The 1997 Tax Act: Principal Tax Increases

Chapter 5
Principal Tax Increases
A Tax News & Views Special Report:
Promises Kept: The 1997 Tax Law

Guide to
Promises Kept

Tax Cuts for Individuals

Principal Tax Increases

Other Key Provisions

Table of Contents

his chapter focuses on the largest tax increases on general businesses, financial instruments, corporate transactions, and partnerships; it also describes other tax increases, including excise taxes. Other less significant, or more targeted, tax increases are described in Chapter 9 and Chapter 10.

Following the 1995 budget debate, which failed to produce a resolution of tax issues, President Clinton countered growing efforts to move a small piece of legislation that included capital gains relief by proposing a dozen tax reform measures directed at financial products and corporate reorganizations. These proposals had the effect of temporarily drawing attention away from the capital gains issue. Once a 1997 budget agreement was reached, many of President Clinton more controversial revenue-raising suggestions fell away. Others are included in the Act along with new revenue-raising ideas identified by Congress.

General Business Tax Increases

Limitation of net operating loss carrybacks: The carryback period for net operating losses (NOLs) is reduced from three years to two years, and the NOL carryforward period is extended from 15 years to 20 years. The three-year carryback rule continues to apply to NOLs incurred by a farming business or certain small businesses attributable to losses in presidentially declared disaster areas. The three-year carryback rule also continues to apply to NOLs related to casualty losses of individual taxpayers.

Effective date: The new carryback rules are effective for NOLs arising in tax years beginning after the date of enactment.

Limitation of general business credit carrybacks: The business credit carryback period is limited to one year and the Act extends the carryforward period to 20 years.

Effective date: The change in the carryback and carryforward periods applies to credits arising in taxable years beginning after Dec. 31, 1997.

Extension of federal unemployment surtax: The current federal unemployment tax rate is 0.8% (6.2 % less maximum credit of 5.4%). There are two components of this rate: a 0.6% permanent rate and a 0.2 % temporary surtax. The Act extends this surtax through Dec. 31, 2007.

Effective date: Effective for labor performed on or after Jan. 1, 1999.

Financial Instruments and Transactions

Elimination of short-against-the-box and similar transactions:

Planning Point: In effect, the Act eliminates the use of transactions such as "short-against-the-box" sales, notional principal contracts, and future and forward contracts to defer the recognition of gain. Congress may have felt that this change was appropriate particularly in light of its concurrent decision to reduce individual capital gains tax rates.

Under the Act, a taxpayer no longer may enter into a financial transaction that allows for the substantial reduction of the risk of loss (or opportunity for gain) without triggering gain for tax purposes. A taxpayer must recognize gain, but not loss, upon entering into a constructive sale of any appreciated position in stock, a partnership interest, or certain debt instruments. A constructive sale occurs if two offsetting positions are acquired that are in property that, although not the same, are substantially identical, and that are intended to reduce the taxpayer's risk associated with the appreciated property. When a constructive sale occurs, the taxpayer will recognize gain as if the position were sold at its fair market value on the date of the constructive sale and immediately repurchased. This recognition of gain increases basis in the financial position and starts a new holding period.

If a taxpayer closes a constructive sales transaction before the 31st day of the next year and stays at risk of loss on the appreciated property for at least 60 days, this rule does not apply to the constructive sales transaction.

Effective date: The provision is generally effective for constructive sales entered into after June 8, 1997, although certain transition rules are provided.

Original issue discount on pooled debt obligations: The Act will require a taxpayer to accrue interest or original issue discount immediately on a pool of debt instruments on which the principal amount can be paid without interest by a specified date (such as credit card receivables). The accrual is to be based upon a reasonable assumption regarding the timing of the payments of the accounts in the pool. A taxpayer may accrue interest based upon actual experience rather than reasonable assumptions for payments received prior to filing its tax return.

Effective date: The provision generally is effective for taxable years beginning after the date of enactment. If the taxpayer is required to change its method of accounting to comply with the Act, the resulting adjustment will be taken into account over a four-year period.

Denial of interest deduction on convertible and similar debt: The Act denies any deduction for interest or OID on certain debt instruments issued by a corporation that are payable in stock of the issuer or a related party of the issuer. This provision is intended to cover certain debt instruments that more closely resemble equity instruments, such as (1) a debt instrument, the substantial portion of which is mandatorily convertible or convertible at the issuer's or a related party's option into stock; (2) an instrument, on which a substantial portion of the principal or interest is to be determined by reference to the value of stock; and (3) any instrument issued as part of an arrangement designed to result in payment of the instrument with or by reference to stock.

Effective date: The provision is effective for instruments issued after June 8, 1997, but will not apply to such instruments (1) issued pursuant to a written agreement that was binding on such date and at all times thereafter; (2) described in a ruling request submitted to the Internal Revenue Service on or before such date; or (3) described in a public announcement or filing with the Securities and Exchange Commission on or before such date.

Modify holding period for dividends-received deduction: The Act tightens the holding period rules for the corporate dividends-received deduction. The deduction will not be allowed if the taxpayer holds the stock for fewer than 46 days during the 90-day period beginning 45 days before the taxpayer becomes entitled to the dividend.

Congress was concerned that taxpayers were converting capital gains into partially deductible dividend income by buying stock immediately before a dividend was declared and then selling the stock at its lower post-dividend value.

Effective date: The Act generally applies to dividends received or accrued after the 30th day after enactment of the law. An exception to this general rule may apply for dividends received or accrued during the two-year period after the date of enactment for certain stock held on June 8, 1997.

Corporate Transactions

Gain recognition on certain distributions of controlled corporation stock: The Act substantially restricts the availability of tax-free spin-offs. Tax-free treatment is not available to the distributing corporation if the direct and indirect shareholders of the distributing corporation, as a group, lose control of either corporation during the four-year period beginning two years prior to the distribution and ending two years after the distribution.

Planning Point: Corporations often use tax-free spin-offs to shed unwanted businesses prior to being acquired, entering into mergers, or issuing new shares. A corporation may spin off a successful subsidiary in anticipation of that subsidiary doing an initial public offering to raise additional capital.

In recent years, corporations have been using spin-offs as a tax-free means of disposing of businesses in transactions that have been characterized inaccurately by the press as "sales." Such deals are commonly grouped under the title "Morris Trust" transactions. In applying the tax law equivalent of a sledge hammer to spin-offs, Congress has eliminated attempted disguised sales, but also has imposed potentially significant new costs on corporate restructurings.

A plan is presumed to exist if the shareholders lose control of either corporation at any time two years before or two years after the distribution. If the acquisition or disposition of stock was unrelated to the distribution of the spun-off corporation, recognition of gain can be avoided. A transaction is unrelated to the distribution if it is not pursuant to a common plan or arrangement that includes the distribution.

If the shareholders lose control of either the distributing corporation or the spun-off corporation, then the distributing corporation will recognize gain on the distribution equal to the appreciation in the stock of the spun-off corporation. Control for this purpose means 50% stock ownership by both vote and value.

The spin-off of a member of an affiliated group to another member of that group, so-called "intragroup spin-offs," are not eliminated. The Treasury Department was given the authority to write regulations determining how the basis of the distributing and spun-off corporations' shares are calculated after a spin-off.

Effective date: The new spin-off rules apply to transactions occurring after April 16, 1997, subject to exceptions for transactions occurring pursuant to a binding contract, described in a public announcement or SEC filing, or subject to an IRS ruling requested by that date, provided the acquirer of either corporation or the transferee had been identified.

Tax treatment of certain extraordinary dividends: A corporate shareholder that receives an "extraordinary dividend" must reduce the basis of the stock with respect to which the dividend is received by the nontaxed portion of the dividend. If the required reduction in basis exceeds the basis in the stock, the Act requires gain to be recognized for the taxable year in which the extraordinary dividend is received. This rule ends a deferral provided under prior law. The Act also expands the definition of an extraordinary dividend to include a number of dividend-like transactions.

Effective date: This provision generally is effective for distributions after May 3, 1995.

Certain preferred stock treated as boot: The Act limits the ability of taxpayers to use preferred stock in tax-free reorganizations and tax-free exchanges. Generally, gain or loss is not recognized in these tax-free transactions except to the extent "other property" (often called "boot") is received. The Act treats nonqualified preferred stock as "boot." Thus, when a taxpayer exchanges property for nonqualified preferred stock in a reorganization or tax-free exchange, gain but not loss is recognized.

The Act applies to stock that is limited and preferred as to dividends and does not participate in corporate growth to any significant extent if the holder or the issuer is protected by certain redemption rights exercisable within 20 years or the dividend rate on the stock varies in whole or in part with reference to interest rates, commodity prices, or other similar indices. The Act provides additional guidance regarding the application of this rule to nonpublicly traded stock and stock transferred in connection with the performance of services.

Gain recognition does not occur in (1) certain exchanges of nonqualified preferred stock for comparable nonqualified preferred stock; (2) an exchange of nonqualified preferred stock for common stock; (3) certain exchanges of debt securities for nonqualified preferred stock; and (4) exchanges of stock in certain recapitalizations of family-owned corporations. The Act provides additional rules regarding the exception for family-owned corporations.

Effective date: The provision is generally effective for transactions after June 8, 1997. An exception is provided for transactions (1) made pursuant to a written agreement that was binding on June 8, 1997, and at all times thereafter; (2) described in a ruling request submitted to the Internal Revenue Service on or before June 8, 1997; or (3) described on or before June 8, 1997, in a public announcement or filing with the Securities and Exchange Commission required solely by reason of the transaction.

Limitation on exception for investment companies: The general rule that gain is not recognized by a transferor upon the transfer of property for stock in a controlled company does not apply for transfers to investment companies. The Act expands the definition of an "investment company" for this purposes.

Under the Act, an investment company includes any corporation if more than 80% of its assets by value consist of money, stocks and other equity interests in a corporation (regardless of whether publicly traded), evidences of indebtedness, options, forward or futures contracts, notional principal contracts or derivatives, foreign currency, certain interests in precious metals, interests in REITS, RICs, common trust funds and publicly-traded partnerships, or other interests in noncorporate entities that are convertible into or exchangeable for any of the assets listed.

Treasury is granted regulatory authority to (1) expand this list and (2) provide look-through rules that apply to interests in an entity if substantially all of its assets are listed assets. This rule also applies to transfers to a partnership that would be treated as an investment company if it were a corporation.

Effective date: The new law is effective for transfers after June 8, 1997, in tax years ending after such date. An exception is made for transfers of a fixed amount of securities pursuant to a binding written contract in effect on June 8, 1997, and until the transfer is made.

Partnerships

Inventory: Income attributable to inventory of a partnership, whether "substantially appreciated" or not, will be ordinary income on the sale or exchange of a partnership interest or in certain partnership distributions.

Effective date: The law is effective for sales, exchanges, and distributions after the date of enactment other than pursuant to a binding contract in effect on and after June 8, 1997.

Basis of distributed property: The Act continues to provide that basis is to be allocated among distributed assets first to unrealized receivables and inventory items in an amount equal, or in proportion, to the partnership's basis in each such property. Any remaining basis is to be allocated to the other distributed properties in proportion to their fair market values rather than basis.

Effective date: This provision applies to partnership distributions after the date of enactment.

Contributions of appreciated property: The Act extends, from 5 years to 7 years, the period in which a partner may recognize "pre-contribution gain" with respect to property contributed to a partnership in the event of a distribution of the contributed property to another partner, or of other property to the contributing partner.

Effective date: The provision is effective for property contributed to a partnership after June 8, 1997, other than distributions pursuant to a binding contract in existence on June 8, 1997.

Other Tax Increases

Tax shelter registration and penalties: The Act requires the registration of confidential tax-planning ideas with the IRS. Specifically, the Act treats any investment, plan, arrangement, or transaction as a tax shelter if (1) its significant purpose is tax

Planning Point: Adequate disclosure of an item involving multiparty financing on a corporate return will no longer reduce or eliminate the substantial understatement penalty.

avoidance or evasion by a corporate participant; (2) it is offered to any potential participant under conditions of confidentiality; and (3) the tax shelter promoters may receive total fees in excess of $100,000. Promoters of tax shelters must register their shelters with the IRS and describe the expected benefits as well as maintain a list of the investors/users of the tax shelter. Investors in the tax shelters may also be required to register a tax shelter if the promoter of the shelter is not a U.S. person, or if the required registration is not otherwise made.

The Act also modifies the substantial understatement penalty rules to limit the use of reasonable basis relief for items attributable to multiparty financing transactions if such treatment does not clearly reflect the income of the corporation. It also modifies the rules to define a tax shelter for penalty purposes as a plan that has a "significant," as opposed to "principal," purpose of avoidance or evasion of federal income tax.

Effective date: The tax shelter registration provision applies to any tax shelter offered to potential participants after the date the Treasury Department issues guidance with respect to the filing requirements. The accuracy-related penalty provision applies to items with respect to transactions entered into after the date of enactment.

Gains and losses from certain terminations with respect to property: The Act extends capital gain or loss treatment to income from the cancellation, lapse, expiration, or other termination of a right or obligation with respect to property that is (or on acquisition would be) a capital asset in the hands of the taxpayer. This rule now applies to all property including interests in real property and nonactively traded personal property.

In addition, if a taxpayer enters into a short sale of property that becomes substantially worthless, the taxpayer shall recognize gain in the same manner as if the short sale was closed when the property became substantially worthless. To the extent provided in regulations, this rule will also apply to options with respect to property, any offsetting notional principal contracts, futures or forward contracts, and any other similar transactions.

The Act extends the recognition of capital gain or loss to amounts received on the retirement of any debt instrument to previously excepted debt instruments issued by individuals (not a corporation, partnership, or trust) after June 8, 1997. Also, any debt instrument issued by an individual before June 9, 1997, and any debt instrument issued before July 2, 1982, by a noncorporate or nongovernment issuer shall not be excepted from capital gain or loss treatment if acquired by purchase after June 8, 1997.

Effective date: The extension of the extinguishment rule applies to terminations occurring more than 30 days after the date of enactment. The provision for short sales of substantially worthless property applies to property becoming substantially worthless after the date of enactment. The provision repealing the exception for certain debt obligations is effective for sales, exchanges, or retirements of obligations after the date of enactment.

Involuntary conversions: The Act extends to individuals and other taxpayers the rule that denies deferral of gain when replacement property in an involuntary conversion is obtained from certain related parties. A de minimis exception applies if a taxpayer has aggregate realized gain of $100,000 or less for the taxable year. The annual $100,000 limitation applies to both partnerships and S corporations, and their respective partners or shareholders.

Effective date: This law applies to involuntary conversions occurring after June 8, 1997.

Mark-to-market for securities traders and commodity traders and dealers: Securities traders and commodities traders and dealers now may elect to follow the mark-to-market accounting rules that had previously applied only to securities dealers. The election to mark-to-market may be made separately for each of the taxpayer's separate lines of business.

Planning Point: This change had been sought by traders and commodity dealers because it will allow them to report taxable income in a manner consistent with their book accounts and will eliminate deferred losses under the straddle rules.

Mark-to-market accounting provides that any security in inventory is valued at its fair market value. Any security held at year-end that is not in inventory is treated as sold for its fair market value, unless identified as held for investment or not held for sale to customers (or as a hedge for such a security). These rules now apply to commodities dealers as if commodities were securities. The inventory rules will not apply to traders because they do not hold inventory.

Effective date: The mark-to-market rules apply to taxable years ending after the date of enactment. Any adjustment resulting from the election is to be taken into account over four years.

Further limitations on company-owned life insurance: Responding to concerns identified with a plan by Fannie Mae to offer insurance to its borrowers, Congress added three further restrictions on the tax benefits accorded insurance products owned or acquired by businesses. These limitations eliminate tax advantages that could have arisen from using life insurance as a marketing tool.

The Act provides an absolute denial of deductions for premiums paid on any life insurance policy, annuity, or endowment contract in which the taxpayer has an interest. In addition, the Act denies any interest deduction on indebtedness with respect to a life insurance, annuity, or endowment contract covering the life of any individual except to the extent allowed for pre-1986 contracts or key person policies under prior law. Finally, Congress adopted a pro rata disallowance of interest expense attributable to life insurance on individuals who are not officers, employees, or former employees of the taxpayer.

Effective date: These provisions affect all contracts issued after June 8, 1997. Any material change in a contract (e.g., a material increase in the death benefit) renders the contract a "new contract," thereby subjecting the owners and beneficiaries of the "new contract" to the above provisions.

Excise Taxes

Reinstate leaking underground storage tank trust fund excise tax: The bill reinstates the prior-law Leaking Underground Storage Tank Trust Fund excise tax through March 31, 2005.

Effective date: Effective upon enactment.

Extension and modification of the Airport and Airway Trust Fund excise taxes: The Airport and Airway Trust Fund excise tax, which was set to expire September 30, 1997, has been extended 10 years, to September 30, 2007. The excise tax is currently 10% of the airfare. The revenue raised by the tax is used to regulate air travel and fund the construction of airports. Over the course of budget negotiations, factions within the airline industry squared off in a highly public debate on whether the tax should remain revenue-based, or be based on the level of usage of airport services and facilities. Long-haul carriers generally argued that the tax should be usage-based, and they supported a tax based primarily on fees for arrivals and departures. By contrast, short-haul carriers, typically regional or discount carriers, preferred to keep the tax based on ticket prices.

The Act modifies the basis of the excise tax to take into account both points of view. When fully phased in, the ticket tax will be 7.5% of the ticket price, plus $3 per flight-segment. Although the excise tax will still raise most of its revenue on the basis of ticket price, the clear winners are the long-haul carriers and their customers, especially the full-fare business traveler.

Take, for example, the typical last-minute, midweek business trip that costs $800 before taxes. Under current law, the federal excise tax would be $80. When the new tax is fully effective, the ticket tax on this trip will be $66 ($800 at 7.5% plus $6 for round-trip flight segments), a 17.5% decrease.

Alternatively, under current fare structures, the same trip might be bought for about $200, if the traveler makes an advance purchase and stays over a Saturday night. The tax on this trip will rise from $20 under current law to $21 ($200 at 7.5% plus $6 for direct round-trip flight segments), a 5% increase. However, the same $200 trip on a regional or short-haul airline that requires a stop-over or a change of planes will be taxed at the rate of $27 ($200 at 7.5% plus $12 in segment fees), a whopping 35% increase. To add some balance to the equation, a special, reduced rate will apply on flights serving small rural airports.

In a related area, the Act makes the 7.5% tax effective on payments to airlines from credit card and other companies that reward their customers with frequent flyer miles. Additionally, the Act imposes a $12 arrival and departure fee for international travel, which raises international round-trips to a total of $24.

Effective date: The provision is effective for travel beginning after September 30, 1997. During the first year, the tax will be a combination of 9.0% of the fare plus $1 per segment and it will be fully phased in by Jan. 1, 2002.

Increase in tobacco excise taxes: The Balanced Budget Act of 1997 (the companion spending-cut bill) raises the taxes on cigarettes and on a broad range of other tobacco products.

The tax on a pack of cigarettes will increase by 10 cents a pack beginning in the year 2000. In 2002, the tax will go up another 5 cents, for a total federal excise tax of 39 cents a pack. Similar increases will be imposed on everything from cigars to snuff, including pipe and chewing tobacco.

Effective date: Effective for sales of tobacco products occurring after December 31, 1999.

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Tax News & Views is produced by the Financial Counseling Specialists and the Legislative & Regulatory Services Group at Deloitte & Touche LLP.