Arguments against the proposal 1. The defined benefit plan funding and deduction rules were designed to encourage employers to fund for projected, rather than accrued, liabilities. A limitation on the employer's ability to deduct plan contributions may create a disincentive for funding. 2. Employers frequently adopt funding methods that permit the cost of an employee's retirement benefits to be funded as a level annual amount over the employee's working career rather than funded as an employee's benefits are accrued. The proposal would discourage the use of these level funding methods. (3) Definition of active participant for IRA rules Present Law Under present law, a taxpayer is permitted to make deductible IRA contributions up to the lesser of $2,000 or 100 percent of compensation (earned income, in the case of a self-employed individual) if the taxpayer (1) has adjusted gross income (AGI) that does not exceed an applicable dollar amount or (2) is not an active participant. In the case of a married couple filing a joint return, the AGI of the couple and the active participant status of either spouse is taken into account in determining whether a taxpayer may make deductible IRA contributions. The term "active participant" means, with respect to any plan year, an individual who, for any part of the plan year ending with or within the taxable year, is an active participant in (1) a qualified plan (sec. 401(a) or 403(a)), (2) a plan established for its employees by the United States, by a State or political subdivision thereof, or by an agency or instrumentality of the United States or a State or political subdivision, (3) a tax-sheltered annuity (sec. 403(b)), or a simplified employee pension (SEP) (sec. 408(k)). In addition, an individual is considered an active participant if the individual makes deductible contributions to a plan described in section 501(c)(18). 1 In a recent Tax Court decision, it was held that Article III judges are not employees of the United States and, therefore, are not active participants in a plan established for its employees by the United States. Whether or not an individual is an employee is also relevant for other purposes under the Code, such as for the exclusion of certain benefits from income and the eligibility for certain deductions. Possible Proposal The decision in Porter v. Commissioner could be overturned and officers of the United States or of a State or political subdivision as described in the decision could be treated as employees for purposes of the Code and as active participants for purposes of the IRA deduction limit. Arguments for the proposal Pros and Cons 1. The IRA deduction rules are designed to permit individuals who otherwise do not participate in a qualified pension plan to make deductible IRA contributions in order to accumulate tax-favored retirement income. This purpose is not served by a rule that 1 Porter v. Commissioner, 88 T.C. No. 28 (March 5, 1987). fails to treat as employees individuals who are earning retirement benefits under an employer-maintained plan. 2. The active participant rules should treat consistently individuals who are covered under tax-favored retirement arrangements. Allowing certain individuals who perform services for the United States or for a State or political subdivision to participate in a taxfavored retirement plan and to make deductible IRA contributions does not promote this consistency of treatment. 3. The decision in Porter v. Commissioner has implications beyond the specific treatment of Article III judges for purposes of the active participant rules. Conceivably, the decision could be interpreted to permit high-level state and Federal officials to make deductible IRA contributions, while other individuals who do not perform services for governmental entities would be denied deductions for IRA contributions. Such a result would be perceived as inequitable. Similarly, the decision could be interpreted to deny an exclusion from income for certain benefits (such as health benefits) for the individuals subject to the decision. Arguments against the proposal 1. Congress intended to treat only certain plans as employermaintained pension plans for purposes of the active participant rules. The type of plan in which an Article III judge participates is not the type of plan intended to be covered by the active participant rules. 2. The proper interpretation of the scope of the decision in Porter v. Commissioner is best left to the courts. c. Repeal certain special rules relating to ESOPS Leveraged ESOPs Present Law Under present law, an employee stock ownership plan (ESOP) is a qualified stock bonus plan, or a combination of a stock bonus and a money purchase pension plan, designed to invest primarily in qualifying employer securities. Present law generally prohibits loans between a plan and a disqualified person. An exception to this rule is provided in the case of an ESOP. Thus, the employer securities held by an ESOP may be acquired through direct employer contributions or with the proceeds of a loan to the trust (or trusts) from the employer or guaranteed by the employer. An ESOP that borrows to acquire employer stock is referred to as a leveraged ESOP. In some cases, a leveraged ESOP borrows from a financial institution the funds needed to purchase the stock and uses the proceeds to purchase the stock. Typically, the loan is guaranteed by the employer. The employer stock may be pledged as collateral (if the loan is nonrecourse and the only assets of the ESOP pledged are shares purchased with the loan proceeds). Alternatively, the employer may borrow from a financial institution or other lender and sell its stock to the ESOP in exchange for the ESOP's installment note. Under this arrangement, the ESOP uses employer contributions to pay off the note to the employer who will, in turn, use those payments to repay its lender. Interest exclusion for ESOP loans Under present law, a bank, an insurance company, a corporation actively engaged in the business of lending money, or a regulated investment company may exclude from gross income 50 percent of the interest received with respect to a securities acquisition loan used to acquire employer securities. A securities acquisition loan generally is defined to include (1) a loan to a corporation or to an ESOP to the extent that the proceeds are used to acquire employer securities (within the meaning of sec. 409(1)) for the plan, or (2) a loan to a corporation to the extent that the corporation transfers an equivalent amount of employer securities to the plan. Employer deductions for ESOP contributions Under present law, the contributions of an employer to a qualified plan are deductible in the year for which the contributions are paid, within limits (sec. 404). The deduction limits applicable to an employer's contribution depend on the type of plan to which the contribution is made and may depend on whether an employee covered by the plan is also covered by another plan of the employer. In the case of an ESOP described in section 4975(e)(7), special deduction limits apply. Contributions to such an ESOP for a year are deductible to the extent they do not exceed the sum of (1) 25 percent of the compensation of the ESOP participants, in the case of principal payments on a loan incurred for the purpose of acquiring employer securities and (2) the amount of any interest repayment on such a loan. Certain dividends paid on stock held in an ESOP are deductible to the extent the dividends are passed through to plan participants or used to repay a loan with which the stock was acquired. Special contribution limits for ESOPS Under present law, overall limits apply to contributions and benefits provided to an individual under all qualified plans, tax-sheltered annuities, and simplified employee plans (SEPs) maintained by any private or public employer or by certain related employers. Under a defined contribution plan (including an ESOP), present law provides an overall limit on annual additions with respect to each plan participant (sec. 415(c)). The annual additions generally are limited to the lesser of (1) 25 percent of an employee's compensation for the year, or (2) $30,000. An employer's deductible ESOP contributions that are applied by the plan to the payment of interest on a loan to acquire employer securities, as well as any forfeitures of employer securities purchased with loan proceeds generally are not taken into account under the rules providing overall limits on contributions and benefits under qualified plans. However, such contributions and forfeitures are disregarded for purposes of the overall limits only if no more than 1/3 of the employer's contributions for the year is allocated to highly compensated employees. If this 1/3 requirement is satisfied, the $30,000 limit on contributions may be raised up to $60,000. Possible Proposals 1. Repeal the special rules providing an exception to the prohibited transaction rules for ESOP loans. Repeal the special interest exclusion for a lender making a securities acquisition loan. 2. Repeal the special deduction limits for contributions to an ESOP. 3. Repeal the special limits on contributions on behalf of an employee to an ESOP. Pros and Cons Arguments for the proposals 1. Employers often prefer to used leveraged ESOPS as a corporate financing technique that, because of the special tax benefits available to the ESOP, the employer, and certain lenders, can produce a lower cost of borrowing than if conventional debt or equity financing were used. Thus, the employer corporation may often use the special tax benefits designed to encourage greater |