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poration. In the Omnibus Reconciliation Act of 1987 (the "1987 Act") Congress enacted a provision treating certain publicly traded limited partnerships as corporations for tax purposes, thereby limiting the opportunity for taxpayer-initiated corporate integration. Not all entities that are considered corporations for State law purposes are subject to the Federal corporate income tax. The Code exempts, in whole or in part, several forms of corporate entities from the corporate income tax. Typically, these entities are subject to significant ownership or operating restrictions. For example, a qualifying small business corporation, or S corporation, is taxed on a pass-through basis, with most items of income and loss accounted for only at the shareholder level. S corporations, however, are permitted no more than 35 shareholders and are subject to several organizational and operational restrictions. (A provision in the conference agreement to H.R. 11 as vetoed by the President on November 5, 1992, would have increased the allowable number of S corporation shareholders from 35 to 50.) Other entities receive a hybrid form of tax treatment. For example, certain income from a qualified regulated investment company ("RIC") is taxed only at the shareholder level, while certain income may be subject to corporate-level taxation. A RIC is subject to several organizational restrictions and is limited in the type and amount of investment activity it may conduct. In addition, financial intermediaries, such as certain banks, savings and loan institutions, and insurance companies, have rules which ameliorate the impact of corporate-level taxation through special deductions for reserves. Other forms of corporations which receive hybrid treatment under the Code include real estate investment trusts, real estate mortgage investment companies, certain cooperatives, and companies specifically exempt from tax, such as charitable institutions.


Due to the complexity and sophistication of corporate transactions and the comprehensive nature of the applicable Code provisions, frequent legislative revisions are made to corporate income tax provisions. The 1986 Act, in particular, made significant modifications to the corporate income tax to broaden the corporate income tax base and reduce the rates. Some recent major legislative developments include the following:

1. Repeal of the General Utilities Doctrine. The 1986 Act repealed a long-standing rule that excluded from taxation, upon liquidation of a corporation, any unrealized or "built-in" gains of the corporation. This rule is generally viewed as originating in General Utilities & Operating Company v. Helvering, 296 U.S. 200 (1935), and was later codified. The 1986 Act repealed the General Utilities doctrine, thereby generally requiring that a corporate-level tax be imposed on the built-in gains of a corporation upon its liquidation. In section 10223 of the 1987 Act, Congress clarified that the requirement of corporate-level taxation in cases of liquidations extends to corporate dispositions utilizing subsidiaries-so-called "mirror subsidiary" transactions.

2. Master Limited Partnerships (MLP's). As part of the policy debate relating to the two-tier corporate income tax system, Congress has focused at times upon taxpayer-initiated or self-help planning

measures aimed at avoiding corporate-level income taxation. One such planning device was the master limited partnership, a limited partnership with publicly traded interests that could conduct business and be owned by investors in a manner similar to a corporation, but which was taxable as a partnership and thereby exempt from corporate-level taxation. In June and July of 1987, the Subcommittee on Select Revenue Measures of the Committee on Ways and Means held hearings on the tax policy implications of master limited partnerships (serial 100-39). As a result of these hearings, the Committee on Ways and Means passed a measure classifying certain publicly traded partnerships with active trade or business income as corporations for purposes of the Code. This provision, in slightly modified form, was adopted by Congress as section 10211 of the 1987 Act.

3. Treatment of Corporate Instruments as Debt or Equity. In the first half of 1989, the Committee on Ways and Means held 7 days of hearings on the tax law implications of corporate mergers, acquisitions and other transactions that increase the aggregate levels of corporate debt. These hearings included testimony on policy issues raised by the two-tier corporate tax system. The testimony also addressed the question of whether the corporate interest deduction is an integral part of a normative system for the taxation of corporate earnings or is an inappropriate tax subsidy in certain circumstances. These hearings also examined the proper tax classification of an instrument issued by a corporation as an obligation of the entity (debt) or an interest subject to the risks of ownership of the entity (equity). This classification issue has great practical significance to the tax liability of a corporation, because interest paid on the debt of a corporation is generally deductible in computing taxable income, while corporate earnings distributed to shareholders in the form of dividends on equity are not deductible.

As a result of these hearings and congressional deliberations, the Ways and Means Committee included several provisions as part of its reconciliation of the budget for fiscal year 1990 (H.R. 3150). These provisions were subsequently enacted into law as part of the Omnibus Budget Reconciliation Act of 1989 ("1989 Act”).

Section 7202 of the 1989 Act modifies the treatment of certain instruments paying a rate of interest in excess of prevailing commercial rates and not paying such interest on a current basis, such as certain original issue discount bonds. The provision has the effect of bifurcating these instruments. In part the yield on such instruments will be deducted by the issuer when paid, while excessive yield rates are treated like equity for certain purposes and are never deductible.

4. The Two-Tier Corporate Tax System. The public hearings on corporate issues held by the Committee on Ways and Means during the first half of 1989 included testimony describing various methods to integrate the corporate tax system on a full or partial basis. Additionally, in January 1992, the Treasury Department issued a report entitled "Integration of the Individual and Corporate Tax Systems-Taxing Business Income Once." Although the report makes no specific legislative recommendations, it concludes that integration is desirable and presents analysis of a variety of integration prototypes. The three principal approaches to integration dis

cussed in the Treasury report include: (i) a dividend exclusion model, in which shareholders would exclude dividends from income, (ii) a shareholder allocation method, in which all corporate income is allocated to shareholders and taxed in a manner similar to partnership income under current law, and (iii) a comprehensive business income tax model, in which provisions would be phased in, over a 10-year period, to allow shareholders and bondholders to exclude both dividends and interest received by corporations from income, but which would allow neither type of payment to be deducted at the corporate level, thereby equalizing the treatment of debt and equity.

During the 103d Congress, the Subcommittee on Select Revenue Measures of the Committee on Ways and Means is expected to hold public hearings on the Treasury report and other proposals for corporate integration, including a model being studied by the representatives of American Law Institute.

5. Omnibus Budget Reconciliation Act of 1990 ("1990 Act"). The 1990 Act contained several provisions modifying the taxation of corporations, including provisions that: (i) require the accrual of redemption premiums of certain preferred stock, (ii) impose corporate level tax on divisive restructuring transactions in connection with certain changes of ownership, provided that a shareholder's 50 percent ownership is attributable to stock that the shareholder acquired directly or indirectly in a purchase or similar transaction within the previous 5 years, and (iii) modify the tax treatment of certain debt-for-debt exchanges and stock-for-debt exchanges in corporate restructurings.

The 1990 Act also requires insurance companies to amortize policy acquisition expenses, and reduces the deduction allowed to property and casualty insurance companies for losses incurred by the estimated recoveries of salvage and subrogation claims attributable to such losses.

6. Provisions Affecting U.S. Corporations Conducting Operations Abroad. Many taxpayers have voiced concern that the tax provisions affecting U.S. corporations conducting foreign operations are too complex and inefficient, thereby hindering a domestic corporation's ability to compete in global markets. In 1991, the Committee on Ways and Means held 10 days of public hearings on factors affecting the international competitiveness of the United States. The hearings covered important issues such as education and human capital, the role of technology, use of natural resources, the effect of the corporate income tax on the cost of capital, as well as detailed discussion of the specific tax provisions affecting multinational corporations.

As a result of the testimony received at these hearings, in May 1992, Chairman Rostenkowski and Congressman Gradison (retired) introduced H.R. 5270, the Foreign Income Tax Rationalization and Simplification Act of 1992. This bill was designed to encourage discussion of comprehensive reform and rationalization of foreign tax law. The bill contained various provisions that would: (i) rationalize the tax treatment of U.S. businesses operating abroad, including modifications to the foreign tax credit rules and the interest allocation rules; (ii) simplify existing law, including provisions related to passive foreign investment companies and translation of foreign

taxes into U.S. dollar denominated amounts; (iii) modify the treatment of U.S.-controlled foreign corporations, including the repeal of deferral of certain income from foreign operations; and (iv) help to ensure the fair taxation of foreign persons deriving income from United States operations and investments, including rules modifying the current law valuation factors for foreign companies transferring goods and services to U.S. subsidiaries for sale in the United States.

The Committee held 2 days of public hearings on the bill in July 1992. The Committee received testimony and specific comments on many aspects of the proposed legislation from representatives of government, industry and academia. These public hearings have been the source of valuable information that could be the basis for future legislation rationalizing and simplifying foreign tax rules.



Present law provides more than 25 different categories of organizations that generally are exempt from Federal income tax. Such organizations include churches, universities and other educational organizations, hospitals, various charities, civic leagues, labor unions, trade associations, social clubs, political organizations, veterans' groups, fraternal organizations, and certain cooperatives. Almost always, a tax-exempt organization is a nonprofit organization; however, not all organizations established as "nonprofit" under State law qualify for Federal tax exemption.

According to IRS data, the number of tax-exempt organizations has increased steadily over the past several years. In 1991, the Internal Revenue Service listed over 1 million exempt organizations on its master file (see table 4). The assets and revenues of public charities have also increased significantly in recent years (see table 5).

Business Income of Exempt Organizations

While organizations may be exempt from Federal income tax on investment income and income derived from activities related to the organization's exempt purpose, such organizations are subject to the unrelated business income tax (UBIT) on certain business income. The UBIT generally applies if (1) the income is derived from a trade or business, (2) the trade or business is regularly carried on, and (3) the conduct of the trade or business is not substantially related to the organization's exempt purpose (aside from its need for revenues) (Internal Revenue Code sections 512(a) and 513(a)). If an organization is operated primarily to carry on an unrelated trade or business, its tax-exempt status may be revoked.


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