section 165. More recently, courts have held that there was a bad debt on the grounds that there was an implied promise on the part of the borrower to reimburse the guarantor for his payments.3

General reasons for change

As discussed above, where a taxpayer makes a loan which is not connected with his trade or business, and the debt becomes worthless, he is generally required to treat the loss as a short-term capital loss. On the other hand, where a third party made the loan, which was guaranteed by the taxpayer, and the proceeds of the loan were used by the borrower in his trade or business, any loss which results could generally be deducted by the taxpayer against ordinary income. The Congress concluded that this distinction made little sense and gave a tax advantage to guaranteeing loans over making them directly.

Explanation of provisions

To provide for more consistent treatment in the area of bad debts and guaranties, the Act repeals section 166 (f) of the Internal Revenue Code, effective for taxable years beginning after December 31, 1975. Thereafter, when a taxpayer has a loss arising from the guaranty of a loan, he is to receive the same treatment as where he has a loss from a loan which he makes directly. Thus, if the guaranty agreement arose out of the guarantor's trade or business, the guarantor would still be permitted to deduct the loss resulting from the transaction against ordinary income. If the guaranty agreement was a transaction entered into for profit by the guarantor (but not as part of his trade or business), he would be able to deduct the resulting loss as a nonbusiness debt.

Also, in the case of a guaranty agreement which is not entered into as part of the guarantor's trade or business, or as a transaction for profit, no deduction is to be available in the event of a payment under the guarantee.

Generally, in the case of a direct loan, the transaction is entered into for profit by the lender, who hopes to realize interest on the loan. However, this may not be true in the case of loans made between friends or family members, and in these cases the Internal Revenue Service will generally treat any loss resulting from such a "loan" as a gift, with respect to which no bad debt deduction is available. (Reg. $ 1.166-1 (c))

In the case of a guaranty agreement, however, it is not always easy to tell whether the transaction has been entered into for profit on the part of the guarantor. It is not uncommon for guaranty agreements to provide for no direct consideration to be paid to the guarantor. Often this may be because the guarantor is receiving indirect consideration in the form of improved business relationships. On the other hand, many other guaranties are given without consideration as a matter of accommodation to friends and relatives.

The Congress believes that a bad debt deduction should be avail

The legal theory led to attempts on the part of some taxpayers to take themselves out of the general rules relating to guaranties of debts by taking steps to insure that they would have no right of subrogation against the borrower if he defaulted. (This was particularly true in the case of guaranties by taxpayers of corporate obligations where the taxpayer was a shareholder in a closely held corporation.) The taxpayer would then attempt to claim an ordinary loss deduction under section 165, instead of receiving nonbusiness bad debt treatment under section 166.

See e.g.. Bert W. Martin, 52 T.C. 140 (reviewed by the Court), aff'd per curiam, 424 F.2d 1368 (9th Cir.) cert. denied, 400 U.S. 902 (1970).

able in the case of a guaranty related to the taxpayer's trade or business, or a guaranty transaction entered into for profit. However, no deduction should be available for a "gift" type of situation. Thus, the Congress intends that for years beginning in 1976 (in the case of guaranties made after 1975) and thereafter, the burden of substantiation is to be on the guarantor, and that no deduction is to be available unless the guaranty is entered as part of the guarantor's trade or business, or unless the transaction has been entered into for profit, as evidenced by the fact that the guarantor can demonstrate that he has received reasonable consideration for giving the guaranty. For this purpose, consideration could include indirect consideration; thus, where the taxpayer can substantiate that a guaranty was given in accordance with normal business practice, or for bona-fide business purposes, the taxpayer would be entitled to his deduction even if he received no direct monetary consideration for giving the guaranty. On the other hand, a father guaranteeing a loan for his son would ordinarily not be entitled to a deduction even if he received nominal consideration for giving the guaranty.

The Congress also wishes to make it clear that in the case of a guarantor of a corporation obligation, any payment under the guaranty agreement must be deducted (if at all) as a nonbusiness bad debt, regardless of whether there is any right of subrogation, unless the guaranty was made pursuant to the taxpayer's trade or business. Of course, if the payment under the guaranty by a corporate shareholder constitutes a contribution to capital, under the facts and circumstances of the particular case, the payment would not be deductible but would increase the stockholder's basis in his shares in the corporation. This rule is consistent with Congress' understanding of present law.

The Congress further wishes to resolve for the future the appropriate timing of the deduction for a payment under a guaranty agreement. If the guaranty agreement (including for this purpose a guaranty, indemnity or endorsement) requires payment by the guarantor upon default by the maker of the note (i.e., the borrower), and the guarantor has a right of subrogation or other right against the maker, no deduction will be allowed to the guarantor until the year in which the right over against the maker becomes worthless (or partially worthless, where the guaranty occurs in connection with the guarantor's trade or business). If the guarantor has no right over against the maker of the obligation, the payment under the guaranty is deductible as a bad debt for the year in which the payment is made. Of course, if the payment is voluntary in the sense that there is no legal obligation to make the payment, or a guaranty agreement is entered after the debt has become worthless, no deduction is to be available.

Effective date

The provisions of this amendment are to be effective for taxable years beginning after December 31, 1975 in connection the guaranties made after that date.

Revenue effect

It is estimated that this provision will result in an increase in budget receipts of $1 million in fiscal year 1977 and of 5 million annually thereafter.

It is not intended that legal action must have been brought against the guarantor in order to entitle him to take an otherwise available deduction; but there must be an enforceable legal obligation on his part to make the payment.

F. ACCUMULATION TRUSTS

(Sec. 701 of the Act and secs. 644 and 665-669 of the Code)

Prior law

A trust is generally treated as a separate entity which is taxed in the same manner as an individual. However, there is one important difference: the trust is allowed a special deduction for any distributions of income to beneficiaries. The beneficiaries then include these distributions in their income for tax purposes. Thus, in the case of income distributed currently, the trust is treated as a conduit through which income passes to the beneficiaries, and the income so distributed retains the same character in the hands of the beneficiaries as it possessed in the hands of the trust.

If a grantor creates a trust under which the trustee is either required, or is given discretion, to accumulate the income for the benefit of designated beneficiaries, however, then, to the extent the income is accumulated, it is taxed at individual rates to the trust. An important factor in the trustee's (or grantor's) decision to accumulate the income may be the fact that the beneficiaries are in higher tax brackets than the trust.

Beneficiaries are taxed on distributions of previously accumlated income from trusts in substantially the same manner as if the income had been distributed to the beneficiaries currently as earned, instead of being accumulated in the trust. This is accomplished through the socalled "throwback rule," under which distributions of accumulated income to beneficiaries are thrown back to the year in which the income would have been taxed to the beneficiary if it had been distributed currently. The Tax Reform Act of 1969 revised the prior throwback rule to provide an unlimited throwback rule with respect to accumulation distributions.

Under prior law, the tax on accumulation distributions was computed in either of two ways. One method was the "exact" method, and the other was a "shortcut" method which did not require the more extensive computations required by the exact method. Under the exact method of computation, the tax on an accumulation distribution could not exceed the aggregate of the taxes that would have been payable if the income had actually been distributed in the prior years when earned. This method required complete trust and beneficiary records for all past years so that the distributable net income of the trust and the taxes of the beneficiary could be determined for each year. The beneficiary's own tax then was recomputed for these years, including in his income the appropriate amount of trust income for each of the years (including his share of any tax paid by the trust). Against the additional tax computed in this manner, the beneficiary was allowed a credit for his share of the taxes paid by the trust. Any remaining tax then was due and payable as a part of the tax for the current year in which the distribution was received.

(159)

The so-called shortcut method in effect determined the tax attributable to the accumulation distribution by averaging the distribution over a number of years during which the income was earned by the trust. This was accomplished by including, for purposes of tentative computations, a fraction of the income received from the trust in the beneficiary's income of each of the 3 immediately prior years. The fraction of the income included in each of these years was based upon the number of years in which the income was accumulated by the trust.

Prior law also provided an unlimited throwback rule for capital gains allocated to the corpus of an accumulation trust. This provision normally did not apply to "simple trusts" (any trust which is required by the terms of its governing instrument to distribute all of its income currently) or any other trusts, which in fact distribute all their income currently, until the first year they accumulated income. For purposes of this provision, a capital gains distribution was deemed to have been made only when the distribution was greater than all of the accumulated ordinary income. If the trust had no accoumulated ordinary income or capital gains, or if the distribution was greater than the ordinary income or capital gain accumulations, then to this extent it was considered a distribution of corpus and no additional tax was imposed.

Reasons for change

The progressive tax rate structure for individuals is avoided if a grantor creates a trust to accumulate income taxed at low rates, and the income in turn is distributed at a future date with little or no additional tax being paid by the beneficiary, even when he is in a high tax bracket. This result occurs because the trust itself is taxed on the accumulated income rather than the grantor or the beneficiary.

The throwback rule (as amended by the Tax Reform Act of 1969) modifies this result by taxing beneficiaries on distributions they receive from accumulation trusts in substantially the same manner as if the income had been distributed to the beneficiaries currently as it was earned. The 1969 Act made a number of significant revisions in the treatment of accumulation trusts. In applying the throwback rule to beneficiaries with respect to the accumulation distributions they receive, the 1969 Act provided two alternative methods, as indicated above, the exact method and the shortcut method. A number of administrative problems have resulted in the application of these alternative methods for both the Internal Revenue Service and the beneficiaries. For example, taxpayers are under an obligation, as a practical matter, to compute the throwback under the rule which results in the least tax; thus, the shortcut method, which was intended to simplify calculations and eliminate recordkeeping problems involved with the exact method has not achieved this result because taxpayers must compute the tax under both methods. As a result, the Congress believed it was more desirable to have one simplified method rather than having two alternative methods in applying the throwback rule. In the case of multiple trusts, however, the Congress was concerned about the potential tax avoidance use of such trusts. As a result, the Act provides a special rule in the case of accumulation distributions received by any beneficiary from three or more trusts.

In addition, a number of questions were raised as to whether the capital gains throwback rule, which was enacted in the 1969 Act,

presented more complexity in its application than was warranted by the concerns raised in 1969 with respect to capital gains. The Congress believed it was appropriate to repeal the capital gains throwback rule and provided instead a rule to deal more directly with the transferring of appreciated assets by grantors into trusts.

The Congress also reviewed other aspects of the tax treatment of accumulation trusts and provided modifications to make the rules easier to apply and be administered. For example, the Act provides an exemption for the income accumulated in a trust during the minority of a beneficiary, as was provided in the law under the throwback rule before 1969.

Explanation of provisions

The Act substitutes for the two alternative methods used in computing the throwback rule for accumulation distributions a single method, which is a revision of the present "shortcut" method. The new shortcut method provided under the Act determines (in effect) the tax attributable to the distribution by averaging the distribution over a number of years equal to the number of years over which the income was earned by the trust. This is accomplished by including, for purposes of tentative computations, a fraction of the income received from the trust in the beneficiary's income for each of the 5 preceding years (rather than the 3 preceding years under present law).1 The fraction of the income included in each of these years is based upon the number of years in which the income was accumulated by the trust (as determined under prior law). This average amount is added to the beneficiary's taxable income for these years (rather than requiring the recomputation of his tax returns as under prior law).2

Of these 5 preceding years, the year with the highest taxable income and the year with the lowest would not be considered; in effect, then, the computation of the additional tax on the accumulation distribution under this shortcut method is based, as under prior law, on a 3-year average basis.

In general, except as indicated below, the rules under the shortcut method continue to apply. Thus, if the accumulated income is attributable to 10 different years (although the trust may have been in existence longer than 10 years), then one-tenth of the amount distributed would be added to the beneficiary's taxable income in each of the 3 years. The additional tax is then computed with respect to these 3 years and the average yearly additional tax for the 3-year period is determined. This amount is then multiplied by the number of years to which the trust income relates (10 in this example). The tax so computed may be offset by a credit for any taxes previously paid by the trust with respect to this income and any remaining tax liability is then due and payable in the same year as the tax on the beneficiary's other income in the year of the distribution. Under the Act, unlike

1 The accumulated income which is to be included in the beneficiary's income for any year under the shortcut method is the income of the trust which would have been included in the beneficiary's income if the trust had made the distributions currently rather than accumulating the income. As a result, the character of any tax-exempt interest would be carried with the accumulated income and, thus, would not be subject to tax to the beneficiary.

2 For purposes of adding the accumulated income to the taxable income of a beneficiary for a year, the beneficiary's taxable income may not be less than zero. Thus, if in any year to which the shortcut method applies a beneficiary has a net operating loss, the beneficiary's taxable income for that particular year will be treated as being zero.