Tax Division testifies on administration's tax proposal.

On Mar. 17, 1993, Leonard Podolin, immediate past chairman of the AICPA Tax Division's Tax Executive Committee, testified at a House Ways and Means Committee public hearing on President Clinton's proposals for public investment and deficit reduction. The Division's testimony was presented as part of a panel that included the New York State Society of CPAs, the ABA Tax Section and the Tax Executive Institute.

The Tax Division staff was forced to quickly pull together the comments of some 20 Tax Division technical committees when the hearing date was moved up on short notice. The technical committees reviewed the Treasury Department's Summary of the Administration's Revenue Proposals and indicated to staff which provisions they thought required comment. The draft testimony was discussed and finalized by the Tax Executive Committee. Because of the time constraints imposed by the scheduling of the hearing as well as the five-minute testimony limit, the Tax Executive Committee decided to limit its March 17 comments but to submit supplementary comments by the April 6 deadline for inclusion in the printed hearing record. In addition, the Tax Division is also anticipating developing comments for the expected Senate Finance Committee hearing (although, to date, none has been scheduled). The following comments were developed based on the AICPA's interest in sound tax policy and administration, rather than from any particular economic or political vantage point.

Simplification

The AICPA has, for some years now, been urging the need for simplification in the U.S. tax system. Year after year, statistics indicate that approximately one-half of individual taxpayers feel it necessary to hire professional preparers to comply with their tax return obligations. Although many members are beneficiaries of this fact, the AICPA strongly believes in the need for constant attention to simplicity as an important tenet of a tax system that aims for voluntary compliance.

In an age of highly complex financial transactions, and economic and equity considerations, there will continue to be a need for complex tax provisions. However, Congress needs to consider carefully whether American taxpayers are approaching a point of diminishing returns when it comes to respect for the tax system and for voluntary compliance.

Congress is aware of the problem. We appreciate the past and present efforts of House Ways and Means Committee Chairman Dan Rostenkowski to include a simplification title in a tax bill (including his reintroduction of a simplification bill this year). And over the past several years, we have been pleased with the approach to "rough justice" generally espoused by the Treasury Department and the IRS.

Still, it is critical that Congress not lose sight of the need for continuous efforts toward a simpler law. Given the limited resources of the IRS to audit returns, the government's interests, as well as those of taxpayers, are served by less complexity. Document matching alone cannot replace a lack of other audit resources in a complex tax world. In short, complexity carries a real cost to the tax system, through lower levels of compliance by taxpayers (inadvertent and illegal) combined with the inability of the government (through lack of resources) to provide adequate monitoring.

Complexity, and lowered respect for the system, also come from "back door" approaches to tax policy. The government can, and should, be more open with American taxpayers. For example, rather than imposing a 10% surtax on individual taxable incomes greater than $250,000, why not simply put a 40% (or 39.6%) bracket in Sec. 1? Instead of making the personal exemption phaseout and the 3% limitation on itemized deductions permanent, why not recognize that this is a back door marginal tax increase on individuals at particular levels of income, and translate that into a direct rate increase for that approximate group?

The AICPA believes a simpler tax system is one that first defines the tax base more directly, and then raises revenue through adjustments of the rates - something political and other considerations seem to have prevented in the past. We believe that should change.

Investment tax credit

With respect to the Administration's proposals, Congress needs to consider the investment tax credit (ITC), both permanent and incremental. However, the complexities inherent in the proposal, especially the incremental credit, are such that a disproportionate amount of the Service's resources will be spent ascertaining that compliance levels are correct - and for what, to a specific taxpayer, may well be a relatively modest benefit. Thus, the AICPA suggests a direct, rather than an incremental, credit, if possible.

Further, in addition to the major definitional and computational complexities, the proposal seems to promise more than it is likely to deliver to most taxpayers. First, while the nominal rate is 7%, the only taxpayers that will receive that rate on qualified investment are "small" businesses investing in 10-year property (barges, tugs, fruit trees, limited other items). As a practical matter, the great bulk of purchased assets will fall in the five-year or seven-year categories, which produce a lower ITC.

For the incremental credit, there is a further limitation, to 50% of qualified investment. Thus, the incremental ITC for larger businesses can never exceed 3.5% of qualified investment. The incremental credit is then scaled down to reflect whether property is less-than-10-year property. Finally, the amount of the credit is take back into income (at the taxpayer's highest bracket) ratably in 1995-1997.

Example: Consider the acquisition of a
$10,000 asset with a seven-year life.

Nominal credit @7%           $700

Limitation:

3.5% of investment
($10,000 x 50% x 7%)          350
Less 20%
for 7-year property           (70)

Maximum credit                280
Additional tax
  payable in
  1995-1997
  ($280 x 34%)         $95

Discounted for
  later payment               (85)

Value of ITC                 $195

  Thus, a presumed 7% credit has worked
its way down to an approximate 2%
credit - and at a cost of tremendous
complexity.

Note: The AICPA does recognize that the credit can be up to 7% of incremental investment - but that only occurs if the result is smaller than a 3.5% credit on qualified investment. Thus, the example is appropriate.

Other comments on the ITC are:

* The AICPA is pleased that there is at least a partial offset against the alternative minimum tax (AMT) for the ITC, since to deny that would merely be to take back with one hand what Congress has given with the other. (Note: The Tax Division has not had the time to determine, through research, if a reduction of tentative minimum tax by 25% (as proposed by the Administration) will give substantial alleviation from the AMT for investment in qualified property; if subsequent investigation indicates significant problems in this area, these comments will be supplemented.)

* The credit is permitted on the amount of qualifying investment in excess of a determined "fixed base" for either 1989-1991 or 1987-1991. However, used property purchases in the base years would increase the amount of fixed base investment, while used property purchases in 1993 or 1994 would not qualify for the credit, which seems inconsistent. Using the same type of property to build the base but not be counted for current year acquisitions simply reduces or eliminates a taxpayer's credit in two ways. It is hard to understand why there is no parallelism in the treatment of used property.

* It is hoped that committee reports will mandate flexibility in the drafting of regulations applying to the determination of base period acquisitions. While depreciation records should provide the bulk of the information needed, such items as qualified progress expenditures will be most difficult to reconstruct going back to 1987 or 1989. Further, since there has been no ITC (except for carryovers) since 1986, requiring reclassification of acquired property from 1987 on into ITC categories (three years, five years, etc.) will likewise cause some substantial complexity, including multiple calculations for many taxpayers who will find - after having gone through it all - that they either are not entitled to the credit or that (for them) it will be nominal at best. The House Ways and Means Committee's report could save many taxpayers untold hours if it directs that regulations should seek to avoid multiple sets of calculations, and that good-faith efforts at record reconstruction will be respected.

* Even for small businesses (perhaps, especially for small businesses), the complexity of basis adjustments to offset part of the ITC's cost to the government is unwarranted and should, if revenue considerations dictate, be replaced with a lower credit rate in the first place. Why is it necessary to reinstate the rules requiring that the amount of the credit reduce depreciation basis for acquired assets, in the case of the small business credit? The result is that the credit given in year 1 is taken back (in part) over later years, reducing its effective benefit and adding further complexity. If a 7% credit is too expensive, why not make it a 6% credit, but allow it to be reflected only once on the tax return?

Modified substantial

understatement penalty

The AICPA is concerned with the two proposals that raise the standard for accuracy-related and preparer penalties, and modify the tax shelter rules for purposes of the substantial understatement penalty. This area of the law was amended a few years ago after a well-thought-out review of penalties by Congress, the Treasury, the IRS and professional organizations that took almost three years, and concluded only in 1989.

Taxpayers should have the right to take a position on a tax return without risk of penalty, provided that the position is not clearly wrong and the position is disclosed. If the law were black and white, without the uncertainties and gray areas that presently exist, the AICPA's view might be different. However, given the fact that the law is subject to much interpretation, taxpayers should not be precluded from taking positions that they believe have merit. A stated reason for the change, in the Treasury release, is that "[t]axpayers and preparers should try to comply with the tax laws in a reasonable manner." Give the nature and state of tax law today, that is an alarmingly simplistic statement. Query: Is it unreasonable for a taxpayer to take a position when the law is unclear if the position is fully disclosed; i.e., should not the taxpayer have the right to "a day in court" without actually paying the tax and suing for a refund? Courts actually do decide cases in favor of taxpayers, and taxpayers should not have to face a choice of giving in to an IRS interpretation or going to court to avoid paying a penalty.

The proposal on tax shelter rules would require taxpayers to demonstrate that the reasonably anticipated tax benefits from the shelter do not significantly exceed the reasonably anticipated pretax economic profit in the shelter. This requirement would be in addition to the requirement that the tax shelter item has "substantial authority" and that the taxpayer believed that the claimed treatment was "more likely than not" the proper treatment. The AICPA also opposes this provision. From an economic perspective, an investor should consider the tax benefits in determining whether or not an investment makes economic sense and whether the investor will obtain an adequate return on the investment. However, the fact that the Internal Revenue Code contains certain tax incentives should not result in a penalty against a taxpayer who uses those incentives when he believes a position with respect to the shelter is more likely than not the proper position.

Targeted small business

capital gains proposal

As with the investment credit, the targeted nature of the capital gains incentive seems likely to add new layers of substantial complexity to the law. The AICPA has reservations about the definitional language in the Treasury summary, but is unable to articulate them at this time because details of the proposal are unavailable.

One point brought to the Treasury's attention was that the proposal applies only to C corporations. Currently, 40% of all filing corporations are S corporations, which clearly tend to be smaller businesses. The AICPA suggested that the Administration's interest in helping small business is not aided by excluding 40% of the corporations most likely to be small in the first place.

Earned income tax credit

The Administration initiative in the February 25 Treasury Department release, "Expansion and Simplification of Earned Income Tax Credit" (to be detailed in the Administration's budget), is to "expand" the credit.

The AICPA suggested that a substantial effort should be made, in this proposal, to simplify the credit as well. The credit is most important to low-income taxpayers; however, many of these taxpayers tend to ignore or miscalculate the credit because it is hard to understand and apply.

The AICPA is willing to assist in any effort to give this very difficult area a badly needed overhaul.

Effective dates

A number of proposals have retroactive effective dates that may create an unnecessary administrative and compliance burden for the IRS, taxpayers and tax professionals. For example, the extension of the research and experimentation credit (and a number of the other so-called expired provisions) is to apply to expenditures paid or incurred after June 30, 1992. Implementing this provision retroactively will require many businesses that have paid or incurred such expenses after that date to file amended income tax returns, and the IRS to process numerous refund claims. This situation should cause Congress to ask itself whether the costs of compliance with a retroactive date are an appropriate trade-off for the benefits sought; and whether there is not a more reasonable alternative, such as requiring the taxpayer to claim the credit on a 1993 return rather than having to amend 1992.

Another problem foreseen with implementing rate changes on Jan. 1, 1993 involves the failure to revise the withholding tables. A year from now, some taxpayers will find that they (1) are receiving a smaller refund than anticipated; (2) have a balance due when they expected a refund; or (3) owe a lot more money than expected. Not only will this situation create a negative impression of the tax system for these taxpayers but it will exacerbate the Service's already severe collection problems. Even though the issue affects only upper-income taxpayers, it will become more serious the farther into the year the legislative process goes. At some point, prospective application of rate increases must be given serious consideration.

Provisions not yet included

in the Clinton tax proposals

Tax simplification: It is hoped that a package of general simplification measures included in HR 13 (introduced earlier this year), as well as important intangible improvements, will be included in this year's major tax legislation.

Individual estimated taxes: The changes to individual estimated tax rules enacted in November 1991 were overly complex and burdensome; experience has proven that taxpayers cannot comply with them. These rules must be fixed, but the AICPA does not endorse the revenue-raising approach adopted in HR 11 last year that affected all taxpayers; rather, the correction should be targeted only to upper-income individuals in a manner that allows compliance with certainty.

Fifty percent excise tax on pension plan reversions: Sec. 4980 imposes a 50% excise tax on reversions on termination of defined benefit pension plans. If a replacement plan is established using 25% of the reversion, or if benefits to employees are increased, the excise tax is only 20%.

This 50% excise tax produces a harsh, unintended result for small business owners who terminate a defined benefit plan at the same time a business is terminated (for example, when the business owner retires, dies or becomes disabled). When the 50% excise tax is added to the regular Federal and state income tax, the total tax associated with the reversion can exceed 90%.

This problem for small business owners could be solved by amending Sec. 4980 to state that the 20%, rather than the 50% excise tax will apply when the plan termination takes place as a result of (or within 60 days before) the cessation of the employer's business. This exception could be limited to employers with less than a specified number of employees or some other definition of small business.

Estimated tax rules for corporations that are not large corporations: Under present law, corporations with prior-year tax liability, regardless of the amount, either regular or alternative minimum, may use this liability as a "safe harbor" for current-year estimated tax payments. However, a corporation with a net operating loss must base its estimated tax payments on its current-year taxable income. This requirement can create an unnecessary burden for many small businesses.

The AICPA endorses a change in the rules to allow a corporation that is not a "large corporation" to use the prior-year safe harbor when the previous year's tax returns showed a zero tax liability and that tax year was a tax year of 12 months.