change. Id.

109. Five of the remaining 34 returns audited for the tax year 2003 remained pending in Appeals as of the time of trial in this matter. Id.

110. A majority of the returns had additional taxes asserted because the taxpayer failed to produce documentation necessary to substantiate deductions taken on the returns.




J. 2004 audit results


111. The Government audited 86 returns for tax year 2004. Def. Ex. 24.

112. These returns represented 1.7% of the approximate 4,960 returns that Defendants prepared for that year.

113. Only returns with large or unusual items and/or high DIF scores were selected.

114. The average loss established by the 86 returns audited for tax year 2004 is $7,858.94. Def. Ex. 24.

115. This does not depart very far from the average recommended tax loss estimated by IRS-published statistics. Def. Ex. 27.

116. Of the 86 returns audited for tax year 2004, 7 taxpayers failed to appear. Def. Ex. 24.

117. Of the remaining 79 returns audited, 2 were determined to have no change. Id.

118. Of the 86 returns audited for tax year 2004, 19 taxpayers remained pending in Appeals as of the time of trial in this matter. Id.

119. A majority of the returns had additional taxes asserted because the taxpayer failed to produce documentation necessary to substantiate deductions taken on the return.




K. 2005 audit results


120. The Government audited 61 returns for tax year 2005. Def. Ex. 25.

121. These returns represented about 1.3% of the over 4,500 returns Defendants prepared for that year.

122. Only returns with large or unusual items and/or high DIF scores were selected.

123. The average loss established by the 61 returns audited for tax year 2005 was $9,711.18. See Def. Ex. 25.

124. This is within the average additional tax recommended by IRS-published statistics. See Def. Ex. 28.

125. Of the 61 returns audited for 2005, 5 taxpayers failed to appear. Def. Ex. 25.

126. Of the 56 remaining returns, 19 remained pending in Appeals as of the time of trial in this matter. Id.

127. Of the 37 remaining returns a majority had additional taxes asserted due to the failure of the taxpayers to produce documentation necessary to substantiate deductions taken on the return.




L. 2006 audit results


128. The Government audited 31 returns for tax year 2006.

129. These returns represented less than 1% of the approximate 5000 returns Defendants prepared for that year.

130. Of the 31 returns audited for 2006, 7 resulted in no change. Def. Ex. 26.

131. Of the remaining 24 returns audited for 2006, 5 remained pending in Appeals as of the time of trial in this matter. Id.

132. A majority of the remaining 19 returns had additional taxes asserted due to the failure of the taxpayers to produce documentation necessary to substantiate deductions taken on the return.

133. The average tax loss established by the 31 returns audited for tax year 2006 was $5,620.65.

134. Neither Party submitted figures for IRS-published statistics for 2006. However, assuming figures from the two previous years provide an adequate benchmark, the figure noted in Paragraph 136 is reasonably close to or below the average recommended additional tax figures published by the IRS for preceding years. See Def. Exs. 27 & 28.




M. Conclusions To Be Drawn From the Investigation


135. The kind and quantity of errors found on the sample of 146 audited tax returns is reflected in the following table:




Number of Number of Number of Number of
returns in returns in returns in returns in
2003 sample 2004 sample 2005 sample 2006 sample
(& percent (& percent (& percent (& percent
of total) of total) of total) of total)

Total returns 46 86 61 31

Schedule C
depreciation 23 (50%) 23 (27%) 4 (6.6%) 0 (0%)

Schedule C
expenses 24 (52%) 37 (43%) 17 (29%) 5 (16%)

Earned income
credit 10 (22%) 18 (21%) 11 (18%) 1 (3.2%)

Child tax credit 11 (24%) 14 (16%) 6 (9.8%) 1 (3.2%)

Add'l child tax
credit 7 (15%) 20 (23%) 10 (16%) 1 (3.2%)

Education credit 7 (15%) 7 (8.1%) N/A 0 (0%)

Casualty/theft
loss N/A N/A 17 (28%) 4 (13%)

Foreignearned N/A 10 (12%) 6 (9.8%) 0 (0%)
income exclusion
( §911)

Employee 8 (17%) 16 (17%) 7 (11%) 0 (0%)
business
expenses

Schedule E 13 (28%) 15 (17%) 4 (6.6%) N/A
expenses or
flow-through

Form 4797 loss 3 (6.5%) 5 (5.8%) 2 (3.2%) 0 (0%)




See Def. Exs. 23-26. 2

136. The losses shown by mistakes and errors on the sample of 149 returns establish that Defendants' actions caused losses to the United States Treasury.

137. Defendants' Exhibits 23-26, as summarized in the chart above, demonstrate that the instances of errors uncovered in the Government's investigation of the sample of 146 returns diminished as the investigation continued.

138. The timing of the decline in these problems coincided with Defendants' knowledge of the Government's investigation and ability to address and correct problems. See ¶¶ 38-42.

139. During the years at issue, NBC/NTS prepared approximately 4,800 returns each year.

140. NBC/NTS prepared over 4,600 tax returns for 2003. A total of 360 returns reported casualty loss claims (7.8% of total), 63 returns claimed the foreign earned income exclusion (1.4% of total), and only 148 returns were tax returns of truckers with Schedule C expenses and/or depreciation expenses (3.2% of total).

141. NBC/NTS prepared 4,960 tax returns for 2004. A total of 528 returns reported casualty loss claims (10.6% of total), 78 returns claimed the foreign earned income exclusion (1.6% of total), and only 144 returns were returns of truckers with Schedule C expenses and/or depreciation expenses (2.9% of total).

142. Following the 7 preparer penalties imposed for returns prepared in 1993 and 1994, Defendants have not filed any return claiming the fuel tax credit for a trucker.

143. During the entire period of this investigation, and indeed since 1998, no preparer penalty was ever assessed against Cruz.

144. As stated previously, no preparer penalty has ever been assessed against Real.




N. Comparison With National Facts


145. Testimony by IRS employees at trial established that a high percentage of tax returns audited nationwide result in additional taxes proposed.

146. Approximately 90% of audits conducted by Revenue Agents, Tax Examiners, and Tax Compliance Officers result in additional taxes being proposed.

147. The major areas resulting in additional taxes after audit include:


A) Depreciation;



B) Schedule C expenses;



C) Employee business expenses, including automobiles;



D) Casualty losses; and



E) Foreign-earned income exclusions.


148. The areas that result in additional taxes throughout the United States are the same areas that the Government has identified as areas of concern on Defendants' returns.

149. The rate of audits resulting in no change to the returns prepared by Defendants is consistent with the rate of audits resulting in no change to returns filed nationally.




O. Audit Representation


150. NBC and NTS provided audit representation services to their clients.

151. They have stopped accepting new engagements for representation before the IRS, but they continue to represent any previously engaged taxpayers.

152. During an audit, a taxpayer may choose to be represented by a Power of Attorney (hereinafter "POA"), sometimes called a "representative."

153. A taxpayer may appoint a POA by submitting IRS Form 2848 to the IRS. Once appointed, the POA can act on behalf of the taxpayer during the audit. The POA can speak directly with the IRS employee who is conducting the audit, and these conversations often occur outside the presence of the taxpayer. The auditor can discuss substantive matters with the POA, and the POA can address any issues or concerns that the auditor might raise throughout the course of the audit.

154. In contrast to appointing a POA, a taxpayer may also merely authorize the release of tax return information to a third party by submitting IRS Form 8821. Form 8821 authorizes the release of taxpayer information to the specific third party named therein. This Form does not appoint the named third party as a POA or authorize that person to act as such.

155. The IRS places restrictions on the people who may be appointed as a POA. This is with good reason, partly to ensure that the taxpayer receives competent representation during the course of the audit.

156. CPAs and attorneys are permitted to act as POAs before the IRS. Additionally, enrolled agents can also represent taxpayers in audits before the IRS.

157. In order to be an enrolled agent, one must demonstrate competence in tax matters by passing an IRS-administered exam and a background examination. An enrolled agent may be appointed as a POA in an audit regardless of whether that person actually prepared the tax return that is being audited.

158. An "unenrolled" preparer is one who is not specifically enrolled by the Internal Revenue Service. An unenrolled preparer may only be appointed as a POA in an audit where the unenrolled preparer prepared and signed the return that is being audited. Even where an unenrolled preparer has signed the return that is being audited, that person may not represent the taxpayer in the IRS appeals process.

159. As previously discussed, in 1998 the IRS barred Cruz from representing any taxpayers in audits before it. See supra ¶ 17; Gov. Ex. 46.

160. As Cruz is no longer permitted to represent clients before the IRS in audits, NBC and NTS provide these services through Defendant Real. No other employee of NBC or NTS is an enrolled agent.

161. Real is an unenrolled preparer because she has not passed the examination or background check to be enrolled.

162. Nevertheless, Real has submitted Form 2848 in cases where she is not qualified to be the POA because she did not prepare the return that is being audited. In other cases Real simply submitted a Form 8821.

163. In some cases when Real submitted a Form 8821, she would still accompany the taxpayer to meetings with the auditor. Although not permitted to do so, she would participate in substantive discussions with the auditor.

164. In other instances where only a Form 8821 was filed Real would attend meetings with the auditor outside the presence of the taxpayer.

165. While it is clear Real either did not understand the difference between Forms 2848 and 8821, or purposely misused them, the evidence established that IRS employees also failed to grasp the difference and proper procedure. See Def. Ex. 31 (email from Leavitt stating: "I have constantly seen both [Tax Compliance Officers] and [Revenue Agents] allowing Ruth Real to function as POA when she has only submitted Form 8821. I have tried to talk to various people individually to drive home the important distinction between Forms 2848 and 8821, but sometimes I feel like I'm hitting a brick wall.").

166. This failure on the part of the IRS to appreciate the difference between Forms 2848 and 8821 is also evidenced by the fact that it allowed Real, without penalty, to engage continuously in the very acts of improper representation of which it now complains.

167. Real was the legitimate third party designated by Form 8821 and was the legitimate unenrolled representative for a great many of Defendants' clients being audited by the IRS.

168. Real found it increasingly difficult to comply with all of the scheduling and document request demands placed on her by the volume of audits conducted by the Government.

169. In numerous instances, IRS employees failed to work reasonably with Real in the conduct of their audits. In one case Real was excluded from an audit meeting with an IRS employee even though she was permitted by IRS procedure to be present at the audit because the taxpayer filed Form 2848 and Real prepared the return.




P. Engagement Letter


170. NBC and NTS use an engagement letter with their clients. E.g., Gov. Ex. 87.

171. The testimony at trial established that identical letters were sent to each client for the purposes of obtaining their consent to Defendants' representation during audit and to receive information about the taxpayer from the IRS.

172. This letter expressly states that for a fee NTS will represent the taxpayer at audits with the IRS and "at the appellate level, if an appeal is necessary." Id.

173. The letter states that Form 8821 is attached, but misnames it "Authorization and Declaration of Representative."

174. Form 8821 is actually titled "Tax Information Authorization."

175. The letter is sent over Cruz's name, with a copy to "Ruth Real/Representative."

176. The letter is misleading to clients. First, no person at NBC or NTS is eligible to represent clients at audits where he or she did not prepare the return. Thus, in many instances Real cannot provide the services promised in the letter because she did not prepare the client's tax return. Second, Form 8821 discussed in the letter does not appoint a representative to an audit. In fact, Form 8821 never uses the term "representative."

177. If the taxpayer does not agree with the recommended change after the audit, he is free to take his case to a designated appeals officer at the IRS.

178. Unenrolled preparers, such as Real, are never permitted to represent a taxpayer in the appeals process, even if they themselves prepared the return that is at issue.

179. By virtue of his ineligibility, Cruz cannot represent taxpayers in appeals.

180. Thus, neither Cruz nor Real could provide the appellate service promised in the letter.

181. As for the actual representation letter admitted by the Government into evidence as its Exhibit 87, the audit conducted for the named taxpayers therein resulted in no change to the return. See Def. Ex. 25, p. 3.




Q. Remedial Measures


182. After the September of 2004 meeting with Leavitt, Cruz created NTS and immediately began to modify his manner of tax preparation.

183. NTS eventually implemented a new procedure that required the person inputting the taxpayer's data into the computer software to sign the return as the tax preparer. Thus, Cruz stopped signing returns he did not prepare.

184. NTS implemented a new procedure that required all return preparers to successfully complete the annual IRS course given on the internet prior to each tax season.

185. NTS began sending Cruz to an annual IRS-sponsored seminar for income tax preparation.

186. NTS implemented a new procedure requiring the taxpayer to initial an instruction letter and a summary of the deductions taken on the return. Def. Ex. 36.

187. NTS also required that each page of the tax return to be signed by the taxpayer.

188. These added procedures are not required by the Internal Revenue Code.

189. These added procedures are not common among tax return preparers.

190. Cruz initiated these policies to reduce erroneous items on returns prepared at NTS.

191. Clients of NBC and NTS are still not required to submit an organized and documented statement of all expenses qualifying for deduction or exclusion on the tax returns prior to their appointments, and no procedure is maintained for documenting what specific information the client provides.

192. It was and remains the responsibility of the taxpayer to maintain cancelled checks, receipts, and other documentation evidencing items listed on his tax return for purposes of supporting positions taken if challenged by the IRS.




III. Conclusions of Law


The United States brought this civil action under 26 U.S.C. §§7402(a), 7407 and 7408 to permanently enjoin Defendants from preparing or assisting in the preparation of tax returns and from engaging in conduct that interferes with the proper administration and enforcement of the internal revenue laws. Those statutes each provide an independent authorization for an injunction.

Under §7407, the Court may enjoin Defendants from engaging in certain prohibited conduct or from further acting as tax return preparers. Relevant to the instant action, the injunction may issue if the Court finds Defendants engaged in any of the following conduct: 1) any conduct subject to penalty under §§6694 or 6695; 2) misrepresenting their eligibility to practice before the IRS; or 3) engaging in any other fraudulent or deceptive conduct that substantially interferes with the proper administration of the internal revenue laws. 26 U.S.C. §7407(b)(1). The Government alleges that Defendants engaged in all of this conduct.

Section 6694 prohibits two different types of conduct. 3 First, it prohibits a tax return preparer from taking an unreasonable position on a tax return. A position is unreasonable if the preparer knew or should have known about it, there was not a reasonable belief that the position would more likely than not be sustained on the merits, and there was no reasonable basis for the position. Second, §6694 also prohibits a return preparer from making a willful attempt to understate a taxpayer's tax liability on the return or engaging in a reckless or intentional disregard of rules or regulations.

Section 6695(d), in relevant part, imposes a duty upon a tax return preparer to comply with §6107(b). Section 6107(b), in turn, requires a tax return preparer to retain a copy of each return prepared or maintain a list of the name and identification number of each taxpayer for inspection by the IRS.

As stated above, a person not a CPA or licensed attorney may represent clients at audits only if he prepared the tax return. He may not represent the taxpayer in any case on appeal, even if he prepared the return. Finally, a range of conduct may be considered fraudulent or deceptive and impeding of the proper enforcement of the internal revenue laws.

In order to grant relief enjoining the offending conduct, §7407 requires the Court to find that injunctive relief is appropriate to prevent the reoccurrence of the same. In order to issue an injunction under §7407 that totally bars Defendants from acting as tax return preparers, the Court must further find that Defendants continually or repeatedly engaged in such conduct and that an injunction limited to prohibiting such conduct would not be sufficient to prevent their interference with the proper administration fo the internal revenue laws. 26 U.S.C. §7407(b).

Under §7408, the Court may issue an injunction upon a finding that Defendants engaged in any "specified conduct" and that injunctive relief is appropriate to prevent reoccurrence of the same. The term "specified conduct" means, in relevant part, any action or failure to act that is subject to penalty under §6701. Section 6701 prohibits any person from aiding, assisting, or advising in the preparation of any portion of a return if he knows or has reason to believe that such portion will be used in connection with any material matter arising under the internal revenue laws and knows that such portion would result in an understatement of the taxpayer's tax liability. Upon a finding that a person has violated §6701 and that injunctive relief is appropriate, the Court may enjoin such conduct or enjoin any other activity subject to penalty by Title 26. 26 U.S.C. §7408(b).

Finally, under §7402(a), the Court has the power to issue any injunctions, writs, processes, judgments, or decrees as may be necessary or appropriate for the enforcement of the internal revenue laws.

The Government seeks only injunctive relief and thus invokes the Court's equitable power. The decision "whether to grant or deny injunctive relief rests with the equitable discretion of the district courts, and ... such discretion must be exercised consistent with traditional principles of equity." eBay Inc. v. MercExchange, L.L.C., 547 U.S. 388, 394 (2006). Consistent with traditional equitable principles, a permanent injunction is warranted when (1) there has been irreparable injury, (2) damages at law are inadequate, (3) a balance of the hardships weighs in favor of the injunction, and (4) the public interest would not be disserved by the permanent injunction. Angel Flight of Ga., Inc. v. Angel Flight of Am., Inc., 522 F.3d 1200, 1208 (11th Cir. Apr. 4, 2008) (citing eBay, Inc., 547 U.S. at 391). The scope of the injunction is likewise in the discretion of the Court. Id. (noting that both the decision to grant and the scope are reviewed for abuse of discretion).

Considering all these factors, the Court finds that an injunction is warranted. The evidence readily establishes that Defendants have been derelict in their duties as tax return preparers. The Court will touch upon each in turn.

Defendants' conduct calls for an injunction under §7407(b)(1)(A). This arises from their conduct subject to penalty under §6694(a) of preparing income tax returns based on fraudulent deductions and credits, which resulted in understatements of liability. The specifics of these improper positions taken on the returns are recounted in the Court's Findings of Fact, supra. Further, Defendants knew or reasonably should have known of the positions being taken in the returns that they prepared. 26 U.S.C. §6694(a). For example, Defendants should clearly know that it is impermissible to claim a deduction for a corporate officer's compensation on a corporate tax return but fail to include that income on the shareholder's personal tax return. Defendants should also know that vehicles should be properly depreciated as five year property instead of three year property. With respect to the §179 deductions, Defendants also prepared returns on behalf of trucking clients that claimed deductions for major overhauls to trucks in two subsequent years. Given that Defendants prepared the returns in both years, they knew or should have known that they were claiming an improper deduction on the second year's return. These and other positions taken are all in direct contravention of the Internal Revenue Code and applicable regulations, and they have no possibility of being sustained upon audit. Therefore, during the time period in question, Defendants prepared tax returns in violation of §6694, which subjects them to liability for injunctive relief under §7407(b)(1)(A).

Defendants are also subject to injunction under §7407(b)(1)(B) because they each have misrepresented their eligibility to practice before the IRS. Defendant Cruz has been barred from practice before the IRS since 1998. As a result, he is barred from participating in "all matters connected with a presentation to the Internal Revenue Service or any of its officers or employees relating to a taxpayer's rights, privileges, or liabilities under laws or regulations administered by the Internal Revenue Service." 31 C.F.R. §10.2(a)(5). This includes corresponding with the IRS and representing a client at conferences, hearings, and meetings. Id.

Although not barred from practice before the IRS, Defendant Real is not a "practitioner" with full rights to practice before the IRS. Id. §10.2(a)(5). Rather, Defendant Real is authorized only to conduct "limited practice" before the Internal Revenue Service pursuant to 31 C.F.R., Part 10.7(c)(1)(viii). Under that regulation, Real is authorized to represent taxpayers on whose behalf she prepared and signed a tax return, but only during an examination with respect to that tax return and only before revenue agents, customer service representatives or similar officers and employees of the I RS. 31 C.F.R. §10.7(c)(1)(viii). The authorization specifically "does not permit [Real] to represent the taxpayer, regardless of the circumstances requiring representation, before appeals officers, revenue officers, Counsel or similar officers or employees of the Internal Revenue Service or the Department of Treasury." Id.

Thus, Defendant Cruz is not authorized to conduct any representation of taxpayers before the Internal Revenue Service, and Defendant Real is authorized only to represent taxpayers on whose behalf she prepared a return, but not in any appeals or other proceedings. Despite these clear and precise restrictions, on numerous occasions, Defendants have both misrepresented to taxpayer clients their authority to represent those taxpayer clients before the Internal Revenue Service. See supra, ¶¶ 150-180. Thus, Defendants Cruz and Real each misrepresented their eligibility to practice before the IRS, which subjects them to liability for injunctive relief under 26 U.S.C. §7407(b)(1)(B).

The same conduct subjects Defendants to an injunction under §7408 because they have engaged in conduct subject to penalty under §6701. All of the tax returns in question were prepared with the aid, assistance, or advice of Defendants. Also, Defendants plainly knew or had reason to believe that the returns would be used in connection with material matters arising under the internal revenue laws, inasmuch as they were preparing the returns for filing with the IRS. Finally, Defendants also knew that those returns containing errors would result in an understatement of tax liability. 26 U.S.C. §6701(a). Thus, Defendants have engaged in conduct subject to penalty under § 6701, which renders them subject to injunction under 26 U.S.C. §7408.

Based on all of the foregoing, the Court is compelled also to exercise its power under §7402 to issue such ruling as is necessary or appropriate for the enforcement of the internal revenue laws. 26 U.S.C. §7402(a). A stable treasury being necessary to the security of this Nation, Defendants' previous conduct requires redressing.

Notwithstanding the need for injunctive relief, the Court is unwilling to go as far as the Government seeks. The Government argues that the average tax loss calculated from the sample of 149 tax returns audited can be extrapolated to the entire population of tax returns prepared by Defendants each year. However, such extrapolation is not a fair inference to be drawn from the evidence introduced at trial. A majority of the returns prepared by Defendants do not contain any of the items for which errors were found in the 149 returns audited. For example, it would not be appropriate to extrapolate the average loss found on the 46 returns audited for 2003 to all 4,600 returns prepared by NBC/NTS for that year when the losses were generated by a deduction or credit that over 90% of the returns did not have. See supra ¶ 140. For the same reason, it would not be appropriate to extrapolate a loss to all 4,960 returns prepared by NBC/NTS for 2004 when the proposed loss was generated by a deduction or credit that over 88% of those returns did not have. See supra, ¶ 141.

In addition, the Government seeks to hold Defendants liable for certain items on tax returns ultimately denied at audit simply because the taxpayer could not provide adequate documentation to substantiate the position. This is improper. The conduct alleged as supporting the injunction sought by the Government requires that Defendants act unreasonably; that is, they must have no reasonable belief that the position on the tax return would be more likely than not sustained on the merits, and there was no reasonable basis for the position. 26 U.S.C. §6694. There is no per se liability for a tax return preparer whose client is found to have errors on the return when the figures appear reasonable on their face. It was and remains the responsibility of taxpayer to support deductions with documentation if questioned by the IRS.

No pattern of fraudulent or deceptive conduct was established such that all returns prepared by Defendants, or even a great majority of them, can be said to suffer from the same errors as found in the sample of 149 returns. The facts demonstrate that Defendants caused losses to the United States Treasury. It can be fairly inferred that some of Defendants' returns not audited have the same errors on them as those in the sample of 149 returns. Thus, it can be fairly inferred that the loss to the Untied States Treasury is greater than the sample of 149 returns demonstrates. However, the Government's allegation that the United States Treasury lost an estimated $55 million due to Defendants' actions for tax years 2003 and 2004 alone, see Complaint, DE 1, ¶ 21, is wholly unsupported by the evidence or permissible inferences drawn therefrom. The evidence in the record establishes that Defendants have peppered their returns with numerous mistakes resulting in losses to the United States Treasury. It does not support the allegation that Defendants are engaged in an ongoing pattern of fraudulent conduct.

Further, the evidence does not support the allegation that Defendants have been undeterred by the preparer penalties asserted in the past or by this investigation. Rather, the evidence clearly establishes that previously penalized positions taken by Cruz did not resurface in the investigation made for the instant action. Moreover, after learning what areas had recurring problems, Defendants worked to seriously reduce the number of errors made on tax returns, as reflected in the rate of errors for the 149 sample returns. See supra, ¶ 135.

Thus, an injunction is warranted under all three statutes invoked by the Government. 26 U.S.C. §§7407, 7408, & 7402. What remains is consideration of the scope of the injunction. The Court turns to the factors recited in Angel Flight, 522 F.3d at 1208.

First, the United States has suffered irreparable harm, and it is likely that it will continue to suffer irreparable harm in the absence of an injunction. Defendants have engaged in numerous instances of conduct that violate provisions of the tax code over a period of many years resulting in losses to the United States Treasury. The Government cannot be expected to audit every tax return filed. Thus, there is no way to recover a portion of the losses caused by errors on Defendants' returns. Second, the Government has no adequate remedy at law. No Party has demonstrated what legal relief is available to the Government. To prevent future reoccurrence of the problems highlighted above, injunctive relief is warranted.

Third, a balance of the hardships weighs clearly in favor of an injunction. The Government proved that Defendants intentionally caused losses to the United States Treasury by their misstatements on tax returns. While human error is always to be expected, the internal revenue laws operate as strict rules that tax return preparers are expected to abide by. Finally, the public interest will clearly be served by an injunction. To the extent that an injunction aids in the reduction in the filing of erroneous returns that cause loss to the United States Treasury --and therefore, to all taxpayers --the public is served by granting injunctive relief. Thus, to improve the status quo, an injunction is clearly warranted. However, the question remains as to the scope of the injunction to be granted.

Defendants have clearly made a good faith effort toward eliminating the kinds of errors, and hopefully all errors, recounted in this Order. The rate of errors uncovered by the Government's audit of the 149 returns diminished year by year, many of them precipitously. See supra, ¶ 135. Defendants have adopted new practices aimed to ensure the taxpayer is informed of the contents of the return and to prevent unintended errors. See supra, ¶¶ 182-187. In addition, a number of the errors found on the tax returns audited can be explained as simple human error. While this does not immunize the need to recoup this loss in revenue, it lessens the culpability of Defendants. Even the IRS makes mistakes sometimes. See, e.g., Def. Ex. 24, p. 1, and Def. Ex. 25, p. 1 (both prepared by the Government and both listing an item in the wrong column). Human error abounds.

Relevant to the fourth factor noted above, the public is served by having tax return preparation businesses in business. It is a rare breed that can competently navigate the intricacies of the Internal Revenue Code. Thus, the public is benefitted by having tax preparation services both available and affordable. When injunctive relief is available that can balance both the public need for tax preparation services and the need for accurate tax filings, it will be preferred over a total ban on tax preparation.

In addition, the Government's own conduct weighs against it as to the scope of the injunction to be imposed. The IRS has refrained for years before instituting any action against Defendants or imposing penalties for the errors and unreasonable positions of which they were undoubtedly aware. If the IRS was so wronged by Defendants' actions, why did it wait for the damages to be aggravated over a number of years? While the Government is not required to seek penalties and relief on a graduated basis --in other words, the statutes noted above plainly allow a firstinstance permanent injunction from tax return preparation --the Court must remember that it is exercising its equitable power. The Court will not levy the business death penalty on these facts. Because of the delay in enforcement by the IRS, coupled with Defendants' impressive effort to redress the wrongs uncovered, the balance of the hardships weighs against a permanent bar from the preparation of tax returns.

A first-instance injunction against prohibited conduct will be effective to prevent this conduct by these Defendants in the future. See United States v. Gleason, 432 F.3d 678, 681 (6th Cir. 2005) (affirming the district court's denial of a permanent bar from preparing taxes based on the fact that tax preparation was the defendant's primary business and livelihood and should thus not be taken lightly). Should Defendants engage in the conduct enjoined by the Court, not only will they be in violation of the law, they will be in violation of this Court's Order. Different facts will surely make for a different outcome.

Accordingly, after due consideration, it is

ORDERED AND ADJUDGED as follows:

1. The Court has jurisdiction of the Parties hereto and the subject matter herein;

2. The Court finds in favor of the Government and against Defendants; and

3. Final Judgment will be entered by separate order.

DONE AND ORDERED.

1 "Total positive income" is defined by the IRS as "the sum of all positive amounts shown for the various sources of income reported on the individual income tax return and, thus, excludes net losses." Def. Ex. 27, p. 2, ¶ 10.

2 Items marked "N/A" do not appear on the Exhibit noted.

3 All references to §6694 herein are to the version predating that which took effect October 3, 2008.

Joint Committee text of Tax Recovery Act of 2009

JCT-DOC, JCX- 10-09, Joint Committee on Taxation Description of the American Recovery and Reinvestment Tax Act of 2009

January 26, 2009

111th Congress
DESCRIPTION OF THE AMERICAN RECOVERY AND REINVESTMENT TAX ACT OF 2009


Scheduled for Markup by the SENATE COMMITTEE ON FINANCE on January 27, 2009

Prepared by the Staff of the JOINT COMMITTEE ON TAXATION

January 23, 2009

JCX-10-09


CONTENTS


INTRODUCTION
I. TAX RELIEF FOR INDIVIDUALS AND FAMILIES

1. Making work pay credit

2. Temporary increase in the earned income tax credit

3. Temporary increase of refundable portion of the child credit

4. American opportunity tax credit

5. Temporarily allow computer technology and equipment as a qualified higher education expense for qualified tuition programs

6. Waiver of requirement to repay first-time homebuyer credit

7. Exclusion from gross income for unemployment compensation benefits

II. RENEWABLE ENERGY INCENTIVES

1. Extension of the renewable electricity credit

2. Election of investment credit in lieu of production tax credits

3. Modification of energy credit

4. Expand new clean renewable energy bonds

5. Expand qualified energy conservation bonds

6. Extension and modification of credit for nonbusiness energy property

7. Credit for residential energy efficient property

8. Temporary increase in credit for alternative fuel vehicle refueling property

9. Energy research credit

10. Five-year carryback of general business credit

11. Temporary provision allowing general business credits to offset 100 percent of Federal income tax liability

III. TAX INCENTIVES FOR BUSINESS

1. Special allowance for certain property acquired during 2009

2. Temporary increase in limitations on expensing of certain depreciable business assets

3. Five-year carryback of operating losses

4. Modification of work opportunity tax credit

5. Extension of election to accelerate AMT and research credits in lieu of bonus depreciation

6. Deferral of certain income from the discharge of indebtedness

7. Qualified small business stock

IV. MANUFACTURING RECOVERY PROVISIONS

1. Expand industrial development bonds to include creation of intangible property and other modifications

2. Credit for investment in advanced energy property

V. ECONOMIC RECOVERY TOOLS

1. Recovery Zone Bonds

2. Tribal Economic Development Bonds

3. Extend and modify the new markets tax credit

VI. INFRASTRUCTURE FINANCING TOOLS

1. De minimis safe harbor exception for tax-exempt interest expense of financial institutions and modification of small issuer exception to tax-exempt interest expense allocation rules for financial institutions

2. Repeal of alternative minimum tax limitations on tax exempt bonds issued in 2009 and 2010

3. One-year delay of withholding on government contractors

4. Qualified school construction bonds

5. Extend and expand qualified zone academy bonds

6. Build America Bonds

VII. DESCRIPTION OF NONTAX ITEMS

1. Prohibition on collection of certain payments

2. Extension of trade adjustment assistance programs

3. Economic recovery payments to recipients of Social Security, supplement security income, railroad retirement, and Veterans disability benefits

4. Increase in the statutory limit on the public debt


INTRODUCTION


The Senate Committee on Finance has scheduled a markup of the American Recovery and Reinvestment Tax Act of 2009. This document, 1 prepared by the staff of the Joint Committee on Taxation, provides a description of the Chairman's Mark.


I. TAX RELIEF FOR INDIVIDUALS AND FAMILIES




1. Making work pay credit


Present Law




Earned income tax credit

Low- and moderate-income workers may be eligible for the refundable earned income tax credit ("EITC"). Eligibility for the EITC is based on earned income, adjusted gross income, investment income, filing status, and immigration and work status in the United States. The amount of the EITC is based on the presence and number of qualifying children in the worker's family, as well as on adjusted gross income and earned income.

The EITC generally equals a specified percentage of earned income 2 up to a maximum dollar amount. The maximum amount applies over a certain income range and then diminishes to zero over a specified phaseout range. For taxpayers with earned income (or adjusted gross income (AGI), if greater) in excess of the beginning of the phaseout range, the maximum EITC amount is reduced by the phaseout rate multiplied by the amount of earned income (or AGI, if greater) in excess of the beginning of the phaseout range. For taxpayers with earned income (or AGI, if greater) in excess of the end of the phaseout range, no credit is allowed.

The EITC is a refundable credit, meaning that if the amount of the credit exceeds the taxpayer's Federal income tax liability, the excess is payable to the taxpayer as a direct transfer payment. Under an advance payment system, eligible taxpayers may elect to receive the credit in their paychecks, rather than waiting to claim a refund on their tax return filed by April 15 of the following year.



Child credit

An individual may claim a tax credit for each qualifying child under the age of 17. The amount of the credit per child is $1,000 through 2010, and $500 thereafter. A child who is not a citizen, national, or resident of the United States cannot be a qualifying child.

The credit is phased out for individuals with income over certain threshold amounts. Specifically, the otherwise allowable child tax credit is reduced by $50 for each $1,000 (or fraction thereof) of modified adjusted gross income over $75,000 for single individuals or heads of households, $110,000 for married individuals filing joint returns, and $55,000 for married individuals filing separate returns. For purposes of this limitation, modified adjusted gross income includes certain otherwise excludable income earned by U.S. citizens or residents living abroad or in certain U.S. territories.

The credit is allowable against the regular tax and the alternative minimum tax. To the extent the child credit exceeds the taxpayer's tax liability, the taxpayer is eligible for a refundable credit (the additional child tax credit) equal to 15 percent of earned income in excess of a threshold dollar amount (the "earned income" formula). The threshold dollar amount is $12,550 (for 2009), and is indexed for inflation.

Families with three or more children may determine the additional child tax credit using the "alternative formula," if this results in a larger credit than determined under the earned income formula. Under the alternative formula, the additional child tax credit equals the amount by which the taxpayer's social security taxes exceed the taxpayer's earned income tax credit.

Earned income is defined as the sum of wages, salaries, tips, and other taxable employee compensation plus net self-employment earnings. Unlike the EITC, which also includes the preceding items in its definition of earned income, the additional child tax credit is based only on earned income to the extent it is included in computing taxable income. For example, some ministers' parsonage allowances are considered self-employment income, and thus are considered earned income for purposes of computing the EITC, but the allowances are excluded from gross income for individual income tax purposes, and thus are not considered earned income for purposes of the additional child tax credit since the income is not included in taxable income.


Description of Proposal




In general

The proposal provides eligible individuals a refundable income tax credit for two years (taxable years beginning in 2009 and 2010).

The credit is the lesser of (1) 6.2 percent of an individual's earned income or (2) $500 ($1,000 in the case of a joint return). For these purposes, the earned income definition is the same as for the earned income tax credit with two modifications. First, earned income for these purposes does not include net earnings from self-employment which are not taken into account in computing taxable income. Second, earned income for these purposes includes combat pay excluded from gross income under section 112. 3

The credit is phased out at a rate of four percent of the eligible individual's modified adjusted gross income above $75,000 ($150,000 in the case of a joint return). For these purposes an eligible individual's modified adjusted gross income is the eligible individual's adjusted gross income increased by any amount excluded from gross income under sections 911, 931, or 933. An eligible individual means any individual other than: (1) a nonresident alien; (2) an individual with respect to whom another individual may claim a dependency deduction for a taxable year beginning in a calendar year in which the eligible individual's taxable year begins; and (3) an estate or trust.

The otherwise allowable credit allowed under the proposal shall be reduced by the amount of any payment received by the taxpayer pursuant to the proposals of the bill providing special payments under the Department of Veterans' Affairs Administration and the Social Security Administration.



Treatment of the U.S. possessions



Mirror code possessions 4

The U.S. Treasury will make two payments (for 2009 and 2010, respectively) to each mirror code possession in an amount equal to the aggregate amount of the credits allowable by reason of the proposal to that possession's residents against its income tax. This amount will be determined by the Treasury Secretary based on information provided by the government of the respective possession. For purposes of this payment, a possession is a mirror code possession if the income tax liability of residents of the possession under that possession's income tax system is determined by reference to the U.S. income tax laws as if the possession were the United States.



Non-mirror code possessions 5

To each possession that does not have a mirror code tax system, the U.S. Treasury will make two payments (for 2009 and 2010, respectively) in an amount estimated by the Secretary as being equal to the aggregate credits that would have been allowed to residents of that possession if a mirror code tax system had been in effect in that possession. Accordingly, the amount of each payment to a non-mirror Code possession will be an estimate of the aggregate amount of the credits that would be allowed to the possession's residents if the credit provided by the proposal to U.S. residents were provided by the possession to its residents. This payment will not be made to any U.S. possession unless that possession has a plan that has been approved by the Secretary under which the possession will promptly distribute the payment to its residents.



General rules

No credit against U.S. income taxes is permitted under the proposal for any person to whom a credit is allowed against possession income taxes as a result of the proposal (for example, under that possession's mirror income tax). Similarly, no credit against U.S. income taxes is permitted for any person who is eligible for a payment under a non-mirror code possession's plan for distributing to its residents the payment described above from the U.S. Treasury.

For purposes of the payments to the possessions, the Commonwealth of Puerto Rico and the Commonwealth of the Northern Mariana Islands are considered possessions of the United States.

For purposes of the rule permitting the Treasury Secretary to disburse appropriated amounts for refunds due from certain credit proposals of the Internal Revenue Code of 1986, the payments required to be made to possessions under the proposal are treated in the same manner as a refund due from the credit allowed under the proposal.



Federal programs or Federally-assisted programs

Any credit or refund allowed or made to an individual under this proposal (including to any resident of a U.S. possession) is not taken into account as income and shall not be taken into account as resources for the month of receipt and the following two months for purposes of determining eligibility of such individual or any other individual for benefits or assistance, or the amount or extent of benefits or assistance, under any Federal program or under any State or local program financed in whole or in part with Federal funds.



Income tax withholding

It is anticipated that taxpayers' reduced tax liability under the proposal shall be expeditiously implemented through revised income tax withholding schedules produced by the Internal Revenue Service. These revised income tax withholding schedules should be designed to reduce taxpayers' income tax withheld for each remaining pay period in the remainder of 2009 so that the full benefit of the proposal is reflected in the income tax withholding schedules during the balance of 2009.


Effective Date


The proposal applies to taxable years beginning after December 31, 2008.



2. Temporary increase in the earned income tax credit


Present Law




Overview

Low- and moderate-income workers may be eligible for the refundable earned income tax credit (EITC). Eligibility for the EITC is based on earned income, adjusted gross income, investment income, filing status, and immigration and work status in the United States. The amount of the EITC is based on the presence and number of qualifying children in the worker's family, as well as on adjusted gross income and earned income.

The EITC generally equals a specified percentage of earned income 6 up to a maximum dollar amount. The maximum amount applies over a certain income range and then diminishes to zero over a specified phaseout range. For taxpayers with earned income (or adjusted gross income (AGI), if greater) in excess of the beginning of the phaseout range, the maximum EITC amount is reduced by the phaseout rate multiplied by the amount of earned income (or AGI, if greater) in excess of the beginning of the phaseout range. For taxpayers with earned income (or AGI, if greater) in excess of the end of the phaseout range, no credit is allowed.

An individual is not eligible for the EITC if the aggregate amount of disqualified income of the taxpayer for the taxable year exceeds $3,100 (for 2009). This threshold is indexed for inflation. Disqualified income is the sum of: (1) interest (taxable and tax exempt); (2) dividends; (3) net rent and royalty income (if greater than zero); (4) capital gains net income; and (5) net passive income (if greater than zero) that is not self-employment income.

The EITC is a refundable credit, meaning that if the amount of the credit exceeds the taxpayer's Federal income tax liability, the excess is payable to the taxpayer as a direct transfer payment. Under an advance payment system, eligible taxpayers may elect to receive the credit in their paychecks, rather than waiting to claim a refund on their tax return filed by April 15 of the following year.



Filing status

An unmarried individual may claim the EITC if he or she files as a single filer or as a head of household. Married individuals generally may not claim the EITC unless they file jointly. An exception to the joint return filing requirement applies to certain spouses who are separated. Under this exception, a married taxpayer who is separated from his or her spouse for the last six months of the taxable year shall not be considered as married (and, accordingly, may file a return as head of household and claim the EITC), provided that the taxpayer maintains a household that constitutes the principal place of abode for a dependent child (including a son, stepson, daughter, stepdaughter, adopted child, or a foster child) for over half the taxable year, 7 and pays over half the cost of maintaining the household in which he or she resides with the child during the year.



Presence of qualifying children and amount of the earned income credit

Three separate credit schedules apply: one schedule for taxpayers with no qualifying children, one schedule for taxpayers with one qualifying child, and one schedule for taxpayers with more than one qualifying child. 8

Taxpayers with no qualifying children may claim a credit if they are over age 24 and below age 65. The credit is 7.65 percent of earnings up to $5,970, resulting in a maximum credit of $457, for 2009. The maximum is available for those with incomes between $5,970 and $7,470 ($10,590 if married filing jointly). The credit begins to phase down at a rate of 7.65 percent of earnings above $7,470 ($10,590 if married filing jointly) resulting in a $0 credit at $13,440 of earnings ($16,560 if married filing jointly).

Taxpayers with one qualifying child may claim a credit in 2009 of 34 percent of their earnings up to $8,950, resulting in a maximum credit of $3,043. The maximum credit is available for those with earnings between $8,950 and $16,420 ($19,540 if married filing jointly). The credit begins to phase down at a rate of 15.98 percent of earnings above $16,420 ($19,540 if married filing jointly). The credit is phased down to $0 at $35,463 of earnings ($38,583 if married filing jointly).

Taxpayers with more than one qualifying child may claim a credit in 2009 of 40 percent of earnings up to $12,570, resulting in a maximum credit of $5,028. The maximum credit is available for those with earnings between $12,570 and $16,420 ($19,540 if married filing jointly). The credit begins to phase down at a rate of 21.06 percent of earnings above $16,420 ($19,540 if married filing jointly). The credit is phased down to $0 at $40,295 of earnings ($43,415 if married filing jointly).

If more than one taxpayer lives with a qualifying child, only one of these taxpayers may claim the child for purposes of the EITC. If multiple eligible taxpayers actually claim the same qualifying child, then a tiebreaker rule determines which taxpayer is entitled to the EITC with respect to the qualifying child. Any eligible taxpayer with at least one qualifying child who does not claim the EITC with respect to qualifying children due to failure to meet certain identification requirements with respect to such children (i.e., providing the name, age and taxpayer identification number of each of such children) may not claim the EITC for taxpayers without qualifying children.


Description of Proposal




Three or more qualifying children

The proposal increases the EITC credit percentage for three or more qualifying children to 45 percent for 2009 and 2010. For example, taxpayers with three or more qualifying children may claim a credit in 2009 of 45 percent of earnings up to $12,570, 9 resulting in a maximum credit of $5,656.50.



Provide additional marriage penalty relief through higher threshold phase-out amounts for married couples filing joint returns

The proposal increases the threshold phase-out amounts for married couples filing joint returns to $5,000 10 above the threshold phase-out amounts for singles, surviving spouses, and heads of households) for 2009 and 2010. For example, in 2009 the maximum credit of $3,043 for one qualifying child is available for those with earnings between $8,950 and $16,420 ($21,420 if married filing jointly). The credit begins to phase down at a rate of 15.98 percent of earnings above $16,420 ($21,420 if married filing jointly). The credit is phased down to $0 at $35,463 of earnings ($40,463 if married filing jointly).


Effective Date


The proposal is effective for taxable years beginning after December 31, 2008.



3. Temporary increase of refundable portion of the child credit


Present Law


An individual may claim a tax credit for each qualifying child under the age of 17. The amount of the credit per child is $1,000 through 2010, and $500 thereafter. A child who is not a citizen, national, or resident of the United States cannot be a qualifying child.

The credit is phased out for individuals with income over certain threshold amounts. Specifically, the otherwise allowable child tax credit is reduced by $50 for each $1,000 (or fraction thereof) of modified adjusted gross income over $75,000 for single individuals or heads of households, $110,000 for married individuals filing joint returns, and $55,000 for married individuals filing separate returns. For purposes of this limitation, modified adjusted gross income includes certain otherwise excludable income earned by U.S. citizens or residents living abroad or in certain U.S. territories.

The credit is allowable against the regular tax and the alternative minimum tax. To the extent the child credit exceeds the taxpayer's tax liability, the taxpayer is eligible for a refundable credit (the additional child tax credit) equal to 15 percent of earned income in excess of a threshold dollar amount (the "earned income" formula). The threshold dollar amount is $12,550 (for 2009), and is indexed for inflation.

Families with three or more children may determine the additional child tax credit using the "alternative formula," if this results in a larger credit than determined under the earned income formula. Under the alternative formula, the additional child tax credit equals the amount by which the taxpayer's social security taxes exceed the taxpayer's earned income tax credit ("EITC").

Earned income is defined as the sum of wages, salaries, tips, and other taxable employee compensation plus net self-employment earnings. Unlike the EITC, which also includes the preceding items in its definition of earned income, the additional child tax credit is based only on earned income to the extent it is included in computing taxable income. For example, some ministers' parsonage allowances are considered self-employment income, and thus are considered earned income for purposes of computing the EITC, but the allowances are excluded from gross income for individual income tax purposes, and thus are not considered earned income for purposes of the additional child tax credit since the income is not included in taxable income.

Any credit or refund allowed or made to an individual under this proposal (including to any resident of a U.S. possession) is not taken into account as income and shall not be taken into account as resources for the month of receipt and the following two months for purposes of determining eligibility of such individual or any other individual for benefits or assistance, or the amount or extent of benefits or assistance, under any Federal program or under any State or local program financed in whole or in part with Federal funds.


Description of Proposal


The proposal modifies the earned income formula for the determination of the refundable child credit to apply to 15 percent of earned income in excess of $6,000 for taxable years beginning in 2009 and 2010.


Effective Date


The proposal is effective for taxable years beginning after December 31, 2008.



4. American opportunity tax credit


Present Law


Individual taxpayers are allowed to claim a nonrefundable credit, the Hope credit, against Federal income taxes of up to $1,800 (for 2009) per eligible student per year for qualified tuition and related expenses paid for the first two years of the student's post-secondary education in a degree or certificate program. 11 The Hope credit rate is 100 percent on the first $1,200 of qualified tuition and related expenses, and 50 percent on the next $1,200 of qualified tuition and related expenses; these dollar amounts are indexed for inflation, with the amount rounded down to the next lowest multiple of $100. Thus, for example, a taxpayer who incurs $1,200 of qualified tuition and related expenses for an eligible student is eligible (subject to the adjusted gross income phaseout described below) for a $1,200 Hope credit. If a taxpayer incurs $2,400 of qualified tuition and related expenses for an eligible student, then he or she is eligible for a $1,800 Hope credit.

The Hope credit that a taxpayer may otherwise claim is phased out ratably for taxpayers with modified adjusted gross income between $50,000 and $60,000 ($100,000 and $120,000 for married taxpayers filing a joint return) for 2009. The adjusted gross income phaseout ranges are indexed for inflation, with the amount rounded down to the next lowest multiple of $1,000.

The qualified tuition and related expenses must be incurred on behalf of the taxpayer, the taxpayer's spouse, or a dependent of the taxpayer. The Hope credit is available with respect to an individual student for two taxable years, provided that the student has not completed the first two years of post-secondary education before the beginning of the second taxable year.

The Hope credit is available in the taxable year the expenses are paid, subject to the requirement that the education is furnished to the student during that year or during an academic period beginning during the first three months of the next taxable year. Qualified tuition and related expenses paid with the proceeds of a loan generally are eligible for the Hope credit. The repayment of a loan itself is not a qualified tuition or related expense.

A taxpayer may claim the Hope credit with respect to an eligible student who is not the taxpayer or the taxpayer's spouse (e.g., in cases in which the student is the taxpayer's child) only if the taxpayer claims the student as a dependent for the taxable year for which the credit is claimed. If a student is claimed as a dependent, the student is not entitled to claim a Hope credit for that taxable year on the student's own tax return. If a parent (or other taxpayer) claims a student as a dependent, any qualified tuition and related expenses paid by the student are treated as paid by the parent (or other taxpayer) for purposes of determining the amount of qualified tuition and related expenses paid by such parent (or other taxpayer) under the proposal. In addition, for each taxable year, a taxpayer may elect either the Hope credit, the Lifetime Learning credit, or an above-the-line deduction for qualified tuition and related expenses with respect to an eligible student.

The Hope credit is available for "qualified tuition and related expenses," which include tuition and fees (excluding nonacademic fees) required to be paid to an eligible educational institution as a condition of enrollment or attendance of an eligible student at the institution. Charges and fees associated with meals, lodging, insurance, transportation, and similar personal, living, or family expenses are not eligible for the credit. The expenses of education involving sports, games, or hobbies are not qualified tuition and related expenses unless this education is part of the student's degree program.

Qualified tuition and related expenses generally include only out-of-pocket expenses. Qualified tuition and related expenses do not include expenses covered by employer-provided educational assistance and scholarships that are not required to be included in the gross income of either the student or the taxpayer claiming the credit. Thus, total qualified tuition and related expenses are reduced by any scholarship or fellowship grants excludable from gross income under section 117 and any other tax-free educational benefits received by the student (or the taxpayer claiming the credit) during the taxable year. The Hope credit is not allowed with respect to any education expense for which a deduction is claimed under section 162 or any other section of the Code.

An eligible student for purposes of the Hope credit is an individual who is enrolled in a degree, certificate, or other program (including a program of study abroad approved for credit by the institution at which such student is enrolled) leading to a recognized educational credential at an eligible educational institution. The student must pursue a course of study on at least a halftime basis. A student is considered to pursue a course of study on at least a half-time basis if the student carries at least one half the normal full-time work load for the course of study the student is pursuing for at least one academic period that begins during the taxable year. To be eligible for the Hope credit, a student must not have been convicted of a Federal or State felony consisting of the possession or distribution of a controlled substance.

Eligible educational institutions generally are accredited post-secondary educational institutions offering credit toward a bachelor's degree, an associate's degree, or another recognized post-secondary credential. Certain proprietary institutions and post-secondary vocational institutions also are eligible educational institutions. To qualify as an eligible educational institution, an institution must be eligible to participate in Department of Education student aid programs.

Effective for taxable years beginning after December 31, 2010, the changes to the Hope credit made by the Economic Growth and Tax Relief Reconciliation Act of 2001 ("EGTRRA") no longer apply. The principal EGTRRA change scheduled to expire is the change that permitted a taxpayer to claim a Hope credit in the same year that he or she claimed an exclusion from a Coverdell education savings account. Thus, after 2010, a taxpayer cannot claim a Hope credit in the same year he or she claims an exclusion from a Coverdell education savings account.


Description of Proposal


The proposal modifies the Hope credit for taxable years beginning in 2009 or 2010. The modified credit is referred to as the American opportunity tax credit. The allowable modified credit is up to $2,500 per eligible student per year for qualified tuition and related expenses paid for each of the first four years of the student's post-secondary education in a degree or certificate program. The modified credit rate is 100 percent on the first $2,000 of qualified tuition and related expenses, and 25 percent on the next $2,000 of qualified tuition and related expenses. For purposes of the modified credit, the definition of qualified tuition and related expenses is expanded to include course materials.

Under the proposal, the modified credit is available with respect to an individual student for four years, provided that the student has not completed the first four years of post-secondary education before the beginning of the fourth taxable year. Thus, the modified credit, in addition to other modifications, extends the application of the Hope credit to two more years of postsecondary education.

The modified credit that a taxpayer may otherwise claim is phased out ratably for taxpayers with modified adjusted gross income between $80,000 and $90,000 ($160,000 and $180,000 for married taxpayers filing a joint return). The modified credit may be claimed against a taxpayer's alternative minimum tax liability.

Thirty percent of a taxpayer's otherwise allowable modified credit is refundable. However, no portion of the modified credit is refundable if the taxpayer claiming the credit is a child to whom section 1(g) applies for such taxable year (generally, any child under age 18 or any child under age 24 who is a student providing less than one-half of his or her own support, who has at least one living parent and does not file a joint return).

In addition, the proposal requires the Secretary of the Treasury to conduct two studies and submit a report to Congress on the results of those studies within one year after the date of enactment. The first study shall examine how to coordinate the Hope and Lifetime Learning credits with the Pell grant program. The second study shall examine requiring students to perform community service as a condition of taking their tuition and related expenses into account for purposes of the Hope and Lifetime Learning credits.


Effective Date


The proposal is effective with respect to taxable years beginning after December 31, 2008.



5. Temporarily allow computer technology and equipment as a qualified higher education expense for qualified tuition programs


Present Law


Section 529 provides specified income tax and transfer tax rules for the treatment of accounts and contracts established under qualified tuition programs. 12 A qualified tuition program is a program established and maintained by a State or agency or instrumentality thereof, or by one or more eligible educational institutions, which satisfies certain requirements and under which a person may purchase tuition credits or certificates on behalf of a designated beneficiary that entitle the beneficiary to the waiver or payment of qualified higher education expenses of the beneficiary (a "prepaid tuition program"). In the case of a program established and maintained by a State or agency or instrumentality thereof, a qualified tuition program also includes a program under which a person may make contributions to an account that is established for the purpose of satisfying the qualified higher education expenses of the designated beneficiary of the account, provided it satisfies certain specified requirements (a "savings account program"). Under both types of qualified tuition programs, a contributor establishes an account for the benefit of a particular designated beneficiary to provide for that beneficiary's higher education expenses.

For this purpose, qualified higher education expenses means tuition, fees, books, supplies, and equipment required for the enrollment or attendance of a designated beneficiary at an eligible educational institution, and expenses for special needs services in the case of a special needs beneficiary that are incurred in connection with such enrollment or attendance. Qualified higher education expenses generally also include room and board for students who are enrolled at least half-time.

Contributions to a qualified tuition program must be made in cash. Section 529 does not impose a specific dollar limit on the amount of contributions, account balances, or prepaid tuition benefits relating to a qualified tuition account; however, the program is required to have adequate safeguards to prevent contributions in excess of amounts necessary to provide for the beneficiary's qualified higher education expenses. Contributions generally are treated as a completed gift eligible for the gift tax annual exclusion. Contributions are not tax deductible for Federal income tax purposes, although they may be deductible for State income tax purposes. Amounts in the account accumulate on a tax-free basis (i.e., income on accounts in the plan is not subject to current income tax).

Distributions from a qualified tuition program are excludable from the distributee's gross income to the extent that the total distribution does not exceed the qualified higher education expenses incurred for the beneficiary. If a distribution from a qualified tuition program exceeds the qualified higher education expenses incurred for the beneficiary, the portion of the excess that is treated as earnings generally is subject to income tax and an additional 10-percent tax. Amounts in a qualified tuition program may be rolled over to another qualified tuition program for the same beneficiary or for a member of the family of that beneficiary.

In general, prepaid tuition contracts and tuition savings accounts established under a qualified tuition program involve prepayments or contributions made by one or more individuals for the benefit of a designated beneficiary, with decisions with respect to the contract or account to be made by an individual who is not the designated beneficiary. Qualified tuition accounts or contracts generally require the designation of a person (generally referred to as an "account owner") whom the program administrator (oftentimes a third party administrator retained by the State or by the educational institution that established the program) may look to for decisions, recordkeeping, and reporting with respect to the account established for a designated beneficiary. The person or persons who make the contributions to the account need not be the same person who is regarded as the account owner for purposes of administering the account. Under many qualified tuition programs, the account owner generally has control over the account or contract, including the ability to change designated beneficiaries and to withdraw funds at any time and for any purpose. Thus, in practice, qualified tuition accounts or contracts generally involve a contributor, a designated beneficiary, an account owner (who oftentimes is not the contributor or the designated beneficiary), and an administrator of the account or contract. 13


Description of Proposal


The proposal expands the definition of qualified higher education expenses for taxable years beginning in 2009 and 2010 to include expenses for computer technology and equipment.


Effective Date


The proposal is effective for taxable years beginning after December 31, 2008.



6. Waiver of requirement to repay first-time homebuyer credit


Present Law


A taxpayer who is a first-time homebuyer is allowed a refundable tax credit equal to the lesser of $7,500 ($3,750 for a married individual filing separately) or 10 percent of the purchase price of a principal residence. The credit is allowed for the tax year in which the taxpayer purchases the home unless the taxpayer makes an election as described below. The credit is allowed for qualifying home purchases on or after April 9, 2008 and before July 1, 2009 (without regard to whether there was a binding contract to purchase prior to April 9, 2008).

The credit phases out for individual taxpayers with modified adjusted gross income between $75,000 and $95,000 ($150,000-$170,000 for joint filers) for the year of purchase.

A taxpayer is considered a first-time homebuyer if such individual had no ownership interest in a principal residence in the United States during the 3-year period prior to the purchase of the home to which the credit applies.

No credit is allowed if the D.C. homebuyer credit is allowable for the taxable year the residence is purchased or a prior taxable year. A taxpayer is not permitted to claim the credit if the taxpayer's financing is from tax-exempt mortgage revenue bonds, if the taxpayer is a nonresident alien, or if the taxpayer disposes of the residence (or it ceases to be a principal residence) before the close of a taxable year for which a credit otherwise would be allowable.

The credit is recaptured ratably over fifteen years with no interest charge beginning in the second taxable year after the taxable year in which the home is purchased. For example, if the taxpayer purchases a home in 2008, the credit is allowed on the 2008 tax return, and repayments commence with the 2010 tax return. If the taxpayer sells the home (or the home ceases to be used as the principal residence of the taxpayer or the taxpayer's spouse) prior to complete repayment of the credit, any remaining credit repayment amount is due on the tax return for the year in which the home is sold (or ceases to be used as the principal residence). However, the credit repayment amount may not exceed the amount of gain from the sale of the residence to an unrelated person. For this purpose, gain is determined by reducing the basis of the residence by the amount of the credit to the extent not previously recaptured. No amount is recaptured after the death of a taxpayer. In the case of an involuntary conversion of the home, recapture is not accelerated if a new principal residence is acquired within a two year period. In the case of a transfer of the residence to a spouse or to a former spouse incident to divorce, the transferee spouse (and not the transferor spouse) will be responsible for any future recapture.

An election is provided to treat a home purchased in the eligible period in 2009 as if purchased on December 31, 2008 for purposes of claiming the credit on the 2008 tax return and for establishing the beginning of the recapture period. Taxpayers may amend their returns for this purpose.


Description of Proposal


The proposal waives the recapture of the credit for qualifying home purchases after December 31, 2008 and before July 1, 2009. This waiver of recapture applies without regard to whether the taxpayer elects to treat the purchase in 2009 as occurring on December 31, 2008. If the taxpayer disposes of the home, or the home otherwise ceases to be the principal residence of the taxpayer, within 36 months from the date of purchase, the present law rules for recapture of the credit will still apply.


Effective Date


The proposal shall apply to residences purchased after December 31, 2008.



7. Exclusion from gross income for unemployment compensation benefits


Present Law


An individual must include in gross income any unemployment compensation benefits received under the laws of the United States or any State.


Description of Proposal


Up to $2,400 of unemployment compensation benefits received in 2009 are excluded from gross income by the recipient.


Effective Date


The proposal is effective for taxable years beginning after December 31, 2008.


II. RENEWABLE ENERGY INCENTIVES




1. Extension of the renewable electricity credit


Present Law




In general

An income tax credit is allowed for the production of electricity from qualified energy resources at qualified facilities. 14 Qualified energy resources comprise wind, closed-loop biomass, open-loop biomass, geothermal energy, solar energy, small irrigation power, municipal solid waste, qualified hydropower production, and marine and hydrokinetic renewable energy. Qualified facilities are, generally, facilities that generate electricity using qualified energy resources. To be eligible for the credit, electricity produced from qualified energy resources at qualified facilities must be sold by the taxpayer to an unrelated person.



Credit amounts and credit period



In general

The base amount of the electricity production credit is 1.5 cents per kilowatt-hour (indexed annually for inflation) of electricity produced. The amount of the credit was 2.1 cents per kilowatt-hour for 2008. A taxpayer may generally claim a credit during the 10-year period commencing with the date the qualified facility is placed in service. The credit is reduced for grants, tax-exempt bonds, subsidized energy financing, and other credits.



Credit phaseout

The amount of credit a taxpayer may claim is phased out as the market price of electricity exceeds certain threshold levels. The electricity production credit is reduced over a 3-cent phaseout range to the extent the annual average contract price per kilowatt-hour of electricity sold in the prior year from the same qualified energy resource exceeds 8 cents (adjusted for inflation; 11.8 cents for 2008).



Reduced credit periods and credit amounts

Generally, in the case of open-loop biomass facilities (including agricultural livestock waste nutrient facilities), geothermal energy facilities, solar energy facilities, small irrigation power facilities, landfill gas facilities, and trash combustion facilities placed in service before August 8, 2005, the 10-year credit period is reduced to five years, commencing on the date the facility was originally placed in service. However, for qualified open-loop biomass facilities (other than a facility described in section 45(d)(3)(A)(i) that uses agricultural livestock waste nutrients) placed in service before October 22, 2004, the five-year period commences on January 1, 2005. In the case of a closed-loop biomass facility modified to co-fire with coal, to co-fire with other biomass, or to co-fire with coal and other biomass, the credit period begins no earlier than October 22, 2004.

In the case of open-loop biomass facilities (including agricultural livestock waste nutrient facilities), small irrigation power facilities, landfill gas facilities, trash combustion facilities, and qualified hydropower facilities the otherwise allowable credit amount is 0.75 cent per kilowatt-hour, indexed for inflation measured after 1992 (1 cent per kilowatt-hour for 2008).



Other limitations on credit claimants and credit amounts

In general, in order to claim the credit, a taxpayer must own the qualified facility and sell the electricity produced by the facility to an unrelated party. A lessee or operator may claim the credit in lieu of the owner of the qualifying facility in the case of qualifying open-loop biomass facilities and in the case of closed-loop biomass facilities modified to co-fire with coal, to co-fire with other biomass, or to co-fire with coal and other biomass. In the case of a poultry waste facility, the taxpayer may claim the credit as a lessee or operator of a facility owned by a governmental unit.

For all qualifying facilities, other than closed-loop biomass facilities modified to co-fire with coal, to co-fire with other biomass, or to co-fire with coal and other biomass, the amount of credit a taxpayer may claim is reduced by reason of grants, tax-exempt bonds, subsidized energy financing, and other credits, but the reduction cannot exceed 50 percent of the otherwise allowable credit. In the case of closed-loop biomass facilities modified to co-fire with coal, to co-fire with other biomass, or to co-fire with coal and other biomass, there is no reduction in credit by reason of grants, tax-exempt bonds, subsidized energy financing, and other credits.

The credit for electricity produced from renewable resources is a component of the general business credit. 15 Generally, the general business credit for any taxable year may not exceed the amount by which the taxpayer's net income tax exceeds the greater of the tentative minimum tax or 25 percent of so much of the net regular tax liability as exceeds $25,000. However, this limitation does not apply to section 45 credits for electricity or refined coal produced from a facility (placed in service after October 22, 2004) during the first four years of production beginning on the date the facility is placed in service. 16 Excess credits may be carried back one year and forward up to 20 years.



Qualified facilities



Wind energy facility

A wind energy facility is a facility that uses wind to produce electricity. To be a qualified facility, a wind energy facility must be placed in service after December 31, 1993, and before January 1, 2010.



Closed-loop biomass facility

A closed-loop biomass facility is a facility that uses any organic material from a plant which is planted exclusively for the purpose of being used at a qualifying facility to produce electricity. In addition, a facility can be a closed-loop biomass facility if it is a facility that is modified to use closed-loop biomass to co-fire with coal, with other biomass, or with both coal and other biomass, but only if the modification is approved under the Biomass Power for Rural Development Programs or is part of a pilot project of the Commodity Credit Corporation.

To be a qualified facility, a closed-loop biomass facility must be placed in service after December 31, 1992, and before January 1, 2011. In the case of a facility using closed-loop biomass but also co-firing the closed-loop biomass with coal, other biomass, or coal and other biomass, a qualified facility must be originally placed in service and modified to co-fire the closed-loop biomass at any time before January 1, 2011.

A qualified facility includes a new power generation unit placed in service after October 3, 2008, at an existing closed-loop biomass facility, but only to the extent of the increased amount of electricity produced at the existing facility by reason of such new unit.



Open-loop biomass (including agricultural livestock waste nutrients) facility

An open-loop biomass facility is a facility that uses open-loop biomass to produce electricity. For purposes of the credit, open-loop biomass is defined as (1) any agricultural livestock waste nutrients or (2) any solid, nonhazardous, cellulosic waste material or any lignin material that is segregated from other waste materials and which is derived from:
 forest-related resources, including mill and harvesting residues, precommercial thinnings, slash, and brush;

 solid wood waste materials, including waste pallets, crates, dunnage, manufacturing and construction wood wastes, and landscape or right-of-way tree trimmings; or

 agricultural sources, including orchard tree crops, vineyard, grain, legumes, sugar, and other crop by-products or residues.

Agricultural livestock waste nutrients are defined as agricultural livestock manure and litter, including bedding material for the disposition of manure. Wood waste materials do not qualify as open-loop biomass to the extent they are pressure treated, chemically treated, or painted. In addition, municipal solid waste, gas derived from the biodegradation of solid waste, and paper which is commonly recycled do not qualify as open-loop biomass. Open-loop biomass does not include closed-loop biomass or any biomass burned in conjunction with fossil fuel (co-firing) beyond such fossil fuel required for start up and flame stabilization.

In the case of an open-loop biomass facility that uses agricultural livestock waste nutrients, a qualified facility is one that was originally placed in service after October 22, 2004, and before January 1, 2009, and has a nameplate capacity rating which is not less than 150 kilowatts. In the case of any other open-loop biomass facility, a qualified facility is one that was originally placed in service before January 1, 2011. A qualified facility includes a new power generation unit placed in service after October 3, 2008, at an existing open-loop biomass facility, but only to the extent of the increased amount of electricity produced at the existing facility by reason of such new unit.



Geothermal facility

A geothermal facility is a facility that uses geothermal energy to produce electricity. Geothermal energy is energy derived from a geothermal deposit that is a geothermal reservoir consisting of natural heat that is stored in rocks or in an aqueous liquid or vapor (whether or not under pressure). To be a qualified facility, a geothermal facility must be placed in service after October 22, 2004, and before January 1, 2011.



Solar facility

A solar facility is a facility that uses solar energy to produce electricity. To be a qualified facility, a solar facility must be placed in service after October 22, 2004, and before January 1, 2006.



Small irrigation facility

A small irrigation power facility is a facility that generates electric power through an irrigation system canal or ditch without any dam or impoundment of water. The installed capacity of a qualified facility must be at least 150 kilowatts but less than five megawatts. To be a qualified facility, a small irrigation facility must be originally placed in service after October 22, 2004, and before October 3, 2008. Marine and hydrokinetic renewable energy facilities, described below, subsume small irrigation power facilities after October 2, 2008.



Landfill gas facility

A landfill gas facility is a facility that uses landfill gas to produce electricity. Landfill gas is defined as methane gas derived from the biodegradation of municipal solid waste. To be a qualified facility, a landfill gas facility must be placed in service after October 22, 2004, and before January 1, 2011.



Trash combustion facility

Trash combustion facilities are facilities that use municipal solid waste (garbage) to produce steam to drive a turbine for the production of electricity. To be a qualified facility, a trash combustion facility must be placed in service after October 22, 2004, and before January 1, 2011. A qualified trash combustion facility includes a new unit, placed in service after October 22, 2004, that increases electricity production capacity at an existing trash combustion facility. A new unit generally would include a new burner/boiler and turbine. The new unit may share certain common equipment, such as trash handling equipment, with other pre-existing units at the same facility. Electricity produced at a new unit of an existing facility qualifies for the production credit only to the extent of the increased amount of electricity produced at the entire facility.



Hydropower facility

A qualifying hydropower facility is (1) a facility that produced hydroelectric power (a hydroelectric dam) prior to August 8, 2005, at which efficiency improvements or additions to capacity have been made after such date and before January 1, 2011, that enable the taxpayer to produce incremental hydropower or (2) a facility placed in service before August 8, 2005, that did not produce hydroelectric power (a nonhydroelectric dam) on such date, and to which turbines or other electricity generating equipment have been added after such date and before January 1, 2011.

At an existing hydroelectric facility, the taxpayer may claim credit only for the production of incremental hydroelectric power. Incremental hydroelectric power for any taxable year is equal to the percentage of average annual hydroelectric power produced at the facility attributable to the efficiency improvement or additions of capacity determined by using the same water flow information used to determine an historic average annual hydroelectric power production baseline for that facility. The Federal Energy Regulatory Commission will certify the baseline power production of the facility and the percentage increase due to the efficiency and capacity improvements.

Nonhydroelectric dams converted to produce electricity must be licensed by the Federal Energy Regulatory Commission and meet all other applicable environmental, licensing, and regulatory requirements.

For a nonhydroelectric dam converted to produce electric power before January 1, 2009, there must not be any enlargement of the diversion structure, construction or enlargement of a bypass channel, or the impoundment or any withholding of additional water from the natural stream channel.

For a nonhydroelectric dam converted to produce electric power after December 31, 2008, the nonhydroelectric dam (1) must have been placed in service before October 3, 2008, (2) must have been operated for flood control, navigation, or water supply purposes and (3) must not have produced hydroelectric power on October 3, 2008. In addition, the hydroelectric project must be operated so that the water surface elevation at any given location and time that would have occurred in the absence of the hydroelectric project is maintained, subject to any license requirements imposed under applicable law that change the water surface elevation for the purpose of improving environmental quality of the affected waterway. The Secretary, in consultation with the Federal Energy Regulatory Commission, shall certify if a hydroelectric project licensed at a nonhydroelectric dam meets this criteria.



Marine and hydrokinetic renewable energy facility

A qualified marine and hydrokinetic renewable energy facility is any facility that produces electric power from marine and hydrokinetic renewable energy, has a nameplate capacity rating of at least 150 kilowatts, and is placed in service after October 2, 2008, and before January 1, 2012. Marine and hydrokinetic renewable energy is defined as energy derived from (1) waves, tides, and currents in oceans, estuaries, and tidal areas; (2) free flowing water in rivers, lakes, and streams; (3) free flowing water in an irrigation system, canal, or other man-made channel, including projects that utilize nonmechanical structures to accelerate the flow of water for electric power production purposes; or (4) differentials in ocean temperature (ocean thermal energy conversion). The term does not include energy derived from any source that uses a dam, diversionary structure (except for irrigation systems, canals, and other man-made channels), or impoundment for electric power production.



Summary of credit rate and credit period by facility type


Table 1.-Summary of Section 45 Credit for Electricity Produced from Certain Renewable Resources



____________________________________________________________________________________
Eligible electricity Credit amount for Credit period for Credit period for
2008 (cents per facilities placed facilities placed in
production activity kilowatt-hour) in service on or
before August 8, service after
2005 (years from August 8, 2005
placed-in-service (years from
date) placed-in-service
date)

____________________________________________________________________________________
Wind 2.1 10 10

Closed-loop biomass 2.1 10 1 10

Open-loop biomass 1.0 5 2 10

(including
agricultural
livestock waste
nutrient
facilities)

Geothermal 2.1 5 10

Solar (pre-2006
facilities only) 2.1 5 10

Small irrigation
power 1.0 5 10

Municipal solid
waste 1.0 5 10

(including
landfill gas
facilities and
trash combustion
facilities)

Qualified hydropower 1.0 N/A 10

Marine and
hydrokinetic 1.0 N/A 10

____________________________________________________________________________________
1 In the case of certain co-firing closed-loop facilities, the credit period begins
no earlier than October 22, 2004.

2 For certain facilities placed in service before October 22, 2004, the five-year
credit period commences on January 1, 2005.





Taxation of cooperatives and their patrons

For Federal income tax purposes, a cooperative generally computes its income as if it were a taxable corporation, with one exception: the cooperative may exclude from its taxable income distributions of patronage dividends. Generally, a cooperative that is subject to the cooperative tax rules of subchapter T of the Code 17 is permitted a deduction for patronage dividends paid only to the extent of net income that is derived from transactions with patrons who are members of the cooperative. 18 The availability of such deductions from taxable income has the effect of allowing the cooperative to be treated like a conduit with respect to profits derived from transactions with patrons who are members of the cooperative.

Eligible cooperatives may elect to pass any portion of the credit through to their patrons. An eligible cooperative is defined as a cooperative organization that is owned more than 50 percent by agricultural producers or entities owned by agricultural producers. The credit may be apportioned among patrons eligible to share in patronage dividends on the basis of the quantity or value of business done with or for such patrons for the taxable year. The election must be made on a timely filed return for the taxable year and, once made, is irrevocable for such taxable year.


Description of Proposal


The proposal extends for three years (generally, through 2013; through 2012 for wind facilities) the period during which qualified facilities producing electricity from wind, closed-loop biomass, open-loop biomass, geothermal energy, municipal solid waste, and qualified hydropower may be placed in service for purposes of the electricity production credit. The proposal extends for two years (through 2013) the placed-in-service period for marine and hydrokinetic renewable energy resources.

The proposal also makes a technical amendment to the definition of small irrigation power facility to clarify its integration into the definition marine and hydrokinetic renewable energy facility.


Effective Date


The extension of the electricity production credit is effective for property placed in service after the date of enactment. The technical amendment is effective as if included in section 102 of the Energy Improvement and Extension Act of 2008.



2. Election of investment credit in lieu of production tax credits


Present Law




Renewable Electricity Credit

An income tax credit is allowed for the production of electricity from qualified energy resources at qualified facilities. 19 Qualified energy resources comprise wind, closed-loop biomass, open-loop biomass, geothermal energy, solar energy, small irrigation power, municipal solid waste, qualified hydropower production, and marine and hydrokinetic renewable energy. Qualified facilities are, generally, facilities that generate electricity using qualified energy resources. To be eligible for the credit, electricity produced from qualified energy resources at qualified facilities must be sold by the taxpayer to an unrelated person. The credit amounts, credit periods, definitions of qualified facilities, and other rules governing this credit are described more fully in section II.1. of this document.



Energy Credit

An income tax credit is also allowed for certain energy property placed in service. Qualifying property includes certain fuel cell property, solar property, geothermal power production property, small wind energy property, combined heat and power system property, microturbine property, and geothermal heat pump property. 20 The amounts of credit, definitions of qualifying property, and other rules governing this credit are described more fully in section II.3. of this document.


Description of Proposal


The proposal allows the taxpayer to make an irrevocable election to have certain qualified facilities placed in service in 2009 and 2010 be treated as energy property eligible for a 30 percent investment credit under section 48. For this purpose, qualified facilities are facilities otherwise eligible for the section 45 production tax credit (other than refined coal, Indian coal, and solar facilities) with respect to which no credit under section 45 has been allowed. A taxpayer electing to treat a facility as energy property may not claim the production credit under section 45.


Effective Date


The proposal applies to facilities placed in service after December 31, 2008.



3. Modification of energy credit 21


Present Law




In general

A nonrefundable, 10-percent business energy credit 22 is allowed for the cost of new property that is equipment that either (1) uses solar energy to generate electricity, to heat or cool a structure, or to provide solar process heat, or (2) is used to produce, distribute, or use energy derived from a geothermal deposit, but only, in the case of electricity generated by geothermal power, up to the electric transmission stage. Property used to generate energy for the purposes of heating a swimming pool is not eligible solar energy property.

The energy credit is a component of the general business credit. 23 An unused general business credit generally may be carried back one year and carried forward 20 years. 24 The taxpayer's basis in the property is reduced by one-half of the amount of the credit claimed. For projects whose construction time is expected to equal or exceed two years, the credit may be claimed as progress expenditures are made on the project, rather than during the year the property is placed in service. The credit is allowed against the alternative minimum tax for credits determined in taxable years beginning after October 3, 2008.

Property financed by subsidized energy financing or with proceeds from private activity bonds is subject to a reduction in basis for purposes of claiming the credit. The basis reduction is proportional to the share of the basis of the property that is financed by the subsidized financing or proceeds. The term "subsidized energy financing" means financing provided under a Federal, State, or local program a principal purpose of which is to provide subsidized financing for projects designed to conserve or produce energy.



Special rules for solar energy property

The credit for solar energy property is increased to 30 percent in the case of periods prior to January 1, 2017. Additionally, equipment that uses fiber-optic distributed sunlight to illuminate the inside of a structure is solar energy property eligible for the 30-percent credit.



Fuel cells and microturbines

The energy credit applies to qualified fuel cell power plants, but only for periods prior to January 1, 2017. The credit rate is 30 percent.

A qualified fuel cell power plant is an integrated system composed of a fuel cell stack assembly and associated balance of plant components that (1) converts a fuel into electricity using electrochemical means, and (2) has an electricity-only generation efficiency of greater than 30 percent and a capacity of at least one-half kilowatt. The credit may not exceed $1,500 for each 0.5 kilowatt of capacity.

The energy credit applies to qualifying stationary microturbine power plants for periods prior to January 1, 2017. The credit is limited to the lesser of 10 percent of the basis of the property or $200 for each kilowatt of capacity.

A qualified stationary microturbine power plant is an integrated system comprised of a gas turbine engine, a combustor, a recuperator or regenerator, a generator or alternator, and associated balance of plant components that converts a fuel into electricity and thermal energy. Such system also includes all secondary components located between the existing infrastructure for fuel delivery and the existing infrastructure for power distribution, including equipment and controls for meeting relevant power standards, such as voltage, frequency and power factors. Such system must have an electricity-only generation efficiency of not less than 26 percent at International Standard Organization conditions and a capacity of less than 2,000 kilowatts.



Geothermal heat pump property

The energy credit applies to qualified geothermal heat pump property placed in service prior to January 1, 2017. The credit rate is 10 percent. Qualified geothermal heat pump property is equipment that uses the ground or ground water as a thermal energy source to heat a structure or as a thermal energy sink to cool a structure.



Small wind property

The energy credit applies to qualified small wind energy property placed in service prior to January 1, 2017. The credit rate is 30 percent. The credit is limited to $4,000 per year with respect to all wind energy property of any taxpayer. Qualified small wind energy property is property that uses a qualified wind turbine to generate electricity. A qualifying wind turbine means a wind turbine of 100 kilowatts of rated capacity or less.



Combined heat and power property

The energy credit applies to combined heat and power ("CHP") property placed in service prior to January 1, 2017. The credit rate is 10 percent.

CHP property is property: (1) that uses the same energy source for the simultaneous or sequential generation of electrical power, mechanical shaft power, or both, in combination with the generation of steam or other forms of useful thermal energy (including heating and cooling applications); (2) that has an electrical capacity of not more than 50 megawatts or a mechanical energy capacity of no more than 67,000 horsepower or an equivalent combination of electrical and mechanical energy capacities; (3) that produces at least 20 percent of its total useful energy in the form of thermal energy that is not used to produce electrical or mechanical power, and produces at least 20 percent of its total useful energy in the form of electrical or mechanical power (or a combination thereof); and (4) the energy efficiency percentage of which exceeds 60 percent. CHP property does not include property used to transport the energy source to the generating facility or to distribute energy produced by the facility.

The otherwise allowable credit with respect to CHP property is reduced to the extent the property has an electrical capacity or mechanical capacity in excess of any applicable limits. Property in excess of the applicable limit (15 megawatts or a mechanical energy capacity of more than 20,000 horsepower or an equivalent combination of electrical and mechanical energy capacities) is permitted to claim a fraction of the otherwise allowable credit. The fraction is equal to the applicable limit divided by the capacity of the property. For example, a 45 megawatt property would be eligible to claim 15/45ths, or one third, of the otherwise allowable credit. Again, no credit is allowed if the property exceeds the 50 megawatt or 67,000 horsepower limitations described above.

Additionally, the proposal provides that systems whose fuel source is at least 90 percent open-loop biomass and that would qualify for the credit but for the failure to meet the efficiency standard are eligible for a credit that is reduced in proportion to the degree to which the system fails to meet the efficiency standard. For example, a system that would otherwise be required to meet the 60-percent efficiency standard, but which only achieves 30-percent efficiency, would be permitted a credit equal to one-half of the otherwise allowable credit (i.e., a 5-percent credit).


Description of Proposal


The proposal eliminates the credit caps applicable to qualified small wind energy property. The proposal also removes the rule that reduces the basis of the property for purposes of claiming the credit if the property is financed in whole or in part by subsidized energy financing or with proceeds from private activity bonds.


Effective Date


The proposal applies to periods after December 31, 2008, under rules similar to the rules of section 48(m) of the Code (as in effect on the day before the enactment of the Revenue Reconciliation Act of 1990).



4. Expand new clean renewable energy bonds


Present Law




New Clean Renewable Energy Bonds

New clean renewable energy bonds ("New CREBs") may be issued by qualified issuers to finance qualified renewable energy facilities. Qualified renewable energy facilities are facilities: (1) that qualify for the tax credit under section 45 (other than Indian coal and refined coal production facilities), without regard to the placed-in-service date requirements of that section; and (2) that are owned by a public power provider, governmental body, or cooperative electric company.

The term "qualified issuers" includes: (1) public power providers; (2) a governmental body; (3) cooperative electric companies; (4) a not-for-profit electric utility that has received a loan or guarantee under the Rural Electrification Act; and (5) clean renewable energy bond lenders. The term "public power provider" means a State utility with a service obligation, as such terms are defined in section 217 of the Federal Power Act (as in effect on the date of the enactment of this paragraph). A "governmental body" means any State or Indian tribal government, or any political subdivision thereof. The term "cooperative electric company" means a mutual or cooperative electric company (described in section 501(c)(12) or section 1381(a)(2)(C)). A clean renewable energy bond lender means a cooperative that is owned by, or has outstanding loans to, 100 or more cooperative electric companies and is in existence on February 1, 2002 (including any affiliated entity which is controlled by such lender).

There is a national limitation for New CREBs of $800 million. No more than one third of the national limit may be allocated to projects of public power providers, governmental bodies, or cooperative electric companies. Allocations to governmental bodies and cooperative electric companies may be made in the manner the Secretary determines appropriate. Allocations to projects of public power providers shall be made, to the extent practicable, in such manner that the amount allocated to each such project bears the same ratio to the cost of such project as the maximum allocation limitation to projects of public power providers bears to the cost of all such projects.

New CREBs are a type of qualified tax credit bond for purposes of section 54A of the Code. As such, 100 percent of the available project proceeds of New CREBs must be used within the three-year period that begins on the date of issuance. Available project proceeds are proceeds from the sale of the bond issue less issuance costs (not to exceed two percent) and any investment earnings on such sale proceeds. To the extent less than 100 percent of the available project proceeds are used to finance qualified projects during the three-year spending period, bonds will continue to qualify as New CREBs if unspent proceeds are used within 90 days from the end of such three-year period to redeem bonds. The three-year spending period may be extended by the Secretary upon the qualified issuer's request demonstrating that the failure to satisfy the three-year requirement is due to reasonable cause and the projects will continue to proceed with due diligence.

New CREBs generally are subject to the arbitrage requirements of section 148. However, available project proceeds invested during the three-year spending period are not subject to the arbitrage restrictions (i.e., yield restriction and rebate requirements). In addition, amounts invested in a reserve fund are not subject to the arbitrage restrictions to the extent: (1) such fund is funded at a rate not more rapid than equal annual installments; (2) such fund is funded in a manner reasonably expected to result in an amount not greater than an amount necessary to repay the issue; and (3) the yield on such fund is not greater than the average annual interest rate of tax-exempt obligations having a term of 10 years or more that are issued during the month the New CREBs are issued.

The maturity of New CREBs is the term that the Secretary estimates will result in the present value of the obligation to repay the principal on such bonds being equal to 50 percent of the face amount of such bonds, using as a discount rate the average annual interest rate of tax-exempt obligations having a term of 10 years or more that are issued during the month the New CREBs are issued.

As with other tax credit bonds, a taxpayer holding New CREBs on a credit allowance date is entitled to a tax credit. Unlike CREBs, however, the credit rate on New CREBs is set by the Secretary at a rate that is 70 percent of the rate that would permit issuance of such bonds without discount and interest cost to the issuer. The applicable credit rate for the bond is the rate that the Secretary estimates will permit the issuance of the qualified tax credit bond with a specified maturity or redemption date without discount and without interest cost to the qualified issuer. 25 The Secretary determines credit rates for tax credit bonds based on general assumptions about credit quality of the class of potential eligible issuers and such other factors as the Secretary deems appropriate. The Secretary may determine credit rates based on general credit market yield indexes and credit ratings.

The amount of the tax credit is determined by multiplying the bond's credit rate by the face amount of the holder's bond. The credit accrues quarterly, is includible in gross income (as if it were an interest payment on the bond), and can be claimed against regular income tax liability and alternative minimum tax liability. Unused credits may be carried forward to succeeding taxable years. In addition, credits may be separated from the ownership of the underlying bond similar to how interest coupons can be stripped for interest-bearing bonds.

An issuer of New CREBs is treated as meeting the "prohibition on financial conflicts of interest" requirement in section 54A(d)(6) if it certifies that it satisfies (i) applicable State and local law requirements governing conflicts of interest and (ii) any additional conflict of interest rules prescribed by the Secretary with respect to any Federal, State, or local government official directly involved with the issuance of New CREBs.


Description of Proposal


The proposal expands the New CREBs program. The proposal authorizes issuance of up to an additional $1.6 billion of New CREBs.


Effective Date


The proposal applies to bonds issued after the date of enactment.



5. Expand qualified energy conservation bonds


Present Law


Qualified energy conservation bonds may be used to finance qualified conservation purposes.

The term "qualified conservation purpose" means:
1. Capital expenditures incurred for purposes of reducing energy consumption in publicly owned buildings by at least 20 percent; implementing green community programs; rural development involving the production of electricity from renewable energy resources; or any facility eligible for the production tax credit under section 45 (other than Indian coal and refined coal production facilities);

2. Expenditures with respect to facilities or grants that support research in: (A) development of cellulosic ethanol or other nonfossil fuels; (B) technologies for the capture and sequestration of carbon dioxide produced through the use of fossil fuels; (C) increasing the efficiency of existing technologies for producing nonfossil fuels; (D) automobile battery technologies and other technologies to reduce fossil fuel consumption in transportation; and (E) technologies to reduce energy use in buildings;

3. Mass commuting facilities and related facilities that reduce the consumption of energy, including expenditures to reduce pollution from vehicles used for mass commuting;

4. Demonstration projects designed to promote the commercialization of: (A) green building technology; (B) conversion of agricultural waste for use in the production of fuel or otherwise; (C) advanced battery manufacturing technologies; (D) technologies to reduce peak-use of electricity; and (D) technologies for the capture and sequestration of carbon dioxide emitted from combusting fossil fuels in order to produce electricity; and

5. Public education campaigns to promote energy efficiency (other than movies, concerts, and other events held primarily for entertainment purposes).

There is a national limitation on qualified energy conservation bonds of $800 million. Allocations of qualified energy conservation bonds are made to the States with sub-allocations to large local governments. Allocations are made to the States according to their respective populations, reduced by any sub-allocations to large local governments (defined below) within the States. Sub-allocations to large local governments shall be an amount of the national qualified energy conservation bond limitation that bears the same ratio to the amount of such limitation that otherwise would be allocated to the State in which such large local government is located as the population of such large local government bears to the population of such State. The term large local government means: any municipality or county if such municipality or county has a population of 100,000 or more. Indian tribal governments also are treated as large local governments for these purposes (without regard to population).

Each State or large local government receiving an allocation of qualified energy conservation bonds may further allocate issuance authority to issuers within such State or large local government. However, any allocations to issuers within the State or large local government shall be made in a manner that results in not less than 70 percent of the allocation of qualified energy conservation bonds to such State or large local government being used to designate bonds that are not private activity bonds (i.e., the bond cannot meet the private business tests or the private loan test of section 141).

Qualified energy conservation bonds are a type of qualified tax credit bond for purposes of section 54A of the Code. As a result, 100 percent of the available project proceeds of qualified energy conservation bonds must be used for qualified conservation purposes. In the case of qualified conservation bonds issued as private activity bonds, 100 percent of the available project proceeds must be used for capital expenditures. In addition, qualified energy conservation bonds may be issued by Indian tribal governments only to the extent such bonds are issued for purposes that satisfy the present law requirements for tax-exempt bonds issued by Indian tribal governments (i.e., essential governmental functions and certain manufacturing purposes).

Under present law 100 percent of the available project proceeds of qualified energy conservation bonds must be used within the three-year period that begins on the date of issuance. Available project proceeds are proceeds from the sale of the issue less issuance costs (not to exceed two percent) and any investment earnings on such sale proceeds. To the extent less than 100 percent of the available project proceeds are used to finance qualified conservation purposes during the three-year spending period, bonds will continue to qualify as qualified energy conservation bonds if unspent proceeds are used within 90 days from the end of such three-year period to redeem bonds. The three-year spending period may be extended by the Secretary upon the issuer's request demonstrating that the failure to satisfy the three-year requirement is due to reasonable cause and the projects will continue to proceed with due diligence.

Qualified energy conservation bonds generally are subject to the arbitrage requirements of section 148. However, available project proceeds invested during the three-year spending period are not subject to the arbitrage restrictions (i.e., yield restriction and rebate requirements). In addition, amounts invested in a reserve fund are not subject to the arbitrage restrictions to the extent: (1) such fund is funded at a rate not more rapid than equal annual installments; (2) such fund is funded in a manner reasonably expected to result in an amount not greater than an amount necessary to repay the issue; and (3) the yield on such fund is not greater than the average annual interest rate of tax-exempt obligations having a term of 10 years or more that are issued during the month the qualified energy conservation bonds are issued.

The maturity of qualified energy conservation bonds is the term that the Secretary estimates will result in the present value of the obligation to repay the principal on such bonds being equal to 50 percent of the face amount of such bonds, using as a discount rate the average annual interest rate of tax-exempt obligations having a term of 10 years or more that are issued during the month the qualified energy conservation bonds are issued.

As with other tax credit bonds, the taxpayer holding qualified energy conservation bonds on a credit allowance date is entitled to a tax credit. The credit rate on the bonds is set by the Secretary at a rate that is 70 percent of the rate that would permit issuance of such bonds without discount and interest cost to the issuer. 26 The Secretary determines credit rates for tax credit bonds based on general assumptions about credit quality of the class of potential eligible issuers and such other factors as the Secretary deems appropriate. The Secretary may determine credit rates based on general credit market yield indexes and credit ratings. The amount of the tax credit is determined by multiplying the bond's credit rate by the face amount of the holder's bond. The credit accrues quarterly, is includible in gross income (as if it were an interest payment on the bond), and can be claimed against regular income tax liability and alternative minimum tax liability. Unused credits may be carried forward to succeeding taxable years. In addition, credits may be separated from the ownership of the underlying bond similar to how interest coupons can be stripped for interest-bearing bonds.

Issuers of qualified energy conservation bonds are required to certify that the financial disclosure requirements that applicable State and local law requirements governing conflicts of interest are satisfied with respect to such issue, as well as any other additional conflict of interest rules prescribed by the Secretary with respect to any Federal, State, or local government official directly involved with the issuance of qualified energy conservation bonds.


Description of Proposal


The proposal expands the present-law qualified energy conservation bond program. The proposal authorizes issuance of an additional $2.4 billion of qualified energy conservation bonds.


Effective Date


The proposal applies to bonds issued after the date of enactment.



6. Extension and modification of credit for nonbusiness energy property


Present Law


Section 25C provides a 10-percent credit for the purchase of qualified energy efficiency improvements to existing homes. A qualified energy efficiency improvement is any energy efficiency building envelope component (1) that meets or exceeds the prescriptive criteria for such a component established by the 2000 International Energy Conservation Code as supplemented and as in effect on August 8, 2005 (or, in the case of metal roofs with appropriate pigmented coatings, meets the Energy Star program requirements); (2) that is installed in or on a dwelling located in the United States and owned and used by the taxpayer as the taxpayer's principal residence; (3) the original use of which commences with the taxpayer; and (4) that reasonably can be expected to remain in use for at least five years. The credit is nonrefundable.

Building envelope components are: (1) insulation materials or systems which are specifically and primarily designed to reduce the heat loss or gain for a dwelling; (2) exterior windows (including skylights) and doors; and (3) metal or asphalt roofs with appropriate pigmented coatings or cooling granules that are specifically and primarily designed to reduce the heat gain for a dwelling.

Additionally, section 25C provides specified credits for the purchase of specific energy efficient property. The allowable credit for the purchase of certain property is (1) $50 for each advanced main air circulating fan, (2) $150 for each qualified natural gas, propane, or oil furnace or hot water boiler, and (3) $300 for each item of qualified energy efficient property.

An advanced main air circulating fan is a fan used in a natural gas, propane, or oil furnace originally placed in service by the taxpayer during the taxable year, and which has an annual electricity use of no more than two percent of the total annual energy use of the furnace (as determined in the standard Department of Energy test procedures).

A qualified natural gas, propane, or oil furnace or hot water boiler is a natural gas, propane, or oil furnace or hot water boiler with an annual fuel utilization efficiency rate of at least 95.

Qualified energy-efficient property is: (1) an electric heat pump water heater which yields an energy factor of at least 2.0 in the standard Department of Energy test procedure, (2) an electric heat pump which has a heating seasonal performance factor (HSPF) of at least 9, a seasonal energy efficiency ratio (SEER) of at least 15, and an energy efficiency ratio (EER) of at least 13, (3) a central air conditioner with energy efficiency of at least the highest efficiency tier established by the Consortium for Energy Efficiency as in effect on Jan. 1, 2006 27 , (4) a natural gas, propane, or oil water heater which has an energy factor of at least 0.80 or thermal efficiency of at least 90 percent, and (5) biomass fuel property.

Biomass fuel property is a stove that burns biomass fuel to heat a dwelling unit located in the United States and used as a principal residence by the taxpayer, or to heat water for such dwelling unit, and that has a thermal efficiency rating of at least 75 percent. Biomass fuel is any plant-derived fuel available on a renewable or recurring basis, including agricultural crops and trees, wood and wood waste and residues (including wood pellets), plants (including aquatic plants, grasses, residues, and fibers.

Under section 25C, the maximum credit for a taxpayer with respect to the same dwelling for all taxable years is $500, and no more than $200 of such credit may be attributable to expenditures on windows.

The taxpayer's basis in the property is reduced by the amount of the credit. Special proration rules apply in the case of jointly owned property, condominiums, and tenant-stockholders in cooperative housing corporations. If less than 80 percent of the property is used for nonbusiness purposes, only that portion of expenditures that is used for nonbusiness purposes is taken into account.

For purposes of determining the amount of expenditures made by any individual with respect to any dwelling unit, there shall not be taken into account expenditures which are made from subsidized energy financing The term "subsidized energy financing" means financing provided under a Federal, State, or local program a principal purpose of which is to provide subsidized financing for projects designed to conserve or produce energy.

The credit applies to expenditures made after December 31, 2008 for property placed in service after December 31, 2008, and prior to January 1, 2010.


Description of Proposal


The proposal raises the 10 percent credit rate to 30 percent. Additionally, all energy property otherwise eligible for the $50, $100, or $150 credits is instead eligible for a 30 percent credit on expenditures for such property.

The proposal additionally extends the proposal for one year, through December 31, 2010. Finally, the $500 lifetime cap (and the $200 lifetime cap with respect to windows) is eliminated and replaced with an aggregate cap of $1,500 in the case of property placed in service after December 31, 2008 and prior to January 1, 2011.

The present law rule related to subsidized energy financing is eliminated.


Effective Date


The proposal is effective for taxable years beginning after December 31, 2008.



7. Credit for residential energy efficient property


Present Law


Section 25D provides a personal tax credit for the purchase of qualified solar electric property and qualified solar water heating property that is used exclusively for purposes other than heating swimming pools and hot tubs. The credit is equal to 30 percent of qualifying expenditures, with a maximum credit of $2,000 with respect to qualified solar water heating property. There is no cap with respect to qualified solar electric property.

Section 25D also provides a 30 percent credit for the purchase of qualified geothermal heat pump property, qualified small wind energy property, and qualified fuel cell power plants. The credit for geothermal heat pump property is capped at $2,000, the credit for qualified small wind energy property is limited to $500 with respect to each half kilowatt of capacity, not to exceed $4,000, and the credit for any fuel cell may not exceed $500 for each 0.5 kilowatt of capacity.

The credit with respect to all qualifying property may be claimed against the alternative minimum tax.

Qualified solar electric property is property that uses solar energy to generate electricity for use in a dwelling unit. Qualifying solar water heating property is property used to heat water for use in a dwelling unit located in the United States and used as a residence if at least half of the energy used by such property for such purpose is derived from the sun.

A qualified fuel cell power plant is an integrated system comprised of a fuel cell stack assembly and associated balance of plant components that (1) converts a fuel into electricity using electrochemical means, (2) has an electricity-only generation efficiency of greater than 30 percent. The qualified fuel cell power plant must be installed on or in connection with a dwelling unit located in the United States and used by the taxpayer as a principal residence.

Qualified small wind energy property is property that uses a wind turbine to generate electricity for use in a dwelling unit located in the U.S. and used as a residence by the taxpayer.

Qualified geothermal heat pump property means any equipment which (1) uses the ground or ground water as a thermal energy source to heat the dwelling unit or as a thermal energy sink to cool such dwelling unit, (2) meets the requirements of the Energy Star program which are in effect at the time that the expenditure for such equipment is made, and (3) is installed on or in connection with a dwelling unit located in the United States and used as a residence by the taxpayer.

The credit is nonrefundable, and the depreciable basis of the property is reduced by the amount of the credit. Expenditures for labor costs allocable to onsite preparation, assembly, or original installation of property eligible for the credit are eligible expenditures.

Special proration rules apply in the case of jointly owned property, condominiums, and tenant-stockholders in cooperative housing corporations. If less than 80 percent of the property is used for nonbusiness purposes, only that portion of expenditures that is used for nonbusiness purposes is taken into account.

For purposes of determining the amount of expenditures made by any individual with respect to any dwelling unit, there shall not be taken into account expenditures which are made from subsidized energy financing. The term "subsidized energy financing" means financing provided under a Federal, State, or local program a principal purpose of which is to provide subsidized financing for projects designed to conserve or produce energy.

The credit applies to property placed in service prior to January 1, 2017.


Description of Proposal


The proposal eliminates the credit caps for solar hot water, geothermal, and wind property and eliminates the reduction in credits for property using subsidized energy financing.


Effective Date


The proposal is effective for property placed in service after December 31, 2008, in taxable years ending after such date.



8. Temporary increase in credit for alternative fuel vehicle refueling property


Present Law


Taxpayers may claim a 30-percent credit for the cost of installing qualified clean-fuel vehicle refueling property to be used in a trade or business of the taxpayer or installed at the principal residence of the taxpayer. 28 The credit may not exceed $30,000 per taxable year per location, in the case of qualified refueling property used in a trade or business and $1,000 per taxable year per location, in the case of qualified refueling property installed on property which is used as a principal residence.

Qualified refueling property is property (not including a building or its structural components) for the storage or dispensing of a clean-burning fuel or electricity into the fuel tank or battery of a motor vehicle propelled by such fuel or electricity, but only if the storage or dispensing of the fuel or electricity is at the point of delivery into the fuel tank or battery of the motor vehicle. The use of such property must begin with the taxpayer.

Clean-burning fuels are any fuel at least 85 percent of the volume of which consists of ethanol, natural gas, compressed natural gas, liquefied natural gas, liquefied petroleum gas, or hydrogen. In addition, any mixture of biodiesel and diesel fuel, determined without regard to any use of kerosene and containing at least 20 percent biodiesel, qualifies as a clean fuel.

Credits for qualified refueling property used in a trade or business are part of the general business credit and may be carried back for one year and forward for 20 years. Credits for residential qualified refueling property cannot exceed for any taxable year the difference between the taxpayer's regular tax (reduced by certain other credits) and the taxpayer's tentative minimum tax. Generally, in the case of qualified refueling property sold to a tax-exempt entity, the taxpayer selling the property may claim the credit.

A taxpayer's basis in qualified refueling property is reduced by the amount of the credit. In addition, no credit is available for property used outside the United States or for which an election to expense has been made under section 179.

The credit is available for property placed in service after December 31, 2005, and (except in the case of hydrogen refueling property) before January 1, 2011. In the case of hydrogen refueling property, the property must be placed in service before January 1, 2015.


Description of Proposal


For property placed in service in 2009 or 2010, the proposal increases the maximum credit available for business property to $200,000 for qualified hydrogen refueling property and to $50,000 for other qualified refueling property. For nonbusiness property, the maximum credit is increased to $2,000. In addition, the credit rate is increased from 30 percent to 50 percent, except in the case of hydrogen refueling property.


Effective Date


The proposal is effective for taxable years beginning after December 31, 2008.



9. Energy research credit


Present Law




General rule

A taxpayer may claim a research credit equal to 20 percent of the amount by which the taxpayer's qualified research expenses for a taxable year exceed its base amount for that year. 29 Thus, the research credit is generally available with respect to incremental increases in qualified research.

A 20-percent research tax credit is also available with respect to the excess of (1) 100 percent of corporate cash expenses (including grants or contributions) paid for basic research conducted by universities (and certain nonprofit scientific research organizations) over (2) the sum of (a) the greater of two minimum basic research floors plus (b) an amount reflecting any decrease in nonresearch giving to universities by the corporation as compared to such giving during a fixed-base period, as adjusted for inflation. This separate credit computation is commonly referred to as the university basic research credit. 30

Finally, a research credit is available for a taxpayer's expenditures on research undertaken by an energy research consortium. This separate credit computation is commonly referred to as the energy research credit. Unlike the other research credits, the energy research credit applies to all qualified expenditures, not just those in excess of a base amount.

The research credit, including the university basic research credit and the energy research credit, expires for amounts paid or incurred after December 31, 2009. 31



Computation of allowable credit

Except for energy research payments and certain university basic research payments made by corporations, the research tax credit applies only to the extent that the taxpayer's qualified research expenses for the current taxable year exceed its base amount. The base amount for the current year generally is computed by multiplying the taxpayer's fixed-base percentage by the average amount of the taxpayer's gross receipts for the four preceding years. If a taxpayer both incurred qualified research expenses and had gross receipts during each of at least three years from 1984 through 1988, then its fixed-base percentage is the ratio that its total qualified research expenses for the 1984-1988 period bears to its total gross receipts for that period (subject to a maximum fixed-base percentage of 16 percent). All other taxpayers (so-called start-up firms) are assigned a fixed-base percentage of three percent. 32

In computing the credit, a taxpayer's base amount cannot be less than 50 percent of its current-year qualified research expenses.

To prevent artificial increases in research expenditures by shifting expenditures among commonly controlled or otherwise related entities, a special aggregation rule provides that all members of the same controlled group of corporations are treated as a single taxpayer. 33 Under regulations prescribed by the Secretary, special rules apply for computing the credit when a major portion of a trade or business (or unit thereof) changes hands, under which qualified research expenses and gross receipts for periods prior to the change of ownership of a trade or business are treated as transferred with the trade or business that gave rise to those expenses and receipts for purposes of recomputing a taxpayer's fixed-base percentage. 34



Alternative incremental research credit regime

Taxpayers are allowed to elect an alternative incremental research credit regime. 35 If a taxpayer elects to be subject to this alternative regime, the taxpayer is assigned a three-tiered fixed-base percentage (that is lower than the fixed-base percentage otherwise applicable under present law) and the credit rate likewise is reduced.

Generally, for amounts paid or incurred prior to 2007, under the alternative incremental credit regime, a credit rate of 2.65 percent applies to the extent that a taxpayer's current-year research expenses exceed a base amount computed by using a fixed-base percentage of one percent (i.e., the base amount equals one percent of the taxpayer's average gross receipts for the four preceding years) but do not exceed a base amount computed by using a fixed-base percentage of 1.5 percent. A credit rate of 3.2 percent applies to the extent that a taxpayer's current-year research expenses exceed a base amount computed by using a fixed-base percentage of 1.5 percent but do not exceed a base amount computed by using a fixed-base percentage of two percent. A credit rate of 3.75 percent applies to the extent that a taxpayer's current-year research expenses exceed a base amount computed by using a fixed-base percentage of two percent. Generally, for amounts paid or incurred after 2006, the credit rates listed above are increased to three percent, four percent, and five percent, respectively. 36

An election to be subject to this alternative incremental credit regime can be made for any taxable year beginning after June 30, 1996, and such an election applies to that taxable year and all subsequent years unless revoked with the consent of the Secretary of the Treasury. The alternative incremental credit regime terminates for taxable years beginning after December 31, 2008.



Alternative simplified credit

Generally, for amounts paid or incurred after 2006, taxpayers may elect to claim an alternative simplified credit for qualified research expenses. 37 The alternative simplified research credit is equal to 12 percent (14 percent for taxable years beginning after December 31, 2008) of qualified research expenses that exceed 50 percent of the average qualified research expenses for the three preceding taxable years. The rate is reduced to six percent if a taxpayer has no qualified research expenses in any one of the three preceding taxable years.

An election to use the alternative simplified credit applies to all succeeding taxable years unless revoked with the consent of the Secretary. An election to use the alternative simplified credit may not be made for any taxable year for which an election to use the alternative incremental credit is in effect. A transition rule applies which permits a taxpayer to elect to use the alternative simplified credit in lieu of the alternative incremental credit if such election is made during the taxable year which includes January 1, 2007. The transition rule applies only to the taxable year which includes that date.



Eligible expenses

Qualified research expenses eligible for the research tax credit consist of: (1) in-house expenses of the taxpayer for wages and supplies attributable to qualified research; (2) certain time-sharing costs for computer use in qualified research; and (3) 65 percent of amounts paid or incurred by the taxpayer to certain other persons for qualified research conducted on the taxpayer's behalf (so-called contract research expenses). 38 Notwithstanding the limitation for contract research expenses, qualified research expenses include 100 percent of amounts paid or incurred by the taxpayer to an eligible small business, university, or Federal laboratory for qualified energy research.

To be eligible for the credit, the research not only has to satisfy the requirements of present-law section 174 (described below) but also must be undertaken for the purpose of discovering information that is technological in nature, the application of which is intended to be useful in the development of a new or improved business component of the taxpayer, and substantially all of the activities of which constitute elements of a process of experimentation for functional aspects, performance, reliability, or quality of a business component. Research does not qualify for the credit if substantially all of the activities relate to style, taste, cosmetic, or seasonal design factors. 39 In addition, research does not qualify for the credit: (1) if conducted after the beginning of commercial production of the business component; (2) if related to the adaptation of an existing business component to a particular customer's requirements; (3) if related to the duplication of an existing business component from a physical examination of the component itself or certain other information; or (4) if related to certain efficiency surveys, management function or technique, market research, market testing, or market development, routine data collection or routine quality control. 40 Research does not qualify for the credit if it is conducted outside the United States, Puerto Rico, or any U.S. possession.



Relation to deduction

Under section 174, taxpayers may elect to deduct currently the amount of certain research or experimental expenditures paid or incurred in connection with a trade or business, notwithstanding the general rule that business expenses to develop or create an asset that has a useful life extending beyond the current year must be capitalized. 41 However, deductions allowed to a taxpayer under section 174 (or any other section) are reduced by an amount equal to 100 percent of the taxpayer's research tax credit determined for the taxable year. 42 Taxpayers may alternatively elect to claim a reduced research tax credit amount under section 41 in lieu of reducing deductions otherwise allowed. 43


Description of Proposal


The proposal creates a new 20 percent credit for all qualified energy research expenses paid or incurred in 2009 or 2010. Qualified energy research expenses are qualified research expenses related to the fields of fuel cells and battery technology, renewable energy, energy conservation technology, efficient transmission and distribution of electricity, and carbon capture and sequestration.


Effective Date


The proposal is effective for taxable years beginning after December 31, 2008.



10. Five-year carryback of general business credit


Present Law


Present law permits a credit against tax for the sum of the business credit carryforwards carried to the taxable year, the amount of the current year business credit, and the business credit carrybacks carried to the taxable year. 44 The business credit is comprised of several different credits, such as the work opportunity credit, the research credit, and the low-income housing credit. 45 The business credit for any taxable year may not exceed the excess of the taxpayer's net income tax over the greater of the taxpayer's tentative minimum tax or 25 percent of so much of the taxpayer's net regular tax liability as exceeds $25,000. 46 Business credits in excess of the limitation may be carried back one taxable year and forward up to 20 taxable years. 47


Description of Proposal


The proposal extends the carryback period of business credits from 2008 and 2009 to five years.


Effective Date


The proposal is effective for taxable years ending after December 31, 2007, and to carrybacks of business credits from such taxable years.



11. Temporary provision allowing general business credits to offset 100 percent of Federal income tax liability


Present Law


The business credit for any taxable year may not exceed the excess of the taxpayer's net income tax over the greater of the taxpayer's tentative minimum tax or 25 percent of so much of the taxpayer's net regular tax liability as exceeds $25,000. 48


Description of Proposal


The proposal allows business credits carried to taxable years ending in 2008 and 2009 to offset the entire net income tax without regard to the present-law limitation. The proposal also allows carrybacks of business credits from taxable years ending in 2008 and 2009 to offset the entire net income tax without regard to the present-law limitation.

The proposal may be illustrated by the following examples:

Example 1 .-Taxpayer has a $50 business credit carryover to 2008. In 2008, Taxpayer has $60 of net income tax, $40 of tentative minimum tax, and $0 of current year business credit. The business credit allowed in 2008 is $50.

Example 2 .-Taxpayer has a $100 business credit carryover from 2002. In 2003, Taxpayer has $100 of net income tax, $60 of tentative minimum tax, and $0 of current year business credit. In 2003, the taxpayer uses $40 of its business credit carryover under the limitation in section 38(c) and carries forward the remaining $60. In 2004 through 2007, Taxpayer utilizes $20 of the carryover and has $40 remaining. In 2008, Taxpayer has $0 of net income tax, $0 of tentative minimum tax, and $100 of current year business credits. Taxpayer may carryback the $40 credit carryover from prior years and $20 of the 2008 credit to offset the $60 of net income tax (equal to the tentative minimum tax) in 2003. 49


Effective Date


The proposal is effective for taxable years ending after December 31, 2007, and to carrybacks of business credits from such taxable years.


III. TAX INCENTIVES FOR BUSINESS




1. Special allowance for certain property acquired during 2009


Present Law


Present law permits an additional first-year depreciation deduction equal to 50 percent of the adjusted basis of qualified property. 50 The additional first-year depreciation deduction is allowed for both regular tax and alternative minimum tax purposes for the taxable year in which the property is placed in service. 51 The basis of the property and the depreciation allowances in the year of purchase and later years are appropriately adjusted to reflect the additional first-year depreciation deduction. In addition, there are no adjustments to the allowable amount of depreciation for purposes of computing a taxpayer's alternative minimum taxable income with respect to property to which the proposal applies. The amount of the additional first-year depreciation deduction is not affected by a short taxable year. The taxpayer may elect out of additional first-year depreciation for any class of property for any taxable year.

The interaction of the additional first-year depreciation allowance with the otherwise applicable depreciation allowance may be illustrated as follows. Assume that in 2008, a taxpayer purchases new depreciable property and places it in service. 52 The property's cost is $1,000, and it is 5-year property subject to the half-year convention. The amount of additional first-year depreciation allowed is $500. The remaining $500 of the cost of the property is deductible under the rules applicable to 5-year property. Thus, 20 percent, or $100, is also allowed as a depreciation deduction in 2008. The total depreciation deduction with respect to the property for 2008 is $600. The remaining $400 cost of the property is recovered under otherwise applicable rules for computing depreciation.

In order for property to qualify for the additional first-year depreciation deduction it must meet all of the following requirements. First, the property must be (1) property to which the modified accelerated cost recovery system ("MACRS") applies with an applicable recovery period of 20 years or less, (2) water utility property (as defined in section 168(e)(5)), (3) computer software other than computer software covered by section 197, or (4) qualified leasehold improvement property (as defined in section 168(k)(3)). 53 Second, the original use 54 of the property must commence with the taxpayer after December 31, 2007. 55 Third, the taxpayer must purchase the property within the applicable time period. Finally, the property must be placed in service after December 31, 2007, and before January 1, 2009. An extension of the placed in service date of one year (i.e., to January 1, 2010) is provided for certain property with a recovery period of ten years or longer and certain transportation property. 56 Transportation property is defined as tangible personal property used in the trade or business of transporting persons or property.

The applicable time period for acquired property is (1) after December 31, 2007, and before January 1, 2009, but only if no binding written contract for the acquisition is in effect before January 1, 2008, or (2) pursuant to a binding written contract which was entered into after December 31, 2007, and before January 1, 2009. 57 With respect to property that is manufactured, constructed, or produced by the taxpayer for use by the taxpayer, the taxpayer must begin the manufacture, construction, or production of the property after December 31, 2007, and before January 1, 2009. Property that is manufactured, constructed, or produced for the taxpayer by another person under a contract that is entered into prior to the manufacture, construction, or production of the property is considered to be manufactured, constructed, or produced by the taxpayer. For property eligible for the extended placed in service date, a special rule limits the amount of costs eligible for the additional first-year depreciation. With respect to such property, only the portion of the basis that is properly attributable to the costs incurred before January 1, 2009 ("progress expenditures") is eligible for the additional first-year depreciation. 58

Property does not qualify for the additional first-year depreciation deduction when the user of such property (or a related party) would not have been eligible for the additional first-year depreciation deduction if the user (or a related party) were treated as the owner. For example, if a taxpayer sells to a related party property that was under construction prior to January 1, 2008, the property does not qualify for the additional first-year depreciation deduction. Similarly, if a taxpayer sells to a related party property that was subject to a binding written contract prior to January 1, 2008, the property does not qualify for the additional first-year depreciation deduction. As a further example, if a taxpayer (the lessee) sells property in a sale-leaseback arrangement, and the property otherwise would not have qualified for the additional first-year depreciation deduction if it were owned by the taxpayer-lessee, then the lessor is not entitled to the additional first-year depreciation deduction.

The limitation on the amount of depreciation deductions allowed with respect to certain passenger automobiles (sec. 280F) is increased in the first-year by $8,000 for automobiles that qualify (and do not elect out of the increased first year deduction). The $8,000 increase is not indexed for inflation.

Corporations otherwise eligible for additional first-year depreciation under section 168(k) may elect to claim additional research or minimum tax credits in lieu of claiming depreciation under section 168(k) for "eligible qualified property." 59


Description of Proposal


The proposal extends the additional first-year depreciation deduction for one year, generally through 2009 (through 2010 for certain longer-lived and transportation property).

The proposal modifies the definition of qualified property to include certain motion picture film or video tape (within the meaning of section 168(f)(3)) for which a deduction is allowable under section 167(a) (without regard to section 168) and with respect to which an election is not in effect under section 181. For purposes of the election out of bonus depreciation, all motion picture film and video tape property is treated as one class of property. The proposal does not apply to any property for which records are required under section 2257 of Title 18 U.S.C. to be maintained with respect to any performer in such film or video.

The proposal does not modify the property eligible for the election to accelerate AMT and research credits in lieu of bonus depreciation under section 168(k)(4). 60


Effective Date


The proposal is generally effective for property placed in service after December 31, 2008.

The technical amendment to section 168(k)(4)(D) is effective for taxable years ending after March 31, 2008.



2. Temporary increase in limitations on expensing of certain depreciable business assets


Present Law


In lieu of depreciation, a taxpayer with a sufficiently small amount of annual investment may elect to deduct (or "expense") such costs under section 179. Present law provides that the maximum amount a taxpayer may expense for taxable years beginning in 2008 is $250,000 of the cost of qualifying property placed in service for the taxable year. 61 For taxable years beginning in 2009 and 2010, the limitation is $125,000. 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 placed in service in taxable years beginning before 2011 is treated as qualifying property. For taxable years beginning in 2008, the $250,000 amount is reduced (but not below zero) by the amount by which the cost of qualifying property placed in service during the taxable year exceeds $800,000. For taxable years beginning in 2009 and 2010, the $125,000 amount is reduced (but not below zero) by the amount by which the cost of qualifying property placed in service during the taxable year exceeds $500,000. The $125,000 and $500,000 amounts are indexed for inflation in taxable years beginning in 2009 and 2010.

The amount eligible to be expensed for a taxable year may not exceed the taxable income for a taxable year that is derived from the active conduct of a trade or business (determined without regard to this proposal). Any amount that is not allowed as a deduction because of the taxable income limitation may be carried forward to succeeding taxable years (subject to similar limitations). No general business credit under section 38 is allowed with respect to any amount for which a deduction is allowed under section 179. An expensing election is made under rules prescribed by the Secretary. 62

For taxable years beginning in 2011 and thereafter (or before 2003), the following rules apply. A taxpayer with a sufficiently small amount of annual investment may elect to deduct up to $25,000 of the cost of qualifying property placed in service for the taxable year. The $25,000 amount is reduced (but not below zero) by the amount by which the cost of qualifying property placed in service during the taxable year exceeds $200,000. The $25,000 and $200,000 amounts are not indexed for inflation. 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 (not including off-the-shelf computer software). An expensing election may be revoked only with consent of the Commissioner. 63


Description of Proposal


The proposal extends the $250,000 and $800,000 amounts to taxable years beginning in 2009.


Effective Date


The proposal is effective for taxable years beginning after December 31, 2008.



3. Five-year carryback of operating losses


Present Law


Under present law, a net operating loss ("NOL") generally means the amount by which a taxpayer's business deductions exceed its gross income. In general, an NOL may be carried back two years and carried over 20 years to offset taxable income in such years. 64 NOLs offset taxable income in the order of the taxable years to which the NOL may be carried. 65

The alternative minimum tax rules provide that a taxpayer's NOL deduction cannot reduce the taxpayer's alternative minimum taxable income ("AMTI") by more than 90 percent of the AMTI.

Different rules apply with respect to NOLs arising in certain circumstances. A three-year carryback applies with respect to NOLs (1) arising from casualty or theft losses of individuals, or (2) attributable to Presidentially declared disasters for taxpayers engaged in a farming business or a small business. A five-year carryback applies to NOLs (1) arising from a farming loss (regardless of whether the loss was incurred in a Presidentially declared disaster area), (2) certain amounts related to Hurricane Katrina, Gulf Opportunity Zone, and Midwestern Disaster Area, or (3) qualified disaster losses. 66 Special rules also apply to real estate investment trusts (no carryback), specified liability losses (10-year carryback), and excess interest losses (no carryback to any year preceding a corporate equity reduction transaction). Additionally, a special rule applies to certain electric utility companies.

In the case of a life insurance company, present law allows a deduction for the taxable year for operations loss carryovers and carrybacks in lieu of the deduction for net operating losses allowed to other corporations. 67 A life insurance company is permitted to treat a loss from operations (as defined under section 810(c)) for any taxable year as an operations loss carryback to each of the three taxable years preceding the loss year and an operations loss carryover to each of the 15 taxable years following the loss year. 68 Special rules apply to new life insurance companies.


Description of Proposal


The proposal increases the general NOL carryback period from two years to five years in the case of an NOL for any taxable year ending during 2008 or 2009. The proposal also suspends the 90-percent limitation on the use of any alternative tax NOL deduction attributable to carrybacks from taxable years ending during 2008 or 2009, and carryovers to taxable years ending during 2008 and 2009.

A taxpayer may elect to have the carryback period determined without regard to the special five year period or may use any whole number of years less than five in its place. For example, a taxpayer incurring a net operating loss in 2008 may elect to carry the loss back to 2004 (i.e., four years).

For life insurance companies, the proposal increases the carryback period for losses from operations from three years to any whole amount of years less than six in the case of losses from operations for any taxable year ending during 2008 or 2009.

For a net operating loss for a taxable year ending during 2008, the proposal includes three transition rules: (1) any election to waive the carryback period under either sections 172(b)(3) or 810(b)(3) with respect to such loss may be revoked before the applicable date; (2) any election to disregard the five year carryback period in favor of a shorter carryback period under section 172(k) or to use a carryback period under section 810(b)(4) with respect to such loss is treated as timely made if made before the applicable date; and (3) any application for a tentative carryback adjustment under section 6411(a) with respect to such loss is treated as timely filed if filed before the applicable date. For purposes of the transition rules, the applicable date is the date which is 60 days after the date of the enactment of the proposal.

The proposal does not apply to: (1) any taxpayer if (a) the Federal Government acquires, at any time, an equity interest in the taxpayer pursuant to the Emergency Economic Stabilization Act of 2008, or (b) the Federal Government acquires, at any time, any warrant (or other right) to acquire any equity interest with respect to the taxpayer pursuant to such Act; (2) the Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation; and (3) any taxpayer that in 2008 or 2009 is a member of the same affiliated group (as defined in section 1504 without regard to subsection (b) thereof) as a taxpayer to which the proposal does not otherwise apply.


Effective Date


The proposal is generally effective for net operating losses arising in taxable years ending after December 31, 2007. The modification to the alternative tax NOL deduction applies to taxable years ending after 1997. The modification with respect to operating loss deductions of life insurance companies applies to losses from operations arising in taxable years ending after December 31, 2007.



4. Modification of work opportunity tax credit


Present Law




In general

The work opportunity tax credit is available on an elective basis for employers hiring individuals from one or more of nine targeted groups. The amount of the credit available to an employer is determined by the amount of qualified wages paid by the employer. Generally, qualified wages consist of wages attributable to service rendered by a member of a targeted group during the one-year period beginning with the day the individual begins work for the employer (two years in the case of an individual in the long-term family assistance recipient category).



Targeted groups eligible for the credit

Generally an employer is eligible for the credit only for qualified wages paid to members of a targeted group.



(1) Families receiving TANF

An eligible recipient is an individual certified by a designated local employment agency (e.g., a State employment agency) as being a member of a family eligible to receive benefits under the Temporary Assistance for Needy Families Program ("TANF") for a period of at least nine months part of which is during the 18-month period ending on the hiring date. For these purposes, members of the family are defined to include only those individuals taken into account for purposes of determining eligibility for the TANF.



(2) Qualified veteran

There are two subcategories of qualified veterans related to eligibility for Food stamps and compensation for a service-connected disability.



Food stamps

A qualified veteran is a veteran who is certified by the designated local agency as a member of a family receiving assistance under a food stamp program under the Food Stamp Act of 1977 for a period of at least three months part of which is during the 12-month period ending on the hiring date. For these purposes, members of a family are defined to include only those individuals taken into account for purposes of determining eligibility for a food stamp program under the Food Stamp Act of 1977.



Entitled to compensation for a service-connected disability

A qualified veteran also includes an individual who is certified as entitled to compensation for a service-connected disability and: (1) having a hiring date which is not more than one year after having been discharged or released from active duty in the Armed Forces of the United States, or (2) having been unemployed for six months or more (whether or not consecutive) during the one-year period ending on the date of hiring.



Definitions

For these purposes, being entitled to compensation for a service-connected disability is defined with reference to section 101 of Title 38, U.S. Code, which means having a disability rating of 10-percent or higher for service connected injuries.

For these purposes, a veteran is an individual who has served on active duty (other than for training) in the Armed Forces for more than 180 days or who has been discharged or released from active duty in the Armed Forces for a service-connected disability. However, any individual who has served for a period of more than 90 days during which the individual was on active duty (other than for training) is not a qualified veteran if any of this active duty occurred during the 60-day period ending on the date the individual was hired by the employer. This latter rule is intended to prevent employers who hire current members of the armed services (or those departed from service within the last 60 days) from receiving the credit.



(3) Qualified ex-felon

A qualified ex-felon is an individual certified as: (1) having been convicted of a felony under any State or Federal law, and (2) having a hiring date within one year of release from prison or the date of conviction.



(4) Designated community residents

A designated community resident is an individual certified as being at least age 18 but not yet age 40 on the hiring date and as having a principal place of abode within an empowerment zone, enterprise community, renewal community or a rural renewal community. For these purposes, a rural renewal county is a county outside a metropolitan statistical area (as defined by the Office of Management and Budget) which had a net population loss during the five-year periods 1990-1994 and 1995-1999. Qualified wages do not include wages paid or incurred for services performed after the individual moves outside an empowerment zone, enterprise community, renewal community or a rural renewal community.



(5) Vocational rehabilitation referral

A vocational rehabilitation referral is an individual who is certified by a designated local agency as an individual who has a physical or mental disability that constitutes a substantial handicap to employment and who has been referred to the employer while receiving, or after completing: (a) vocational rehabilitation services under an individualized, written plan for employment under a State plan approved under the Rehabilitation Act of 1973; (b) under a rehabilitation plan for veterans carried out under Chapter 31 of Title 38, U.S. Code; or (c) an individual work plan developed and implemented by an employment network pursuant to subsection (g) of section 1148 of the Social Security Act. Certification will be provided by the designated local employment agency upon assurances from the vocational rehabilitation agency that the employee has met the above conditions.



(6) Qualified summer youth employee

A qualified summer youth employee is an individual: (a) who performs services during any 90-day period between May 1 and September 15, (b) who is certified by the designated local agency as being 16 or 17 years of age on the hiring date, (c) who has not been an employee of that employer before, and (d) who is certified by the designated local agency as having a principal place of abode within an empowerment zone, enterprise community, or renewal community (as defined under Subchapter U of Subtitle A, Chapter 1 of the Internal Revenue Code). As with designated community residents, no credit is available on wages paid or incurred for service performed after the qualified summer youth moves outside of an empowerment zone, enterprise community, or renewal community. If, after the end of the 90-day period, the employer continues to employ a youth who was certified during the 90-day period as a member of another targeted group, the limit on qualified first year wages will take into account wages paid to the youth while a qualified summer youth employee.



(7) Qualified food stamp recipient

A qualified food stamp recipient is an individual at least age 18 but not yet age 40 certified by a designated local employment agency as being a member of a family receiving assistance under a food stamp program under the Food Stamp Act of 1977 for a period of at least six months ending on the hiring date. In the case of families that cease to be eligible for food stamps under section 6(o) of the Food Stamp Act of 1977, the six-month requirement is replaced with a requirement that the family has been receiving food stamps for at least three of the five months ending on the date of hire. For these purposes, members of the family are defined to include only those individuals taken into account for purposes of determining eligibility for a food stamp program under the Food Stamp Act of 1977.



(8) Qualified SSI recipient

A qualified SSI recipient is an individual designated by a local agency as receiving supplemental security income ("SSI") benefits under Title XVI of the Social Security Act for any month ending within the 60-day period ending on the hiring date.



(9) Long-term family assistance recipients

A qualified long-term family assistance recipient is an individual certified by a designated local agency as being: (a) a member of a family that has received family assistance for at least 18 consecutive months ending on the hiring date; (b) a member of a family that has received such family assistance for a total of at least 18 months (whether or not consecutive) after August 5, 1997 (the date of enactment of the welfare-to-work tax credit) 69 if the individual is hired within two years after the date that the 18-month total is reached; or (c) a member of a family who is no longer eligible for family assistance because of either Federal or State time limits, if the individual is hired within two years after the Federal or State time limits made the family ineligible for family assistance.



Qualified wages

Generally, qualified wages are defined as cash wages paid by the employer to a member of a targeted group. The employer's deduction for wages is reduced by the amount of the credit.

For purposes of the credit, generally, wages are defined by reference to the FUTA definition of wages contained in section 3306(b) (without regard to the dollar limitation therein contained). Special rules apply in the case of certain agricultural labor and certain railroad labor.



Calculation of the credit

The credit available to an employer for qualified wages paid to members of all targeted groups except for long-term family assistance recipients equals 40 percent (25 percent for employment of 400 hours or less) of qualified first-year wages. Generally, qualified first-year wages are qualified wages (not in excess of $6,000) attributable to service rendered by a member of a targeted group during the one-year period beginning with the day the individual began work for the employer. Therefore, the maximum credit per employee is $2,400 (40 percent of the first $6,000 of qualified first-year wages). With respect to qualified summer youth employees, the maximum credit is $1,200 (40 percent of the first $3,000 of qualified first-year wages). Except for long-term family assistance recipients, no credit is allowed for second-year wages.

In the case of long-term family assistance recipients, the credit equals 40 percent (25 percent for employment of 400 hours or less) of $10,000 for qualified first-year wages and 50 percent of the first $10,000 of qualified second-year wages. Generally, qualified second-year wages are qualified wages (not in excess of $10,000) attributable to service rendered by a member of the long-term family assistance category during the one-year period beginning on the day after the one-year period beginning with the day the individual began work for the employer. Therefore, the maximum credit per employee is $9,000 (40 percent of the first $10,000 of qualified first-year wages plus 50 percent of the first $10,000 of qualified second-year wages).

In the case of a qualified veteran who is entitled to compensation for a service connected disability, the credit equals 40 percent of $12,000 of qualified first-year wages. This expanded definition of qualified first-year wages does not apply to the veterans qualified with reference to a food stamp program, as defined under present law.



Certification rules

An individual is not treated as a member of a targeted group unless: (1) on or before the day on which an individual begins work for an employer, the employer has received a certification from a designated local agency that such individual is a member of a targeted group; or (2) on or before the day an individual is offered employment with the employer, a pre-screening notice is completed by the employer with respect to such individual, and not later than the 28th day after the individual begins work for the employer, the employer submits such notice, signed by the employer and the individual under penalties of perjury, to the designated local agency as part of a written request for certification. For these purposes, a pre-screening notice is a document (in such form as the Secretary may prescribe) which contains information provided by the individual on the basis of which the employer believes that the individual is a member of a targeted group.



Minimum employment period

No credit is allowed for qualified wages paid to employees who work less than 120 hours in the first year of employment.



Other rules

The work opportunity tax credit is not allowed for wages paid to a relative or dependent of the taxpayer. No credit is allowed for wages paid to an individual who is a more than fifty-percent owner of the entity. Similarly, wages paid to replacement workers during a strike or lockout are not eligible for the work opportunity tax credit. Wages paid to any employee during any period for which the employer received on-the-job training program payments with respect to that employee are not eligible for the work opportunity tax credit. The work opportunity tax credit generally is not allowed for wages paid to individuals who had previously been employed by the employer. In addition, many other technical rules apply.



Expiration

The work opportunity tax credit is not available for individuals who begin work for an employer after August 31, 2011.


Description of Proposal


The proposal creates a new targeted group for the work opportunity tax credit. That new category is unemployed veterans and disconnected youth who begin work for the employer in 2009 or 2010.

An unemployed veteran is defined as an individual certified by the designated local agency as someone who: (1) has served on active duty (other than for training) in the Armed Forces for more than 180 days or who has been discharged or released from active duty in the Armed Forces for a service-connected disability; (2) has been discharged or released from active duty in the Armed Forces during 2008, 2009, or 2010; and (3) has received unemployment compensation under State or Federal law for not less than four weeks during the one-year period ending on the hiring date.

A disconnected youth is defined as an individual certified by the designated local agency as someone: (1) at least age 16 but not yet age 25 on the hiring date; (2) not regularly attending any secondary, technical, or post-secondary school during the six-month period preceding the hiring date; (3) not regularly employed during the six-month period preceding the hiring date; and (4) not readily employable by reason of lacking a sufficient number of skills.


Effective Date


The proposals are effective for individuals who begin work for an employer after December 31, 2008.



5. Extension of election to accelerate AMT and research credits in lieu of bonus depreciation


Present Law


Corporations otherwise eligible for additional first year depreciation under section 168(k) may elect to claim additional research or minimum tax credits in lieu of claiming depreciation under section 168(k) for "eligible qualified property" placed in service after March 31, 2008. 70 A corporation making the election forgoes the depreciation deductions allowable under section 168(k) and instead increases the limitation under section 38(c) on the use of research credits or section 53(c) on the use of minimum tax credits. 71 The increases in the allowable credits are treated as refundable for purposes of this proposal. The depreciation for qualified property is calculated for both regular tax and AMT purposes using the straight-line method in place of the method that would otherwise be used absent the election under this proposal.

The research credit or minimum tax credit limitation is increased by the bonus depreciation amount, which is equal to 20 percent of bonus depreciation 72 for certain eligible qualified property that could be claimed absent an election under this proposal. Generally, eligible qualified property included in the calculation is bonus depreciation property that meets the following requirements: (1) the original use of the property must commence with the taxpayer after March 31, 2008; (2) the taxpayer must purchase the property either (a) after March 31, 2008, and before January 1, 2009, but only if no binding written contract for the acquisition is in effect before April 1, 2008, 73 or (b) pursuant to a binding written contract which was entered into after March 31, 2008, and before January 1, 2009; 74 and (3) the property must be placed in service after March 31, 2008, and before January 1, 2009 (January 1, 2010 for certain longer-lived and transportation property).

The bonus depreciation amount is limited to the lesser of: (1) $30 million, or (2) six percent of the sum of research credit carryforwards from taxable years beginning before January 1, 2006 and minimum tax credits allocable to the adjusted minimum tax imposed for taxable years beginning before January 1, 2006. All corporations treated as a single employer under section 52(a) shall be treated as one taxpayer for purposes of the limitation, as well as for electing the application of this proposal.


Description of Proposal


The proposal generally permits corporations to increase the research credit or minimum tax credit limitation by the bonus depreciation amount with respect to certain property placed in service in 2009 (2010 in the case of certain longer-lived and transportation property).

The proposal applies with respect to extension property, which is defined as property that is eligible qualified property solely because it meets the requirements under the extension of the special allowance for certain property acquired during 2009. 75

The proposal allows a taxpayer that has made an election to increase the research credit or minimum tax credit limitation for its first taxable year ending after March 31, 2008, to have that election not apply to extension property. Further, the proposal allows a taxpayer that has not made an election for its first taxable year ending after March 31, 2008, to elect under this proposal for extension property for its first taxable year ending after December 31, 2008. In the case of a taxpayer electing to increase the research or minimum tax credit for both eligible qualified property and extension property, separate maximum increase amounts are applied to these two groups of property.


Effective Date


The proposal is effective for taxable years ending after December 31, 2008.



6. Deferral of certain income from the discharge of indebtedness


Present Law


In general, gross income includes income that is realized by a debtor from the discharge of indebtedness, subject to certain exceptions for debtors in Title 11 bankruptcy cases, insolvent debtors, certain student loans, certain farm indebtedness, and certain real property business indebtedness. 76 In cases involving discharges of indebtedness that are excluded from gross income under the exceptions to the general rule, taxpayers generally are required to reduce certain tax attributes, including net operating losses, general business credits, minimum tax credits, capital loss carryovers, and basis in property, by the amount of the discharge of indebtedness. 77

The amount of discharge of indebtedness excluded from income by an insolvent debtor not in a Title 11 bankruptcy case cannot exceed the amount by which the debtor is insolvent. In the case of a discharge in bankruptcy or where the debtor is insolvent, any reduction in basis may not exceed the excess of the aggregate bases of properties held by the taxpayer immediately after the discharge over the aggregate of the liabilities of the taxpayer immediately after the discharge. 78

For all taxpayers, the amount of discharge of indebtedness generally is equal to the difference between the adjusted issue price of the debt being cancelled and the amount used to satisfy the debt. These rules generally apply to the exchange of an old obligation for a new obligation, including a modification of indebtedness that is treated as an exchange (a debt-for-debt exchange). Similarly, if a debtor repurchases its debt instrument for an amount that is less than the "adjusted issue price" of such debt instrument, the debtor realizes income equal to the excess of the adjusted issue price over the repurchase price. 79 In addition, indebtedness acquired by a person who bears a relationship to the debtor described in section 267(b) or section 707(b) is treated as if it were acquired by the debtor. 80 Thus, where a debtor's indebtedness is acquired for less than its adjusted issue price by a person related to the debtor (within the meaning of section 267(b) or 707(b)), the debtor recognizes income from the cancellation of indebtedness.


Description of Proposal


The proposal permits a taxpayer to elect to defer income from cancellation of indebtedness recognized by the taxpayer as a result of a repurchase by (1) the taxpayer or (2) a person who bears a relationship to the taxpayer described in section 267(b) or section 707(b), of a "debt instrument" that was issued by the taxpayer. The proposal applies only to repurchases of debt that (1) occur after December 31, 2008, and prior to January 1, 2011, and (2) are repurchases for cash. Thus, for example, the proposal does not apply to a debt-for-debt exchange or to any exchange of the taxpayer's equity for a debt instrument of the taxpayer. For purposes of the proposal, a "debt instrument" is broadly defined to include any bond, debenture, note, certificate or any other instrument or contractual arrangement constituting indebtedness.

A taxpayer electing to defer cancellation of debt from income under the proposal is required to include in income an amount equal to 25 percent of the deferred amount in each of the four taxable years beginning in the year following the year of the repurchase.


Effective Date


The proposal is effective for repurchases after December 31, 2008.



7. Qualified small business stock


Present Law


Under present law, individuals may exclude 50-percent (60-percent for certain empowerment zone businesses) of the gain from the sale of certain small business stock acquired at original issue and held for at least five years. The taxable portion of the gain is taxed at a maximum rate of 28 percent. Seven percent (forty-two percent after 2010) of the excluded gain is an alternative minimum tax preference. The amount of gain eligible for the exclusion by an individual with respect to any corporation is the greater of (1) ten times the taxpayer's basis in the stock or (2) $10 million. In order to qualify as a small business, when the stock is issued, the gross assets of the corporation may not exceed $50 million. The corporation also must meet certain active trade or business requirements.


Description of Proposal


Under the proposal, the percentage exclusion for qualified small business stock sold by an individual is increased to 75 percent for stock issued after the date of enactment and before January 1, 2011.


Effective Date


The provision is effective for stock issued after the date of enactment.


IV. MANUFACTURING RECOVERY PROVISIONS




1. Expand industrial development bonds to include creation of intangible property and other modifications


Present Law


Qualified small issue bonds (commonly referred to as "industrial development bonds" or "small issue IDBs") are tax-exempt bonds issued by State and local governments to finance private business manufacturing facilities (including certain directly related and ancillary facilities) or the acquisition of land and equipment by certain farmers. In both instances, these bonds are subject to limits on the amount of financing that may be provided, both for a single borrowing and in the aggregate. In general, no more than $1 million of small-issue bond financing may be outstanding at any time for property of a business (including related parties) located in the same municipality or county. Generally, this $1 million limit may be increased to $10 million if, in addition to outstanding bonds, all other capital expenditures of the business (including related parties) in the same municipality or county are counted toward the limit over a six-year period that begins three years before the issue date of the bonds and ends three years after such date. Outstanding aggregate borrowing is limited to $40 million per borrower (including related parties) regardless of where the property is located.

For bonds issued after September 30, 2009, the Code permits up to $10 million of capital expenditures to be disregarded, in effect increasing from $10 million to $20 million the maximum allowable amount of total capital expenditures by an eligible business in the same municipality or county. However, no more than $10 million of bond financing may be outstanding at any time for property of an eligible business (including related parties) located in the same municipality or county. Other limits (e.g., the $40 million per borrower limit) also continue to apply.

A manufacturing facility is any facility which is used in the manufacturing or production of tangible personal property (including the processing resulting in a change in the condition of such property). Manufacturing facilities include facilities that are directly related and ancillary to a manufacturing facility (as described in the previous sentence) if (1) such facilities are located on the same site as the manufacturing facility and (2) not more than 25 percent of the net proceeds of the issue are used to provide such facilities. 81



Description of Proposal

The proposal expands the definition of manufacturing facilities to mean any facility that is used in the manufacturing, creation, or production of tangible property or intangible property (within the meaning of section 197(d)(1)(C)(iii)). For this purpose, intangible property means any patent, copyright, formula, process, design, knowhow, format, or other similar item.

In addition, the proposal provides that facilities that are functionally related and subordinate to the manufacturing facility are treated as a manufacturing facility and the 25 percent of net proceeds restriction does not apply to such facilities. Functionally related and subordinate facilities must be located on the same site as the manufacturing facility.

The proposal is effective for bonds issued after the date of enactment and before January 1, 2011.


Effective Date


The proposal is effective for bonds issued after the date of enactment.



2. Credit for investment in advanced energy property


Present Law


An income tax credit is allowed for the production of electricity from qualified energy resources at qualified facilities. 82 Qualified energy resources comprise wind, closed-loop biomass, open-loop biomass, geothermal energy, solar energy, small irrigation power, municipal solid waste, qualified hydropower production, and marine and hydrokinetic renewable energy. Qualified facilities are, generally, facilities that generate electricity using qualified energy resources.

An income tax credit is also allowed for certain energy property placed in service. Qualifying property includes certain fuel cell property, solar property, geothermal power production property, small wind energy property, combined heat and power system property, and geothermal heat pump property. 83

In addition to these, numerous other credits are available to taxpayers to encourage renewable energy production and energy conservation, including, among others, credits for certain biofuels, plug-in electric vehicles, and energy efficient appliances, and for improvements to heating, air conditioning, and insulation.

No credit is specifically designed under present law to encourage the development of a domestic manufacturing base to support the industries described above.


Description of Proposal


The proposal establishes a 30 percent credit for investment in qualified property used in a qualified advanced energy manufacturing project. A qualified advanced energy manufacturing project is a project that re-equips, expands, or establishes a manufacturing facility for the production of property: (1) designed to be used to produce energy from the sun, wind, or geothermal deposits (within the meaning of section 613(e)(2)); (2) designed to manufacture fuel cells, microturbines, or an energy storage system for use with electric or hybrid-electric motor vehicles; (3) designed to manufacture electric grids to support the transmission of intermittent sources of renewable energy; or (4) designed to manufacture equipment for use for carbon capture or sequestration.

Qualified property must be depreciable (tangible) property used in a qualified advanced energy manufacturing project. The construction, reconstruction, or erection of such property must be completed by the taxpayer after October 31, 2008 (or, if purchased, the original use 84 of the property must commence with the taxpayer after such date). Qualified property does not include property designed to manufacture equipment for use in the refining or blending of any transportation fuel. The basis of qualified property must be reduced by the amount of credit received.

Credits are available only for qualified advanced energy manufacturing projects certified by the Secretary of Treasury, in consultation with the Secretary of Energy. The Secretary of Treasury must establish a certification program no later than 180 days after date of enactment, and may allocate up to $2 billion in credits. Each project application must be submitted during the three-year period beginning on the date such certification program is established. An applicant for certification has two years from the date the Secretary accepts the application to provide the Secretary with evidence that the requirements for certification have been met. Upon certification, the applicant has five years from the date of issuance of the certification to place the project in service.


Effective Date


The proposal is effective on date of enactment.


V. ECONOMIC RECOVERY TOOLS




1. Recovery Zone Bonds


Present Law




In general

Under present law, gross income does not include interest on State or local bonds. State and local bonds are classified generally as either governmental bonds or private activity bonds. Governmental bonds are bonds the proceeds of which are primarily used to finance governmental functions or which are repaid with governmental funds. Private activity bonds are bonds in which the State or local government serves as a conduit providing financing to nongovernmental persons (e.g., private businesses or individuals). The exclusion from income for State and local bonds does not apply to private activity bonds unless the bonds are issued for certain permitted purposes ("qualified private activity bonds") and other Code requirements are met.



Private activity bonds

The Code defines a private activity bond as any bond that satisfies (1) the private business use test and the private security or payment test ("the private business test"); or (2) "the private loan financing test." 85



Private business test

Under the private business test, a bond is a private activity bond if it is part of an issue in which:
1. More than 10 percent of the proceeds of the issue (including use of the bond-financed property) are to be used in the trade or business of any person other than a governmental unit ("private business use"); and

2. More than 10 percent of the payment of principal or interest on the issue is, directly or indirectly, secured by (a) property used or to be used for a private business use or (b) to be derived from payments in respect of property, or borrowed money, used or to be used for a private business use ("private payment test"). 86

A bond is not a private activity bond unless both parts of the private business test (i.e., the private business use test and the private payment test) are met. Thus, a facility that is 100 percent privately used does not cause the bonds financing such facility to be private activity bonds if the bonds are not secured by or paid with private payments. For example, land improvements that benefit a privately-owned factory may be financed with governmental bonds if the debt service on such bonds is not paid by the factory owner or other private parties and such bonds are not secured by the property.



Private loan financing test

A bond issue satisfies the private loan financing test if proceeds exceeding the lesser of $5 million or five percent of such proceeds are used directly or indirectly to finance loans to one or more nongovernmental persons. Private loans include both business and other (e.g., personal) uses and payments to private persons; however, in the case of business uses and payments, all private loans also constitute private business uses and payments subject to the private business test.



Arbitrage restrictions

The exclusion from income for interest on State and local bonds does not apply to any arbitrage bond. 87 An arbitrage bond is defined as any bond that is part of an issue if any proceeds of the issue are reasonably expected to be used (or intentionally are used) to acquire higher yielding investments or to replace funds that are used to acquire higher yielding investments. 88 In general, arbitrage profits may be earned only during specified periods (e.g., defined "temporary periods") before funds are needed for the purpose of the borrowing or on specified types of investments (e.g., "reasonably required reserve or replacement funds"). Subject to limited exceptions, investment profits that are earned during these periods or on such investments must be rebated to the Federal Government.



Qualified private activity bonds

Qualified private activity bonds permit States or local governments to act as conduits providing tax-exempt financing for certain private activities. The definition of qualified private activity bonds includes an exempt facility bond, or qualified mortgage, veterans' mortgage, small issue, redevelopment, 501(c)(3), or student loan bond (sec. 141(e)).

The definition of an exempt facility bond includes bonds issued to finance certain transportation facilities (airports, ports, mass commuting, and high-speed intercity rail facilities); qualified residential rental projects; privately owned and/or operated utility facilities (sewage, water, solid waste disposal, and local district heating and cooling facilities, certain private electric and gas facilities, and hydroelectric dam enhancements); public/private educational facilities; qualified green building and sustainable design projects; and qualified highway or surface freight transfer facilities (sec. 142(a)).

In most cases, the aggregate volume of qualified private activity bonds is restricted by annual aggregate volume limits imposed on bonds issued by issuers within each State ("State volume cap"). For calendar year 2007, the State volume cap, which is indexed for inflation, equals $85 per resident of the State, or $256.24 million, if greater. Exceptions to the State volume cap are provided for bonds for certain governmentally owned facilities (e.g., airports, ports, high-speed intercity rail, and solid waste disposal) and bonds which are subject to separate local, State, or national volume limits (e.g., public/private educational facility bonds, enterprise zone facility bonds, qualified green building bonds, and qualified highway or surface freight transfer facility bonds).

Qualified private activity bonds generally are subject to restrictions on the use of proceeds for the acquisition of land and existing property. In addition, qualified private activity bonds generally are subject to restrictions on the use of proceeds to finance certain specified facilities (e.g., airplanes, skyboxes, other luxury boxes, health club facilities, gambling facilities, and liquor stores), and use of proceeds to pay costs of issuance (e.g., bond counsel and underwriter fees). Small issue and redevelopment bonds also are subject to additional restrictions on the use of proceeds for certain facilities (e.g., golf courses and massage parlors).

Moreover, the term of qualified private activity bonds generally may not exceed 120 percent of the economic life of the property being financed and certain public approval requirements (similar to requirements that typically apply under State law to issuance of governmental debt) apply under Federal law to issuance of private activity bonds.



Qualified tax credit bonds

In lieu of interest, holders of qualified tax credit bonds receive a tax credit that accrues quarterly. The following bonds are qualified tax credit bonds: qualified forestry conservation bonds, new clean renewable energy bonds, qualified energy conservation bonds, and qualified zone academy bonds. 89

Section 54A of the Code sets forth general rules applicable to qualified tax credit bonds. These rules include requirements regarding the expenditure of available project proceeds, reporting, arbitrage, maturity limitations, and financial conflicts of interest, among other special rules.

A taxpayer who holds a qualified tax credit bond on one or more credit allowance dates of the bond during the taxable year shall be allowed a credit against the taxpayer's income tax for the taxable year. In general, the credit amount for any credit allowance date is 25 percent of the annual credit determined with respect to the bond. The annual credit is determined by multiplying the applicable credit rate by the outstanding face amount of the bond. The applicable credit rate for the bond is the rate that the Secretary estimates will permit the issuance of the qualified tax credit bond with a specified maturity or redemption date without discount and without interest cost to the qualified issuer. 90 The Secretary determines credit rates for tax credit bonds based on general assumptions about credit quality of the class of potential eligible issuers and such other factors as the Secretary deems appropriate. The Secretary may determine credit rates based on general credit market yield indexes and credit ratings.

The credit is included in gross income and, under regulations prescribed by the Secretary, may be stripped. 91

Section 54A of the Code requires that 100 percent of the available project proceeds of qualified tax credit bonds must be used within the three-year period that begins on the date of issuance. Available project proceeds are proceeds from the sale of the bond issue less issuance costs (not to exceed two percent) and any investment earnings on such sale proceeds. To the extent less than 100 percent of the available project proceeds are used to finance qualified projects during the three-year spending period, bonds will continue to qualify as qualified tax credit bonds if unspent proceeds are used within 90 days from the end of such three-year period to redeem bonds. The three-year spending period may be extended by the Secretary upon the issuer's request demonstrating that the failure to satisfy the three-year requirement is due to reasonable cause and the projects will continue to proceed with due diligence.

Qualified tax credit bonds generally are subject to the arbitrage requirements of section 148. However, available project proceeds invested during the three-year spending period are not subject to the arbitrage restrictions (i.e., yield restriction and rebate requirements). In addition, amounts invested in a reserve fund are not subject to the arbitrage restrictions to the extent: (1) such fund is funded at a rate not more rapid than equal annual installments; (2) such fund is funded in a manner reasonably expected to result in an amount not greater than an amount necessary to repay the issue; and (3) the yield on such fund is not greater than the average annual interest rate of tax-exempt obligations having a term of 10 years or more that are issued during the month the qualified tax credit bonds are issued.

The maturity of qualified tax credit bonds is the term that the Secretary estimates will result in the present value of the obligation to repay the principal on such bonds being equal to 50 percent of the face amount of such bonds, using as a discount rate the average annual interest rate of tax-exempt obligations having a term of 10 years or more that are issued during the month the qualified tax credit bonds are issued.


Description of Proposal




In general

The proposal permits an issuer to designate one or more areas as recovery zones. The area must have significant poverty, unemployment, or rate of home foreclosures, or be any area for which a designation as an empowerment zone or renewal community is in effect. Issuers may issue recovery zone economic development bonds and recovery zone facility bonds with respect to these zones.

There is a national recovery zone economic development bond limitation of $10 billion. In addition, there is a separate national recovery zone facility bond limitation of $15 billion. The Secretary is to separately allocate the bond limitations among the States in the proportion that each State's employment decline bears to the aggregate 2008 State employment declines for all States. In turn each State is to reallocate its allocation among the counties (parishes) and large municipalities in such State in the proportion that each such county or municipality's 2008 employment decline bears to the aggregate employment declines for all counties and municipalities in such State. In calculating the local employment decline with respect to a county, the portion of such decline attributable to a large municipality is disregarded for purposes of determining the county's portion of the State employment decline and is attributable to the large municipality only.

In making allocations to the States, the Secretary shall ensure that the minimum allocation for each State does not fall below two percent of the respective national bond limitation.

For purposes of the proposal "2008 State employment decline" means, with respect to any State, the excess (if any) of (i) the number of individuals employed in such State as determined for December 2007, over (ii) the number of individuals employed in such State as determined for December 2008. The term "large municipality" means a municipality with a population of more than 100,000.



Recovery Zone Economic Development Bonds

New section 54AA(h) of the proposal creates a special rule for qualified bonds (a type of taxable governmental bond) issued before January 1, 2011, that entitles the issuer of such bonds to receive an advance tax credit equal to 35 percent of the interest payable on an interest payment date. 92 For taxable governmental bonds that are designated recovery zone economic development bonds, the applicable percentage is 40 percent.

A recovery zone economic development bond is a taxable governmental bond issued as part of an issue if 100 percent of the available project proceeds of such issue are to be used for one or more qualified economic development purposes and the issuer designates such bond for purposes of this section. A qualified economic development purpose means expenditures for purposes of promoting development or other economic activity in a recovery zone, including (1) capital expenditures paid or incurred with respect to property located in such zone, (2) expenditures for public infrastructure and construction of public facilities located in a recovery zone.

The aggregate face amount of bonds which may be designated by any issuer cannot exceed the amount of the recovery zone economic development bond limitation allocated to such issuer.



Recovery Zone Facility Bonds

The proposal creates a new category of exempt facility bonds, "recovery zone facility bonds." A recovery zone facility bond means any bond issued as part of an issue if: (1) 95 percent or more of the net proceeds of such issue are to be used for recovery zone property and (2) such bond is issued before January 1, 2011, and (3) the issuer designates such bond as a recovery zone facility bond. The aggregate face amount of bonds which may be designated by any issuer cannot exceed the amount of the recovery zone facility bond limitation allocated to such issuer.

Under the proposal, the term "recovery zone property" means any property subject to depreciation to which section 168 applies (or would apply but for section 179) if (1) such property was acquired by the taxpayer by purchase after the date on which the designation of the recovery zone took effect; (2) the original use of such property in the recovery zone commences with the taxpayer; and (3) substantially all of the use of such property is in the recovery zone and is in the active conduct of a qualified business by the taxpayer in such zone. The term "qualified business" means any trade or business except that the rental to others of real property located in a recovery zone shall be treated as a qualified business only if the property is not residential rental property (as defined in section 168(e)(2)) and does not include any trade or business consisting of the operation of any facility described in section 144(c)(6)(B) (i.e., any private or commercial golf course, country club, massage parlor, hot tub facility, suntan facility, racetrack or other facility used for gambling, or any store the principal purpose of which is the sale of alcoholic beverages for consumption off premises).

Subject to the following exceptions and modifications, issuance of recovery zone facility bonds is subject to the general rules applicable to issuance of qualified private activity bonds:
1. Issuance of the bonds is not subject to the aggregate annual State private activity bond volume limits (sec. 146);

2. The restriction on acquisition of existing property does not apply (sec. 147(d));


Effective Date


The proposal is effective for obligations issued after the date of enactment.



2. Tribal Economic Development Bonds


Present Law


Under present law, gross income does not include interest on State or local bonds. 93 State and local bonds are classified generally as either governmental bonds or private activity bonds. Governmental bonds are bonds the proceeds of which are primarily used to finance governmental facilities or the debt is repaid with governmental funds. Private activity bonds are bonds in which the State or local government serves as a conduit providing financing to nongovernmental persons. For these purposes, the term "nongovernmental person" includes the Federal government and all other individuals and entities other than States or local governments. 94 Interest on private activity bonds is taxable, unless the bonds are issued for certain purposes permitted by the Code and other requirements are met. 95

Although not States or subdivisions of States, Indian tribal governments are provided with a tax status similar to State and local governments for specified purposes under the Code. 96 Among the purposes for which a tribal government is treated as a State is the issuance of tax-exempt bonds. Under section 7871(c), tribal governments are authorized to issue tax-exempt bonds only if substantially all of the proceeds are used for essential governmental functions. 97 The term essential governmental function does not include any function that is not customarily performed by State and local governments with general taxing powers. Section 7871(c) further prohibits Indian tribal governments from issuing tax-exempt private activity bonds (as defined in section 141(a) of the Code) with the exception of certain bonds for manufacturing facilities.


Description of Proposal




Tribal Economic Development Bonds

The proposal allows Indian tribal governments to issue "tribal economic development bonds." There is a national bond limitation of $2 billion, to be allocated as the Secretary determines appropriate, in consultation with the Secretary of the Interior. Tribal economic development bonds issued by an Indian tribal government are treated as if such bond were issued by a State except that section 146 (relating to State volume limitations) does not apply.

A tribal economic development bond is any bond issued by an Indian tribal government (1) the interest on which would be tax-exempt if issued by a State or local government but would be taxable under section 7871(c), and (2) that is designated by the Indian tribal government as a tribal economic development bond. The aggregate face amount of bonds that may be designated by any Indian tribal government cannot exceed the amount of national tribal economic development bond limitation allocated to such government.

Tribal economic development bonds cannot be used to finance any portion of a building in which class II or class III gaming (as defined in section 4 of the Indian Gaming Regulatory Act) is conducted, or housed, or any other property used in the conduct of such gaming. Nor can tribal economic development bonds be used to finance any facility located outside of the Indian reservation.



Treasury Study

The proposal requires that the Treasury Department study the effects of tribal economic development bonds. One year after the date of enactment, a report is to be submitted to Congress providing the results of such study along with any recommendations, including whether the restrictions of section 7871(c) should be eliminated or otherwise modified.


Effective Date


The proposal applies to obligations issued after the date of enactment.



3. Extend and modify the new markets tax credit


Present Law


Section 45D provides a new markets tax credit for qualified equity investments made to acquire stock in a corporation, or a capital interest in a partnership, that is a qualified community development entity ("CDE"). 98 The amount of the credit allowable to the investor (either the original purchaser or a subsequent holder) is (1) a five-percent credit for the year in which the equity interest is purchased from the CDE and for each of the following two years, and (2) a six-percent credit for each of the following four years. The credit is determined by applying the applicable percentage (five or six percent) to the amount paid to the CDE for the investment at its original issue, and is available for a taxable year to the taxpayer who holds the qualified equity investment on the date of the initial investment or on the respective anniversary date that occurs during the taxable year. The credit is recaptured if, at any time during the seven-year period that begins on the date of the original issue of the qualified equity investment, the issuing entity ceases to be a qualified CDE, the proceeds of the investment cease to be used as required, or the equity investment is redeemed.

A qualified CDE is any domestic corporation or partnership: (1) whose primary mission is serving or providing investment capital for low-income communities or low-income persons; (2) that maintains accountability to residents of low-income communities by providing them with representation on any governing board of or any advisory board to the CDE; and (3) that is certified by the Secretary as being a qualified CDE. A qualified equity investment means stock (other than nonqualified preferred stock) in a corporation or a capital interest in a partnership that is acquired directly from a CDE for cash, and includes an investment of a subsequent purchaser if such investment was a qualified equity investment in the hands of the prior holder. Substantially all of the investment proceeds must be used by the CDE to make qualified low-income community investments. For this purpose, qualified low-income community investments include: (1) capital or equity investments in, or loans to, qualified active low-income community businesses; (2) certain financial counseling and other services to businesses and residents in low-income communities; (3) the purchase from another CDE of any loan made by such entity that is a qualified low-income community investment; or (4) an equity investment in, or loan to, another CDE.

A "low-income community" is a population census tract with either (1) a poverty rate of at least 20 percent or (2) median family income which does not exceed 80 percent of the greater of metropolitan area median family income or statewide median family income (for a non-metropolitan census tract, does not exceed 80 percent of statewide median family income). In the case of a population census tract located within a high migration rural county, low-income is defined by reference to 85 percent (rather than 80 percent) of statewide median family income. For this purpose, a high migration rural county is any county that, during the 20-year period ending with the year in which the most recent census was conducted, has a net out-migration of inhabitants from the county of at least 10 percent of the population of the county at the beginning of such period.

The Secretary has the authority to designate "targeted populations" as low-income communities for purposes of the new markets tax credit. For this purpose, a "targeted population" is defined by reference to section 103(20) of the Riegle Community Development and Regulatory Improvement Act of 1994 (12 U.S.C. sec. 4702(20)) to mean individuals, or an identifiable group of individuals, including an Indian tribe, who (A) are low-income persons; or (B) otherwise lack adequate access to loans or equity investments. Under such Act, "lowincome" means (1) for a targeted population within a metropolitan area, less than 80 percent of the area median family income; and (2) for a targeted population within a non-metropolitan area, less than the greater of 80 percent of the area median family income or 80 percent of the statewide non-metropolitan area median family income. 99 Under such Act, a targeted population is not required to be within any census tract. In addition, a population census tract with a population of less than 2,000 is treated as a low-income community for purposes of the credit if such tract is within an empowerment zone, the designation of which is in effect under section 1391, and is contiguous to one or more low-income communities.

A qualified active low-income community business is defined as a business that satisfies, with respect to a taxable year, the following requirements: (1) at least 50 percent of the total gross income of the business is derived from the active conduct of trade or business activities in any low-income community; (2) a substantial portion of the tangible property of such business is used in a low-income community; (3) a substantial portion of the services performed for such business by its employees is performed in a low-income community; and (4) less than five percent of the average of the aggregate unadjusted bases of the property of such business is attributable to certain financial property or to certain collectibles.

The maximum annual amount of qualified equity investments is capped at $3.5 billion per year for calendar years 2006 through 2009. Lower caps applied for calendar years 2001 through 2005.


Description of Proposal


For calendar years 2008 and 2009, the proposal increases the maximum amount of qualified equity investments by $1.5 billion (to $5 billion for each year). The proposal requires that the additional amount for 2008 be allocated to qualified CDEs that submitted an allocation application with respect to calendar year 2008 and either (1) did not receive an allocation for such calendar year, or (2) received an allocation for such calendar year in an amount less than the amount requested in the allocation application. The proposal also provides alternative minimum tax relief for equity investment allocations subject to the 2009 annual limitation.


Effective Date


The proposal is effective for taxable years ending after the date of enactment and to carrybacks of such credits.


VI. INFRASTRUCTURE FINANCING TOOLS




1. De minimis safe harbor exception for tax-exempt interest expense of financial institutions and modification of small issuer exception to tax-exempt interest expense allocation rules for financial institutions


Present Law


Present law disallows a deduction for interest on indebtedness incurred or continued to purchase or carry obligations the interest on which is exempt from tax. 100 In general, an interest deduction is disallowed only if the taxpayer has a purpose of using borrowed funds to purchase or carry tax-exempt obligations; a determination of the taxpayer's purpose in borrowing funds is made based on all of the facts and circumstances. 101


Two-percent rule for individuals and certain nonfinancial corporations


In the absence of direct evidence linking an individual taxpayer's indebtedness with the purchase or carrying of tax-exempt obligations, the Internal Revenue Service takes the position that it ordinarily will not infer that a taxpayer's purpose in borrowing money was to purchase or carry tax-exempt obligations if the taxpayer's investment in tax-exempt obligations is "insubstantial." 102 An individual's holdings of tax-exempt obligations are presumed to be insubstantial if during the taxable year the average adjusted basis of the individual's tax-exempt obligations is two percent or less of the average adjusted basis of the individual's portfolio investments and assets held by the individual in the active conduct of a trade or business.

Similarly, in the case of a corporation that is not a financial institution or a dealer in tax-exempt obligations, where there is no direct evidence of a purpose to purchase or carry tax-exempt obligations, the corporation's holdings of tax-exempt obligations are presumed to be insubstantial if the average adjusted basis of the corporation's tax-exempt obligations is two percent or less of the average adjusted basis of all assets held by the corporation in the active conduct of its trade or business.



Financial institutions

In the case of a financial institution, the Code generally disallows that portion of the taxpayer's interest expense that is allocable to tax-exempt interest. 103 The amount of interest that is disallowed is an amount which bears the same ratio to such interest expense as the taxpayer's average adjusted bases of tax-exempt obligations acquired after August 7, 1986, bears to the average adjusted bases for all assets of the taxpayer.



Exception for certain obligations of qualified small issuers

The general rule in section 265(b), denying financial institutions' interest expense deductions allocable to tax-exempt obligations, does not apply to "qualified tax-exempt obligations." 104 Instead, as discussed in the next section, only 20 percent of the interest expense allocable to "qualified tax-exempt obligations" is disallowed. 105 A "qualified tax-exempt obligation" is a tax-exempt obligation that (1) is issued after August 7, 1986, by a qualified small issuer, (2) is not a private activity bond, and (3) is designated by the issuer as qualifying for the exception from the general rule of section 265(b).

A "qualified small issuer" is an issuer that reasonably anticipates that the amount of tax-exempt obligations that it will issue during the calendar year will be $10 million or less. 106 The Code specifies the circumstances under which an issuer and all subordinate entities are aggregated. 107 For purposes of the $10 million limitation, an issuer and all entities that issue obligations on behalf of such issuer are treated as one issuer. All obligations issued by a subordinate entity are treated as being issued by the entity to which it is subordinate. An entity formed (or availed of) to avoid the $10 million limitation and all entities benefiting from the device are treated as one issuer.

Composite issues (i.e., combined issues of bonds for different entities) qualify for the "qualified tax-exempt obligation" exception only if the requirements of the exception are met with respect to (1) the composite issue as a whole (determined by treating the composite issue as a single issue) and (2) each separate lot of obligations that is part of the issue (determined by treating each separate lot of obligations as a separate issue). 108 Thus a composite issue may qualify for the exception only if the composite issue itself does not exceed $10 million, and if each issuer benefitting from the composite issue reasonably anticipates that it will not issue more than $10 million of tax-exempt obligations during the calendar year, including through the composite arrangement.



Treatment of financial institution preference items

Section 291(a)(3) reduces by 20 percent the amount allowable as a deduction with respect to any financial institution preference item. Financial institution preference items include interest on debt to carry tax-exempt obligations acquired after December 31, 1982, and before August 8, 1986. 109 Section 265(b)(3) treats qualified tax-exempt obligations as if they were acquired on August 7, 1986. As a result, the amount allowable as a deduction by a financial institution with respect to interest incurred to carry a qualified tax-exempt obligation is reduced by 20 percent.


Description of Proposal




Two-percent safe harbor for financial institutions

The proposal provides that tax-exempt obligations issued during 2009 or 2010 and held by a financial institution, in an amount not to exceed two percent of the adjusted basis of the financial institution's assets, are not taken into account for the purpose of determining the portion of the financial institution's interest expense subject to the pro rata interest disallowance rule of section 265(b). For purposes of this rule, a refunding bond (whether a current or advance refunding) is treated as issued on the date of the issuance of the refunded bond (or in the case of a series of refundings, the original bond).

The proposal also amends section 291(e) to provide that tax-exempt obligations issued during 2009 and 2010, and not taken into account for purposes of the calculation of a financial institution's interest expense subject to the pro rata interest disallowance rule, are treated as having been acquired on August 7, 1986. As a result, such obligations are financial institution preference items, and the amount allowable as a deduction by a financial institution with respect to interest incurred to carry such obligations is reduced by 20 percent.



Modifications to qualified small issuer exception

With respect to tax-exempt obligations issued during 2009 and 2010, the proposal increases from $10 million to $30 million the annual limit for qualified small issuers.

In addition, in the case of "qualified financing issue" issued in 2009 or 2010, the proposal applies the $30 million annual volume limitation at the borrower level (rather than at the level of the pooled financing issuer). Thus, for the purpose of applying the requirements of the section 265(b)(3) qualified small issuer exception, the portion of the proceeds of a qualified financing issue that are loaned to a "qualified borrower" that participates in the issue are treated as a separate issue with respect to which the qualified borrower is deemed to be the issuer.

A "qualified financing issue" is any composite, pooled or other conduit financing issue the proceeds of which are used directly or indirectly to make or finance loans to one or more ultimate borrowers all of whom are qualified borrowers. A "qualified borrower" means (1) a State or political subdivision of a State or (2) an organization described in section 501(c)(3) and exempt from tax under section 501(a). Thus, for example, a $100 million pooled financing issue that was issued in 2009 could qualify for the section 265(b)(3) exception if the proceeds of such issue were used to make four equal loans of $25 million to four qualified borrowers. However, if (1) more than $30 million were loaned to any qualified borrower, (2) any borrower were not a qualified borrower, or (3) any borrower would, if it were the issuer of a separate issue in an amount equal to the amount loaned to such borrower, fail to meet any of the other requirements of section 265(b)(3), the entire $100 million pooled financing issue would fail to qualify for the exception.

For purposes of determining whether an issuer meets the requirements of the small issuer exception, qualified 501(c)(3) bonds issued in 2009 or 2010 are treated as if they were issued by the 501(c)(3) organization for whose benefit they were issued (and not by the actual issuer of such bonds). In addition, in the case of an organization described in section 501(c)(3) and exempt from taxation under section 501(a), requirements for "qualified financing issues" shall be applied as if the section 501(c)(3) organization were the issuer. Thus, in any event, an organization described in section 501(c)(3) and exempt from taxation under section 501(a) shall be limited to the $30 million per issuer cap for qualified tax exempt obligations described in section 265(b)(3).


Effective Date


The proposals are effective for obligations issued after December 31, 2008.



2. Repeal of alternative minimum tax limitations on tax exempt bonds issued in 2009 and 2010


Present Law


Present law imposes an alternative minimum tax ("AMT") on individuals and corporations. AMT is the amount by which the tentative minimum tax exceeds the regular income tax. The tentative minimum tax is computed based upon a taxpayer's alternative minimum taxable income ("AMTI"). AMTI is the taxpayer's taxable income modified to take into account certain preferences and adjustments. One of the preference items is tax-exempt interest on certain tax-exempt bonds issued for private activities (sec. 57(a)(5)). Also, in the case of a corporation, an adjustment based on current earnings is determined, in part, by taking into account 75 percent of items, including tax-exempt interest, that are excluded from taxable income but included in the corporation's earnings and profits (sec. 56(g)(4)(B)).


Description of Proposal


The proposal provides that tax-exempt interest on private activity bonds issued in 2009 and 2010 is not an item of tax preference for purposes of the alternative minimum tax and interest on tax exempt bonds issued in 2009 and 2010 is not included in the corporate adjustment based on current earnings. For these purposes, a refunding bond is treated as issued on the date of the issuance of the refunded bond (or in the case of a series of refundings, the original bond).




Effective Date


The proposal applies to interest on bonds issued after December 31, 2008.



3. One-year delay of withholding on government contractors


Present law


For payments made after December 31, 2010, the Code imposes a withholding requirement at a three-percent rate on certain payments to persons providing property or services made by the Government of the United States, every State, every political subdivision thereof, and every instrumentality of the foregoing (including multi-State agencies). The withholding requirement applies regardless of whether the government entity making such payment is the recipient of the property or services. Political subdivisions of States (or any instrumentality thereof) with less than $100 million of annual expenditures for property or services that would otherwise be subject to withholding under this proposal are exempt from the withholding requirement.

Payments subject to the three-percent withholding requirement include any payment made in connection with a government voucher or certificate program which functions as a payment for property or services. For example, payments to a commodity producer under a government commodity support program are subject to the withholding requirement. The proposal imposes information reporting requirements on the payments that are subject to withholding under the proposal.

The three-percent withholding requirement does not apply to any payments made through a Federal, State, or local government public assistance or public welfare program for which eligibility is determined by a needs or income test. The three-percent withholding requirement also does not apply to payments of wages or to any other payment with respect to which mandatory (e.g., U.S.-source income of foreign taxpayers) or voluntary (e.g., unemployment benefits) withholding applies under present law. Although the proposal applies to payments that are potentially subject to backup withholding under section 3406, it does not apply to those payments from which amounts are actually being withheld under backup withholding rules.

The three-percent withholding requirement also does not apply to the following: payments of interest; payments for real property; payments to tax-exempt entities or foreign governments; intra-governmental payments; payments made pursuant to a classified or confidential contract (as defined in section 6050M(e)(3)), and payments to government employees that are not otherwise excludable from the new withholding proposal with respect to the employees' services as employees.


Description of Proposal


The proposal delays the implementation of the three percent withholding requirement by one year to apply to payments after December 31, 2011.


Effective Date


The proposal is effective on the date of enactment.



4. Qualified school construction bonds


Present Law




Tax-exempt bonds

Interest on State and local governmental bonds generally is excluded from gross income for Federal income tax purposes if the proceeds of the bonds are used to finance direct activities of these governmental units or if the bonds are repaid with revenues of the governmental units. These can include tax-exempt bonds which finance public schools. 110 An issuer must file with the IRS certain information about the bonds issued in order for that bond issue to be tax-exempt. 111 Generally, this information return is required to be filed no later than the 15th day of the second month after the close of the calendar quarter in which the bonds were issued.

The tax exemption for State and local bonds does not apply to any arbitrage bond. 112 An arbitrage bond is defined as any bond that is part of an issue if any proceeds of the issue are reasonably expected to be used (or intentionally are used) to acquire higher yielding investments or to replace funds that are used to acquire higher yielding investments. 113 In general, arbitrage profits may be earned only during specified periods (e.g., defined "temporary periods") before funds are needed for the purpose of the borrowing or on specified types of investments (e.g., "reasonably required reserve or replacement funds"). Subject to limited exceptions, investment profits that are earned during these periods or on such investments must be rebated to the Federal Government.



Qualified zone academy bonds

As an alternative to traditional tax-exempt bonds, States and local governments were given the authority to issue "qualified zone academy bonds." 114 A total of $400 million of qualified zone academy bonds is authorized to be issued annually in calendar years 1998 through 2009. The $400 million aggregate bond cap is allocated each year to the States according to their respective populations of individuals below the poverty line. Each State, in turn, allocates the credit authority to qualified zone academies within such State.

A taxpayer holding a qualified zone academy bond on the credit allowance date is entitled to a credit. The credit is includible in gross income (as if it were a taxable interest payment on the bond), and may be claimed against regular income tax and alternative minimum tax liability.

The Treasury Department sets the credit rate at a rate estimated to allow issuance of qualified zone academy bonds without discount and without interest cost to the issuer. 115 The Secretary determines credit rates for tax credit bonds based on general assumptions about credit quality of the class of potential eligible issuers and such other factors as the Secretary deems appropriate. The Secretary may determine credit rates based on general credit market yield indexes and credit ratings. The maximum term of the bond is determined by the Treasury Department, so that the present value of the obligation to repay the principal on the bond is 50 percent of the face value of the bond.

"Qualified zone academy bonds" are defined as any bond issued by a State or local government, provided that (1) at least 95 percent of the proceeds are used for the purpose of renovating, providing equipment to, developing course materials for use at, or training teachers and other school personnel in a "qualified zone academy" and (2) private entities have promised to contribute to the qualified zone academy certain equipment, technical assistance or training, employee services, or other property or services with a value equal to at least 10 percent of the bond proceeds.

A school is a "qualified zone academy" if (1) the school is a public school that provides education and training below the college level, (2) the school operates a special academic program in cooperation with businesses to enhance the academic curriculum and increase graduation and employment rates, and (3) either (a) the school is located in an empowerment zone or enterprise community designated under the Code, or (b) it is reasonably expected that at least 35 percent of the students at the school will be eligible for free or reduced-cost lunches under the school lunch program established under the National School Lunch Act.

The arbitrage requirements which generally apply to interest-bearing tax-exempt bonds also generally apply to qualified zone academy bonds. In addition, an issuer of qualified zone academy bonds must reasonably expect to and actually spend 100 percent or more of the proceeds of such bonds on qualified zone academy property within the three years period that begins on the date of issuance. To the extent less than 100 percent of the proceeds are used to finance qualified zone academy property during the three years spending period, bonds will continue to qualify as qualified zone academy bonds if unspent proceeds are used within 90 days from the end of such three years period to redeem any nonqualified bonds. The three years spending period may be extended by the Secretary if the issuer establishes that the failure to meet the spending requirement is due to reasonable cause and the related purposes for issuing the bonds will continue to proceed with due diligence.

Two special arbitrage rules apply to qualified zone academy bonds. First, available project proceeds invested during the three-year period beginning on the date of issue are not subject to the arbitrage restrictions (i.e., yield restriction and rebate requirements). Available project proceeds are proceeds from the sale of an issue of qualified zone academy bonds, less issuance costs (not to exceed two percent) and any investment earnings on such proceeds. Thus, available project proceeds invested during the three-year spending period may be invested at unrestricted yields, but the earnings on such investments must be spent on qualified zone academy property. Second, amounts invested in a reserve fund are not subject to the arbitrage restrictions to the extent: (1) such fund is funded at a rate not more rapid than equal annual installments; (2) such fund is funded in a manner reasonably expected to result in an amount not greater than an amount necessary to repay the issue; and (3) the yield on such fund is not greater than the average annual interest rate of tax-exempt obligations having a term of 10 years or more that are issued during the month the qualified zone academy bonds are issued.

Issuers of qualified zone academy bonds are required to report issuance to the IRS in a manner similar to the information returns required for tax-exempt bonds.


Description of Proposal




In general

The proposal creates a new category of tax-credit bonds, qualified school construction bonds. Qualified school construction bonds must meet three requirements: (1) 100 percent of the available project proceeds of the bond issue is used for the construction, rehabilitation, or repair of a public school facility or for the acquisition of land on which such a bond-financed facility is to be constructed; (2) the bond is issued by a State or local government within which such school is located; and (3) the issuer designates such bonds as a qualified school construction bond.


National limitation


There is a national limitation on qualified school construction bonds of $5 billion for calendar years 2009 and 2010, respectively. Allocations of the national limitation of qualified school construction bonds are divided between the States and certain large school districts. The States receive 60 percent of the national limitation for a calendar year and the remaining 40 percent of the national limitation for a calendar year is allocated to certain of the largest school districts.


Allocation to the States


Generally allocations are made to the States under the 60 percent allocation according to their respective populations of children aged five through seventeen. However, the Secretary of the Treasury shall adjust the annual allocations among the States to ensure that for each State the sum of its allocations under the 60 percent allocation plus any allocations to large educational agencies within the States is not less than a minimum percentage. A State's minimum percentage for a calendar year is a product of 1.68 and the minimum percentage described in section 1124(d) of the Elementary and Secondary Education Act of 1965 for such State for the most recent fiscal year ending before such calendar year.

For allocation purposes, a State includes the District of Columbia and any possession of the United States. The proposal provides a special allocation for possessions of the United States other than Puerto Rico under the 60 percent share of the national limitation for States. Under this special rule an allocation to a possession other than Puerto Rico is made on the basis of the respective populations of individuals below the poverty line (as defined by the Office of Management and Budget) rather than respective populations of children aged five through seventeen. This special allocation reduces the State allocation share of the national limitation otherwise available for allocation among the States. Under another special rule the Secretary of the Interior may allocate $200 million of school construction bonds for 2009 and 2010, respectively to Indian schools. This special allocation for Indian schools is to be used for purposes of the construction, rehabilitation, and repair of schools funded by the Bureau of Indian Affairs. For purposes of such allocations Indian tribal governments are qualified issuers. The special allocation for Indian schools does not reduce the State allocation share of the national limitation otherwise available for allocation among the States.

If an amount allocated under this allocation to the States is unused for a calendar year it may be carried forward by the State to the next calendar year.



Allocation to large school districts

The remaining 40 percent of the national limitation for a calendar year is allocated by the Secretary of the Treasury among local educational agencies which are large local educational agencies for such year. This allocation is made in proportion to the respective amounts each agency received for Basic Grants under subpart 2 of Part A of Title I of the Elementary and Secondary Education Act of 1965 for the most recent fiscal year ending before such calendar year. Any unused allocation of any agency within a State may be allocated by the agency to such State. With respect to a calendar year, the term large local educational agency means: any local educational agency if such agency is: (1) among the 100 local educational agencies with the largest numbers of children aged 5 through 17 from families living below the poverty level, or (2) one of not more than 25 local educational agencies (other than in 1, immediately above) that the Secretary of Education determines are in particular need of assistance, based on a low level of resources for school construction, a high level of enrollment growth, or other such factors as the Secretary of Education deems appropriate. If any amount allocated to large local educational agency is unused for a calendar year the agency may reallocate such amount to the State in which the agency is located.

The proposal makes qualified school construction bonds a type of qualified tax credit bond for purposes of section 54A of the Code. In addition, qualified school construction bonds may be issued by Indian tribal governments only to the extent such bonds are issued for purposes that satisfy the present law requirements for tax-exempt bonds issued by Indian tribal governments (i.e., essential governmental functions and certain manufacturing purposes).

The proposal requires 100 percent of the available project proceeds of qualified school construction bonds to be used within the three-year period that begins on the date of issuance. Available project proceeds are proceeds from the sale of the issue less issuance costs (not to exceed two percent) and any investment earnings on such sale proceeds. To the extent less than 100 percent of the available project proceeds are used to finance qualified purposes during the three-year spending period, bonds will continue to qualify as qualified school construction bonds if unspent proceeds are used within 90 days from the end of such three-year period to redeem bonds. The three-year spending period may be extended by the Secretary upon the issuer's request demonstrating that the failure to satisfy the three-year requirement is due to reasonable cause and the projects will continue to proceed with due diligence.

Qualified school construction bonds generally are subject to the arbitrage requirements of section 148. However, available project proceeds invested during the three-year spending period are not subject to the arbitrage restrictions (i.e., yield restriction and rebate requirements). In addition, amounts invested in a reserve fund are not subject to the arbitrage restrictions to the extent: (1) such fund is funded at a rate not more rapid than equal annual installments; (2) such fund is funded in a manner reasonably expected to result in an amount not greater than an amount necessary to repay the issue; and (3) the yield on such fund is not greater than the average annual interest rate of tax-exempt obligations having a term of 10 years or more that are issued during the month the qualified school construction bonds are issued.

The maturity of qualified school construction bonds is the term that the Secretary estimates will result in the present value of the obligation to repay the principal on such bonds being equal to 50 percent of the face amount of such bonds, using as a discount rate the average annual interest rate of tax-exempt obligations having a term of 10 years or more that are issued during the month the qualified school construction bonds are issued.

As with present-law tax credit bonds, the taxpayer holding qualified school construction bonds on a credit allowance date is entitled to a tax credit. The credit rate on the bonds is set by the Secretary at a rate that is 100 percent of the rate that would permit issuance of such bonds without discount and interest cost to the issuer. The amount of the tax credit is determined by multiplying the bond's credit rate by the face amount on the holder's bond. The credit accrues quarterly, is includible in gross income (as if it were an interest payment on the bond), and can be claimed against regular income tax liability and alternative minimum tax liability. Unused credits may be carried forward to succeeding taxable years. In addition, credits may be separated from the ownership of the underlying bond similar to how interest coupons can be stripped for interest-bearing bonds.

Issuers of qualified school construction bonds are required to certify that the financial disclosure requirements that applicable State and local law requirements governing conflicts of interest are satisfied with respect to such issue, as well as any other additional conflict of interest rules prescribed by the Secretary with respect to any Federal, State, or local government official directly involved with the issuance of qualified school construction bonds.


Effective Date


The proposal is effective for bonds issued after December 31, 2008.



5. Extend and expand qualified zone academy bonds


Present Law




Tax-exempt bonds

Interest on State and local governmental bonds generally is excluded from gross income for Federal income tax purposes if the proceeds of the bonds are used to finance direct activities of these governmental units or if the bonds are repaid with revenues of the governmental units. These can include tax-exempt bonds which finance public schools. 116 An issuer must file with the IRS certain information about the bonds issued in order for that bond issue to be tax-exempt. 117 Generally, this information return is required to be filed no later the 15th day of the second month after the close of the calendar quarter in which the bonds were issued.

The tax exemption for State and local bonds does not apply to any arbitrage bond. 118 An arbitrage bond is defined as any bond that is part of an issue if any proceeds of the issue are reasonably expected to be used (or intentionally are used) to acquire higher yielding investments or to replace funds that are used to acquire higher yielding investments. 119 In general, arbitrage profits may be earned only during specified periods (e.g., defined "temporary periods") before funds are needed for the purpose of the borrowing or on specified types of investments (e.g., "reasonably required reserve or replacement funds"). Subject to limited exceptions, investment profits that are earned during these periods or on such investments must be rebated to the Federal Government.



Qualified zone academy bonds

As an alternative to traditional tax-exempt bonds, States and local governments were given the authority to issue "qualified zone academy bonds." 120 A total of $400 million of qualified zone academy bonds is authorized to be issued annually in calendar years 1998 through 2009. The $400 million aggregate bond cap is allocated each year to the States according to their respective populations of individuals below the poverty line. Each State, in turn, allocates the credit authority to qualified zone academies within such State.

A taxpayer holding a qualified zone academy bond on the credit allowance date is entitled to a credit. The credit is includible in gross income (as if it were a taxable interest payment on the bond), and may be claimed against regular income tax and alternative minimum tax liability.

The Treasury Department sets the credit rate at a rate estimated to allow issuance of qualified zone academy bonds without discount and without interest cost to the issuer. 121 The Secretary determines credit rates for tax credit bonds based on general assumptions about credit quality of the class of potential eligible issuers and such other factors as the Secretary deems appropriate. The Secretary may determine credit rates based on general credit market yield indexes and credit ratings. The maximum term of the bond is determined by the Treasury Department, so that the present value of the obligation to repay the principal on the bond is 50 percent of the face value of the bond.

"Qualified zone academy bonds" are defined as any bond issued by a State or local government, provided that (1) at least 95 percent of the proceeds are used for the purpose of renovating, providing equipment to, developing course materials for use at, or training teachers and other school personnel in a "qualified zone academy" and (2) private entities have promised to contribute to the qualified zone academy certain equipment, technical assistance or training, employee services, or other property or services with a value equal to at least 10 percent of the bond proceeds.

A school is a "qualified zone academy" if (1) the school is a public school that provides education and training below the college level, (2) the school operates a special academic program in cooperation with businesses to enhance the academic curriculum and increase graduation and employment rates, and (3) either (a) the school is located in an empowerment zone or enterprise community designated under the Code, or (b) it is reasonably expected that at least 35 percent of the students at the school will be eligible for free or reduced-cost lunches under the school lunch program established under the National School Lunch Act.

The arbitrage requirements which generally apply to interest-bearing tax-exempt bonds also generally apply to qualified zone academy bonds. In addition, an issuer of qualified zone academy bonds must reasonably expect to and actually spend 100 percent or more of the proceeds of such bonds on qualified zone academy property within the three-year period that begins on the date of issuance. To the extent less than 100 percent of the proceeds are used to finance qualified zone academy property during the three-year spending period, bonds will continue to qualify as qualified zone academy bonds if unspent proceeds are used within 90 days from the end of such three-year period to redeem any nonqualified bonds. The three-year spending period may be extended by the Secretary if the issuer establishes that the failure to meet the spending requirement is due to reasonable cause and the related purposes for issuing the bonds will continue to proceed with due diligence.

Two special arbitrage rules apply to qualified zone academy bonds. First, available project proceeds invested during the three-year period beginning on the date of issue are not subject to the arbitrage restrictions (i.e., yield restriction and rebate requirements). Available project proceeds are proceeds from the sale of an issue of qualified zone academy bonds, less issuance costs (not to exceed two percent) and any investment earnings on such proceeds. Thus, available project proceeds invested during the three-year spending period may be invested at unrestricted yields, but the earnings on such investments must be spent on qualified zone academy property. Second, amounts invested in a reserve fund are not subject to the arbitrage restrictions to the extent: (1) such fund is funded at a rate not more rapid than equal annual installments; (2) such fund is funded in a manner reasonably expected to result in an amount not greater than an amount necessary to repay the issue; and (3) the yield on such fund is not greater than the average annual interest rate of tax-exempt obligations having a term of 10 years or more that are issued during the month the qualified zone academy bonds are issued.

Issuers of qualified zone academy bonds are required to report issuance to the IRS in a manner similar to the information returns required for tax-exempt bonds.


Description of Proposal


The proposal extends and expands the present-law qualified zone academy bond program. The proposal authorizes issuance of up to $1.4 billion of qualified zone academy bonds annually for 2009 and 2010, respectively.


Effective Date


The proposal applies to bonds issued after December 31, 2008.



6. Build America Bonds


Present Law




In general

Under present law, gross income does not include interest on State or local bonds. State and local bonds are classified generally as either governmental bonds or private activity bonds. Governmental bonds are bonds the proceeds of which are primarily used to finance governmental functions or which are repaid with governmental funds. Private activity bonds are bonds in which the State or local government serves as a conduit providing financing to nongovernmental persons (e.g., private businesses or individuals). The exclusion from income for State and local bonds does not apply to private activity bonds, unless the bonds are issued for certain permitted purposes ("qualified private activity bonds") and other Code requirements are met.



Private activity bonds

The Code defines a private activity bond as any bond that satisfies (1) the private business use test and the private security or payment test ("the private business test"); or (2) "the private loan financing test." 122



Private business test

Under the private business test, a bond is a private activity bond if it is part of an issue in which:
1. More than 10 percent of the proceeds of the issue (including use of the bond-financed property) are to be used in the trade or business of any person other than a governmental unit ("private business use"); and

2. More than 10 percent of the payment of principal or interest on the issue is, directly or indirectly, secured by (a) property used or to be used for a private business use or (b) to be derived from payments in respect of property, or borrowed money, used or to be used for a private business use ("private payment test"). 123

A bond is not a private activity bond unless both parts of the private business test (i.e., the private business use test and the private payment test) are met. Thus, a facility that is 100 percent privately used does not cause the bonds financing such facility to be private activity bonds if the bonds are not secured by or paid with private payments. For example, land improvements that benefit a privately-owned factory may be financed with governmental bonds if the debt service on such bonds is not paid by the factory owner or other private parties.


Private loan financing test


A bond issue satisfies the private loan financing test if proceeds exceeding the lesser of $5 million or five percent of such proceeds are used directly or indirectly to finance loans to one or more nongovernmental persons. Private loans include both business and other (e.g., personal) uses and payments by private persons; however, in the case of business uses and payments, all private loans also constitute private business uses and payments subject to the private business test.



Arbitrage restrictions

The exclusion from income for interest on State and local bonds does not apply to any arbitrage bond. 124 An arbitrage bond is defined as any bond that is part of an issue if any proceeds of the issue are reasonably expected to be used (or intentionally are used) to acquire higher yielding investments or to replace funds that are used to acquire higher yielding investments. 125 In general, arbitrage profits may be earned only during specified periods (e.g., defined "temporary periods") before funds are needed for the purpose of the borrowing or on specified types of investments (e.g., "reasonably required reserve or replacement funds"). Subject to limited exceptions, investment profits that are earned during these periods or on such investments must be rebated to the Federal Government.



Qualified tax credit bonds

In lieu of interest, holders of qualified tax credit bonds receive a tax credit that accrues quarterly. The following bonds are qualified tax credit bonds: qualified forestry conservation bonds, new clean renewable energy bonds, qualified energy conservation bonds, and qualified zone academy bonds. 126

Section 54A of the Code sets forth general rules applicable to qualified tax credit bonds. These rules include requirements regarding credit allowance dates, the expenditure of available project proceeds, reporting, arbitrage, maturity limitations, and financial conflicts of interest, among other special rules.

A taxpayer who holds a qualified tax credit bond on one or more credit allowance dates of the bond during the taxable year shall be allowed a credit against the taxpayer's income tax for the taxable year. In general, the credit amount for any credit allowance date is 25 percent of the annual credit determined with respect to the bond. The annual credit is determined by multiplying the applicable credit rate by the outstanding face amount of the bond. The applicable credit rate for the bond is the rate that the Secretary estimates will permit the issuance of the qualified tax credit bond with a specified maturity or redemption date without discount and without interest cost to the qualified issuer. 127 The Secretary determines credit rates for tax credit bonds based on general assumptions about credit quality of the class of potential eligible issuers and such other factors as the Secretary deems appropriate. The Secretary may determine credit rates based on general credit market yield indexes and credit ratings.

The credit is included in gross income and, under regulations prescribed by the Secretary, may be stripped (a separation (including at issuance) of the ownership of a qualified tax credit bond and the entitlement to the credit with respect to such bond).

Section 54A of the Code requires that 100 percent of the available project proceeds of qualified tax credit bonds must be used within the three-year period that begins on the date of issuance. Available project proceeds are proceeds from the sale of the bond issue less issuance costs (not to exceed two percent) and any investment earnings on such sale proceeds. To the extent less than 100 percent of the available project proceeds are used to finance qualified projects during the three-year spending period, bonds will continue to qualify as qualified tax credit bonds if unspent proceeds are used within 90 days from the end of such three-year period to redeem bonds. The three-year spending period may be extended by the Secretary upon the issuer's request demonstrating that the failure to satisfy the three-year requirement is due to reasonable cause and the projects will continue to proceed with due diligence.

Qualified tax credit bonds generally are subject to the arbitrage requirements of section 148. However, available project proceeds invested during the three-year spending period are not subject to the arbitrage restrictions (i.e., yield restriction and rebate requirements). In addition, amounts invested in a reserve fund are not subject to the arbitrage restrictions to the extent: (1) such fund is funded at a rate not more rapid than equal annual installments; (2) such fund is funded in a manner reasonably expected to result in an amount not greater than an amount necessary to repay the issue; and (3) the yield on such fund is not greater than the average annual interest rate of tax-exempt obligations having a term of 10 years or more that are issued during the month the qualified tax credit bonds are issued.

The maturity of qualified tax credit bonds is the term that the Secretary estimates will result in the present value of the obligation to repay the principal on such bonds being equal to 50 percent of the face amount of such bonds, using as a discount rate the average annual interest rate of tax-exempt obligations having a term of 10 years or more that are issued during the month the qualified tax credit bonds are issued.


Description of Proposal




In general

For bonds issued in 2009 through 2011, the proposal permits an issuer to elect to have an otherwise tax-exempt bond treated as a "taxable governmental bond." A "taxable governmental bond" is any obligation (other than a private activity bond) if the interest on such obligation would be (but for this proposal) excludable from gross income under section 103 and the issuer makes an irrevocable election to have the proposal apply. In determining if an obligation would be tax-exempt under section 103, the credit (or the payment discussed below for qualified bonds) is not treated as a Federal guarantee. Further, the yield on a taxable governmental bond is determined without regard to the credit. A taxable governmental bond does not include any bond if the issue price has more than a de minimis amount of premium over the stated principal amount of the bond.

The holder of a taxable governmental bond will accrue a tax credit in the amount of 35 percent of the interest payable on the interest payment dates of the bond during the calendar year. The interest payment date is any date on which the holder of record of the taxable governmental bond is entitled to a payment of interest under such bond. The sum of the accrued credits is allowed against regular and alternative minimum tax. Unused credit may be carried forward to succeeding taxable years. The credit, as well as the interest paid by the issuer, is included in gross income and the credit may be stripped under rules similar to those provided in section 54A regarding qualified tax credit bonds. Rules similar to those that apply for S corporations, partnerships and regulated investment companies with respect to qualified tax credit bonds also apply to the credit.



Special rule for qualified bonds issued during 2009 and 2010

A "qualified bond" is any taxable governmental bond issued as part of an issue if 100 percent of the available project proceeds of such issue are to be used for capital expenditures. 128 The bond must be issued after the date of enactment of the proposal and before January 1, 2011. The issuer must make an irrevocable election to have the special rule for qualified bonds apply.

Under the special rule for qualified bonds, in lieu of the tax credit to the holder, the issuer is allowed a credit equal to 35 percent of each interest payment made under such bond. Under the proposal, the Secretary will pay to the issuer the amount of the credit accrued with respect to an interest payment date. The payment by the Secretary is to be made contemporaneously with the interest payment made by the issuer, and may be made either in advance or as reimbursement. In lieu of payment to the issuer, the payment may be made to a person making interest payments on behalf of the issuer. For purposes of the arbitrage rules, the yield on a qualified bond is reduced by the amount of the credit/payment.



Transitional coordination with State law

As noted above, interest on a taxable governmental bond and the related credit are includible in gross income to the holder for Federal tax purposes. The proposal provides that until a State provides otherwise, the interest on any taxable governmental bond and the amount of any credit determined with respect to such bond shall be treated as being exempt from Federal income tax for purposes of State income tax laws.


Effective Date


The proposal is effective for obligations issued after the date of enactment.


VII. DESCRIPTION OF NONTAX ITEMS




1. Prohibition on collection of certain payments 129


Present Law


The Continued Dumping and Subsidy Offset Act of 2000 (CDSOA) (19 U.S.C. 1675c), which was repealed in the Deficit Reduction Act of 2005 (Pub. L. No. 109-171), required U.S. Customs and Border Protection (CBP) to distribute certain duties collected on imports to U.S. companies that petitioned the U.S. Government for relief. From 2001 - 2005, CBP distributed these duties to eligible U.S. companies, including those companies that petitioned for relief from Mexican and Canadian imports.

In 2006, CBP stopped distributing duties collected on Mexican and Canadian imports on the grounds that the U.S. Court of International Trade (CIT) and the U.S. Court of Appeals for the Federal Circuit (CAFC) found that the CDSOA did not specifically apply to Canada and Mexico, and was therefore inconsistent with U.S. legislation implementing the North American Free Trade Agreement. The CIT and CAFC granted prospective relief, and specifically refused to opine on whether CBP should require repayment of, or otherwise recoup, duties collected on imports of Canadian and Mexican imports that were previously distributed.

In November 2008, CBP sent letters to several U.S. companies that received distributions of duties collected on Mexican and Canadian imports, demanding that the companies repay duties distributed between January 1, 2001, and January 1, 2006. CBP granted the companies an extension for repayment until March 28, 2009.


Description of Proposal


The proposal has four sections. First, it prohibits the Secretary of Homeland Security, or any other person, from requiring repayment of, or in any other way recouping, duties that were (1) distributed pursuant to the CDSOA; (2) assessed and paid on imports of goods from Canada and Mexico; and (3) distributed on or after January 1, 2001, and before January 1, 2006. Second, it prohibits CBP from offsetting any current or future duty distributions on goods from countries other than Canada and Mexico in an attempt to recoup duties described above. Third, the provision requires CBP to refund any such duty repayments or recoupments it has already received. Further, it requires CBP to fully distribute any duties it is withholding as an offset against current or future duty distributions. Fourth, the provision clarifies that CBP is not prohibited from collecting payments resulting from (1) false statements or other misconduct by a recipient of a duty payment or (2) re-liquidation of entries with respect to which duty payments were made.



2. Extension of trade adjustment assistance programs 130


Present Law


The current TAA programs (19 U.S.C. 2271 et seq.) provide U.S. workers, firms, and farmers who are negatively impacted by trade with various forms of government-funded adjustment assistance.

Chapter 2 of the Trade Act of 1974 provides for the TAA for Workers Program. Workers who lose their jobs due to increased imports or shifts in production to certain countries, including those with a free trade agreement with the United States, are eligible to receive adjustment assistance such as career counseling; up to two years of training; income support during training; a health care tax credit; and job search and relocation allowances. Chapter 2 also provides for an Alternative TAA Program, which permits older workers (over 50 years old) for whom retraining may not be appropriate to accept reemployment at a lower wage and receive a wage subsidy.

Chapter 3 of the Trade Act of 1974 provides for a TAA for Firms Program. The TAA for Firms Program provides manufacturing firms that (1) separate, or may have to separate, a significant part of their workforce and (2) experience declining sales or production; as a result of import competition with financial and technical assistance to improve the manufacturer's competitiveness.

Chapter 4 of the Trade Act of 1974 provided for a TAA for Communities Program, which was terminated in 1982. The program provided assistance to distressed communities.

Chapter 6 of the Trade Act of 1974 establishes the TAA for Farmers program, which permits agricultural commodity producers to seek adjustment assistance if there has been (1) a 20% decline in the price for a commodity; (2) an increase in imports of that commodity; and (3) such increased imports contributed importantly to the decline in price. Once a commodity is certified by the Secretary of Agriculture, individual producers may qualify for benefits, which include technical assistance and cash payments. Authorization for the TAA for Farmers program expired on December 31, 2007, and has not been renewed.

The TAA for Workers and Firms programs expired on December 31, 2007; however, the Workers and Firms programs continue to operate under appropriations provided to the Departments of Labor and Commerce, respectively, under H.R. 2638, the Consolidated Security, Disaster Assistance, and Continuing Appropriations Act, 2009 (Pub. L. 110-329).


Description of Proposal


First, the proposal amends section 245(a) of the Trade Act of 1974 to extend the authorization for the TAA for Workers program until December 31, 2010. Second, the proposal amends section 246(b)(1) of the Trade Act of 1974 to extend the authorization for Alternative Trade Adjustment Assistance program by two years. Third, the proposal amends section 256(b) of the Trade Act of 1974 to extend the authorization for the TAA for Firms program until December 31, 2010. Fourth, the proposal amends section 298(a) of the Trade Act of 1974 to extend the TAA for Farmers program until December 31, 2010. Fifth, the proposal amends section 285 of the Trade Act of 1974 to extend the overall termination date of the TAA programs until December 31, 2010. Sixth, the proposal provides that these amendments shall have an effective date of January 1, 2008. Seventh, the proposal includes a Sense of the Senate that a TAA for Communities program should be revived.



3. Economic recovery payments to recipients of Social Security, supplement security income, railroad retirement, and Veterans disability benefits 131


Present Law


No provision.


Description of Proposal


The provision directs the Secretary of the Treasury to provide a onetime economic recovery payment of $300 to adults who were eligible for Social Security benefits, Railroad Retirement benefits, or veterans compensation or pension benefits; 132 or individuals 133 who were eligible for Supplement Security Income (SSI) benefits (excluding individuals who receive SSI while in a Medicaid institution). Only individuals who were eligible for one of the four programs for any of the three months prior to the month of enactment shall receive an economic recovery payment.

The provision stipulates that economic recovery payments will only be made to individuals whose address of record is in 1 of the 50 states, the District of Columbia, Puerto Rico, Guam, the United States Virgin Islands, American Samoa, or the Northern Mariana Islands.

An individual shall only receive one $300 economic recovery payment under this section regardless of whether the individual is eligible for a benefit from more than one of the four federal programs. If the individual is also eligible for the "Making Work Pay" credit from Section XX, that credit shall be reduced by the economic recovery payment made under this section.

An individual who is otherwise eligible for a economic recovery payment will not receive a payment if their federal program benefits have been suspended because they are in prison, a fugitive, a probation or parole violator, they committed fraud, or they are no longer lawfully present in the United States.

The provision directs the Commissioner of Social Security, the Railroad Retirement Board, and the Secretary of Veterans Affairs to provide the Secretary of the Treasury with information and data necessary in order to identify individuals eligible for economic recovery payments and to make the payments.

The provision provides that the $300 economic recovery payments shall not be taken into account as income or taken into account as resources for the month of receipt and the following 9 months, for purposes of determining the eligibility of such individual or any other individual for benefits or assistance, or the amount or extent of benefits or assistance, under any Federal program or under any State or local program financed in whole or in part with Federal funds.

The provision provides that economic recovery payments shall not be considered gross income for income tax purposes and that the payments are protected by the assignment and garnishment provisions of the four federal benefit programs.

The provision stipulates that if an individual who is eligible for an economic recovery payment has a representative payee, the payment shall be made to the representative payee and the entire payment shall only be used for the benefit of the individual who is entitled to the economic recovery payment.

The provision appropriates the following amounts for FY2009 to carry out the provisions of this section: to the Secretary of the Treasury, funds to make the payments and $7 million for administrative cost; to the Commissioner of Social Security, $90 million; to the Railroad Retirement Board, $1 million; and to the Secretary of Veterans Affairs, $7.2 million.


Effective Date


The Secretary of the Treasury shall commence making payments as soon as possible, but no later than 120 days after the date of enactment. No economic recovery payments shall be made after December 31, 2010.



4. Increase in the statutory limit on the public debt 134


Present Law


The statutory limit on the public debt is $11,315 billion.


Description of Proposal


The provision increases the statutory limit on the public debt by $825 billion to $12,140 billion.


Effective Date


The provision is effective on the date of enactment.

1 This document may be cited as follows: Joint Committee on Taxation, "Description of the American Recovery and Reinvestment Tax Act of 2009," January 23, 2009, (JCX-10-09). This document can also be found on our website at www.jct.gov .

2 Earned income is defined as (1) wages, salaries, tips, and other employee compensation, but only if such amounts are includible in gross income, plus (2) the amount of the individual's net self-employment earnings.

3 Unless otherwise stated, all section references are to the Internal Revenue Code of 1986, as amended (the "Code" ).

4 Possessions with mirror code tax systems are the United States Virgin Islands, Guam, and the Commonwealth of the Northern Mariana Islands.

5 Possessions that do not have mirror code tax systems are Puerto Rico and American Samoa.

6 Earned income is defined as (1) wages, salaries, tips, and other employee compensation, but only if such amounts are includible in gross income, plus (2) the amount of the individual's net self-employment earnings.

7 A foster child must reside with the taxpayer for the entire taxable year.

8 All income thresholds are indexed for inflation annually.

9 All income thresholds are indexed for inflation annually.

10 All income thresholds are indexed for inflation annually.

11 Sec. 25A. The Hope credit generally may not be claimed against a taxpayer's alternative minimum tax liability. However, the credit may be claimed against a taxpayer's alternative minimum tax liability for taxable years beginning prior to January 1, 2009.

12 For purposes of this description, the term "account" is used interchangeably to refer to a prepaid tuition benefit contract or a tuition savings account established pursuant to a qualified tuition program.

13 Section 529 refers to contributors and designated beneficiaries, but does not define or otherwise refer to the term account owner, which is a commonly used term among qualified tuition programs.

14 Sec. 45. In addition to the electricity production credit, section 45 also provides income tax credits for the production of Indian coal and refined coal at qualified facilities.

15 Sec. 38(b)(8).

16 Sec. 38(c)(4)(B)(ii).

17 Secs. 1381-1383.

18 Sec. 1382.

19 Sec. 45. In addition to the electricity production credit, section 45 also provides income tax credits for the production of Indian coal and refined coal at qualified facilities.

20 Sec. 48.

21 An additional proposal that allows section 45 facilities to elect to be treated as section 48 energy property is described in section II.2 of this document.

22 Sec. 48.

23 Sec. 38(b)(1).

24 Sec. 39.

25 Given the differences in credit quality and other characteristics of individual issuers, the Secretary cannot set credit rates in a manner that will allow each issuer to issue tax credit bonds at par.

26 Given the differences in credit quality and other characteristics of individual issuers, the Secretary cannot set credit rates in a manner that will allow each issuer to issue tax credit bonds at par.

27 The highest tier in effect at this time was tier 2, requiring SEER of at least 15 and EER of at least 12.5 for split central air conditioning systems and SEER of at least 14 and EER of at least 12 for packaged central air conditioning systems.

28 Sec. 30C.

29 Sec. 41.

30 Sec. 41(e).

31 Sec. 41(h).

32 The Small Business Job Protection Act of 1996 expanded the definition of start-up firms under section 41(c)(3)(B)(i) to include any firm if the first taxable year in which such firm had both gross receipts and qualified research expenses began after 1983. A special rule (enacted in 1993) is designed to gradually recompute a start-up firm's fixed-base percentage based on its actual research experience. Under this special rule, a start-up firm is assigned a fixed-base percentage of three percent for each of its first five taxable years after 1993 in which it incurs qualified research expenses. A start-up firm's fixed-base percentage for its sixth through tenth taxable years after 1993 in which it incurs qualified research expenses is a phased-in ratio based on the firm's actual research experience. For all subsequent taxable years, the taxpayer's fixed-base percentage is its actual ratio of qualified research expenses to gross receipts for any five years selected by the taxpayer from its fifth through tenth taxable years after 1993. Sec. 41(c)(3)(B).

33 Sec. 41(f)(1).

34 Sec. 41(f)(3).

35 Sec. 41(c)(4).

36 A special transition rule applies for fiscal year 2006-2007 taxpayers.

37 A special transition rule applies for fiscal year 2006-2007 taxpayers.

38 Under a special rule, 75 percent of amounts paid to a research consortium for qualified research are treated as qualified research expenses eligible for the research credit (rather than 65 percent under the general rule under section 41(b)(3) governing contract research expenses) if (1) such research consortium is a tax-exempt organization that is described in section 501(c)(3) (other than a private foundation) or section 501(c)(6) and is organized and operated primarily to conduct scientific research, and (2) such qualified research is conducted by the consortium on behalf of the taxpayer and one or more persons not related to the taxpayer. Sec. 41(b)(3)(C).

39 Sec. 41(d)(3).

40 Sec. 41(d)(4).

41 Taxpayers may elect 10-year amortization of certain research expenditures allowable as a deduction under section 174(a). Secs. 174(f)(2) and 59(e).

42 Sec. 280C(c).

43 Sec. 280C(c)(3).

44 Sec. 38(a).

45 See section 38(b) for a complete list of business credits.

46 Sec. 38(c)(1).

47 Sec. 39(a)(1).

48 Sec. 38(c)(1).

49 The business credit carryback period is extended to five years for 2008 and 2009 carrybacks in another section of the Chairman's Mark.

50 Sec. 168(k). The additional first-year depreciation deduction is subject to the general rules regarding whether an item is deductible under section 162 or instead is subject to capitalization under section 263 or section 263A.

51 However, the additional first-year depreciation deduction is not allowed for purposes of computing earnings and profits.

52 Assume that the cost of the property is not eligible for expensing under section 179.

53 A special rule precludes the additional first-year depreciation deduction for any property that is required to be depreciated under the alternative depreciation system of MACRS.

54 The term "original use" means the first use to which the property is put, whether or not such use corresponds to the use of such property by the taxpayer.

If in the normal course of its business a taxpayer sells fractional interests in property to unrelated third parties, then the original use of such property begins with the first user of each fractional interest (i.e., each fractional owner is considered the original user of its proportionate share of the property).

55 A special rule applies in the case of certain leased property. In the case of any property that is originally placed in service by a person and that is sold to the taxpayer and leased back to such person by the taxpayer within three months after the date that the property was placed in service, the property would be treated as originally placed in service by the taxpayer not earlier than the date that the property is used under the leaseback.

If property is originally placed in service by a lessor (including by operation of section 168(k)(2)(D)(i)), such property is sold within three months after the date that the property was placed in service, and the user of such property does not change, then the property is treated as originally placed in service by the taxpayer not earlier than the date of such sale.

56 In order for property to qualify for the extended placed in service date, the property is required to have an estimated production period exceeding one year and a cost exceeding $1 million.

57 Property does not fail to qualify for the additional first-year depreciation merely because a binding written contract to acquire a component of the property is in effect prior to January 1, 2008.

58 For purposes of determining the amount of eligible progress expenditures, it is intended that rules similar to sec. 46(d)(3) as in effect prior to the Tax Reform Act of 1986 shall apply.

59 Sec. 168(k)(4).

60 The proposal includes a technical amendment to section 168(k)(4)(D) providing that no written binding contract for the acquisition of eligible qualified property may be in effect before April 1, 2008.

61 Additional section 179 incentives are provided with respect to qualified property meeting applicable requirements that is used by a business in an empowerment zone (sec. 1397A) or a renewal community (sec. 1400J), qualified section 179 Gulf Opportunity Zone property (sec. 1400N(e)), qualified Recovery Assistance property placed in service in the Kansas disaster area (Pub. L. No. 110-234, sec. 15345 (2008)), and qualified disaster assistance property (sec. 179(e)).

62 Sec. 179(c)(1). Under Treas. Reg. sec. 1.179-5, applicable to property placed in service in taxable years beginning after 2002 and before 2008, a taxpayer is permitted to make or revoke an election under section 179 without the consent of the Commissioner on an amended Federal tax return for that taxable year. This amended return must be filed within the time prescribed by law for filing an amended return for the taxable year. T.D. 9209, July 12, 2005.

63 Sec. 179(c)(2).

64 Sec. 172(b)(1)(A).

65 Sec. 172(b)(2).

66 Sec. 172(b)(1)(J).

67 Secs. 810, 805(a)(5).

68 Sec. 810(b)(1).

69 The welfare-to-work tax credit was consolidated into the work opportunity tax credit in the Tax Relief and Health Care Act of 2006, for qualified individuals who begin to work for an employer after December 31, 2006.

70 In the case of an electing corporation that is a partner in a partnership, the corporate partner's distributive share of partnership items is determined as if section 168(k) does not apply to any eligible qualified property and the straight line method is used to calculate depreciation of such property.

71 Special rules apply to an applicable partnership.

72 For this purpose, bonus depreciation is the difference between (i) the aggregate amount of depreciation for all eligible qualified property determined if section 168(k)(1) applied using the most accelerated depreciation method (determined without regard to this proposal), and shortest life allowable for each property, and (ii) the amount of depreciation that would be determined if section 168(k)(1) did not apply using the same method and life for each property.

73 In the case of passenger aircraft, the written binding contract limitation does not apply.

74 Special rules apply to property manufactured, constructed, or produced by the taxpayer for use by the taxpayer.

75 The additional first year depreciation under section 168(k) is extended to certain property placed in service in 2009 in another proposal contained in the Chairman's Mark.

76 See sections 61(a)(12) and 108; but see sec. 102 (a debt cancellation which constitutes a gift or bequest is not treated as income to the donee debtor).

77 Sec. 108(b).

78 Sec. 1017.

79 Treas. Reg. sec. 1.61-12(c)(2)(ii). Treas. Reg. sec. 1.1275-1(b) defines "adjusted issue price."

80 Sec. 108(e)(4).

81 The 25 percent restriction was enacted by the Technical and Miscellaneous Tax Act of 1988 because of concern over the scope of the definition of manufacturing facility. See H.R. Rpt. No. 100-795 (1988). The amendment was intended to clarify that while the manufacturing facility definition does not preclude the financing of ancillary activities, the 25 percent restriction was intended to limit the use of bond proceeds to finance facilities other than for "core manufacturing."

82 Sec. 45. In addition to the electricity production credit, section 45 also provides income tax credits for the production of Indian coal and refined coal at qualified facilities.

83 Sec. 48.

84 The term "original use" means the first use to which the property is put, whether or not such use corresponds to the use of such property by the taxpayer. If in the normal course of its business a taxpayer sells fractional interests in property to unrelated third parties, then the original use of such property begins with the first user of each fractional interest (i.e., each fractional owner is considered the original user of its proportionate share of the property).

85 Sec. 141.

86 The 10 percent private business test is reduced to five percent in the case of private business uses (and payments with respect to such uses) that are unrelated to any governmental use being financed by the issue.

87 Sec. 103(a) and (b)(2).

88 Sec. 148.

89 See secs. 54B, 54C, 54D, and 54E.

90 Given the differences in credit quality and other characteristics of individual issuers, the Secretary cannot set credit rates in a manner that will allow each issuer to issue tax credit bonds at par.

91 "Stripped" means a separation (including at issuance) of the ownership of a qualified tax credit bond from the entitlement to the credit with respect to such bond.

92 See "Build America Bonds" discussed below.

93 Sec. 103.

94 Sec. 141(b)(6); Treas. Reg. sec. 1.141-1(b).

95 Secs. 103(b)(1) and 141.

96 Sec. 7871.

97 Sec. 7871(c).

98 Section 45D was added by section 121(a) of the Community Renewal Tax Relief Act of 2000, Pub. L. No. 106-554 (2000).

99 12 U.S.C. sec. 4702(17) (defines "low-income" for purposes of 12 U.S.C. sec. 4702(20)).

100 Sec. 265(a).

101 See Rev. Proc. 72-18, 1972-1 C.B. 740.

102 Id.

103 Sec. 265(b)(1). A "financial institution" is any person that (1) accepts deposits from the public in the ordinary course of such person's trade or business and is subject to Federal or State supervision as a financial institution or (2) is a corporation described in section 585(a)(2). Sec. 265(b)(5).

104 Sec. 265(b)(3).

105 Secs. 265(b)(3)(A), 291(a)(3) and 291(e)(1).

106 Sec. 265(b)(3)(C).

107 Sec. 265(b)(3)(E).

108 Sec. 265(b)(3)(F).

109 Sec. 291(e)(1).

110 Sec. 103.

111 Sec. 149(e).

112 Sec. 103(a) and (b)(2).

113 Sec. 148.

114 Sec. 1397E.

115 Given the differences in credit quality and other characteristics of individual issuers, the Secretary cannot set credit rates in a manner that will allow each issuer to issue tax credit bonds at par.

116 Sec. 103.

117 Sec. 149(e).

118 Sec. 103(a) and (b)(2).

119 Sec. 148.

120 Sec. 1397E.

121 Given the differences in credit quality and other characteristics of individual issuers, the Secretary cannot set credit rates in a manner that will allow each issuer to issue tax credit bonds at par.

122 Sec. 141.

123 The 10 percent private business test is reduced to five percent in the case of private business uses (and payments with respect to such uses) that are unrelated to any governmental use being financed by the issue.

124 Sec. 103(a) and (b)(2).

125 Sec. 148.

126 See secs. 54B, 54C, 54D, and 54E.

127 Given the differences in credit quality and other characteristics of individual issuers, the Secretary cannot set credit rates in a manner that will allow each issuer to issue tax credit bonds at par.

128 Under Treas. Reg. sec. 150-1(b), capital expenditure means any cost of a type that is properly chargeable to capital account (or would be so chargeable with a proper election or with the application of the definition of placed in service under Treas. Reg. sec. 1.150-2(c)) under general Federal income tax principles. For purposes of applying the "general Federal income tax principles" standard, an issuer should generally be treated as if it were a corporation subject to taxation under subchapter C of chapter 1 of the Code. An example of a capital expenditure would include expenditures made for the purchase of fiber-optic cable to provide municipal broadband service.

129 Description of present law and the proposal were prepared by the majority staff of the Senate Committee on Finance.

130 Description of present law and the proposal were prepared by the majority staff of the Senate Committee on Finance.

131 Description of present law and the proposal were prepared by the majority staff of the Senate Committee on Finance.

132 Due to administrative constraints, this category includes a small number of individuals under age 18 who are eligible for veteran compensation or pension benefits.

133 This includes SSI recipients who are under age 18.

134 Description of present law and the proposal were prepared by the majority staff of the Senate Committee on Finance.

Final 7216 regulations

The IRS will look at 7216 disclosure issues when they examine tax return preparers for the 6694 penalty. The IRS will be highly motivated to go ater the penalties.

T.D. 9437 , December 15, 2008.

[ Code Sec. 7216]


Disclosure: Tax return preparers: Social Security numbers. --

Amendments of Reg. §301.7216-3, relating to the disclosure and use of tax return information by tax return preparers, are adopted. Temporary Reg. §301.7216-3T is removed.






DEPARTMENT OF THE TREASURY



Internal Revenue Service

26 CFR Part 301

[ TD 9437]

RIN 1545-BI00

Amendments to the Section 7216 Regulations --Disclosure or Use of Information by Preparers of Returns

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final and removal of temporary regulations.

SUMMARY: This document contains final regulations that provide rules relating to the disclosure and use of tax return information by tax return preparers. These regulations affect tax return preparers and provide updated guidance regarding the disclosure of a taxpayer's social security number to a tax return preparer located outside of the United States.

DATES: Effective Date: These regulations are effective on [ INSERT DATE OF PUBLICATION OF THIS DOCUMENT IN THE FEDERAL REGISTER].

Applicability Date: See §301.7216-3(d), which states that the regulations apply to disclosures or uses of tax return information occurring on or after January 1, 2009. FOR FURTHER INFORMATION CONTACT: Molly K. Donnelly, (202) 622-4940 (not a toll-free number).

SUPPLEMENTARY INFORMATION:



Background

This document amends 26 CFR part 301. On December 8, 2005, the Treasury Department and the IRS published a notice of proposed rulemaking (REG-137243-02) in the Federal Register (70 FR 72954) proposing amendments to the regulations under section 7216 (regarding the use or disclosure of tax return information by income tax return preparers). On January 3, 2008, the Treasury Department and the IRS issued final regulations under section 7216 ( TD 9375) applicable to disclosures or uses of tax return information occurring on or after January 1, 2009. Thus, TD 9375 replaced previously issued final regulations that remain applicable to disclosures or uses of tax return information occurring prior to January 1, 2009.

TD 9375 included a revision of §301.7216-3(b)(4) which, for disclosures and uses of tax return information occurring on or after January 1, 2009, provided that an income tax return preparer located in the United States may not disclose the taxpayer's social security number (SSN) to a tax return preparer located outside of the United States even if the taxpayer consents to the disclosure.

On July 1, 2008, a temporary regulation ( TD 9409) was published in the Federal Register (73 FR 37804) that created a limited exception to the rule prohibiting the disclosure of a taxpayer's SSN outside of the United States. This temporary regulation modified the rules under §301.7216-3(b)(4). A notice of proposed rulemaking (REG-121698-08) cross-referencing the temporary regulations was published in the Federal Register for the same day (73 FR 37910), requesting comments and setting a public hearing date.



Summary of Comments and Explanation of Revisions

The IRS and the Treasury Department requested written or electronic comments by September 30, 2008. Persons wishing to present oral comments at the public hearing scheduled for October 6, 2008, were to submit an outline of the topics to be discussed at the hearing by September 15, 2008, and written or electronic comments by September 30, 2008. No written or electronic comments or requests to speak at the hearing, together with the required outline of topics, were submitted, and the hearing was cancelled (73 FR 56534).

The final regulations adopt the rules published in the proposed regulations without substantial change. The final regulations maintain the general rule in §301.7216-3(b)(4) providing that an income tax return preparer located in the United States may not disclose the taxpayer's SSN to a tax return preparer located outside of the United States even if the taxpayer consents to the disclosure. The final regulations create a limited exception to the general rule providing that a tax return preparer located within the United States, including any territory or possession of the United States, may obtain consent to disclose the taxpayer's SSN to a tax return preparer located outside of the United States or any territory or possession of the United States only if the tax return preparer discloses the SSN through the use of an adequate protection safeguard as described in guidance published in the Internal Revenue Bulletin and verifies the maintenance of the adequate data protection safeguards in the request for the taxpayer's consent pursuant to the specifications described in guidance published in the Internal Revenue Bulletin.

The rules adopted in the final regulations are substantially identical to those proposed in the notice of proposed rulemaking with the exception that §301.7216-3T(d), which set forth the effective date for the rules contained in the temporary regulations, was removed and not adopted in the final regulations because the identical effective date is currently set forth in §301.7216-3(d). In addition, minor and non-substantive edits were made to provide grammatical consistency and clarity throughout the regulations. Additional guidance regarding the adequate data protection safeguard set forth in the regulations may be found in Revenue Procedure 2008-35, 2008-29 I.R.B. 132. See § 601.601(d)(2)(ii)(b).



Special Analyses

It has been determined that this Treasury decision is not a significant regulatory action as defined in Executive Order 12866. Therefore, a regulatory assessment is not required. It also has been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to these regulations, and because the regulations do not impose a collection of information on small entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not apply. Pursuant to section 7805(f) of the Internal Revenue Code, the notice of proposed rulemaking preceding these regulations were submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on their impact on small business.



Drafting Information

The principal author of these regulations is Molly K. Donnelly, Office of the Associate Chief Counsel (Procedure and Administration).



List of Subjects in 26 CFR Part 301

Employment taxes, Estate taxes, Excise taxes, Gift taxes, Income taxes, Penalties, Reporting and recordkeeping requirements.



Adoption of Amendments to the Regulations

Accordingly, 26 CFR part 301 is amended as follows:



PART 301 --PROCEDURE AND ADMINISTRATION

Paragraph 1. The authority citation for part 301 continues to read in part as follows:

Authority: 26 U.S.C. 7805 * * *

Paragraph 2. Section 301.7216-3 is amended by revising paragraph (b)(4) to read as follows:



§301.7216-3 Disclosure or use permitted only with the taxpayer's consent.

* * * * *

(b) * * *

(4) No consent to the disclosure of a taxpayer's social security number to a return preparer outside of the United States with respect to a taxpayer filing a return in the Form 1040 Series --(i) In general. Except as provided in paragraph (b)(4)(ii) of this section, a tax return preparer located within the United States, including any territory or possession of the United States, may not obtain consent to disclose the taxpayer's social security number (SSN) with respect to a taxpayer filing a return in the Form 1040 Series, for example, Form 1040, Form 1040NR, Form 1040A, or Form 1040EZ, to a tax return preparer located outside of the United States or any territory or possession of the United States. Thus, if a tax return preparer located within the United States (including any territory or possession of the United States) obtains consent from an individual taxpayer to disclose tax return information to another tax return preparer located outside of the United States, as provided under §§301.7216-2(c) and 301.7216-2(d), the tax return preparer located in the United States may not disclose the taxpayer's SSN, and the tax return preparer must redact or otherwise mask the taxpayer's SSN before the tax return information is disclosed outside of the United States. If a tax return preparer located within the United States initially receives or obtains a taxpayer's SSN from another tax return preparer located outside of the United States, however, the tax return preparer within the United States may, without consent, retransmit the taxpayer's SSN to the tax return preparer located outside the United States that initially provided the SSN to the tax return preparer located within the United States. For purposes of this section, a tax return preparer located outside of the United States does not include a tax return preparer who is continuously and regularly employed in the United States or any territory or possession of the United States and who is in a temporary travel status outside of the United States.

(ii) Exception. A tax return preparer located within the United States, including any territory or possession of the United States, may obtain consent to disclose the taxpayer's SSN to a tax return preparer located outside of the United States or any territory or possession of the United States only if the tax return preparer within the United States discloses the SSN to a tax return preparer outside of the United States through the use of an adequate data protection safeguard as defined by the Secretary in guidance published in the Internal Revenue Bulletin (see §601.601(d)(2)(ii)(b) of this chapter) and verifies the maintenance of the adequate data protection safeguards in the request for the taxpayer's consent pursuant to the specifications described by the Secretary in guidance published in the Internal Revenue Bulletin.

* * * * *



§301.7216-3T [Removed]

Paragraph 3. Section 301.7216-3T is removed.


/s/ Linda E. Stiff



Deputy Commissioner for Services and Enforcement.


Approved: December 10, 2008


/s/Eric Solomon



Assistant Secretary of the Treasury (Tax Policy).

Another loophole in Notice 2009-5

Notice 2009-5 is copied below. I have previously commented on the bizzare position taken that a tax return preparer will be deemed to have met the the substantial authority standard in section 6694(a)(2)(A) if the tax return preparer relies in good faith and without verification on the advice of another advisor, another tax return preparer, or other party. Factors used in evaluating a tax return preparer’s good faith reliance on the advice of another are found in § 1.6694-2(e)(5).

When Congress substituted the substantial authority standard for the more likely than not standard, it was guided by the present section 6662 regulations on substantial authority which are limited to and reference only tax law. Therefore, it is extraordinary in the extreme to see the "reliance on another person" as a qualification for the substantial authority standard.

Section 1.6694-2(e)(5) provides:


(5) Reliance on advice of others . For purposes of demonstrating reasonable cause and good faith, a tax return preparer may rely without verification upon advice and information furnished by the taxpayer and information and advice furnished by another advisor, another tax return preparer or other party, as provided in §1.6694-1(e) . The tax return preparer may rely in good faith on the advice of, or schedules or other documents prepared by, the taxpayer, another advisor, another tax return preparer, or other party (including another advisor or tax return preparer at the tax return preparer's firm), who the tax return preparer had reason to believe was competent to render the advice or other information. The advice or information may be written or oral, but in either case the burden of establishing that the advice or information was received is on the tax return preparer. A tax return preparer is not considered to have relied in good faith if --

(i) The advice or information is unreasonable on its face;

(ii) The tax return preparer knew or should have known that the other party providing the advice or information was not aware of all relevant facts; or

(iii) The tax return preparer knew or should have known (given the nature of the tax return preparer's practice), at the time the return or claim for refund was prepared, that the advice or information was no longer reliable due to developments in the law since the time the advice was given.

The loophole is the rule that you can rely on another "person" Thus, you can rely on a person who knows little about tax law and who does not have the ability to even research the tax law. And the person requesting the opinion, a nonsigning return preparer, knows just as little about the tax law and does not have the ability to research the tax law. I will call this the "double dummy" loophole.

Example: A CPA firm hires two senior citizens looking for some extra money to prepare tax returns. Both learn how to use tax preparation software. Senior citizen Y is given the ability to request a tax opinion from senior citizen Z. Z has no assets and is paid $10 per hour for his time. Z's only other income is received as social security income. Z is "another person" within the meaning of Notice 2009-5. None of the provisions of Reg. 1.6694-2(e)(5)will taint the advice. If Z gets hit with $5,000 penalties, Z is not "collecible" and cannot be levied under the "hardship" rule of 6343(a)(1)(D). The tax preparation firm can get all of its opinions from Z for all of the 2008 tax year. What about firm liability for the 6694(a)or (b) penalties? The tax preparation firm can avoid liability with comprehensive technical review procedures with senior citizen X as the technical reviewer. X, Y, and Z will never be able to determine if the technical advice or information is unreasonable on its face. The final 6694 regulations do not

Although the above example has extreme facts, most return preparation firms are likely to have persons working there who have some of the attributes of X, Y, and Z who each have little tax technical training or experiece. Therefore, none of the provisions of Reg. 1.6694-2(e)(5)will inhibit the double dummy loophole.

My only point is that Noice 2009-5 provides administrative rules that will not extend into 2009. I expect that the new Treasury will eliminate the reliance on another person rule for a number of reasons including the fact that it deviates from the classic technical rules already in place in defining "substantial authority."

For questions, contact ab@irstaxattorney.com



The full text of Notice 2009-5 is attached below:




------------------------------------------------------------



Internal Revenue Bulletin: 2009-3
January 21, 2009

Notice 2009-5
Guidance Under the Preparer Penalty Modification in the Tax Extenders and Alternative Minimum Tax Relief Act of 2008

--------------------------------------------------------------------------------

Table of Contents


BACKGROUND
INTERIM GUIDANCE UNDER SECTION 6694(a)
A. Effect of the 2008 Act on Applicability of Notices 2007-54, 2008-11, and 2008-13
B. Definition of Substantial Authority
C. Interim Penalty Compliance Rules for Tax Shelter Transactions
REQUESTS FOR COMMENTS
Effect on Other Documents
EFFECTIVE DATE
CONTACT INFORMATION
This notice provides guidance regarding implementation of the tax return preparer penalty under section 6694(a) of the Internal Revenue Code, as amended by the Tax Extenders and Alternative Minimum Tax Relief Act of 2008, Div. C. of Pub. L. No. 110-343, 122 Stat. 3765 (October 3, 2008) (the 2008 Act).

With this notice, the Treasury Department and the IRS are simultaneously issuing final regulations revising the regulatory scheme governing tax return preparer penalties in accordance with the amendments to sections 6694 and 6695 (and related provisions under sections 6060, 6107, 6109, 6696, and 7701(a)(36)) in both the 2008 Act and the Small Business and Work Opportunity Tax Act of 2007, Title VIII-B of Pub. L. No. 110-28 (121 Stat. 190) (May 25, 2007) (the 2007 Act). Section 1.6694-2 of the final regulations, however, does not provide substantive guidance reflecting certain amendments to section 6694(a) made by the 2008 Act. Rather, the Treasury Department and the IRS are reserving §1.6694-2(c) in those final regulations and are issuing this notice. This notice provides interim guidance on the 2008 Act’s changes to section 6694(a) and solicits public comments on this guidance.

BACKGROUND
Section 6694(a) imposes a penalty on a tax return preparer who prepares a return or claim for refund reflecting an understatement of liability due to an “unreasonable position” if the tax return preparer knew (or reasonably should have known) of the position. No penalty is imposed, however, if it is shown that there is reasonable cause for the understatement and the tax return preparer acted in good faith. Immediately prior to the 2008 Act, under the standards of conduct implemented by the 2007 Act’s amendment to section 6694(a), a position would be treated as unreasonable unless (i) there was a reasonable belief that it would more likely than not be sustained on the merits, or (ii) the position was properly disclosed and had a reasonable basis. The Treasury Department and the IRS issued Notice 2007-54, 2007-27 I.R.B. 12, on June 11, 2007, which provided transitional relief under section 6694(a). On December 31, 2007, the Treasury Department and the IRS released both Notice 2008-11, 2008-3 I.R.B. 279, which clarified the earlier transition relief provided in Notice 2007-54, and Notice 2008-13, 2008-3 I.R.B. 282, which provided interim penalty compliance rules under the 2007 Act version of section 6694. On June 17, 2008, the Treasury Department and the IRS published in the Federal Register (REG-129243-07, 2008-27 I.R.B. 32 [73 F.R. 34560]) proposed amendments to the section 6694 regulations reflecting amendments made by the 2007 Act.

After the issuance of the proposed regulations, the 2008 Act revised section 6694(a) to provide that a position would be treated as unreasonable unless (i) there is or was substantial authority for the position or (ii) the position was properly disclosed and had a reasonable basis. The 2008 Act also enacted a special rule if the position is with respect to a tax shelter (as defined in section 6662(d)(2)(C)(ii)) or a reportable transaction to which section 6662A applies (including both reportable transactions with a significant purpose of Federal tax avoidance or evasion and listed transactions), under which a position is treated as unreasonable unless it is reasonable to believe that the position would more likely than not be sustained on the merits. The 2008 Act did not modify the section 6694(b) penalty for understatements due to willful or reckless conduct.

The 2008 Act’s change in the general standard under section 6694(a) to substantial authority is retroactively effective for tax returns and claims for refund prepared after May 25, 2007. The special rule applicable to tax shelters and reportable transactions to which section 6662A applies is effective for tax returns and claims for refund prepared for taxable years ending after October 3, 2008, the 2008 Act’s date of enactment.

This notice provides interim guidance to tax return preparers regarding the application of section 6694(a) as revised by the 2008 Act in order to provide immediate guidance for signing and nonsigning tax return preparers. Specifically, this interim guidance discusses the following issues: (1) the effect of the 2008 Act’s changes to Notices 2007-54, 2008-11, and 2008-13, which provide guidance on the application of section 6694(a) under the 2007 Act; (2) the definition of substantial authority for purposes of section 6694(a)(2)(A); and (3) the interim penalty compliance rules for “tax shelter” transactions as defined in section 6662(d)(2)(C)(ii). Tax return preparers may rely on the interim guidance in this notice with respect to these issues until further guidance is issued. The final regulations under section 6694 govern all other issues with respect to this penalty.

The guidance regarding effective dates addresses the retroactive effect of the 2008 Act’s revisions to section 6694 and also addresses the different effective dates for the 2008 Act’s general standard (which applies retroactively) and the special rule for tax shelters and reportable transactions to which section 6662A applies (which does not apply retroactively). The guidance also clarifies the interaction between the 2008 Act’s effective dates and the effective dates for Notices 2007-54, 2008-11, and 2008-13.

The interim guidance regarding substantial authority generally adopts the analysis provided under existing substantial authority regulations under section 6662. The interim guidance clarifies certain aspects of the application of the substantial authority regulations in § 1.6662-4(d) in the context of section 6694.

This interim guidance addresses the application of section 6694 while the Treasury Department and IRS consider further guidance for tax return preparers and taxpayers on the definition of tax shelter for purposes of sections 6694 and 6662(d)(2)(C). A broad interpretation of tax shelter for purposes of section 6694 could be inconsistent with the 2008 Act’s changes to section 6694 by requiring tax return preparers to comply with the general standard previously imposed under the 2007 Act (a reasonable belief that the position would more likely than not be sustained on the merits) rather than the new general standard under the 2008 Act (substantial authority).

INTERIM GUIDANCE UNDER SECTION 6694(a)

A. Effect of the 2008 Act on Applicability of Notices 2007-54, 2008-11, and 2008-13
Notices 2007-54 and 2008-11 provided transitional relief for (1) all tax returns, amended tax returns, and claims for refund (other than employment and excise tax returns) filed on or after May 25, 2007, and on or before December 31, 2007; (2) all employment and excise tax returns filed on or after May 25, 2007, and on or before January 31, 2008; and (3) advice provided on or after May 25, 2007, and on or before December 31, 2007. Tax return preparers may continue to rely upon the transitional relief rules provided in Notices 2007-54 and 2008-11 for returns or claims for refund for the periods covered by those notices.

Notice 2008-13 provided interim guidance on, among other issues, the standards of conduct applicable to tax return preparers under section 6694(a) and interim penalty compliance obligations applicable to tax return preparers. Notice 2008-13 is effective for (1) all tax returns, amended tax returns, and claims for refund (other than 2007 employment and excise tax returns) filed on or after January 1, 2008, and before January 1, 2009 (the effective date of the final regulations under section 6694(a)); (2) all 2007 employment and excise tax returns filed on or after February 1, 2008, and before January 1, 2009; and (3) advice provided on or after January 1, 2008 and before January 1, 2009.

Consistent with the 2007 Act, the interim guidance provided by Notice 2008-13 generally held tax return preparers to a more stringent standard under section 6694(a) than the substantial authority standard imposed by the 2008 Act’s revisions to section 6694. Accordingly, for positions other than with respect to tax shelters (as defined in section 6662(d)(2)(C)(ii)) and reportable transactions to which section 6662A applies, tax return preparers may apply the substantial authority standard consistent with the 2008 Act or may rely upon the interim guidance provided in Notice 2008-13 when preparing returns or claims for refund for the periods covered by that notice.

The 2008 Act’s special rule for tax shelters (as defined in section 6662(d)(2)(C)(ii)) and reportable transactions to which section 6662A applies does not apply retroactively, and therefore the provisions of Notice 2008-13 will apply to tax shelter and section 6662A reportable transaction positions on returns or claims for refund for tax years ending prior to the date of enactment of the 2008 Act and otherwise covered by Notice 2008-13, as set forth above. The interim guidance provided in this notice with respect to tax shelters (as defined in section 6662(d)(2)(C)(ii)) and reportable transactions to which section 6662A applies is effective for returns or claims for refund for tax years ending after the date of enactment of the 2008 Act.

B. Definition of Substantial Authority
Until further guidance is issued, solely for purposes of section 6694(a), “substantial authority” has the same meaning as in § 1.6662-4(d)(2) (or any successor provision) of the accuracy-related penalty regulations. The analysis prescribed by § 1.6662-4(d)(3)(i) through (ii) (or any successor provisions) applies for purposes of determining whether substantial authority is present. The authorities considered in determining whether there is substantial authority for a position are those authorities described in § 1.6662-4(d)(3)(iii) (or any successor provision).

There is substantial authority for a position for purposes of section 6694 if the taxpayer is the subject of a “written determination” as provided in § 1.6662-4(d)(3)(iv)(A). In the case of a tax return preparer, however, a written determination with a misstatement or omission of material fact is substantial authority unless the tax return preparer knew or should have known of the misstatement or omission of material fact when the return or claim for refund was filed. The applicability of court cases to the taxpayer’s situation by reason of the taxpayer’s residence in a particular jurisdiction is not taken into account in determining whether there is substantial authority for a position in accordance with § 1.6662-4(d)(3)(iv)(B). Notwithstanding the preceding sentence, there is substantial authority for a position if the position is supported by controlling precedent of a United States Court of Appeals to which the taxpayer has a right of appeal with respect to the position. Finally, there is substantial authority for a position only if there is substantial authority on the date the return or claim for refund is deemed prepared, as prescribed by § 1.6694-1(a)(2), or there was substantial authority on the last day of the taxable year to which the return relates.

Conclusions reached in treatises, legal periodicals, legal opinions, or opinions rendered by tax professionals (including tax return preparers) are not authority. The authorities underlying such expressions of opinion, if applicable to the facts of a particular case, however, may give rise to substantial authority for the position. Solely for purposes of section 6694(a), a tax return preparer nevertheless will be considered to have met the standard in section 6694(a)(2)(A) if the tax return preparer relies in good faith and without verification on the advice of another advisor, another tax return preparer, or other party. Factors used in evaluating a tax return preparer’s good faith reliance on the advice of another are found in § 1.6694-2(e)(5).

C. Interim Penalty Compliance Rules for Tax Shelter Transactions
Until further guidance is issued, solely for purposes of section 6694(a), a position with respect to a tax shelter (as defined in section 6662(d)(2)(C)(ii)) will not be deemed an “unreasonable position” described in section 6694(a)(2)(A) through (C) if there is substantial authority for the position and the tax return preparer advises the taxpayer of the penalty standards applicable to the taxpayer in the event that the transaction is deemed to have a significant purpose of Federal tax avoidance or evasion. This advice to the taxpayer must explain that, if the position has a significant purpose of tax avoidance or evasion, then there needs to be at a minimum substantial authority for the position, the taxpayer must possess a reasonable belief that the tax treatment was more likely than not the proper treatment in order to avoid a penalty under section 6662(d) as applicable, and disclosure in accordance with § 1.6662-4(f) will not protect the taxpayer from assessment of an accuracy-related penalty if section 6662(d)(2)(C) applies to the position. The tax return preparer must contemporaneously document the advice in the tax return preparer’s files.

If a nonsigning tax return preparer provides advice to another tax return preparer regarding a position with respect to a tax shelter (as defined in section 6662(d)(2)(C)(ii)), the position will not be deemed an “unreasonable position” described in section 6694(a)(2)(A) through (C) if there is substantial authority for the position and the nonsigning tax return preparer provides a statement to the other tax return preparer about the penalty standards applicable to the tax return preparer under section 6694.Contemporaneously prepared documentation in the nonsigning tax return preparer’s files is sufficient to establish that the statement was given to the other tax return preparer. If a nonsigning tax return preparer and other tax return preparer are employed by the same firm, then contemporaneous documentation of advice provided by any tax return preparer in that firm to the taxpayer regarding applicable penalty standards, as described in the immediately preceding paragraph, is also sufficient to establish that the statement was given by a nonsigning tax return preparer to the other tax return preparers within the firm.

The above interim penalty compliance rules do not apply to a position described in section 6662A (a reportable transaction with a significant purpose of Federal tax avoidance or evasion or a listed transaction).

REQUESTS FOR COMMENTS
Interested parties are invited to submit comments on this notice by Monday, March 16, 2009. Comments should be submitted to: Internal Revenue Service, CC:PA:LPD:PR (Notice 2009-5), Room 5203, P.O. Box 7604, Ben Franklin Station, Washington, DC 20224. Alternatively, comments may be hand-delivered Monday through Friday between the hours of 8:00 a.m. to 4:00 p.m. to: CC:PA:LPD:PR (Notice 2009-5), Courier’s Desk, Internal Revenue Service, 1111 Constitution Avenue, N.W., Washington, DC. Comments may also be submitted electronically via the following e-mail address: Notice.Comments@irscounsel.treas.gov. Please include Notice 2009-5 in the subject line of any electronic submissions.

Effect on Other Documents
This notice modifies and clarifies Notice 2008-13, 2008-3 I.R.B. 282.

EFFECTIVE DATE
For positions other than tax shelters and reportable transaction positions, this notice is effective for all advice rendered or returns, amended returns, and claims for refund prepared after May 25, 2007. The interim guidance in this notice for tax shelters (within the meaning of section 6662(d)(2)(C)(ii)) and reportable transactions to which section 6662A applies is effective for tax shelter and reportable transaction positions on tax returns for taxable years ending after the 2008 Act’s date of enactment, October 3, 2008.

CONTACT INFORMATION
The principal authors of this notice are Matthew S. Cooper and Michael E. Hara of the Office of Associate Chief Counsel (Procedure and Administration). For further information regarding this notice, contact Mr. Cooper at (202) 622-4940 or Mr. Hara at (202) 622-4910 (not toll-free calls).

Confidentiality of work papers - important case

In United States, Petitioner-Appellant v. Textron Inc. and Subsidiaries, Respondent-Appellee, Textron did not have to provide the IRS with documents it used to calculate its tax reserve liability because they were protected by the work product privilege. The tax accrual workpapers listed the questionable positions the corporation took on its tax returns and calculated the amount of additional tax liability that would result if those positions were reversed after audit or litigation. For purposes of the work product privilege, the resolution of disputes through an administrative process, including audits and appeals, met the definition of litigation. Further, even though the corporation also used them for other business and regulatory purposes, the documents satisfied the "because of" test for purposes of the privilege because their principal function was to analyze litigation for the purpose of creating and auditing a reserve fund. The fact that the corporation rated some of its positions as certain to fail and that it had a history of resolving its tax disputes without litigating them did not defeat the privilege. In addition, the corporation met its burden to identify the litigation for which the documents were created and explain why the work-product privilege applied to them. Finally, the fact that the corporation had disclosed the documents to its auditor did not defeat the privilege, because the corporation and the auditor were not adversaries. However, the case was remanded to determine whether the corporation could obtain the auditor's own work papers that were related to the tax accrual workpapers and, if so, whether the surrendering the auditor's papers to the IRS would effectively disclose the corporation's tax accrual workpapers.


United States, Petitioner-Appellant v. Textron Inc. and Subsidiaries, Respondent-Appellee.

U.S. Court of Appeals, 1st Circuit; 07-2631, January 21, 2009.

Affirming in part, reversing in part and remanding a DC R.I. decision, 2007-2 USTC ¶50,605.



Practice and procedure: Discovery: Work product privilege: Dual purpose documents: Waiver. --

.
Robert Clark Corrente, United States Attorney, Nathan J. Hochman, Assistant Attorney General, Richard T. Morrison, Deputy Assistant Attorney General, Kevin J. O'Connor, Gilbert S. Rothenberg, David I. Pincus, Robert W. Metzler, Judith A. Hagley, Department of Justice, for petitioner-appellant. John A. Tarantino, Patricia K. Rocha, Adler Pollock & Sheehan P.C., Arthur L. Bailey, J. Walker Johnson, Steptoe & Johnson LLP, for respondent-appellee. David M. Brodsky, Robert J. Malionek, Adam J. Goldberg, Lathan & Watkins LLP, Robin S. Conrad, Amar D. Sarwal, Susan Hackett, Senior Vice President and General Counsel, for Chamber of Commerce of U.S., Corporate Counsel, as amicus curiae in support of Textron Inc. Kevin L. Kenworthy, Alam I. Horowitz, Miller & Chevalier Chartered, for Financial Executives Intl., as amicus curiae in support of Textron Inc.

Before: Torruella and Boudin, Circuit Judges, and Schwarzer, District Judge.

Before Torruella, Boudin, Circuit Judges, and Schwarzer, * District Judge.

TORRUELLA, Circuit Judge: The question presented by this appeal is whether the work-product doctrine protects documents prepared by Textron Inc. for the purpose of calculating tax reserve liability from production to the IRS pursuant to an investigative subpoena. Like other companies, Textron prepares "tax accrual workpapers" which, generally speaking, list the questionable positions Textron took on its tax returns, estimate the likelihood that those positions will not withstand scrutiny, and calculate the amount of additional tax liability that would result from revision of those positions. Textron prepares these estimates so that it can maintain an adequate reserve fund, properly report its assets and liabilities, and obtain independent certification of its financial statements. As part of the auditing process, Textron showed these tax accrual workpapers to Ernst & Young ("E&Y") an independent auditor.

This case arose when the Internal Revenue Service ("IRS"), after noticing potential tax shelter transactions, issued an administrative summons to Textron pursuant to I.R.C. § 7602 seeking tax accrual workpapers for Textron's 2001 tax returns. Textron refused to comply and asserted a number of defenses. The IRS sued to enforce the subpoena. After an evidentiary hearing, the district court ruled for Textron on its work-product protection claim, but rejected its other defenses. The district court also found that Textron's disclosure to E&Y did not constitute waiver. The IRS appeals. After careful review, 1 we affirm in part, vacate in part, and remand.


I. Background


The IRS subpoena sought "Tax Accrual Workpapers," defined as:
[A]11 accrual and other financial workpapers or documents created or assembled by the Taxpayer, an accountant for the Taxpayer, or the Taxpayer's independent auditor relating to any tax reserve for current, deferred, and potential or contingent tax liabilities, however classified or reported on audited financial statements, and to any footnotes disclosing reserves or contingent liabilities on audited financial statements. They include, but are not limited to, any and all analyses, computations, opinions, notes, summaries, discussions, and other documents relating to such reserves and any footnotes.

The subpoena sought all documents in the actual or constructive possession, custody, or control of Textron or its accountants. The district court held oral arguments where the government reiterated that it was seeking tax accrual documents prepared by Textron or E&Y. Textron argued that it had created the documents in anticipation of a dispute with the IRS regarding its tax returns.

The district court then held an evidentiary hearing on the types of documents included in the definition of "tax accrual workpapers" and the basis for Textron's work product claim. At the evidentiary hearing, the IRS's expert witness, Professor Douglas Carmichael, testified that securities law requires that public companies obtain a letter from an independent auditor approving the company's financial statements, and that part of that audit was an analysis of the company's reserves for covering tax loss. Textron's former Director of Tax Reporting, Roxanne Cassidy, countered that the tax accrual workpapers were created "to determine whether Textron was adequately reserved with respect to any potential disputes or litigations that would happen in the future." Cassidy and Norman Richter, Textron tax counsel, explained that the tax accrual workpapers listed positions Textron was taking on its tax returns that might require that a reserve be set aside. These positions were then analyzed by Textron attorneys who estimated a percentage likelihood that the position would not prevail if challenged by the IRS. Textron calls this the "hazards of litigation percentage." The reserve requirement was calculated by multiplying this percentage times the tax benefit claimed.

In response, Carmichael, the IRS expert witness, contended that public companies prepare these papers every year to comply with securities law regardless of whether they expect litigation. But, Richter testified that the tax accrual workpapers were prepared under the assumption that issues identified would be challenged by the IRS and would need to be defended. He further testified that if Textron did not anticipate any disputes, the tax accrual workpapers would be blank. The IRS disagreed, arguing that some workpapers would nevertheless be necessary to handle deferred taxes or to justify setting aside no tax reserve.

It was undisputed that the IRS audits every Textron return in multi-year cycles. Testimony also showed that in each audit cycle hundreds of IRS adjustments to Textron's returns were simply accepted by Textron. Where Textron and the IRS do dispute tax liability, their dispute could be resolved through a conference with the audit team, by presentation of arguments to the IRS Office of Appeals, or, ultimately, federal court litigation. In seven of the last eight audit cycles, Textron and the IRS have brought at least one issue to the IRS Office of Appeals. Between 1959 and present, Textron and the IRS have litigated three disputes in federal court. Textron admitted that it expected to concede several issues identified in the workpapers, and that the percentage for those issues was listed as "100%." Textron explained that those items were due to instances where legal developments rendered a prior position undefendable.

IRS agents explained that access to the workpapers would help them navigate Textron's 4000 page tax return which was accompanied by "9 four-drawer file cabinets" of paper. The IRS witnesses explained that the tax accrual workpapers would help the IRS understand the substance of a transaction and could help the IRS identify potential issues with Textron's return. An agent testified that in 2006 the IRS adopted the policy of seeking tax accrual workpapers when the audit team becomes aware (sometime through self-reporting) of certain transactions by the taxpayer which potentially constitute abusive tax shelters.

As to the waiver issue, the IRS's expert, Carmichael, testified that companies create these tax accrual workpapers, knowing that they will be shared with an auditor. Evidence also showed that the auditor's code of ethics requires information be kept confidential unless required to be produced in response to a subpoena or other legal obligation. Mark Weston, a partner at E&Y, submitted an affidavit explaining these confidentiality obligations and further stating that E&Y had not in fact disclosed any information regarding Textron's 2001 tax accrual computations. But the IRS expert opined that auditors ultimately owe an allegiance to the investing public and have legal obligations of disclosure in some instances.

Textron countered that it let E&Y look at its tax accrual workpapers, but did not allow E&Y to retain a copy of them. Debra Raymond, a Textron tax manager, averred that she had reviewed E&Y's files and that E&Y did not in fact retain a copy of Textron's workpapers.

The IRS subpoena also requested any tax-accrual documents prepared by E&Y regarding Textron. After the evidentiary hearing, the district court found that the "tax accrual workpapers" at issue did not include facts about the issues they identified, and could be described as follows:
1. A spreadsheet that contains:

(a) lists of items on Textron's tax returns, which, in the opinion of Textron's counsel, involve issues on which the tax laws are unclear, and, therefore, may be challenged by the IRS;

(b) estimates by Textron's counsel expressing, in percentage terms, their judgments regarding Textron's chances of prevailing in any litigation over those issues (the "hazards of litigation percentages"); and

(c) the dollar amounts reserved to reflect the possibility that Textron might not prevail in such litigation (the "tax reserve amounts").

2. Backup workpapers consisting of the previous year's spreadsheet and earlier drafts of the spreadsheet together with notes and memoranda written by Textron's in-house tax attorneys reflecting their opinions as to which items should be included on the spreadsheet and the hazard of litigation percentage that should apply to each item.

United States v. Textron Inc., 507 F. Supp. 2d 138, 142-143 (D.R.I. 2007). The government objects on appeal that the district court did not include in this definition any tax accrual workpaper that E&Y prepared in its audit of Textron.

The district court then found that the subpoenaed documents were relevant, requested for a proper purpose, and were privileged attorney-client communications. Id. at 143-48. But, the district court found that the attorney-client privilege was waived by disclosure to E&Y. Id. at 151-52.

As to the work-product protection claim, the district court credited Textron's testimony that its ultimate purpose in preparing the tax accrual workpapers was to ensure that it was "'adequately reserved with respect to any potential disputes or litigation that would happen in the future.'" Id. at 143 (quoting the testimony of Norman Richter). The court found that this desire to ensure adequate reserves was also prompted, in part, by its wish to satisfy independent auditors that Textron had properly reported its financial information. Id. at 150. The court acknowledged the First Circuit's "because of" test for determining whether documents were prepared in anticipation of litigation and recognized that under that test there is no protection for "'documents that are prepared in the ordinary course of business or that would have been created in essentially similar form irrespective of the litigation.'" Id. (quoting Maine v. United States Dep't of the Interior, 298 F.3d 60, 70 (1st Cir. 2002)). The district court then held that the tax accrual workpapers "would not have been prepared at all 'but for' the fact that Textron anticipated the possibility of litigation with the IRS." Id. The district court reasoned that while the papers were used to obtain a favorable opinion letter from E&Y regarding Textron's reserves, there would have been no need for such reserves "if Textron had not anticipated a dispute with the IRS that was likely to result in litigation or some other adversarial proceeding." Id. The IRS appeals the conclusion that the work-product doctrine protects the tax accrual workpapers.

The district court then noted that the standard for waiver of the work-product protection was different than for attorney-client privilege. Id. at 152. The district court concluded that disclosure of Textron's tax accrual workpapers to E&Y did not effect a waiver since disclosure "did not substantially increase the IRS's opportunity to obtain the information contained in them." Id. at 153. The district court based its decision on E&Y's professional confidentiality obligations and the fact that E&Y averred that it had not actually disclosed the information. Id. 2 The IRS also appeals this conclusion.

The district court then ruled that the government could not make the showing needed to overcome work-product protection since the government sought Textron's "mental impressions, conclusions, opinions or legal theories." Id. at 154 (internal quotations omitted). The IRS does not appeal this conclusion.


II. Discussion


Three issues are thus presented for appeal: (1) whether the work-product doctrine protects Textron's workpapers; (2) whether any such work-product protection was waived through disclosure to E&Y; and (3) whether the district court erred in not considering the IRS's request for E&Y's workpapers.

On these evidentiary issues, we "review district court rulings on questions of law de novo; we review district court fact findings for clear error; and we review 'discretionary judgments such as evidentiary rulings' for abuse of discretion." Cavallaro v. United States, 284 F.3d 236, 245 (1st Cir. 2002) (quoting United States v. Mass. Inst. of Tech. ("MIT"), 129 F.3d 681, 683 (1st Cir. 1997)).

"[T]he party who invokes the privilege bears the burden of establishing that it applies to the communications at issue and that it has not been waived." XYZ Corp. v. United States, 348 F.3d 16, 22 (1st Cir. 2003).



A. Work-Product Protection



1. Applicable law

"[T]he work-product doctrine does apply in tax summons enforcement proceedings." Upjohn Co. v. United States, 449 U.S. 383, 386 (1981). The work-product doctrine protects "documents and tangible things that are prepared in anticipation of litigation or for trial by or for another party or its representative." Fed. R. Civ. P. 26(b)(3)(A). In assessing whether a document was prepared in anticipation of litigation, this circuit uses the "because of" test. Maine, 298 F.3d at 68. Under this test, a document is protected "if, 'in light of the nature of the document and the factual situation in the particular case, the document can be fairly said to have been prepared or obtained because of the prospect of litigation.'" Id. at 70 (quoting United States v. Adlman, 134 F.3d 1194, 1202 (2d Cir. 1998)) (emphasis in original). It is also our law that, "the 'because of' standard does not protect from disclosure 'documents that are prepared in the ordinary course of business or that would have been created in essentially similar form irrespective of the litigation.'" Id. (quoting Adlman, 134 F.3d at 1202). As discussed below, we hold in this case that the presence of a business purpose does not defeat work-product protection.

The work-product doctrine originates in Hickman v. Taylor, where the Supreme Court laid out the problems with allowing the discovery of work product:
Were such materials open to opposing counsel on mere demand, much of what is now put down in writing would remain unwritten. An attorney's thoughts, heretofore inviolate, would not be his own. Inefficiency, unfairness and sharp practices would inevitably develop in the giving of legal advice and in the preparation of cases for trial. The effect on the legal profession would be demoralizing. And the interests of the clients and the cause of justice would be poorly served.

Hickman v. Taylor, 329 U.S. 495, 511 (1947). The doctrine is rightly seen as a protection for the adversary system, not simply the attorney. Coastal States Gas Corp. v. Department of Energy, 617 F.2d 854, 864 (D.C. Cir. 1980) (noting the doctrine does not protect all documents prepared by a lawyer and instead "focuses on the integrity of the adversary trial process itself" (quotation omitted)).

The Restatement has offered a definition of litigation in the work product context:
"Litigation" includes civil and criminal trial proceedings, as well as adversarial proceedings before an administrative agency, an arbitration panel or a claims commission, and alternative-dispute-resolution proceedings such as mediation or mini-trial. It also includes a proceeding such as a grand jury or a coroner's inquiry or an investigative legislative hearing. In general, a proceeding is adversarial when evidence or legal argument is presented by parties contending against each other with respect to legally significant factual issues.

Restatement (Third) of the Law Governing Lawyers § 87 cmt. h (2000). "'Adversarialness' is the touchstone of this approach to the 'litigation' question ..." In re Grand Jury Subpoena, 220 F.R.D. 130, 147 (D. Mass. 2004).



2. Are tax disputes "litigation?"

The IRS argues that preparation of tax returns is not meant to be an adversary process, but rather is a self-reporting regime that relies on the good faith of taxpayers. The IRS reasons that it is not seeking to gain unfair litigation advantage but rather to verify self-assessment in an environment where the taxpayer holds all the relevant information. Textron responds that it routinely engages in administrative disputes and even federal court litigation with the IRS.

Citing Roxworthy, Textron argues that anticipation of audit disputes can constitute anticipation of litigation. United States v. Roxworthy, 457 F.3d 590, 600-01 (6th Cir. 2006) (finding memos prepared analyzing legal arguments supporting and opposing specific tax positions to be protected work product). But, Roxworthy cites another case, Hodges, for the proposition that "a document prepared 'in anticipation of dealing with the IRS ... may well have been prepared in anticipation of an administrative dispute and this may constitute litigation within the meaning of Rule 26.'" Id. at 600 (quoting Hodges, Grant & Kaufmann v. IRS, 768 F.2d 719, 719-22 (5th Cir. 1985)) (emphasis added). Hodges, however, was not expressing a holding, but simply remanding to the district court to consider a work-product claim. Considering that Roxworthy dealt with anticipation of litigation with respect to specific transactions, Roxworthy does not establish that all documents prepared analyzing tax returns are protected. Instead, Roxworthy holds that documents created to analyze specific areas of likely dispute may be protected.

Nonetheless, after considering the applicable test, we conclude that, while not all "dealing with the IRS" during an audit is "litigation," the resolution of disputes through adversary administrative processes, including proceedings before the IRS Appeals Board, meets the definition of litigation. The IRS is correct that preparation and filing of returns relies on good faith self-reporting. But, good-faith disputes regarding the proper application of tax law also arise during the audit process. Thus, though the initial processing of these disputes in the audit process may not be adversarial, the disputes themselves are essentially adversarial; the subject of these disputes will become the subject of litigation unless the dispute is resolved. 3



3. Were the tax accrual workpapers prepared in anticipation of litigation?

In addition to the question of whether audit disputes with the IRS are litigation, we must confront the question of whether Textron's tax accrual workpapers are prepared in anticipation of such disputes. The district court reasoned that the business need to cover potential liabilities arose out of the anticipation of potential disputes, and thus would not occur "but for" those disputes. Textron, 507 F. Supp. 2d at 150. The IRS argues that the district court's conclusion is factually and legally wrong.



a. Analysis

The IRS argues that, as a legal matter, the documents were not prepared in anticipation of litigation and that the district court misapplied the "because of" test when it reasoned that the documents would not have been created "but for" the prospect of litigation.

We agree with the district court's finding that one of the purposes behind the creation of the documents was anticipation of litigation. As the district court explained, the need to estimate the likelihood of success in litigation was a result of the need to set up a reserve fund to cover tax positions for which Textron could foresee disputes with the IRS.

Of course, simple relation to litigation is insufficient to trigger work-product protection. Maine, 298 F.3d at 69. Further, work-product protection must be assessed in reference to a "the function that the document serves," not its content. Roxworthy, 457 F.3d at 595. And it is not enough that the preparer "had the prospect of litigation in mind when it" created the documents. Adlman, 134 F.3d at 1204. Rather, the "because of" test "really turns on whether it would have been prepared irrespective of the expected litigation with the IRS." Id.

But, here, the function of the documents was to analyze litigation for the purpose of creating and auditing a reserve fund. It can be fairly said that "'the driving force behind the preparation'" of the documents, Roxworthy, 457 F.3d at 595 (quoting Nat'l Union Fire Ins. Co. v. Murray Sheet Metal Co., 967 F.2d 980, 984 (4th Cir. 1992)), was the need to reserve money in anticipation of disputes with the IRS. The district court so found, and we find no clear error. See Cavallaro, 284 F.3d at 245 (clear error standard applied to findings of fact of district court in privilege case). 4 In this way, we read the district court's "but for" reasoning as a way of expressing its conclusion that the documents would not have been prepared irrespective of the prospect of litigation, but rather were prepared "because of" the risk of disputes and litigation which gave rise to a need to compute and report tax reserves. 5

The IRS next argues that the district court found that the "workpapers helped Textron determine what amount should be reserved to cover any potential tax liabilities and that the workpapers were useful in obtaining a 'clean' opinion from E&Y regarding the adequacy of the reserve amount." Textron, 507 F. Supp. 2d at 150. The IRS argues that this finding legally compels a ruling that the tax accrual workpapers are not protected, since documents prepared in the ordinary course of business receive no protection. Maine, 298 F.3d at 70. The IRS further reasons that since the documents were required to comply with reporting and securities obligations, the tax accrual workpapers were prepared pursuant to "regulatory requirements" and are therefore not protected. See Nat'l Union, 967 F.2d at 984. The IRS reasons that, as a simple matter of law, Rule 26 does not apply to "[m]aterials assembled in the ordinary course of business, or pursuant to public requirements unrelated to litigation, or for other nonlitigation purposes." Fed. R. Civ. P. 26 Notes of Advisory Committee on 1970 amendments.

We reject the IRS's contention that the mere presence of a business or regulatory purpose defeats work-product protection. To be sure, "there is no work-product immunity for documents prepared in the regular course of business rather than for purposes of the litigation," even though "litigation is already in prospect." 8 Charles Alan Wright, Arthur R. Miller & Richard L. Marcus, Federal Practice and Procedure, § 2024 (2008) (emphasis added). But, it is also true that "'[d]ual purpose' documents created because of the prospect of litigation are protected even though they were also prepared for a business purpose." Id.; see also In re Grand Jury Subpoena, 357 F.3d 900, 907 (9th Cir. 2004) (adopting Wright and Miller's "because of" test in order to handle "dual purpose" documents).

Thus, the best reading of the advisory committee's note is simply that preparation for business or for public requirements is preparation for a nonlitigation purpose insufficient in itself to warrant protection. The note states that there is no protection for documents created for business, regulatory, or "other nonlitigation purposes." This language suggests the note is considering business and regulatory purposes as nonlitigation purposes, but does not suggest that the presence of such a purpose should somehow override a litigation purpose, should one exist. To the contrary, the language of the note does not suggest that the advisory committee was considering the problem of dual purpose documents. Thus, we do not read the note as stating that there should be no protection where a document is prepared because of the possibility of litigation but also for a business or regulatory purpose. 6

Like in the case where a company analyzes pending litigation for the purpose of setting aside a reserve, cf. Adlman, 134 F.3d at 1200 (describing hypothetical examples where workproduct protection applies), here the business purpose derives from and is inextricably related to anticipating litigation. That the anticipation of such disputes (and corresponding potential litigation) also triggered certain business and accounting obligations does not bar the protection of the work-product doctrine. See id. at 1202 ("Where a document is created because of the prospect of litigation, analyzing the likely outcome of that litigation, it does not lose protection under this formulation merely because it is created in order to assist with a business decision."); In re Special September 1978 Grand Jury (II), 640 F.2d 49, 61 (7th Cir. 1980) ("We conclude that the materials ... were indeed prepared in anticipation of litigation, even though they were prepared as well for the filing of the Board of Elections reports."). In arguing against this conclusion, the IRS points to a Third Circuit case where that court instructed the district court on remand to assess whether a tax reserve file was prepared to assist in litigation or to comply with securities requirements. United States v. Rockwell Int'l, 897 F.2d 1255, 1266 (3d Cir. 1990). In the present case, however, the district court has already conducted such analysis and has concluded that the workpapers were created because of both purposes.

The dissent disagrees with this legal conclusion and relies primarily on the language in Maine that "the 'because of' standard does not protect from disclosure 'documents that are prepared in the ordinary course of business or that would have been created in essentially similar form irrespective of the litigation.'" Maine, 298 F.3d at 70 (quoting Adlman, 134 F.3d at 1202). Based on this language, the dissent charges we are going against established circuit precedent. But, for the reasons described above, it is error to read this "ordinary course of business" language as implying that all documents prepared with some business purpose in mind are necessarily unprotected. The court in Maine was not confronted with dual purpose documents like those at issue here. Rather, that court recited the above quoted language in the course of holding that there was insufficient information to see if the documents at issue were prepared for litigation or rather in the ordinary course of business. Id. Thus, Maine's "ordinary course of business" language should not be read as barring protection for dual purpose documents where one business purpose is present. This conclusion is all the more clear when one consider's Adlman's reason for adopting the "because of" test:
The issue is less clear, however, as to documents which, although prepared because of expected litigation, are intended to inform a business decision influenced by the prospects of the litigation. The formulation applied by some courts in determining whether documents are protected by work-product privilege is whether they are prepared "primarily or exclusively to assist in litigation" --a formulation that would potentially exclude documents containing analysis of expected litigation, if their primary, ultimate, or exclusive purpose is to assist in making the business decision. Others ask whether the documents were prepared "because of" existing or expected litigation --a formulation that would include such documents, despite the fact that their purpose is not to "assist in" litigation. Because we believe that protection of documents of this type is more consistent with both the literal terms and the purposes of the Rule, we adopt the latter formulation.

Adlman, 134 F.3d at 1197-98, quoted in part in Maine, 298 F.3d at 68.

Further, a contrary holding would lead to undesirable results in other cases. Consider a document prepared to analyze a specific litigation in order to compute for an auditor how much must be retained in a litigation reserve fund. Were we to adopt the IRS position that documents created to satisfy audit reporting responsibilities were not protected, opposing counsel in the litigation might be able to discover such a memo, effectively disclosing counsel's ultimate mental impression of the case. In fact, in similar circumstances, the Sixth and Second circuits have suggested that memoranda analyzing a transaction or position to be protected by the work-product doctrine. Roxworthy, 457 F.3d at 600; Adlman, 134 F.3d at 1200-04 (remanding for the district court to apply the correct standard).



b. Countervailing concerns

Having explained why application of the work-product doctrine leads us to the conclusion that Textron's tax accrual workpapers are protected, we pause to address the IRS's arguments against such a conclusion.



i. Arthur Young

The IRS asserts our decision will run afoul of Supreme Court precedent. In Arthur Young, the Court declined to recognize an accountant's work-product doctrine, thus holding that tax accrual workpapers created by an independent auditor were not protected. United States v. Arthur Young & Co., 465 U.S. 805, 815- 21 (1984). The Court recognized that the auditor's papers necessarily included the taxpayer's own thinking about tax "soft spots." Id. at 813. The Court also rejected some of the fairness concerns implicated in that case. Id. at 820 (rejecting argument that "enforcement of an IRS summons for accountants' tax accrual workpapers permits the Government to probe the thought processes of its taxpayer citizens, thereby giving the IRS an unfair advantage in negotiating and litigating tax controversies"). Further, the Court rejected policy concerns that, without a new privilege, companies would be tempted to withhold information from auditors. Id. at 818-19 (finding that "[r]esponsible corporate management would not risk a qualified evaluation of a corporate taxpayer's financial posture to afford cover for questionable positions reflected in a prior tax return" and concluding that "the independent auditor's obligation to serve the public interest assures that the integrity of the securities markets will be preserved, without the need for a work-product immunity for accountants' tax accrual workpapers").

Following this precedent, we have recognized that "the doctrine of construing the [attorney-client] privilege narrowly ... has particular force in the context of IRS investigations given the 'congressional policy choice in favor of disclosure of all information relevant to a legitimate IRS inquiry.'" Cavallaro, 284 F.3d at 245-46 (quoting Arthur Young, 465 U.S. at 816). But unlike the Court in Arthur Young, we are not now confronted with the question of whether to recognize a new privilege. Here, the doctrinal decision we face is whether to afford protection to documents created because of both business and litigation --a question not presented in Arthur Young. 7 Since this question has broader implications, the Supreme Court's policy judgment that a new privilege is not necessary for the accurate preparation of accountants' tax accrual workpapers is not controlling. Further, our prior analysis of this issue does not rely on the policy considerations rejected in Arthur Young. That case is not an obstacle to our conclusion that protection of dual-purpose documents is consistent with the purpose and doctrine of the workproduct doctrine.



ii. El Paso

Because of a contrary outcome in a Fifth Circuit case, the IRS argues that our decision will create a circuit split. See United States v. El Paso Co., 682 F.2d 530, 542 (5th Cir. 1982), cert. denied, 466 U.S. 94 (1984). In El Paso, the Fifth Circuit found that a company's own tax accrual workpapers were not protected as they were created for purposes of complying with securities law:
In sum, we believe that the tax pool analysis does not contemplate litigation in the sense required to bring it within the work product doctrine. The tax pool analysis concocts theories about the results of possible litigation; such analyses are not designed to prepare a specific case for trial or negotiation. Their sole function, from all that appears in the record, is to back up a figure on a financial balance sheet. Written ultimately to comply with SEC regulations, the tax pool analysis carries much more the aura of daily business than it does of courtroom combat. We hold, therefore, that the tax pool analysis and backup memoranda are not protected work product materials.

Id. at 543-44. However, in El Paso the Fifth Circuit applied a different definition of the work-product doctrine, asking whether the "primary motivating purpose behind the creation of the document was to aid in possible future litigation." Id. at 542 (internal quotation marks omitted). Thus, the result here does not create a circuit split with El Paso, but is merely the application of an existing split in the definition of the "anticipation of litigation." It is precisely in these "dual purpose" situations that the "because of" test used in this circuit distinguishes itself from the "primary purpose" test used in the Fifth Circuit. Maine, 298 F.3d at 68 (citing Adlman for the proposition that the primary purpose test "is at odds with the text and the policies of Rule 26 because nothing in it suggests that documents prepared for dual purposes of litigation and business or agency decisions do not fall within its scope"). Thus, unlike the Fifth Circuit, we need not assess whether the tax accrual workpapers carry more of one aura than another. We need only conclude that since the analysis was undertaken "because of" the anticipation of litigation, workproduct protection applies.



iii. Factual argument

Since some tax positions in the accrual papers carry a 100 percent chance of failing, the IRS argues, as a factual matter, that Textron could not have been anticipating litigation. But, Textron explained that those entries were the result of identifying positions that were incorrect as a result of subsequent legal developments. The IRS also argues that most disputes are resolved informally. But the fact that most disputes are resolved before litigation commences does not mean that analysis of those disputes could not have been in anticipation of "the prospect of litigation" over those disputes. To the contrary, assessing the likelihood that a tax position will not withstand scrutiny necessarily entails analysis which anticipates how litigation of that position would be resolved.



4. Has Textron adequately identified the specific litigation for which the workpapers were prepared?

Adlman and Roxworthy, cases we relied on above, are also not directly on point as they involved documents analyzing the consequences of a specific litigation or specific transaction. The IRS argues that this distinction is controlling, that to protect Textron's tax accrual workpapers is in effect to afford a "blanket" protection --a work-product doctrine that is so broad it will "swallow" the attorney-client privilege. It is true that we have required proponents of a work-product protection claim to "'identify the litigation for which the document was created ... and explain why the work-product privilege applies to all portions of the document.'" Maine, 298 F.3d at 69 (quoting Church of Scientology Int'l v. United States Dep't of Justice, 30 F.3d 224, 237 (1st Cir. 1994)). These "identification and explanation requirements are not to be given a hypertechnical construction," but "they can neither be brushed aside nor satisfied by vague generalities." Id.

Here, Textron has met its burden. The tax accrual workpapers identify and numerically evaluate a number of tax positions Textron took on its 2001 returns. As described above, Textron has shown that its analysis of each position was prepared by anticipating the possibility of litigation with the IRS arising over a dispute regarding that position. Thus, the tax accrual workpapers identify specific positions, and the litigation projections were created in anticipation of disputes and possible litigation over those positions. 8

The IRS again argues that Textron could not have consistently had specific litigation in mind since most tax disputes were resolved before litigation and since Textron could not reasonably intend to litigate every challenged position. But these facts do not change our analysis. As the district court found, the spreadsheet at issue assessed the likelihood of succeeding in litigation over each specific position. Thus, the function served by creating this analysis is to assess what funds must be set aside in anticipation of litigation over each of the positions identified. That Textron might ultimately decide not to dispute a specific position does not contradict the conclusion that when it estimated its litigation success, it was anticipating specific litigation.

Again, we note that a contrary result would lead to an undesirable result. If we were only to afford work product protection over documents of this sort by requiring a showing, as the IRS suggests, that there was some specific quantum of expectation that the position at issue would mature into fullfledged litigation, we would essentially be offering protection only to the cantankerous and combative taxpayer who intends to thoroughly litigate every position.

Precedent does suggest that a party claiming work-product protection must "'have had a subjective belief that litigation was a real possibility, and that belief must have been objectively reasonable.'" Roxworthy, 457 F.3d at 594 (quoting In re Sealed Case, 146 F.3d 881, 888 (D.C. Cir. 1998)). The district court found that, considering its history, it was reasonable for Textron to conclude that litigation with the IRS was likely. We see the matter differently but reach the same result.

In the context of these facts, we do not think that a history of litigation with the IRS should be the deciding factor. A company with a history of challenging the IRS creates these documents "because of" the same reason as another company without such a history: the possibility of a dispute compels them to anticipate litigation so as to prepare and assess their tax reserve funds. In this case, the anticipation of litigation coupled with securities and reporting requirements forced Textron to analyze and project its likelihood of success in litigation. Thus, Textron was effectively forced to operate under the hypothetical belief that litigation would occur. For this reason, regardless of its specific history with the IRS, it was objectively reasonable for Textron to forecast litigation.

The IRS argues that this holding will "immunize nearly every document generated by lawyers because clients can always be said to be aware of possible litigation." The IRS worries that work-product protection would "encompass essentially all legal advice," since any lawyer analyzing the risks inherent in a legal transaction or