Congressional Research Service Reports 4/8/2009
Congressional Research Service (CRS) released the following reports:
CRS Report --Business Tax Issues in 2009, April 8, 2009
CRS Report --Personal Exemption Phaseout (PEP) and Limitation on Itemized Deductions (Pease), April 14, 2009
CRS Report --Retirement Savings and Household Wealth in 2007, April 8, 2009
CRS Report --Health Care Flexible Spending Accounts, April 9, 2009
CRS Report --Tax Issues Relating to Charitable Contributions and Organizations, April 6, 2009
The Reports are added below:
Research Service Report for Congress --Business Tax Issues in 2009, April 8, 2009
April 16, 2009
111th Congress
Business Tax Issues in 2009
Donald J. Marples
Specialist in Public Finance
April 8, 2009
Congressional Research Service
7-5700
www.crs.gov
R40500
Summary
In 2008, congressional business tax issues focused on stimulating the economy and renewing general farm legislation. In February, Congress enacted the Economic Stimulus Act of 2008. The act's two business investment provisions provided for a temporary increase of small business expensing and temporary "bonus" depreciation limits. In May, the Food, Conservation, and Energy Act of 2008 (P.L. 110-234) was enacted and modified several alternative fuel production tax credits. As 2008 came to a close, the Emergency Economic Stabilization Act of 2008 (P.L. 110-343), which extended a number of business tax provisions and created or modified a number of renewable energy and energy efficiency provisions, was enacted.
In 2009 attention has continued to focus on stimulating the economy. In February, Congress enacted the American Recovery and Reinvestment Act of 2009 (P.L. 111-5). Two of the act's business tax provisions provided for a temporary increase of small business expensing and temporary "bonus" depreciation limits, while other provisions allow a delayed recognition of cancelation of debt income and five-year carryback of net operating losses for small-businesses. The act also modified several renewable energy provisions, including the Renewable Energy Production Tax Credit, the Investment Tax Credit, and tax credit for Alternative Fueling Property.
As the year progresses, it is anticipated that congressional deliberations will once again turn towards the extension of several expiring business tax provisions, energy taxation, tax shelters, and international taxation. This report will be updated in the event of significant legislative activity.
Contents
The Current System
Legislation in 2009
American Recovery and Reinvestment Act of 2009 (P.L. 111-5)
Selected Business Tax Issues
Business Tax Cuts to Stimulate the Economy
Research and Experimentation Tax Credit and Other Temporary Benefits
Energy Taxation
Tax Shelters
International Taxation
Appendixes
Appendix. Business Tax Legislation and Issues, 2001-2008
Contacts
Author Contact Information
At the beginning of 2009, economic stimulus proposals dominated the congressional debate. In February Congress enacted the American Recovery and Reinvestment Act of 2009 (P.L. 111-5). Two of the act's business provisions provided for a temporary increase of small business expensing and temporary "bonus" depreciation limits, while other provisions allow a delayed recognition of cancelation of debt income and five-year carryback of net operating losses for small-businesses. The act also modified several renewable energy provisions, including the Renewable Energy Production Tax Credit, the Investment Tax Credit, and tax credit for Alternative Fueling Property.
As the year progresses, it is anticipated that congressional deliberations will once again turn towards the extension of several expiring business tax provisions, energy taxation, tax shelters, and international taxation, while continuing to examine opportunities to stimulate the economy.
The Current System
The United States has what tax analysts sometimes term a "classical" system for taxing corporate income. That is, it imposes a tax on corporate profits --the corporate income tax --that is separate and generally in addition to the individual income taxes that corporate stockholders pay on their corporate-source capital gains and dividends. The corporate income tax applies a 35% rate to most corporate taxable income, although reduced rates ranging from 15% to 34% apply to corporations earning smaller amounts of income. The base of the tax is corporate profits as defined by the tax code --generally gross revenue minus interest, wages, the cost of purchased inputs, and an allowance for depreciation.
Since 1980, federal corporate tax revenue has generally varied between 1% and just over 2% of gross domestic product (GDP). Congressional Budget Office (CBO) data show that corporate tax receipts registered an "uptick" in FY2005 and FY2007, rising to 2.3% and 2.7% of GDP, respectively --before reverting to a historically normal 2.1% in 2008. CBO projects corporate tax revenue as a percentage of GDP to continue declining through 2010, reflecting reduced corporate profits due to the economic recession. 1
CBO data show a similar trend regarding corporate tax receipts as a share of total taxes, with an "uptick" in FY2005 and FY2007 from 12.9% to14.4% of total federal revenues --before reverting to a 12.1% in 2008. CBO, again, projects the percentage of total revenue from corporate tax revenue to recede through 2010.
Not all businesses are subject to the corporate income tax. Income earned by partnerships is "passed through" and taxed to the individual partners under the individual income tax without imposition of a separate level of tax at the partnership level. Also, businesses that have no more than 100 stockholders and that meet certain other requirements ("S" corporations), as well as certain other "pass through entities" are not subject to the corporate income tax, but are taxed in the same manner as partnerships.
Legislation in 2009
American Recovery and Reinvestment Act of 2009 (P.L. 111-5)
The American Recovery and Reinvestment Act of 2009 (ARRA) contained multiple business tax provisions. The majority of these provisions can be grouped into two general categories of incentives: those which promote investment in alternative energy and those which benefit the cash-flow of businesses.
The major business-related energy incentives in ARRA focus on promoting renewable energy. 2 The principal renewable energy provision increases the number of facilities eligible for the Renewable Energy Production Tax Credit (PTC) through a three-year extension of the placed-in-service date requirement. This provision is estimated to cost $13.1 billion over the next 10 years and comprises approximately 73% of the cost of the business-related energy provisions in ARRA. 3 The remainder of the energy provisions focus on modifications to the Investment Tax Credit (ITC), including the creation of the Advanced Energy Manufacturing Facility Investment Tax Credit which is estimated to cost $2.3 billion over 10 years.
The major business incentives in ARRA focus on increasing near term cash flow through the acceleration of capital cost recovery options and deferral of certain income related to the discharge of indebtedness. ARRA contains two provisions which accelerate capital cost recovery: an extension of bonus depreciation and enhanced small business expensing. The deferral of certain income related to the discharge-of-indebtedness provision allows cancellation of debt income (CODI) to be deferred for four or five years and recognized as income over the following four years. These three provisions are estimated to cost approximately $6.7 billion over 10 years. In contrast, the remaining business incentives in ARRA are estimated to raise nearly $600 million over 10 years.
Selected Business Tax Issues
Business Tax Cuts to Stimulate the Economy
After the passage of ARRA, the 111 th Congress has continued deliberations focused on stimulating the economy. One topic of these discussions was on how the tax code --and business provisions --could aid economic conditions. Given the policy goal of increasing aggregate demand, business tax cuts, such as in ARRA, have traditionally focused on "cash-flow" and investment measures.
Cash-flow provisions attempt to stimulate the economy by allowing businesses to realize existing tax attributes in the current period, as opposed to in future years. These measures allow businesses immediate access to working capital that may be useful to maintaining business operations. An example of a cash-flow measure in ARRA was the extension of the net operating loss carryback period from two to five years. The Gulf Opportunity Zone Act of 2005 (P.L. 109-135) enacted a similar provision for qualified losses occurring in the Gulf Opportunity Zone (or GO Zone).
Investment measures attempt to stimulate the economy by inducing investment spending. Typically this is attempted through measures that change the cost of capital. Examples of investment measures in ARRA were one year extensions --through the end of 2009 --of bonus depreciation and small business expensing. 4 The Economic Stimulus Act of 2008 (P.L. 110-185) also contained a one-year extension of these provisions, covering 2008.
Research and Experimentation Tax Credit and Other Temporary Benefits
The tax code contains a set of relatively narrowly applicable tax benefits (the "extenders") that are temporary in nature --they each were enacted for only fixed periods of time, and are each scheduled to expire on various dates. The benefits tend to be tax incentives: provisions designed to encourage certain types of investment or activity thought to be economically or socially desirable. As targeted tax incentives, the benefits tend to raise a similar policy question: according to traditional economic theory, smoothly functioning markets and undistorted prices generally allocate the economy's scare resources in the most efficient way. Absent market malfunctions --failures that economists believe are more the exception than the rule --economic theory indicates that tax benefits or penalties that interfere with the market reduce economic efficiency and reduce overall economic welfare. The question with each extender, then, is whether there is a market failure or socially desirable goal that makes the incentive's intervention in the market desirable.
One extender is the research and experimentation (R&E) tax credit, which was first enacted in 1981, and which has been renewed on numerous occasions. The credit provides businesses a tax benefit that is linked to firms' increases in research outlays in the current year over a statutorily defined base period. The credit is based on economic theory's notion that free markets do not operate smoothly in the case of research and development --that is, absent government support, firms would not spend as much on research as is economically efficient. (It could also be argued, however, that the amount of support provided by the R&E credit and several other extant research subsidies more than compensate for the theoretical shortfall in research.) 5
The R&E credit's most recent extension was provided by the Emergency Economic Stabilization Act of 2008 (P.L. 110-343) in October 2008. The act also increased the rate for the alternative simplified credit (ASIC) from 12% to 14% and repealed the alternative incremental research credit (AIRC) for the 2009 tax year only. In the 111 th Congress, there has been interest in extending the R&E credit and in making the tax credit permanent.
The extenders in general have been a continuing issue for Congress --in part because their temporary nature necessitates periodic action if they are not to expire, and in part because of the strong support for many of the benefits. 6 As noted above, an element of Division C of P.L. 110-343, the Tax Extenders and Alternative Minimum Tax Relief Act of 2008, extended the R&E credit. In addition, the act retroactively extended several temporary tax provisions for individuals and businesses through December 31, 2009.
It is expected that the extenders will continue to receive congressional attention in 2009.
Energy Taxation
At the outset of the 111 th Congress, the focus of energy taxation appears to be two-fold: enactment of a new set of incentives aimed at energy conservation and promotion of alternative energy sources and a revenue-raising, scaling-back of tax cuts that were enacted in recent years for the oil and gas companies.
The first of these two goals were addressed, in part, in ARRA, which contained a number of provisions to encourage investment in alternative energy and alternative energy production. These previsions are outlined above.
In addition, the President's FY2010 Budget Outline contains several provisions aimed at achieving the second goal. 7 If fully enacted the provisions would eliminate tax preferences for the oil and gas industry estimated to raise $25.3 billion over 10 years. 8 The repeal of the Section 199 domestic production deduction, enacted in JOBS ACT 2004 and never fully implemented, accounts for over 40% of this total. Another nearly 44% of the total is achieved through the elimination of two provisions enacted during World War I: the expensing of intangible drilling costs and percentage depletion.
Tax Shelters
Corporate "tax shelters" are another area where Congress may look for tax-increasing revenues. They concern policymakers because of their corrosive effect on tax equity and popular perceptions about the tax system's fairness. In popular usage, the term "tax shelter" denotes the use of tax deductions or credits produced by one activity to reduce taxes on another: the first activity "shelters" the second from tax. In economic terms, a tax shelter can be defined as a transaction (for example, an investment or sale) that reduces taxes without resulting in a reduced return or increased risk for the participant. 9 But the term is so vague and general in most usages that it is sometimes defined simply as a tax-saving activity that is viewed as undesirable by the observer using the term. Under most definitions, tax shelters can be either illegal and constitute "tax evasion" or legal, constituting "tax avoidance."
Congress has evinced considerable interest in tax shelters in recent years and has enacted some restrictions into law. The American Jobs Creation Act of 2004 (AJCA; P.L. 108-357) contained a number of provisions designed to restrict tax shelters. In part, the act's provisions were directed at specific tax shelters --for example, leasing activities and the acquisition of losses for tax purposes ("built in" losses). In addition, the act included provisions --for example, revised penalties and reporting requirements --designed to restrict sheltering activity in general. 10 In 2006, the Senate version of the Tax Increase Prevention and Reconciliation Act (TIPRA, P.L. 109-222) contained a number of tax shelter restrictions, but the provisions were not included in the conference report.
The Senate's TIPRA provisions included what the bill termed a "clarification" of the economic substance doctrine that has been followed in a number of court decisions applying to tax shelters. Generally, the economic substance doctrine disallows tax deductions, credits, or similar benefits in the case of transactions not having economic substance. The Senate version of TIPRA would have integrated aspects of the doctrine into the tax code itself. A similar measure was contained in the Senate version of the AJCA, but was not adopted.
The President's FY2010 Budget Outline includes the codification of the economic substance doctrine as a revenue-raising "offset" for tax cuts elsewhere in the tax code. This provision is estimated to raise $8.1 billion over 10 years.
International Taxation
There are some indications that Congress may look to the tax treatment of U.S. firms' foreign income in searching for additional tax revenue. In part, the focus on international taxation stems from a concern about tax benefits that are perceived to promote foreign "outsourcing" --the movement of U.S. jobs overseas.
Economic theory is skeptical about whether tax policy towards U.S. multinationals can have a long-term impact on domestic employment, although short-term and localized impacts are certainly possible. Taxes can, however, alter the extent to which firms engage in overseas operations rather than domestic investment. Under current law, a tax benefit known as "deferral" poses an incentive for U.S. firms to invest overseas in countries with relatively low tax rates. Deferral provides its benefit by permitting U.S. firms to postpone their U.S. tax on foreign income as long as that income is reinvested abroad in foreign subsidiaries. The benefit is generally available for active business operations abroad, but the tax code's Subpart F provisions restrict deferral in the case of income from passive investment. If made, proposals to restrict deferral may consist of expansion of the range of income subject to Subpart F.
In recent years, however, the thrust of legislation has been more in the direction of expanding deferral and cutting taxes for overseas operations. For example, the AJCA cut taxes on overseas operations in several ways, while in 2006, TIPRA restricted Subpart F in the case of banking and related businesses receiving "active financing" income and in the case of the "look through" treatment overseas operations receive from subsidiary firms. 11 Further, several analysts have argued that attempts to tax overseas operations are either counterproductive or outmoded in the modern integrated world economy. 12 Traditional economic analysis, however, suggests that overseas investment that is taxed at a lower or higher rate than domestic income impairs economic efficiency. However, a consensus appears to be emerging that the U.S. corporate income tax rate should be reduced. 13
Appendix. Business Tax Legislation and Issues, 2001-2008
The major tax cuts enacted in 2001 and 2003 with the Economic Growth and Tax Relief Reconciliation Act (EGTRRA; P.L. 107-16) and the Jobs and Growth Tax Relief Reconciliation Act (JGTRRA; P.L. 108-27), respectively, focused more on individual income taxes than corporate taxes, and included measures such as reductions in statutory tax rates, tax cuts for married couples, and expansion of the child tax credit. JGTRRA, however, contained a number of tax cuts aimed at businesses, as did legislation enacted in nearly each year since 2004.
The most prominent business tax cuts can be summarized as follows: temporary "bonus" depreciation provisions designed to spur investment spending; capital gains and dividend reductions, intended (in part) to increase capital formation and the flow of savings to the corporate sector; extension of a set of narrowly-applicable temporary tax benefits (the "extenders") that were addressed by several acts; and provisions enacted in 2004 designed to boost U.S. manufacturing and competitiveness (the domestic production deduction and foreign tax credit provisions).
The policy questions the business tax legislation raised --again, in broadest terms --were as follows:
What would be the impact of the investment incentives on the economy's capital stock? Does the reduced tax burden increase the supply of capital and saving, thus increasing long-run growth? Or, is the economy's supply of capital relatively fixed, meaning the investment incentives simply interfere with the efficient allocation of investment?
Were the enacted business tax cuts effective in stimulating the economy in the short run, thus aiding recovery from the 2001 recession? Or, do planning lags and other factors make business tax cuts ineffective as a fiscal stimulus, meaning the relation between the business tax cuts and economic recovery was serendipitous?
What was the effect of the business tax cuts on the overall fairness of the tax system? Did the reductions accrue primarily to relatively high-income stockholders and corporate creditors, or were any reductions on tax progressivity outweighed by positive employment effects?
How did the business tax cuts affect U.S. economic competitiveness? Have provisions such as the domestic production deduction helped revitalize domestic manufacturing, or do the deduction and other competitiveness provisions interfere with the efficient and flexible participation of U.S. businesses in the world economy?
Enacted Legislation
The Job Creation and Worker Assistance Act of 2002 (JCWA; P.L. 107-147) contained temporary "bonus" depreciation provisions that permitted firms to deduct an additional 30% of the cost of property in its first year of service rather than requiring that portion to be depreciated over a period of years. The provision generally applied to machines and equipment (but not structures) and was limited to property placed in service after September 11, 2001, and before January 1, 2005. JCWA also temporarily extended the net operating loss "carryback" period (the years in the past from whose income a firm can deduct losses) to five years from two years. The provision only applied to losses in 2001 and 2002. JCWA also temporarily extended a set of expiring tax benefits (the "extenders" discussed above), many of which applied to business taxes.
While a principal thrust of the Jobs and Growth Tax Relief Reconciliation Act (JGTRRA; P.L. 108-27) was accelerating the effective date of individual income tax cuts enacted in 2001, the act also contained a number of business provisions. JGTRRA's tax cuts for dividends and capital gains applied to individual income taxes, but nonetheless reduced the tax burden on stockholders' corporate-source income. Under the U.S. classical method of business taxation, corporate source income is taxed twice: once under the corporate income tax and once under the individual income tax --an instance of double-taxation that is thought by economists to inefficiently restrict the flow of capital to the corporate sector. JGTRRA's reductions were an incremental step in the direction of removing the double-taxation --a reform economists term tax "integration." The reductions were temporary, and were originally scheduled to expire at the end of 2008.
In addition to its capital gains and dividend reduction, JGTRRA increased bonus depreciation to 50% and extended its coverage to the period between May 5, 2003, and January 1, 2005. JGTRRA also temporarily (for 2003, 2004, and 2005) increased the "expensing" allowance for small-business investment from $25,000 to $100,000.
The American Jobs Creation Act of 2004 (AJCA; P.L. 108-357) grew out of legislation designed to end a dispute between the European Union (EU) and the United States over a U.S. tax benefit for exporting (the extraterritorial or ETI provisions) that had been determined to contravene the World Trade Organization agreements' prohibition on export subsidies. The EU objected to the ETI benefit and imposed countervailing tariffs authorized by the WTO. AJCA repealed ETI, but also enacted a set of new WTO-legal business tax cuts designed, in part, to offset the impact of ETI's repeal on domestic businesses. However, the scope of AJCA substantially transcended ETI and its offsets, and the act was, in its final form, an omnibus business tax bill.
Aside from ETI's repeal, AJCA's most prominent provisions were a new domestic production deduction equal to 9% of income from domestic (but not foreign) production, and a set of tax cuts for multinational firms, including more generous foreign tax credit rules governing interest expense. AJCA also temporarily extended the $100,000 small business expensing allowance (through 2007).
The Tax Increase Prevention and Reconciliation Act of 2006 (TIPRA; P.L. 109-222) extended JGTRRA's reduced rates for dividends and capital gains for two years, through 2010. TIPRA also extended JGTRRA's $100,000 small-business expensing-allowance for two years, through 2009. (In early 2007, P.L. 110-28 extended the increased expensing allowance through 2010.)
The Tax Relief and Health Care Act of 2006 (TRHCA; P.L. 109-432) was passed in the postelection session of the 109 th Congress. Many of the extenders had expired at the end of 2005, and TRHCA extended them, generally for two years (through 2007).
The Small Business and Work Opportunity Tax Act of 2007 (P.L. 110-28) continued Congress's long-standing interest in tax policy towards small business. Tax cuts for small business (increased business expensing and the work-opportunity tax credit) were included as a means of offsetting the extra cost burden the higher minimum wage.
The Economic Stimulus Act of 2008 (P.L. 110-185) contained two provisions which affect business investment; a temporary, one year increase in the limitations on the expensing of certain depreciable business assets and temporary "bonus" depreciation, for certain property acquired in 2008. Both provisions permit firms to deduct a greater percentage of the cost of property in the first year of service rather than gradually depreciating the whole value of the asset over time.
The Food, Conservation, and Energy Act of 2008 (P.L. 110-234) included tax-provisions which affect businesses were several tax credits for the production of fuels from alternative sources. 14
The Emergency Economic Stabilization Act of 2008 (P.L. 110-343) extended a number of business tax provisions and created or modified a number of renewable energy and energy efficiency provisions.
Author Contact Information
Donald J. Marples
Specialist in Public Finance
dmarples@crs.loc.gov, 7-3739
1 U.S. Congress, Congressional Budget Office, The Budget and Economic Outlook: Fiscal Years 2009-2019 , (Washington: GPO, 2009).
2 See CRS Report R40412, Energy Provisions in the American Recovery and Reinvestment Act of 2009 (P.L. 111-5) , coordinated by Fred Sissine, for a complete description of the energy provisions in ARRA.
3 The revenue estimates used in the section are all contained in U.S. Congress, Joint Committee on Taxation, Estimated Budget Effects of the Revenue Provisions Contained in The Conference Agreement For H.R. 1, The "American Recovery And Reinvestment Tax Act of 2009" , committee print, 111 th Cong., 1 st sess., February 12, 2009, JCX-19-09.
4 CRS Report RL31852, Small Business Expensing Allowance: Current Status, Legislative Proposals, and Economic Effects , by Gary Guenther
5 See CRS Report RL31181, Research and Experimentation Tax Credit: Current Status and Selected Issues for Congress , by Gary Guenther, for a more complete description of the R&E credit.
6 For a list of extenders addressed by TRHCA, see CRS Report RL33768, Major Tax Issues in the 110 th Congress , by Jane G. Gravelle, and for a broader discussion on extenders, see CRS Report RL32367, Certain Temporary Tax Provisions ( "Extenders" ) Expired in 2007 , by Pamela J. Jackson and Jennifer Teefy.
7 Office of Management and Budget, Budget of the Federal Government: Fiscal Year 2010 , Washington, D.C., February 26, 2009, Table S-6.
8 All revenue estimates of the President's FY2010 Budget Outline are contained in U.S. Congress, Joint Committee on Taxation, Estimated Budget Effects of The Revenue Provisions Contained in the President's Fiscal Year 2010 Budget Proposal , committee print, 111 th Cong., March 30, 2009, JCX-22-09.
9 These definitions are taken from Joseph J. Cordes and Harvey Galper, "Tax Shelter Activity: Lessons from Twenty Years of Evidence," National Tax Journal , vol. 38, Sept., 1985, pp. 305, 307.
10 For a list and description, see CRS Report RL32193, Anti-Tax-Shelter and Other Revenue-Raising Tax Proposals Considered in the 108 th Congress , by Jane G. Gravelle.
11 "Lookthrough" rules generally apply the same treatment of particular items of income in the hands of the recipient as in the hands of a payor. Thus, for example, a dividend paid to a parent firm out of active business income of a subsidiary would remain active business income in the hands of the parent rather than dividend income (i.e., passive investment income).
12 Mihir A. Desai and James R. Hines, Jr., "Old Rules and New Realities: Corporate Tax Policy in a Global Setting," National Tax Journal , vol. 57, Dec. 2004, pp. 937-960. For a critique of Desai and Hines, see Harry Grubert, "Comment on Desai and Hines, Old Rules and New Realities: Corporate Tax Policy in a Global Setting," National Tax Journal , vol. 58, June 2005, pp. 263-278.
13 House Committee on Ways and Means, "Chairman Rangel Pledges to Work with Administration and Congressional Republicans to Restore America's Fiscal Health," press release, February 23, 2009.
14 See CRS Report RL34696, The 2008 Farm Bill: Major Provisions and Legislative Action , by Renée Johnson et al., for a more complete description of the act's energy-related provisions.
Congressional Research Service Report for Congress --Personal Exemption Phaseout (PEP) and Limitation on Itemized Deductions (Pease), April 14, 2009
April 16, 2009
111th Congress
Personal Exemption Phaseout (PEP) and Limitation on Itemized Deductions (Pease)
Maxim Shvedov
Analyst in Public Finance
April 14, 2009
Congressional Research Service
7-5700
www.crs.gov
R40508
Summary
Personal exemptions and deductions are typically allowed for taxpayers in order to exclude low-income households from the tax rolls, exempt a minimum level of income from taxation, and provide other tax benefits. The personal exemption phaseout (PEP) was enacted to reduce or eliminate the benefits of personal exemptions. The limitation on itemized deductions, referred to as Pease after its sponsor, Representative Don Pease of Ohio, reduces the benefits of itemized deductions. By design, both PEP and Pease place more of a tax burden on largely overlapping groups of higher-income taxpayers. The provisions were adopted as a means of raising additional revenue without having to explicitly raise statutory marginal income tax rates. They do raise effective marginal tax rates, however, for most of the affected taxpayers.
Both PEP and Pease were enacted temporarily under the Omnibus Budget Reconciliation Act of 1990 (OBRA90, P.L. 101-508) and later extended permanently without modification by the Omnibus Budget Reconciliation Act of 1993 (OBRA93; P.L. 103-66). The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA, P.L. 107-15) authorized repeal of PEP and Pease. It contained provisions for a gradual reduction of both phaseouts beginning in 2006 and eventual repeal of PEP and Pease in 2010. Under current law, PEP and Pease would be reinstated in 2011 in their original, pre-EGTRRA forms.
In his FY2010 budget outline, released on February 26, 2009, President Obama proposes to reinstate the PEP and Pease for married taxpayers earning over $250,000 and single taxpayers earning over $200,000 ($200,000/$250,000 income threshold). This report examines various issues raised by the reinstatement of PEP and Pease in the context of the budget proposal.
In 2006, the latest year data are available, 6.8 million taxpayers were affected by Pease. This represents less than 5% of all 138.4 million tax filers. Taxpayers with adjusted gross income (AGI) below $75,000 were not materially affected. Once AGI exceeded $200,000, however, nearly all returns became subject to the Pease rule. PEP affected taxpayers at the same or higher income levels.
The PEP and, especially, the Pease provisions are quite complex elements of the tax system. The new $200,000/$250,000 threshold proposed in the budget would significantly reduce the number of affected taxpayers, but it might increase the complexity of these measures for those who would remain subject to PEP and Pease. Another new proposal in the budget limiting the benefits from some itemized deductions for higher-income taxpayers to 28% might generate additional interactions. The provisions' complexity might be reduced, for example, by harmonizing the phaseout rules of PEP and Pease, modifying their structure in other ways, or explicitly increasing the marginal tax rates for higher-income taxpayers.
The President's FY2010 budget outline estimates a potential revenue gain from enacting his PEP-and Pease-related proposal at $179.9 billion over FY2010-2019. The revenue effects depend greatly on interaction between these two provisions and such elements of the tax code as the alternative minimum tax (AMT) and marginal tax rates. The President's FY2010 budget outline includes changes to both. The budget proposal limiting the benefits from some itemized deductions, such as mortgage interest and charitable giving, for taxpayers above the $200,000/$250,000 threshold to 28% might also interact with Pease revenue projections.
This report will be updated as legislative action warrants.
Contents
Legislative History and Recent Developments
Personal Exemption Phaseout (PEP)
Limitation on Itemized Deductions (Pease)
Issues
Complexity
Effects on Economic Incentives
Distribution of the Tax Burden
Projected Revenue Gain
Tables
Table 1. Elimination and Reduction of PEP and Pease Limitations under EGTRRA
Table 2. Returns with Itemized Deductions and Pease Limitation, 2006
Table 3. Effects of PEP/Pease Repeal --Distribution of Federal Tax Change by Cash Income Class, 2010
Contacts
Author Contact Information
Acknowledgments
Personal exemptions and deductions are typically allowed for taxpayers in order to exclude low-income households from the tax rolls, exempt a minimum level of income from taxation, and provide other tax benefits. The personal exemption phaseout (PEP) reduces or eliminates the benefits of personal exemptions. The limitation on itemized deductions reduces the benefits of itemized deductions. It is often referred to as "Pease" after its sponsor, Representative Don Pease of Ohio. By design, both PEP and Pease place more of a tax burden on largely overlapping groups of taxpayers in the higher range of the income spectrum. Under current law, both provisions are repealed in 2010, but reinstated in 2011.
Legislative History and Recent Developments
Originally, both PEP and Pease were enacted under the Omnibus Budget Reconciliation Act of 1990 (OBRA90, P.L. 101-508) and later extended without modification by the Omnibus Budget Reconciliation Act of 1993 (OBRA93; P.L. 103-66). OBRA90 contained an assortment of spending cuts and tax increases that was expected to reduce the federal budget deficit by an estimated $496 billion over five years. At the time, it was estimated that OBRA90's tax increases would raise, on a net basis, $146 billion. This represented only about 29% of the estimated total five-year deficit reduction. The phaseout of the personal exemption and the limitation on itemized deductions accounted for approximately 20% of the net tax increase under OBRA90. Although the spending reductions represented a much larger part of this deficit-reduction package, it was OBRA90's tax increases that were the focus of most of the debate.
Under OBRA90 provisions, the PEP and Pease rules were originally scheduled to expire after 1995. Continued budgetary pressures, however, led to the passage of a second round of tax increases in 1993. Under OBRA93, the PEP and Pease provisions became permanent.
Repeal of PEP and Pease provisions was authorized by the Economic Growth and Tax Relief Reconciliation Act (EGTRRA, P.L. 107-15), enacted on June 5, 2001. It contained provisions for a gradual reduction of both phaseouts beginning in 2006 and an eventual complete repeal of PEP and Pease in 2010. Table 1Error! Reference source not found. shows the schedule under the EGTRRA. Like all other EGTRRA measures, however, these repeal provisions are set to expire after 2010. 1
Table 1. Elimination and Reduction of PEP and Pease Limitations under EGTRRA
_________________________________________________________________________________
2001-2005 2006-2007 2008-2009 2010 Thereafter
_________________________________________________________________________________
Reduce limitations No change By By Eliminate Reinstate
on personal one-third two-thirds completely in full
exemptions and
itemized deductions
_________________________________________________________________________________
Source: CRS adaptation of Congressional Budget Office and Joint Committee on
Taxation tables and publications
According to the Joint Committee on Taxation (JCT), Congress repealed both the PEP and Pease provisions largely for similar reasons. Congress believed that they were "an unnecessarily complex way to impose income taxes and that the 'hidden' way in which the phase-out raises marginal tax rates undermines respect for the tax laws," and that their repeal "would significantly reduce complexity for affected taxpayers." 2 Additionally, Congress believed that PEP imposed "excessively high effective marginal tax rates on families with children." 3
At the time, the Joint Committee on Taxation (JCT) estimated that the phaseout of the PEP provision would reduce federal revenues by $8.1 billion and the phaseout of the Pease provision would reduce them by $24.9 billion over the 2006 through 2010 time period. 4 The highest single-year impact for both measures was estimated to occur in FY2010, which would include parts of tax years 2009 (two-thirds reduction) and 2010 (complete repeal). In FY2010, the PEP-related measure was estimated to cost $2.2 billion and the Pease-related measure $7.2 billion.
In his FY2010 budget outline, President Obama proposes to reinstate PEP and Pease in 2011 for married taxpayers earning over $250,000 and single taxpayers earning over $200,000 ($200,000/$250,000 income threshold). 5 Under current law, when reinstated in 2011, PEP and Pease would apply to taxpayers with income above the estimated threshold of $175,000-$180,000 (the thresholds are indexed annually for inflation and their 2011 values are currently unknown). Thus, though the budget outline would revive PEP and Pease, it would apply them to fewer taxpayers than would current law. In other words, the budget proposal represents an extension of the tax cut enacted in 2001 for taxpayers below the $200,000/$250,000 income threshold. For the rest of taxpayers, the proposal would represent the rollback of the 2001 tax cut.
Personal Exemption Phaseout (PEP)
Prior to OBRA90, provisions in the Tax Reform Act of 1986 (TRA86, P.L. 99-514) had created an individual marginal income tax rate structure that consisted of two statutory marginal tax rates, 15% and 28%. TRA86, however, also created a 5% surcharge on the taxable income of certain high-income taxpayers, which effectively created a third marginal tax rate of 33% (28% statutory rate plus the 5% surcharge).
Because the surcharge was first phased in and then phased out as incomes increased, the effective marginal tax rate first rose to 33% and then fell back to 28%, creating the tax rate "bubble." Ostensibly, the surcharge was created to phase out the tax benefits of the 15% tax bracket and the personal exemptions for high-income taxpayers. In reality, the surcharge was adopted so that TRA86 would not change the distribution of the tax burden relative to its distribution under pre-1986 tax law, would meet the needed revenue targets, and would still allow TRA86 to be characterized as having only two statutory marginal income tax rates.
OBRA90 eliminated the tax "bubble" by repealing the 5% tax surcharge and instituted three explicit statutory marginal tax rates and a personal exemption phaseout (PEP) --a new approach to phasing out the tax benefits of the personal exemption for higher-income taxpayers. Taxpayers calculate the amount of the PEP reduction using the special worksheet found in the instructions to the Internal Revenue Service (IRS) Form 1040, the standard form for individual income tax filing.
This new phaseout of the tax benefits of the personal exemption (PEP) was structured as follows. Each personal exemption was phased out by a factor of 2% for each $2,500 (or fraction of $2,500) by which a taxpayer's adjusted gross income (AGI) exceeded a given threshold amount. In 1991, the threshold amount for a joint return was set at $150,000; for a single return the threshold was $100,000; and for heads of households the threshold was set at $125,000. By 2009, these amounts grew due to indexation to $250,200, $166,800, and $208,500, respectively. 6 Barring deflation, these thresholds would increase further between 2009 and 2011.
For example, in 1991, a joint filer whose AGI was $183,000 would lose 28% of their total personal exemptions claimed. The AGI amount in excess of the threshold in this instance would be $33,000 --$183,000 AGI less $150,000 threshold limit. The $33,000 excess divided by $2,500 would produce a factor of 13.2, which when rounded up would equal 14. This figure is multiplied by 2% to arrive at the final disallowance amount of 28%. Hence, if the family had claimed two personal exemptions, which at $2,150 each would total $4,300, they would be allowed to deduct only $3,096 ($4,300 total personal exemptions less the $1,204 disallowance, which is 28% of the total).
EGTRRA stipulated a gradual reduction in PEP limitation beginning in 2006, and its complete repeal in 2010. For 2006 and 2007, the personal exemption phaseout was reduced by one-third and, for 2008 and 2009, it was reduced by two-thirds. Finally, EGTRRA repealed the PEP provisions completely in 2010. So, for example, in 2009, taxpayers calculate the PEP reduction in the usual way, but then divide it by three to calculate the disallowance of the personal exemptions. In 2010, they will not need to calculate PEP reductions at all.
PEP-related provisions of EGTRRA, like the rest of EGTRRA, are scheduled to expire after 2010, however. This expiration would reinstate the PEP in the same form as it existed prior to EGTRRA reductions. Absent legislation, PEP would apply to single taxpayers with incomes below the $200,000 threshold stipulated in the FY2010 budget outline. Barring deflation, current law 2011 PEP thresholds for married taxpayers and heads of household would exceed $250,000 and $200,000 respectively. Thus, for taxpayers using these two filing statuses the new thresholds set forward in the budget outline do not limit applicability of PEP.
Limitation on Itemized Deductions (Pease)
Under the Pease provision, for tax years starting in 1991, otherwise allowable itemized deductions were reduced by 3% of the amount by which a taxpayer's AGI exceeded $100,000. By 2009, the threshold increased to $166,800 due to the indexation. 7 This threshold applies to all filing statuses, except for married couples filing separate returns, for whom it is set at one-half of the amount. Total deductions subject to the Pease limitation cannot be reduced by more than 80%.
For example, if a taxpayer's AGI in 1991 were $140,000 then his otherwise allowable deductions would be reduced by $1200 ($140,000 less $100,000 threshold times 3%). Taxpayers calculate the amount of the reduction using the special worksheet found in the instructions to Schedule A of the IRS Form 1040, the standard form for individual income tax filing.
In a far less typical example, if a taxpayer's AGI in 1991 were $1.1 million, and the itemized deductions subject to the Pease rule were $35,000, the effect of the Pease would be capped by the 80% rule. In the absence of the cap, Pease would have reduced the taxpayer's allowable deductions by $30,000 (equal to 3% of the difference between AGI of $1.1 million and the threshold of $100,000). However the deductions cannot be reduced by more than 80%, which in this example is equal to $28,000. This taxpayer could claim a $7,000 itemized deduction (equal to the initial deduction amount of $35,000 less the reduction of $28,000).
In addition, taxpayers can choose to claim a standard deduction instead of itemizing. So, if as a result of the Pease rule the itemized deduction becomes smaller than the standard deduction, taxpayers may reduce their tax liability by switching to the standard deduction. In 1991, the standard deduction for joint returns was $5,700. So, the taxpayer in the 1991 example above might still be better off by using the itemized deduction. In 2009, standard deduction for joint returns is $11,400. Standard deductions vary by filing status and change every year to account for inflation.
Similarly to the PEP rules, EGTRRA stipulated a gradual reduction in the Pease limitation beginning in 2006, and its complete repeal in 2010. For 2006 and 2007, the Pease was reduced by one-third, and for 2008 and 2009 it was reduced by two-thirds. Finally, EGTRRA repealed the Pease provisions completely in 2010. So, for example, in 2009, taxpayers calculate the Pease reduction in the usual way, but then reduce the disallowance of the itemized deductions by two-thirds. In 2010, they will not need to calculate the Pease reduction at all.
Pease-related provisions of EGTRRA, like the rest of EGTRRA, are scheduled to expire after 2010. This expiration would reinstate the Pease rule in the same form as it existed prior to EGTRRA. In the absence of legislative action, Pease would apply taxpayers with income above the estimated $175,000-$180,000 threshold (since the threshold is indexed annually for inflation its exact 2011 value is currently unknown).
Examples of itemized deductions subject to Pease include mortgage interest, state and local taxes, charitable contributions, and others. Allowable deductions for medical expenses, gambling or casualty and theft losses, and investment interest are not subject to the limitation.
The Pease rule does not apply to deductions that small business owners might claim in calculating profits from business. Such deductions are not part of itemized deductions at all; rather, they indirectly enter the calculation of a taxpayer's AGI.
Table 2 reproduces the latest available data from the IRS about the number and distribution of taxpayers affected by the Pease provision. 8 In 2006, 6.8 million of 49.1 million, or 13.8%, itemizers were affected by the limitation. This represents slightly less than 5% of all 138.4 million tax filers (both itemizers and non-itemizers). The table shows the data for the first year when EGTRRA reductions began to phase in, thus the dollar amounts of the limitation reflect the one-third phaseout. At the same time, EGTRRA's Pease-related provisions did not affect the number of taxpayers subject to the limitation in 2006.
Table 2 also shows, perhaps not surprisingly, that the affected taxpayers were concentrated in the upper parts of income distribution. Taxpayers with AGIs below $75,000 are not materially affected by the limitation. Once AGI exceeds $200,000, however, nearly all returns become subject to the Pease rule.
Based on Table 2 data, there appear to be roughly three million taxpayers in 2006 who would become subject to Pease under current law upon EGTRRA's expiration in 2011, but would be exempt from this limitation under the higher threshold in the President's proposal. These are taxpayers who would have been subject to the Pease phaseout, but would be below the Pease reinstatement limits stipulated in the outline of the President's FY2010 budget. This represents approximately 40% of all taxpayers that would be affected by Pease. While three million is an approximate number based on unadjusted 2006 income levels, it is likely that the number of taxpayers in this category would have the same order of magnitude in 2011 and the following years.
Table 2. Returns with Itemized Deductions and Pease Limitation, 2006
All figures are estimates based on samples --money amounts are in thousands of
dollars
____________________________________________________________________________________
Number of Number of
Returns Returns
with Itemized Showing Pease Amount of Pease
Size of Adjusted Gross Income Deductions Reduction Reduction
____________________________________________________________________________________
All returns, total 49,123,555 6,789,435 35,152,244
below $60,000 20,009,281 0 0
$60,000 under $75,000 6,306,552 137 a 7 a
$75,000 under $100,000 8,297,996 102,855 23,483
$100,000 under $200,000 10,655,930 2,833,121 1,270,065
$200,000 under $500,000 2,962,237 2,962,137 8,188,936
$500,000 under $1,000,000 552,797 552,466 5,858,010
$1,000,000 under $1,500,000 142,284 142,277 2,948,618
$1,500,000 under $2,000,000 61,068 61,063 1,841,180
$2,000,000 under $5,000,000 95,326 95,309 4,922,580
$5,000,000 under $10,000,000 24,348 24,341 2,841,111
$10,000,000 or more 15,735 15,729 7,258,254
Taxable returns, total 42,402,082 6,775,400 35,097,675
Nontaxable returns, total 6,721,474 14,035 54,569
____________________________________________________________________________________
Source: Internal Revenue Service
a. Estimate should be used with caution due to the small number of sample returns
on which it is based.
Issues
Under current law PEP and Pease will become ineffective for a single year, 2010, but will return in the following year in their original, pre-EGTRRA, forms. In 2009, Pease would generally affect taxpayers with AGIs above $166,800. PEP income limits vary by filing status, but are at the same or higher level: $166,800 for single filers, $250,200 for joint filers, and $208,500 for heads of households. These amounts would increase between 2009 and 2011 due to the indexation.
The President's FY2010 budget outline includes reinstatement of PEP and Pease only for taxpayers with incomes above the threshold of $250,000 for joint returns or $200,000 for others ($200,000/$250,000 threshold). Currently details of the proposal's implementation are unknown. It appears, however, that the proposal would represent an extension of the PEP and Pease repeal for taxpayers below the $200,000/$250,000 threshold. At the same time, for taxpayers above the threshold the proposal would represent a rollback of PEP and Pease repeal enacted by EGTRRA.
Complexity
The PEP and, especially, the Pease provisions are quite complex elements of the tax system. For example, in 2001 Congress noted that computation of the Pease phaseout "requires a 10-line worksheet. Moreover, the first line of that worksheet requires the adding up of seven line items from Schedule A of the Form 1040, and the second line requires adding up of four line items of Schedule A of the Form 1040." 9
Some might argue, however, that due to the wide availability of tax-preparation software and other options, especially given the resources available to higher-income taxpayers, the complexity of PEP and Pease might be a less important consideration than in the past. Indeed, computer programs are capable of calculating these phaseouts without any additional efforts by the user.
Despite this argument, the complexity of PEP and Pease, as well as the overall complexity of the tax system, remains an important consideration because it complicates taxpayers' decision-making process. Economists believe that economic agents tend to make optimal decisions if they know true after-tax costs associated with every option. Complex tax provisions, such as PEP and Pease, obscure this cost information. As a result, economic agents base their decisions on incomplete or distorted data, which may lead to sub-optimal decisions at the individual level and a loss of social welfare at the economy-wide level.
Originally, PEP and Pease were adopted as a means of raising additional revenue without having to explicitly raise marginal income tax rates. At the same time, they do raise effective marginal tax rates for many of the affected taxpayers. Thus, they may be characterized by some as a "stealth tax," a tax levied in a non-conspicuous, hidden way. 10 Arguably, an explicit increase in marginal tax rates would have made the tax system more transparent and simple.
The FY2010 budget outline does not provide any details on how the new proposed $200,000/$250,000 income threshold would be implemented. Depending on specifics, the PEP and Pease provisions could become even more complex. The effects of the new policy on taxpayers with incomes near the new threshold might require particular attention.
Policymakers would be unlikely to propose simply setting the PEP and Pease reductions to zero for taxpayers below the $200,000/$250,000 threshold and keeping the reductions intact for taxpayers above the threshold. This approach would result in a "cliff" --a jump in tax liability once taxpayers' income reaches a threshold point --which is considered undesirable by many.
The cliff means that under certain circumstances earning more would reduce taxpayers' disposable income. Using 2009 parameters and the $250,000 threshold as an example, it means that the after-tax income of a taxpayer earning $249,999 might be higher than the after-tax income of a taxpayer earning $250,001. Even though income before taxes rises by $2, after-tax-income falls by roughly $700 (equal to the 28% assumed applicable tax rate multiplied by the $2,496 potential reduction in the deductions of 3% of the amount by which $250,001 exceeds $166,800).
Avoiding cliffs may generate problems of its own. A typical solution designed to avoid them utilizes phase-ins and phase-outs. These mechanisms eliminate cliffs, but they affect marginal tax rates. If the new PEP and Pease mechanism is phased in starting at or around $200,000/$250,000, this would raise marginal tax rates for taxpayers in the phase-in income range above the increase created by the PEP and Pease under current law.
One technically simple way to implement the $200,000/$250,000 threshold would be to replace the current thresholds of $166,800 with $200,000 for single filers, $250,000 for joint returns, and so on, whenever the current threshold value falls below $200,000 or $250,000 as applicable. This approach would make combined PEP and Pease reductions smaller at every income level compared to the current law. Hence this option would provide tax relief for many taxpayers above the $200,000/$250,000 threshold, as well as all taxpayers below it, but at a cost of lower government revenues.
For example, itemized deductions of a married taxpayer with AGI of $270,000 would be reduced by $3,096 assuming a $166,800 threshold (equal to 3% of $103,200, the difference between $270,000 and $166,800). If the threshold were replaced by $250,000, however, the Pease reduction would fall to just $600 (3% of $20,000, the difference between $270,000 and $250,000). In this example savings to the taxpayer, and corresponding reduction to the government revenue, might be almost $700, using the 28% marginal tax rate as an example, or more for higher marginal tax rates.
It might be possible to restructure the PEP and Pease formulae in a way that does not increase tax liabilities of taxpayers below the $200,000/$250,000 threshold, but also does not reduce government revenues. Since higher-income taxpayers would benefit from some of the middle class tax reductions retained under the President's proposal --such as, for example, the 10% lowest income tax bracket or marriage tax penalty relief --the PEP and Pease formulae might start phasing out exemptions and deductions slightly below the $200,000/$250,000 AGI threshold and still hold the target group harmless. In effect, PEP and Pease would take away some of the benefits of the middle-income tax cuts for taxpayers with AGIs slightly below the $200,000/$250,000 threshold, but their liabilities would still remain below the current law levels. In order to maintain the revenue gain at the current law level other adjustments to the formulae might be necessary.
There is one more provision included in the President's FY2010 budget outline which might interact with Pease and further complicate tax computations. Under the budget outline, the President proposes to limit the benefits of some itemized deductions for taxpayers above the $200,000/$250,000 threshold to 28% (the 28% rule). While no details are currently available about the specifics of the 28% rule implementation, this new provision might introduce another layer of complexity.
One way to reduce the combined complexity of both measures and meet the requirement of preventing a tax increase on taxpayers with income below $200,000 or $250,000 would be to harmonize both phaseouts. In this case, taxpayers could calculate the sum of personal exemptions and itemized deductions subject to Pease and then apply a single phaseout formula to the result. This uniformity might also make implementation of the new 28% rule easier.
This approach may be justified given the fact that both PEP and Pease were targeted at the same general group of taxpayers. As noted above, Congress cited similar reasons for their repeal in 2001. In fact, while Congress pointed out only the effects of PEP, but not Pease, on families with children, most such taxpayers subject to PEP would generally be subject to Pease as well, because Pease thresholds are lower than PEP's. Furthermore, a large majority of taxpayers in this income group are families and itemizers: almost 85% and 95%, respectively, in 2006, for example. The number of exemptions for children per return is also among the highest for taxpayers with AGIs above $200,000. 11
Effects on Economic Incentives
Both PEP and Pease affect how much of an additional dollar of income taxpayers get to keep after they pay their taxes. In other words, PEP and Pease effectively change marginal tax rates, the rates of tax on the last dollar of taxpayer's income, even though they do not explicitly affect statutory marginal tax rates, the rates of tax prescribed by law. Economists believe that taxpayers change their behavior in response to the effective (real), not statutory, marginal tax rates. It means that when deciding, for example, whether to work more, taxpayers consider by how much their real after-tax income would actually change as a result of this decision.
For example, Pease provisions effectively raise the marginal income tax rate of some of the affected taxpayers by approximately one percentage point. In 1991, a dollar of income in excess of $100,000 was taxed as if it were $1.03, since in addition to the tax on an extra dollar of income, the taxpayer lost tax deductions by giving up $0.03 of itemized deductions. Unless the amount of the Pease reduction were determined by the 80% of the allowable itemized deductions rule, which is a fairly uncommon occurrence, the reduction would increase the marginal tax rate.
The logic would be similar in case of the PEP, but since for most taxpayers the total amount of personal exemptions is relatively small and fixed by the number of dependents, the effect would be less pronounced. Again, once taxpayers' income exceeds the level at which the exemptions are completely phased out, PEP ceases to affect marginal tax rates.
Finally, since the amount of a Pease reduction in a typical case depends on the taxpayer's AGI, and not on the amount of the itemized deductions, the Pease provision does not change the marginal benefit of the itemized deductions for a taxpayer. This means that an economic incentive of an extra dollar of, say, charitable contributions is the same whether Pease applies or not. Economic theory suggests that taxpayers would be as likely to make charitable contributions when they are subject to Pease as when they are not.
The formula for PEP works differently. It changes the marginal benefit of personal exemption for taxpayers with less than a complete PEP phaseout, but since taxpayers have little control over the number or amounts of the personal exemptions, this fact is unlikely to have a meaningful economic effect.
Distribution of the Tax Burden
Both PEP and Pease provisions by design place more of a tax burden on taxpayers at the upper range of the income spectrum. Table 2 demonstrates this fact for the Pease provision using historic 2006 IRS data. The distribution for PEP would be different, but still concentrated among higher-income taxpayers. While no direct data are available, 2006 IRS data suggest that taxpayers with AGIs below $200,000 are not materially affected by PEP, while almost all taxpayers with AGIs above $500,000 are. 12
Table 3 reproduces portions of the distributional analysis of the combined PEP and Pease repeal offered by the Tax Policy Center (TPC), a joint project of the Urban Institute and Brookings Institution. 13 These estimates indicate that in 2010 the tax benefits from repeal of these two provisions accrue to only 3.3% of all taxpayers, and that, with a rare exception, those taxpayers have incomes in excess of approximately $100,000. The largest average tax reductions, around $19,000, accrue to taxpayers with incomes in excess of $1 million.
Table 3. Effects of PEP/Pease Repeal --Distribution of Federal Tax Change by Cash Income Class, 2010
_______________________________________________________________________________
Tax Units
_________________________________
Cash Income
Class Percent Percent Average
(thousands Percent of Percent Change in of Total Tax Change
of 2003 Number with Tax After-Tax Tax
dollars) (thousands) Total Cut Income Change ($)
_______________________________________________________________________________
Less than 10 20,774 13.4 0.0 0.0 0.0 0
10-20 27,902 18.0 0.0 0.0 0.0 0
20-30 21,378 13.8 0.0 0.0 0.0 0
30-40 16,596 10.7 0.0 0.0 0.0 0
40-50 12,306 7.9 0.0 0.0 0.0 0
50-75 20,306 13.1 0.0 0.0 0.0 0
75-100 12,845 8.3 0.8 0.0 0.1 -1
100-200 17,016 10.9 14.6 0.0 3.2 -25
200-500 4,600 3.0 40.5 0.2 19.1 -558
500-1,000 779 0.5 58.9 0.7 24.0 -4,141
More than
1,000 374 0.2 73.7 0.9 53.5 -19,234
All 155,433 100.0 3.3 0.2 100.0 -86
_______________________________________________________________________________
Source: Urban-Brookings Tax Policy Center Microsimulation Model, version
0304-3
Notes: Baseline is current law minus the repeal of PEP and PEASE with
extension of expiring provisions and the AMT indexed to 2005 levels. See
source for additional notes.
Projected Revenue Gain
PEP and Pease raise federal revenues, which is especially important given the near doubling of the national debt during the last decade, the projected long term fiscal imbalance of the federal government, and the annual budget deficits projected in the near future. The President's FY2010 budget outline estimates a potential gain of $179.9 billion over FY2010-FY2019. PEP and Pease will raise approximately $21.5 billion per year on average, when fully effective.
The revenue effects of reinstating PEP and Pease provisions depend greatly on interaction between them and some other elements of the tax code. Two of the most important ones are the alternative minimum tax (AMT) and marginal tax rates. The President's FY2010 budget outline includes changes to both.
The budget outline would index to inflation the AMT parameters and reinstate 36% and 39.6% marginal tax brackets for taxpayers above the $200,000/$250,000 threshold. Both would tend to increase the revenue impact of the PEP and Pease measures. The change in the AMT would result in a smaller number of taxpayers subject to the AMT, a parallel income tax system. Thus, a larger number of taxpayers would be subject to the ordinary income tax system and PEP and Pease.
Reinstating the 39.6% and 36% rates would make the revenue effects of any reduction in the itemized deductions or exemptions larger than under the currently effective rate structure with lower marginal tax rates. This occurs because itemized deductions and exemptions reduce taxpayers' tax liability (and government receipts) at most proportionately to the marginal tax rate. Reducing personal exemptions or deductions leads to an increase in taxable income. If PEP or Pease increase taxable income by a dollar for a taxpayer in a 39.6% tax bracket, the federal revenues increase by 39.6 cents. The same increase in taxable income for a taxpayer in a 35% bracket generates only 35 cents of additional revenue for the government (about a 12% reduction).
The 28% rule proposed in the budget might also interact with Pease revenue projections. The details of the measure are currently unavailable. It is possible, however, that this interactive effect is incorporated in the revenue estimates of the 28% rule in the budget tables, rather than in the PEP and Pease entry. If this is the case, the PEP and Pease revenue projections should not be affected by the specifics of the 28% proposal or its evolution.
The revenue estimate presented by the Administration appears to be consistent with some other independent estimates discussed below. These estimates are not directly comparable, though, due to the difference in assumptions and economic projections. For estimates to be directly comparable, not only PEP and Pease reinstatement provisions should be identical, but baselines and assumptions about interacting provisions should be identical as well. Moreover, either methodology should allocate interactive effects identically. Underlying economic projections should also be similar.
In 2006, the Tax Policy Center (TPC) estimated the potential revenue effects of the PEP and Pease using the baseline of extended tax cuts and repeal of the AMT. 14 TPC estimated PEP and Pease generating on average $28.5 billion per year in FY2010-FY2015.
This average annual amount is significantly larger than the Administration's own projections of about $21.5 billion per year. There may be two reasons for that. First, the estimate assumes full repeal of the AMT, while the Administration only proposes to index the AMT parameters. Second, the estimate was performed in 2006, when economic forecasts were in all likelihood much more optimistic than the ones used in estimating the FY2010 Budget Proposal. These two factors should result in TPC's projections being higher than the Administration's.
On the other hand, the Administration does propose to repeal the elements of the 2001 tax cuts affecting many taxpayers subject to PEP and Pease. This factor should reduce the TPC's projections relative to the Administration's. On balance it appears that the Administration's estimate is consistent with the TPC's estimates, because factors increasing the TPC's estimates are likely to outweigh the ones decreasing it.
CBO provided another relevant estimate in early 2008. 15 According to this estimate, the provisions generate an average of $18.2 billion per year. At the same time, this figure does not incorporate any interactive effects. CBO provided a separate estimate for interaction, but it includes interaction among all expiring tax provisions, not only the ones related to PEP and Pease. That interactive estimate is several times larger than the estimate for PEP and Pease itself, but it is not directly relevant to the scenario proposed in the President's budget.
The Administration's and CBO's estimates appear to be consistent between themselves as well. In fact, they are fairly close, but this might be a coincidental confluence of two mutually offsetting factors. First, as discussed above, CBO's forecast does not incorporate interactions, which would tend to reduce the CBO estimate. Second, CBO's estimate relied on an economic forecast of early 2008, which probably was considerably more optimistic than the forecast of early 2009. The second factor would tend to increase the CBO estimate.
Author Contact Information
Maxim Shvedov
Analyst in Public Finance
mshvedov@crs.loc.gov, 7-4639
Acknowledgments
This report includes significant contributions from Gregg Esenwein, now retired from CRS.
1 All of the changes in EGTRRA, including the PEP and Pease provisions, will expire (sunset) after 2010. Congress included the sunset in EGTRRA to avoid a Byrd rule (Section 313 of the 1974 Congressional Budget Act, as amended) violation in the Senate. The Byrd rule prohibits "extraneous matter" in reconciliation legislation. Under the rule, extraneous matter includes, among other things, language that would cause an increase in the budget deficit (or reduce budget surpluses) in a fiscal year beyond those covered by the reconciliation legislation. As a result of the Byrd rule, EGTRRA contained language providing for the expiration of all of its provisions at the end of calendar year 2010, since the years after 2010 were outside the reconciliation budget window. For more information see CRS Report RL30862, The Budget Reconciliation Process: The Senate's "Byrd Rule" , by Robert Keith. Other procedural aspects related to the budget process are discussed in CRS Report 97-865, Points of Order in the Congressional Budget Process , by James V. Saturno; and CRS Report RL32835, PAYGO Rules for Budget Enforcement in the House and Senate , by Robert Keith and Bill Heniff Jr.
2 U.S. Congress, Joint Committee on Taxation, General Explanation of Tax Legislation Enacted in the 107 th Congress , committee print, Prepared by the Staff of the Joint Committee on Taxation, 108 th Cong., 1 st sess., January 24, 2003, JCS-1-03 (Washington: GPO, 2003), pp. 12-15.
3 Ibid.
4 U.S. Congress, Joint Committee on Taxation (JCT), Estimated Budget Effects Of The Conference Agreement For H.R. 1836 , JCX-51-01, May 26, 2001.
5 Office of Management and Budget, A New Era of Responsibility: Renewing America's Promise , Washington, DC, February 26, 2009, p. 123.
6 For additional listing of current and recent historic parameters please see CRS Report RL34498, Statutory Individual Income Tax Rates and Other Elements of the Tax System: 1988 through 2009 , by Maxim Shvedov.
7 For additional listing of current and recent historic parameters please see CRS Report RL34498, Statutory Individual Income Tax Rates and Other Elements of the Tax System: 1988 through 2009 , by Maxim Shvedov.
8 IRS, Table 2.1 --Returns with Itemized Deductions: Sources of Income, Adjustments, Itemized Deductions by Type, Exemptions, and Tax Items, by Size of Adjusted Gross Income, Tax Year 2006, http://www.irs.ustreas.gov/taxstats/indtaxstats/article/0,,id=96981,00.html.
9 U.S. Congress, Joint Committee on Taxation, General Explanation of Tax Legislation Enacted in the 107 th Congress , committee print, Prepared by the Staff of the Joint Committee on Taxation, 108 th Cong., 1 st sess., January 24, 2003, JCS-1-03 (Washington: GPO, 2003), p. 13.
10 See, for example, Commerce Clearing House (CCH), "CCH Projects Key Tax Figures for 2007," press release, September 20, 2006, http://www.cch.com/press/news/2006/20060920t.asp.
11 CRS analysis of IRS, Table 2.3 --All Returns: Exemptions by Type and Number of Exemptions, by Size of Adjusted Gross Income, Tax Year 2006, http://www.irs.ustreas.gov/taxstats/indtaxstats/article/0,,id=96981,00.html and Table 2 --Individual Income and Tax Data, by State and Size of Adjusted Gross Income, Tax Year 2006, http://www.irs.ustreas.gov/taxstats/article/0,,id=171535,00.html.
12 CRS analysis of IRS, Table 2.1 --Returns with Itemized Deductions: Sources of Income, Adjustments, Itemized Deductions by Type, Exemptions, and Tax Items, by Size of Adjusted Gross Income, Tax Year 2006, http://www.irs.ustreas.gov/taxstats/indtaxstats/article/0,,id=96981,00.html.
13 Urban-Brookings Tax Policy Center, Table T05-0023, Effects of PEP/PEASE Repeal Distribution of Federal Tax Change by Cash Income Class, 2010, Feb. 1, 2005, http://taxpolicycenter.org/numbers/displayatab.cfm?DocID=768.
14 Table T06-0001, Repeal Personal Exemption Phaseout (PEP) and Limitation on Itemized Deductions (Pease), Static Impact on Individual Income Tax Liability and Revenue ($ billions), 2006-15.
15 Congressional Budget Office, Updated Estimates for Table 4-9, "Effects of Extending Tax Provisions Scheduled to Expire Before 2018," in The Budget and Economic Outlook: Fiscal Years 2008 to 2018 , January 2008, pp. 101-106, downloaded on March 9, 2009, from https://www.cbo.gov/ftpdocs/90xx/doc9040/ExpiringProvisions.pdf.
Congressional Research Service Report for Congress --Retirement Savings and Household Wealth in 2007, April 8, 2009
April 16, 2009
111th Congress
Retirement Savings and Household Wealth in 2007
Patrick Purcell
Specialist in Income Security
April 8, 2009
Congressional Research Service
7-5700
www.crs.gov
RL30922
Summary
About half of all workers in the United States participate in an employer-sponsored retirement plan of some kind, a proportion that has remained relatively stable over the past thirty years. Beginning in the early 1980s, however, employers began to move away from traditional pension plans - also known as defined benefit (DB) plans - to defined contribution (DC) plans, like those authorized under section 401(k) of the Internal Revenue Code. Unlike DB plans, which are required by federal law to offer a benefit in the form of a life annuity, DC plans are individual accounts that typically pay the employee a lump sum at retirement. In 2007, approximately 21 million workers in the private sector participated in defined benefit plans, while more than 40 million workers participated in defined contribution plans.
One of the key distinctions between a defined benefit plan and a defined contribution plan is that in a DB plan, it is the employer who bears the investment risk. The employer must ensure that the pension plan has sufficient assets to pay the benefits promised to workers and their surviving dependents. In a DC plan, the worker bears the risk of investment losses. The worker's account balance at retirement will depend on how much has been contributed to the plan over the years and on the performance of the assets in which the plan is invested. Because DC plans and Individual Retirement Accounts (IRAs) represent a large share of the assets available to households to pay their expenses during retirement, Congress needs current, detailed information on amounts that workers have accumulated in these plans to assess both workers' preparedness for retirement and the effectiveness of the tax incentives created for retirement savings plans.
Once every three years, the Board of Governors of the Federal Reserve System collects data on household assets and liabilities through the Survey of Consumer Finances (SCF). The most recent such survey was conducted in 2007, and the survey results were released to the public in February 2009. This CRS report presents data from the 2007 SCF with respect to household ownership of, and balances in, retirement savings accounts.
Because the majority of assets held in retirement accounts are invested in stocks, trends in stock prices have a significant impact on households' retirement account balances. As a result of the broad decline in stock prices in 2008, the retirement account balances that households reported on the 2007 SCF may be greater than many of those households would report in 2009. The effect of the current recession on household finances will be reflected in the next SCF, which will be fielded in 2010. Nevertheless, the 2007 SCF provides the most comprehensive and current data available on the amount and type of retirement assets owned by American households.
In 2007, 53% of U.S. households owned at least one retirement account, whether an individual retirement account, a 401(k) plan, or other employment-based retirement account. The median combined balance of all retirement accounts owned by households with at least one account was $45,000. Twenty-five percent of households had total retirement account balances of $140,000 or more, and 25% of households had total retirement account balances of $11,000 or less.
The median value in 2007 of all retirement accounts owned by households headed by persons between the ages of 55 and 64 was $100,000. For a 65-year-old man retiring in April 2009, $100,000 would be sufficient to purchase a level, single-life annuity that would pay income of $700 per month for life, based on current interest rates. Because women have longer average life expectancies than men of the same age, $100,000 would purchase a level, single-life annuity that would pay income of $650 per month for life to a 65-year-old woman retiring in April 2009.
Contents
Trends in Retirement Plan Design
The Survey of Consumer Finances
Participation in Employer-Sponsored Retirement Plans of All Kinds
Participation in Defined Contribution Plans
Retirement Savings of American Households
Retirement Account Ownership in 2007
Retirement Account Balances in 2007
All Households
Households with One or More Workers under Age 65
Retirement Account Balances by Age of Household Head
Retirement Plan Contributions in 2007
Plan Loans
Household Net Worth
Conclusion
References
Tables
Table 1. Participation in Employer-Sponsored Retirement Plans of Any Kind
Table 2. Participation in Defined Contribution Plans: 2001, 2004, 2007
Table 3. Household Retirement Account Ownership: 2001, 2004, and 2007
Table 4. Household Retirement Account Balances: 2001, 2004, and 2007
Table 5. Household Retirement Account Balances by Age of Householder
Table 6. Monthly Contributions to Defined Contribution Plans in 2007
Table 7. Median Household Net Worth in 2001, 2004, and 2007
Contacts
Author Contact Information
Trends in Retirement Plan Design
Since the 1970s, the proportion of workers who participate in employer-sponsored retirement plans has remained relatively stable at approximately half of the workforce. Since the early 1980s, however, employers have moved away from defined benefit (DB) plans to defined contribution (DC) plans. Defined benefit plans - what most people think of as traditional pensions - are required by federal law to offer plan participants a retirement benefit in the form of a lifelong annuity. The amount of the annuity typically is based on the employee's length of service and average salary. In the private sector, DB plans usually are funded solely by employer contributions and investment earnings on those contributions. Defined contribution plans, in contrast, are more like savings accounts maintained by employers on behalf of each participating employee. In the most common type of DC plan --those established under section 401(k) of the tax code --the employee defers a portion of his or her salary, which is invested in stocks, bonds, or other assets. The employer often matches some or all of the employee's contribution to the plan. At retirement, the balance in the account is the sum of past contributions plus interest, dividends, and capital gains --or losses. The account balance is often distributed to the departing employee as a single lump sum.
One of the key distinctions between a defined benefit plan and a defined contribution plan is that in a DB plan, the employer bears the investment risk. The employer must ensure that the plan has sufficient assets to pay the benefits promised to workers and their surviving dependents. In a DC plan, the worker bears the risk of investment losses. The worker's account balance depends on how much has been contributed to the plan over the years and how the plan's underlying investments have performed. At year-end 2007, 78% of the $3.7 trillion in assets held by DC plans was invested in stocks and stock mutual funds. 1 The high percentage of DC plan assets invested in equities makes these plans sensitive to trends in stock prices. Due to the sharp decline in the major stock market indices during 2008, the total assets held by DC plans fell by almost $1.1 trillion (28%) between December 31, 2007, and December 31, 2008. By year-end 2008, the proportion of DC plan assets invested in stocks and stock mutual funds had fallen to 70%.
The Survey of Consumer Finances
This Congressional Research Service (CRS) report presents data on retirement savings account ownership and retirement account balance collected through the Survey of Consumer Finances (SCF) in 2001, 2004, and 2007. The SCF is a survey of households sponsored by the Board of Governors of the Federal Reserve System in cooperation with the Department of the Treasury. It is conducted once every three years to collect information on the assets and liabilities of U.S. households, the sources and amounts of their income, their demographic characteristics, employment, and participation in employer-sponsored health and retirement plans. Data from the SCF are widely used by economists at the Federal Reserve, other government agencies, and by private-sector research organizations and academic institutions to study trends in the amount and distribution of assets and liabilities among U.S. households. Since 1992, SCF data have been collected by the National Organization for Research at the University of Chicago (NORC). In 2001, members of 4,449 households were interviewed for the SCF. In 2004, members of 4,522 households were interviewed. 2 For the 2007 SCF, members of 4,422 households were interviewed. With the appropriate sample weights applied, the 2001, 2004, and 2007 SCF interview samples were representative of all U.S. households.
Most of the information collected in the Survey of Consumer Finances --such as total assets and liabilities --is reported at the household level. The only data that are reported separately for the householder and his or her spouse or partner describe these individuals' employment, pension coverage, and demographic characteristics. In this report, retirement plan participation is shown for employed household heads and employed spouses of household heads. 3 Contributions to retirement accounts are shown for both employed household heads and employed spouses. Their combined contributions are shown as the household's total retirement plan contributions. Account balances are shown only at the household level, i.e. as the sum of the account balances owned by the members of the household. Net worth - the sum of household assets minus the sum of household liabilities - is reported at the household level.
Data from a survey of employers - the Department of Labor's National Compensation Survey (NCS) - indicate that 61% of workers in the private sector worked for employers that sponsored retirement plans in 2007, and that 51% of private-sector workers participated in employer-sponsored retirement plans. 4 The Department of Labor's employer survey also indicates that 55% of employees in the private sector worked for employers that sponsored defined contribution plans, and that 43% of private-sector employees participated in DC plans in 2007. The rates of DC plan sponsorship and participation reported by employers on the National Compensation Survey are slightly higher than those reported by households on the SCF. Surveys of households typically find lower rates of participation in employer-sponsored retirement plans than are found in surveys of employers. In some cases, the person responding for the household is unsure what kind of retirement plan he or she participates in. Under-reporting is also common with respect to the respondent's spouse. Although the SCF reports lower participation in employer-sponsored DC plans than the NCS, it collects information that is not available from the employer survey, such as workers' demographic characteristics, their retirement account balances, and the amount of their contributions to retirement accounts.
Participation in Employer-Sponsored Retirement Plans of All Kinds
Data from the Survey of Consumer Finances indicate that 62% of workers under age 65 were employed at jobs that offered some form of employer-sponsored retirement plan in 2007. This figure includes both defined benefit plans and defined contribution plans. Forty-nine percent of workers under age 65 participated in employer-sponsored retirement plans in 2007, little changed from the 48% who participated in employer-sponsored plans in 2004 and the 50% who participated in 2001. 5 (See Table 1 .) Workers at large firms were much more likely to have been offered a retirement plan than those employed at small firms. In 2007, 77% of workers employed at firms with 100 to 499 employees, and 88% of workers employed at firms with 500 or more employees, worked for employers that offered a retirement plan of some kind. In contrast, just 15% of employees at firms with fewer than 20 employees worked for employers that offered a retirement plan in 2007. This represents a substantial drop from 2001, when 22% of employees at firms with fewer than 20 employees worked at firms that offered a retirement plan.
Full-time workers were much more likely than part-time workers to have been offered the opportunity to participate in an employer-sponsored retirement plan. In 2007, 66% of full-time workers were offered a retirement plan at work, compared to 36% of part-time workers. More than half of full-time workers (53%) participated in employer-sponsored retirement plans in 2007, compared to just 19% of part-time workers.
Table 1. Participation in Employer-Sponsored Retirement Plans of Any Kind (Working Household Heads and Spouses Under Age 65, in percent)
__________________________________________________________________________________
Offered Any Type of Participated in Any
Plan Plan
________________________________________________
2001 2004 2007 2001 2004 2007
__________________________________________________________________________________
Size of Firm
500 or more workers 88.5 86.5 87.5 69.8 69.3 70.2
100 to 499 workers 80.1 77.9 76.5 60.0 56.2 59.1
21 to 99 workers 56.0 57.8 56.6 41.9 43.0 42.5
Under 20 workers 22.4 19.5 15.4 16.9 15.1 10.9
Employment
Full-time 68.8 67.0 66.2 54.6 53.1 53.4
Part-time 38.1 38.2 36.4 21.2 23.1 19.4
Total 64.3 61.9 62.0 49.6 47.9 48.6
__________________________________________________________________________________
Source: CRS analysis of the Federal Reserve Board's 2001, 2004, and 2007 Survey
of Consumer Finances.
Notes: Data represent 109.9 million workers in 2001, 112.0 million workers in
2004, and 115.3 million workers in 2007. Data include workers in both the public
sector and the private sector.
Participation in Defined Contribution Plans
The data displayed in Table 1 show the percentage of workers participating in employer-sponsored retirement plans of any kind, whether defined benefit, defined contribution, or both types of plan. To participate in a defined contribution plan, an employee usually must elect to defer some of his or her salary into the plan. As a result, participation rates in DC plans depend on both the percentage of employers who offer a plan and the percentage of employees who elect to contribute to the plan.
Table 2 shows the percentage of private-sector workers whose employer sponsored a defined contribution plan, the percentage of workers who participated in DC plans, and the percentage of workers who were offered a plan who participated in it. This last percentage --the "take-up rate" --differs among workers with different economic and demographic characteristics.
The first three columns of Table 2 show the percentage of workers whose employer offered a DC plan in 2001, 2004, and 2007. The middle three columns show the percentage of workers who participated in DC plans in those years. 6 The last three columns show the take-up rate among employees who were offered the opportunity to participate in a DC plan. The percentage of workers whose employer offered a defined contribution plan fell from 51% in 2001 to 47% in 2004 and then rose to 49% in 2007. The percentage of workers who participated in employer-sponsored defined contribution plan also fell between 2001 and 2004 and rose from 2004 to 2007. In 2001, 38% of private-sector wage and salary workers participated in employer-sponsored DC plans. This proportion fell to 37% in 2004 and rose to 39% in 2007. The take-up rate rose throughout the period. In 2001, 74% of workers who were offered a DC plan participated in the plan. The take-up rate in DC plans rose to 78% in 2004 and to 79% in 2007.
The data presented in Table 2 show that workers under age 35, those who did not attend college, those with income in the lowest quartile, and those who worked at small firms were relatively less likely than other workers to have worked for an employer that sponsored a defined contribution retirement plan. In 2007, 46% of workers under age 35 worked for an employer that sponsored a defined contribution plan, compared to 49% of workers between the ages of 35 and 44, and 55% of those aged 45 to 54. Thirty-nine percent of workers with a high school diploma or less education worked for employers that sponsored defined contribution plans, compared to 51% of workers with some college and 60% of workers with a college degree. Only 30% of workers whose household was in the lowest income quartile worked for firms that sponsored defined contribution plans in 2007, compared to 62% of workers in the top income quartile and 55% of workers in the second-highest income quartile. Just 12% of workers employed at firms with fewer than 20 employees worked for firms that sponsored defined contribution plans in 2007, compared to 46% of workers at firms with 20 to 99 employees, 59% of workers employed at firms with 100 to 499 employees, and 70% of workers employed at firms with 500 or more employees.
Participation in defined contribution plans usually requires the employee to elect to participate in the plan. Although some plans have adopted automatic enrollment for eligible employees, almost two-thirds of DC plans continue to require employees to elect to participate in the plan. The percentage of employees offered a plan who elect to participate is called the "take-up rate." The participation rate in DC plans depends on both the percentage of workers offered a plan and the take-up rate among those whose employers sponsor a plan. Low participation rates can result from either a low percentage of employers offering a plan, a low percentage of employees who are offered a plan electing to participate, or both.
The distinction between low participation rates that result mainly from low take-up rates and those that mainly result from relatively few workers being offered a plan can have important implications for public policy. For example, only 32% of workers under the age of 35 participated in defined contribution plans in 2007. Although this was due in part to the lower percentage of these workers working for employers who sponsored plans, another important factor was the low take-up rate among younger workers who were offered a plan. Only 70% of workers under age 35 whose employers sponsored DC plans participated in those plans in 2007. In contrast, the take-up rate among workers aged 35 to 44 was 82%, and the take-up rate among workers aged 45 to 54 was 83%. 7 On the other hand, the low participation rate among employees of small firms was attributable mainly to the much lower proportion of these workers who were employed at firms that sponsored plans for their employees rather than to low take-up rates.
In 2007, only 9% of workers employed at firms with fewer than 20 employees participated in a defined contribution plan, compared to 35% of workers at firms with 20 to 99 employees, 46% of employees at firms with 100 to 499 employees, and 57% of employees at firms with 500 or more employees. It is important to note, however, that only 12% of employees who worked at firms with fewer than 20 employees worked for firms that offered DC plans to their employees. Among workers employed at firms with 20 to 99 employees, 46% worked at firms that sponsored DC plans, and among workers employed at firms with 100 to 499 employees, 59% worked for firms that sponsored DC plans. Seventy percent of workers at firms with 500 or more employees were employed by firms that sponsored a DC plan in 2007. The take-up rate in 2007 among employees at firms with fewer than 20 employees (77%) was similar to the take-up rates among workers at firms with 20 to 99 employees (75%) and only slightly lower than the take-up rates at firms with 100 to 499 employees (78%) and firms with 500 or more employees (81%). These results imply that efforts to boost plan participation among younger workers should be targeted at raising take-up rates (e.g., through automatic enrollment or more education for workers about the importance of saving for retirement), while boosting participation among workers at small firms will require policymakers to find ways to make offering a retirement plan less burdensome and costly to the employer.
Table 2. Participation in Defined Contribution Plans: 2001, 2004, 2007 (Working Householders and Spouses Under Age 65, in percent)
_______________________________________________________________________________
Participated in a
Offered a DC Plan Plan Take-up Rate
_______________________________________________________________
2001 2004 2007 2001 2004 2007 2001 2004 2007
_______________________________________________________________________________
Relationship
Householder 53.6 48.6 50.8 40.5 37.8 40.5 75.5 77.7 79.6
Spouse/partner 47.3 44.8 46.7 34.1 34.5 36.8 72.1 77.0 78.8
Age
Under 35 47.5 42.4 45.6 33.1 28.6 31.8 69.6 67.5 69.7
35 to 44 56.1 48.4 49.0 43.9 38.2 40.2 78.3 79.1 82.1
45 to 54 54.5 50.1 54.6 40.2 40.0 45.3 73.7 79.9 83.0
55 to 64 43.0 49.9 48.2 32.9 43.1 40.2 76.4 86.5 83.5
Race/ethnicity
Caucasian 52.4 50.0 51.4 39.4 39.7 41.6 75.1 79.5 80.9
Other 48.0 40.4 45.0 34.5 28.8 33.9 72.0 71.2 75.2
Sex
Male 51.3 49.5 50.4 42.1 38.7 40.9 82.2 78.1 81.1
Female 47.6 45.1 48.4 34.1 34.6 37.4 71.7 76.8 77.3
Marital status
Married 52.1 49.1 49.9 39.9 39.3 41.2 76.6 79.9 82.5
Not married 50.0 44.0 48.5 35.0 31.9 35.4 70.0 72.4 72.9
Education
College grad. 61.1 58.6 59.5 50.4 49.1 50.6 82.5 83.8 85.0
Some college 50.5 46.3 50.5 36.2 35.1 39.3 71.7 75.7 77.9
High school
less 43.9 37.8 39.4 29.3 26.5 28.6 66.9 70.2 72.7
HH Income
Top quartile 61.4 60.9 61.5 50.4 53.0 53.9 82.2 87.1 87.5
Second quartile 61.8 52.6 54.5 46.2 41.4 45.6 74.7 78.7 83.8
Third quartile 46.2 43.5 46.3 31.8 31.1 33.6 68.7 71.4 72.5
Bottom quartile 29.0 25.8 29.7 17.4 13.9 17.0 60.0 54.1 57.4
Firm size
500 or more 72.3 67.7 70.4 52.5 52.8 57.0 72.7 78.0 80.9
100 to 499 62.8 56.1 58.7 45.8 41.4 45.8 72.9 73.7 78.0
20 to 99 44.1 43.6 46.3 34.3 34.3 34.9 77.7 78.8 75.4
Under 20 17.2 14.9 11.9 14.1 11.9 9.2 82.3 80.1 76.9
Employment
Full-time 56.5 52.6 53.9 42.4 40.7 43.3 75.0 77.3 80.3
Part-time 22.3 22.9 22.0 14.7 17.6 14.3 65.7 76.7 65.3
Union status
Union 67.2 58.4 62.3 46.1 45.4 49.5 68.6 77.6 79.5
Non-union 48.1 45.3 47.1 36.6 35.1 37.4 76.1 77.5 79.3
Total 51.4 47.3 49.4 38.2 36.7 39.2 74.4 77.5 79.3
_______________________________________________________________________________
Source: CRS analysis of the Federal Reserve Board's 2001, 2004, and 2007
Survey of Consumer Finances .
Notes: Data represent 109.9 million workers in 2001, 112.0 million workers in
2004, and 115.3 million in 2007.
Retirement Savings of American Households
With the trend away from defined benefit plans to defined contribution plans, workers now bear much of the responsibility of preparing for retirement. Workers who contribute to DC plans, such as those authorized under sections 401(k), 403(b), and 457 of the Internal Revenue Code, or to an IRA can accumulate retirement savings on a tax-deferred basis while they are working. 8
The following tables show the retirement savings of all households and of households in which there was at least one worker under age 65. According to the SCF, of the 116.1 million U.S. households in 2007, there were 81 million households in which either the household head, the household head's spouse, or both, were employed adults under age 65.
Retirement Account Ownership in 2007
Data from the SCF show that the percentage of households that owned a retirement account of some kind --whether an individual retirement account (IRA) or a 401(k) plan or other DC plan --fell from 2001 to 2004 and rose from 2004 to 2007. (See the top panel of Table 3 .) Fifty-three percent of all households owned at least one retirement account in 2007, compared to 51% in 2004 and 53% in 2001. Thirty-eight percent of households owned a defined contribution plan from current or past employment in 2007, compared to 36% in 2004 and 35% in 2001. Thirty-one percent of households owned an IRA or Keogh plan in 2007, compared to 29% in 2004 and 31% in 2001. In 2007, 15% of households owned both a defined contribution account from current or past employment and an IRA or Keogh plan. This was up slightly from 14% in 2004 and 13% in 2001.
Sixty-three percent of households in which either the household head, the household head's spouse, or both, were workers under age 65 owned a retirement account of some kind in 2007. (See the bottom panel of Table 3 .) This was higher than in 2004, but roughly the same percentage as in 2001. Fifty percent of households with at least one worker under age 65 owned a defined contribution plan from current or past employment in 2007, compared to 47% in both 2004 and 2001. Thirty-three percent of households with one or more workers under age 65 owned an IRA or Keogh plan in 2007. This was three percentage points higher than in 2004 and the same percentage as in 2001. Twenty percent of households with one or more workers under age 65 owned both a defined contribution account from current or past employment and also owned an IRA or Keogh plan in 2007. This was up slightly from 18% in both 2004 and 2001.
Table 3. Household Retirement Account Ownership: 2001, 2004, and 2007
____________________________________________________________________________________
All Households 2001 2004 2007
____________________________________________________________________________________
Number of households, in thousands 106,496 112,109 116,122
Percent with either an IRA/Keogh or a defined
contribution plan 52.8 51.1 53.4
Percent with a defined contribution plan a 34.7 35.8 37.7
Percent with an IRA or Keogh plan b 31.3 29.0 30.6
Percent with both an IRA/Keogh plan and a defined
contribution plan 13.2 13.7 14.7
Percent with neither IRA/Keogh nor a defined
contribution plan 47.2 48.9 46.4
____________________________________________________________________________________
Households with a worker under age 65 2001 2004 2007
____________________________________________________________________________________
Number of households, in thousands 75,693 79,622 80,997
Percent with either an IRA/Keogh or a defined
contribution plan 62.5 59.4 63.2
Percent with a defined contribution plan a 47.3 47.3 50.2
Percent with an IRA or Keogh plan b 33.0 29.9 32.5
Percent with both an IRA/Keogh plan and a defined
contribution plan 17.8 17.8 19.5
Percent with neither IRA/Keogh nor a defined
contribution plan 37.5 40.6 36.8
____________________________________________________________________________________
Source: CRS analysis of the Federal Reserve Board's 2001, 2004, and 2007 Survey of
Consumer Finances .
a. Includes DC accounts from current and past jobs. Household may also have owned
an IRA or Keogh plan.
b. Household ay also have owned a defined contribution plan.
Retirement Account Balances in 2007
All Households
As shown in Table 3 , 53% of all households owned at least one retirement account in 2007. Table 4 shows the balances in these accounts at the 50 th percentile (the median), as well as at the 75 th and 25 th percentiles. In 2007, among all households that owned one or more retirement accounts, the median balance of all accounts owned by those households was $45,000. This was $5,430 more than the median balance of all household retirement accounts in 2004, and $9,940 higher than the median balance of household retirement accounts in 2001. (All amounts shown in Table 4 have been adjusted to 2007 dollars.) Twenty-five percent of all households with at least one retirement account in 2007 had retirement savings of $140,000 or more and 25% of households with one or more accounts had retirement savings of $11,000 or less.
Among households that owned one or more defined contribution accounts from current or past employment of the householder or the householder's spouse, the median combined balance of all DC accounts owned by the household in 2007 was $35,000. Twenty-five percent of households with at least one defined contribution account had account balances of $110,000 or more in 2007, and 25% of households with one or more DC accounts had balances of $8,900 or less.
Among households that owned one or more individual retirement accounts or Keogh accounts for the self-employed, the median combined balance of all IRAs and Keogh accounts owned by those households in 2007 was $34,000. Twenty-five percent of all households with at least one IRA or Keogh account in 2007 had IRA/Keogh balances of $100,000 or more and 25% of households with one or more IRAs or Keogh accounts had balances of $10,000 or less.
Households with One or More Workers under Age 65
The median value in 2007 of all retirement accounts owned by households with at least one worker under age 65 was $45,000. Twenty-five percent of all households with one or more workers had combined retirement account balances of $137,700 or more, and 25% of households with at least one worker under 65 had total retirement account balances of $10,220 or less.
Among households with one or more workers under age 65 that owned one or more defined contribution accounts from current or past employment of the householder or the householder's spouse, the median combined balance of all defined contribution accounts owned by the household in 2007 was $32,500. Twenty-five percent of all worker households with at least one defined contribution account in 2007 had DC plan balances of $106,000 or more and 25% of households with one or more DC accounts had combined DC account balances of $8,700 or less.
Among the households with one or more workers under age 65 that owned one or more individual retirement accounts or Keogh accounts for the self-employed, the median combined balance of all IRAs and Keogh accounts owned by the household in 2007 was $30,000. Twenty-five percent of all households with at least one IRA or Keogh account in 2007 had account balances of $89,500 or more, and 25% of households with one or more IRAs or Keogh accounts had account balances of $9,600 or less.
Table 4. Household Retirement Account Balances: 2001, 2004, and 2007 (Amounts in 2007 dollars)
__________________________________________________________________________________
All households with retirement accounts 2001 2004 2007
__________________________________________________________________________________
Households with any type of retirement account
Combined balance of all retirement accounts:
75 th percentile $111,250 $131,900 $140,000
50 th percentile (median) 35,060 39,570 45,000
25 th percentile 8,180 10,990 11,000
Households with one or more defined contribution accounts a
Combined balance of all defined contribution accounts:
75 th percentile 75,960 100,130 110,000
50 th percentile (median) 23,370 29,680 35,000
25 th percentile 5,840 8,240 8,900
Household with one or more IRA or Keogh accounts b
Combined balance of all IRA/Keogh accounts:
75 th percentile 93,490 109,910 100,000
50 th percentile (median) 31,550 32,970 34,000
25 th percentile 9,000 9,000 10,000
__________________________________________________________________________________
Households with a worker under age 65 2001 2004 2007
__________________________________________________________________________________
Households with any type of retirement account
Combined balance of all household retirement accounts:
75 th percentile $99,330 $131,670 $137,700
50 th percentile (median) 31,550 37,370 45,000
25 th percentile 7,010 10,880 10,220
Households with one or more defined contribution accounts a
Combined balance of all defined contribution accounts:
75 th percentile 72,450 98,920 106,000
50 th percentile (median) 23,370 29,680 32,500
25 th percentile 5,840 8,570 8,700
Households with one or more IRA or Keogh accounts b
Combined balance of all IRA/Keogh accounts:
75 th percentile 75,960 94,520 89,500
50 th percentile (median) 24,540 30,550 30,000
25 th percentile 7,010 7,690 9,600
__________________________________________________________________________________
Source: CRS analysis of the Federal Reserve Board's 2001, 2004, and 2007 Survey
of Consumer Finances .
a. Includes defined contribution plans from current and past jobs. May also have
owned an IRA or Keogh plan.
b. May also have owned a defined contribution plan.
Retirement Account Balances by Age of Household Head
An individual's age is an important consideration when evaluating the adequacy of his or her retirement savings. The more time that a person has until reaching retirement, the greater the opportunity to make additional contributions and for investment earnings to build up his or her retirement account balance. Table 5 shows rates of retirement account ownership and average retirement account balances, categorized by the age of the household head.
Between 2004 and 2007, the percentage of households that owned a retirement account of any kind rose among households headed by persons aged 45 to 54 and among households headed by persons aged 65 and older. It remained relatively stable among other age groups. In 2007, 43% of households in which the householder was under age 35 owned one or more retirement accounts. Among households in which the householder was 35 to 44 years old, 59% owned at least one retirement account, as did 66% of households headed by persons aged 45 to 54 and 62% of households headed by persons aged 55 to 64. Forty-one percent of households headed by persons aged 65 and older owned a retirement account in 2007.
The median combined balance of all retirement accounts owned by households with at least one such account was $45,000 in 2007. The median balance of household retirement accounts was just $9,600 among households headed by persons under age 35. Median balances were progressively higher for the next three age groups. Households headed by persons aged 35 to 44 had median retirement savings of $37,000 in 2007. Households headed by persons aged 45 to 54 had median retirement savings of $63,000, and households headed by persons aged 55 to 64 had median retirement savings of $100,000 in 2007. Among households with at least one retirement account that were headed by persons aged 65 and older, the median combined balance of all household retirement accounts was $60,800 in 2007.
Table 5. Household Retirement Account Balances by Age of Householder (Number of households in thousands; Account balances in 2007 dollars)
_________________________________________________________________________________
Households Percent Mean Median
Age of Number of with with Value, all Value, all
householder Households Accounts Accounts Accounts Accounts
_________________________________________________________________________________
2001
_________________________________________________________________________________
Under 35 24,211 11,067 45.7% $22,262 $ 8,180
35 to 44 23,751 14,837 62.5 76,573 33,890
45 to 54 21,941 14,063 64.1 152,920 56,090
55 to 64 14,107 8,395 59.5 230,540 64,270
65 or older 22,486 7,913 35.2 178,180 64,270
All households 106,496 56,275 52.8% $122,227 $35,060
_________________________________________________________________________________
2004
_________________________________________________________________________________
Under 35 24,874 10,254 41.2% $29,786 $12,090
35 to 44 23,115 13,550 58.6 78,008 30,775
45 to 54 23,279 13,892 59.7 163,656 65,946
55 to 64 17,086 10,938 64.0 253,048 93,424
65 or older 23,755 8,707 36.7 188,822 57,153
All households 112,109 57,340 51.1% $140,350 $39,570
_________________________________________________________________________________
2007
_________________________________________________________________________________
Under 35 25,148 10,708 42.6% $25,279 $ 9,600
35 to 44 22,745 13,306 58.5 81,308 37,000
45 to 54 24,120 15,968 66.2 156,124 63,000
55 to 64 19,564 12,199 62.4 271,920 100,000
65 or older 24,545 10,050 40.9 207,321 60,800
All households 116,122 62,231 53.6% $148,579 $45,000
_________________________________________________________________________________
Source: CRS analysis of the Federal Reserve Board's 2001, 2004, and 2007 Survey
of Consumer Finances .
Note: Includes defined contribution plan account balances from both current and
past employment.
Retirement Plan Contributions in 2007
In defined contribution plans, the benefit available to the worker is the amount in his or her account. The account balance depends on the amount that the employer and employee have contributed to the plan, the investment gains or losses on those contributions, and the fees charged to participants. The maximum permissible annual contribution is limited by federal law, but very few workers contribute amounts near the legal maximum. 9 Table 6 shows workers' monthly contributions to defined contribution plans in 2007.
The top panel of Table 6 shows the distribution of employee salary deferrals, employer contributions, and total contributions from the employee and employer. Contributions are shown separately for householders and for spouses that participated in DC plans, and also at the household level. Household contributions are the combined contributions made by householders and their spouses.
The median monthly salary deferral by household heads in 2007 was $280. This is equivalent to $3,360 on an annual basis. 10 Twenty-five percent of household heads that contributed to a DC plan in 2007 contributed $600 or more per month, and 25% contributed $130 or less. The median monthly salary deferral by spouses of household heads in 2007 was $200. This is equivalent to $2,400 on an annual basis. Twenty-five percent of spouses of household heads that contributed to a DC plan in 2007 contributed $430 or more per month and 25% contributed $100 or less.
The median monthly contribution in 2007 by employers of household heads was $180 and the median monthly contribution by employers of spouses was $130. The median monthly total contribution --including both employee deferrals and employer contributions --was $420 for working householders who participated in DC plans and $300 for working spouses.
Just as retirement account balances may be considered a financial resource of the entire household, so too are contributions to retirement plans generally made for the future retirement security of both the householder and his or her spouse. Table 6 shows the combined contributions of the householder and spouse and their employers. The median monthly household contribution in 2007 among households in which either the householder, the householder's spouse or both contributed to a DC plans was $290. Twenty-five percent of households contributed $656 per month or more, and 25% of households contributed $130 per month or less. The median monthly employer contribution in 2007 among households in which employers made contributions on behalf of either the householder, the householder's spouse, or both was $190. Twenty-five percent of households received monthly employer contributions of $360 or more, and 25% of households received employer contributions of $92 per month or less. The median monthly total contribution to DC plans in 2007 from all sources --the householder, the householder's spouse, and/or an employer --was $440. In 25% of households, monthly contributions from all sources were $920 or more, and in 25% of households total monthly contributions were $208 or less.
The bottom panel of Table 6 shows employee contributions, employer contributions, and total contributions to DC plans in 2007 as a percentage of earnings. The median employee salary deferral by household heads who contributed to a DC plan in 2007 was 6.0% of the household head's earnings. The median salary deferral by working spouses who contributed to a DC plan in 2007 was 6.0% of the spouse's earnings. The median salary deferral by households in which either the householder or the householder's spouse contributed to a DC plan in 2007 was 5.1% of total household earnings.
Table 6. Monthly Contributions to Defined Contribution Plans in 2007 (Monthly Contributions in dollars and as a percentage of earnings)
________________________________________________________________________________
Relationship to Employee Employer Total
Householder Contributions Contributions Contributions
____________________________________________________________________________________
Householder
75 th percentile $600 $330 $845
50 th percentile
(median) 280 180 420
25 th percentile 130 90 200
Spouse/partner
75 th percentile $430 $242 $630
50 th percentile
(median) 200 130 300
25 th percentile 100 60 150
Householder and Spouse/partner
75 th percentile $656 $360 $920
50 th percentile
(median) 290 190 440
25 th percentile 130 92 208
____________________________________________________________________________________
Householder
____________________________________________________________________________________
75 th percentile 9.9% 5.8% 13.0%
50 th percentile
(median) 6.0 3.8 9.4
25 th percentile 3.9 2.7 6.0
Spouse/partner
75 th percentile 10.0% 5.5% 1.9%
50 th percentile
(median) 6.0 3.5 8.9
25 th percentile 3.5 2.7 5.3
Householder and Spouse/partner
75 th percentile 8.3% 5.0% 11.9%
50 th percentile
(median) 5.1 3.1 8.0
25 th percentile 2.9 1.8 4.5
____________________________________________________________________________________
Source: CRS analysis of the Federal Reserve Board's 2007 Survey of Consumer
Finances .
Notes: Householder's contributions are reported as a percentage of the
householder's earnings. Spouse's contributions are reported as a percentage of the
spouse's earnings. Household's contributions are reported as a percentage of the
household's earnings.
Plan Loans
Ten percent of households in which either the householder, the householder's spouse, or both participated in a defined contribution plan in 2007 reported that they had a loan currently outstanding against at least one plan. The mean outstanding balance of all household loans against retirement plans was $6,672 and the median household loan balance was $5,000. Twenty-five percent of all households with loans against retirement plans had outstanding balances of less than $1,800, and 25% of households outstanding loan balances of more than $9,000. Five percent of households with loans against retirement plans had outstanding loan balances of more than $20,000.
Household Net Worth
Many households have wealth other than retirement accounts on which they will be able to draw during retirement. More than 96% of workers in the United States are covered by Social Security, and about one-fifth of workers in the private sector participate in defined-benefit pension plans. 11 In addition, many households have other assets that could be used to pay expenses during retirement. For example, the most valuable asset owned by many families is their home, and some may find when they are older that they prefer to live in a smaller house or apartment, or they may choose to move to an area where property taxes and other living expenses are lower than where they lived during their working years. In addition to equity in their homes, many individuals have financial assets, equity in businesses, real estate, or other valuables that can either provide a stream of income through interest, dividends, or rents, or that can be fully or partially liquidated to finance their consumption needs during retirement. The broadest measure of net household wealth --the difference between a household's total assets and total liabilities --is called "net worth." The median net worth of all households in the United States in 2001, 2004, and 2007 is shown in Table 7 in 2007 dollars.
Table 7. Median Household Net Worth in 2001, 2004, and 2007 (Amounts in 2007 dollars)
_________________________________________________________________________________
Age of
Householder Median Net Worth Percentage Change
____________________________________________________________
2001 2004 2007 2001-2004 2004-2007
_________________________________________________________________________________
Under 35 $13,700 $15,600 $11,800 13.9% -24.4%
35 to 44 90,700 76,200 86,600 -16.0 13.6
45 to 54 155,400 158,900 182,500 2.3 14.9
55 to 64 216,800 273,100 253,700 26.0 -7.1
65 to 74 207,900 208,800 329,400 0.4 57.8
75 or older 181,600 179,100 213,500 -1.4 19.2
All households 101,200 102,200 120,300 1.0 17.7
_________________________________________________________________________________
Source: Bucks, Kennickell, Mach, and Moore, Federal Reserve Bulletin , Feb.
2009.
Between 2001 and 2004, median net worth among all U.S. households (in 2007 dollars) rose by just 1%, increasing from $101,200 to $102,200. From 2004 to 2007, median household net worth rose by almost 18% to $120,300. Changes in median net worth between 2004 and 2007 differed substantially by the age of the household head. Median net worth fell by 24% among households headed by persons under age 35, although the percentage change in net worth from 2004 to 2007 among households in this age group must be viewed in light of the small base ($15,600 in 2004) against which it is measured. Among households headed by individuals between 35 and 44 years old, median net worth rose by 14% between 2004 and 2007, increasing from $76,200 to $86,600. The median net worth of households headed by persons between the ages of 45 and 54 rose by 15% between 2004 and 2007, while median net worth fell by 7% among households headed by persons aged 55 to 64. The greatest increase in median net worth between 2004 and 2007 occurred among households headed by persons aged 65 to 74. Among these households, net worth rose from $208,800 to $329,400, an increase of nearly 58%. Households headed by persons 75 or older experienced an increase in median net worth of 18% between 2004 and 2007.
Conclusion
Are Americans saving adequately - and wisely - for retirement? The median retirement account balances reported on the 2007 Survey of Consumer Finances would not by themselves provide an income in retirement that most people in the United States would find adequate. Among the 12.2 million households headed by persons aged 55 to 64 in 2007 and that owned at least one retirement account, the median balance of all their accounts was $100,000. This is less than twice the median annual income of households in this age group. Moreover, almost 7.4 million households headed by persons 55 to 64 years old had no retirement savings accounts in 2007. Including the households with zero balances, a total of 13.5 million households headed by persons aged 55 to 64-69% of all households in this age group --had retirement account balances of less than $100,000 in 2007. Among the 81 million households that included at least one worker under age 65 in 2007, 29.8 million --or 37% --did not own a retirement savings account of any kind. The median retirement account balance among households with one or more workers under age 65 that owned a retirement account in 2007 was just $45,000.
For workers who are not included in a defined-benefit pension where they are employed --which is about 80% of all workers in the private sector --saving from current income is essential to preparing for retirement. Whether workers save by putting money into accounts that are earmarked for retirement or by accumulating other assets on which they can draw after they have retired is not necessarily important. The act of saving is of greater consequence to retirement security than the manner in which it is accomplished. Nevertheless, the fact that 30 million households that included a worker under age 65 had no retirement savings accounts in 2007 indicates that many households are not taking advantage of the tax deferrals available to virtually all workers through IRAs and to many workers through employer-sponsored retirement plans.
On the one hand, the widespread adoption of tax-favored retirement savings plans over the past 30 years indicates that many workers are taking seriously their responsibility to save for retirement. On the other hand, the balances in these accounts --even among those who are near retirement --are generally low. For example, if the median retirement account balance of $100,000 among households headed by persons 55 to 64 years old in 2007 were converted to an annuity, it would provide a monthly income of $700 per month ($8,400 annually) to a man retiring at age 65 in 2009. This amount would replace just 15% of the median income of households headed by individuals who were 55 to 64 years old in 2007. 12 Another issue that many households - particularly those nearing retirement age - must consider in the wake of the sharp decline the major stock market indices that occurred in 2008 is whether their retirement savings are adequately diversified. Although stocks have historically earned a higher average annual rate of return on investment than bonds, the annual rates of return on stocks are more volatile than the rates of return on bonds. A sharp decline in retirement account balances in the years just before - or after - retirement could throw a household's finances into disarray.
The uncertain future of Social Security and the declining prevalence of defined-benefit pensions that provide a guaranteed lifelong income have put much of the responsibility for preparing for retirement directly on workers. The low rate of personal saving in the United States and the lack of any retirement savings accounts among millions of American households indicate that there is a need for greater awareness among the public about the importance of setting aside funds to prepare for life after they have stopped working. Most workers in the United States will need to begin saving more of their income if they wish to maintain a standard of living in retirement comparable to that which they enjoyed while working. The alternatives would be to work longer or to greatly reduce their standard of living when they retire.
References
Brian K. Bucks, Arthur B. Kennickell, Traci L. Mach, and Kevin B. Moore. "Changes in U.S. Family Finances from 2004 to 2007: Evidence from the Survey of Consumer Finances." The Federal Reserve Bulletin , February 2009. http://www.federalreserve.gov/pubs/bulletin/2009/pdf/scf09.pdf
Author Contact Information
Patrick Purcell
Specialist in Income Security
ppurcell@crs.loc.gov, 7-7571
1 Board of Governors of the Federal Reserve System, Flow of Funds Accounts of the United States: Flows and Outstandings, Fourth Quarter 2008, March 12, 2009, p. 113.
2 For more information, see http://www.federalreserve.gov/pubs/oss/oss2/scfindex.html.
3 This report refers to households rather than to families because the unit of analysis in the SCF is more comparable to the Census Bureau's definition of a household than to its definition of a family. In the survey, the household head is designated as the male in a mixed-sex couple and the older person in a same-sex couple. The SCF staff note that this designation is not intended to convey a judgment about how an individual family is structured. It is merely a means of organizing the data consistently. For more information, see Bucks, Kennickell, Mach, and Moore, Federal Reserve Bulletin , 2009 or refer to the survey documentation on the Federal Reserve Board's website at http://www.federalreserve.gov/Pubs/OSS/oss2/2007/scf2007home.html.
4 U.S. Department of Labor, Bureau of Labor Statistics, National Compensation Survey: Employee Benefits in Private Industry in the United States, March 2007, Summary 07-05, August 2007.
5 The data presented in Table 1 reflect the plan participation of workers who were identified as either the household head or the spouse or partner of the household head.
6 ERISA allows employers to exclude workers who have completed less than one year of service or who work fewer than 1,000 hours during the year.
7 The take-up rate is the percentage of workers who participated divided by the percentage offered a plan. For workers under age 35, the take-up rate in 2007 was 0.318/0.456 = 0.697.
8 In a traditional IRA, pre-tax contributions can be made only if the worker is not covered by an employer-sponsored retirement plan or has income below amounts specified in law. Taxes are deferred on contributions and investment earnings until money is withdrawn from the account. Roth IRAs accept only after-tax contributions; however, qualified withdrawals from a Roth IRA are tax-free.
9 The maximum annual employee salary deferral into a defined contribution plan is limited by I.R.C. §402(g). As amended by P.L. 107-16, this limit was set at $11,000 in 2002 and increased in $1,000 dollar increments to $15,000 in 2006. Since 2007, the limit has been indexed to the Consumer Price Index in $500 increments. The limit in 2009 is $16,500. I.R.C. §415(c) limits the total annual addition to defined contribution plans --comprising the sum of employer and employee contributions. The §415(c) limit in 2009 is $49,000.
10 The maximum permissible employee salary deferral under I.R.C. §402(g) in 2007 was $15,000.
11 All permanent federal employees and about four-fifths of employees of state and local governments participate in defined benefit pension plans.
12 In 2007, the median income of households headed by persons aged 55 to 64 was $54,600.
Congressional Research Service Report for Congress --Health Care Flexible Spending Accounts, April 9, 2009
April 16, 2009
111th Congress
Health Care Flexible Spending Accounts
Bob Lyke
Janemarie Mulvey
Specialist in Aging Policy
April 9, 2009
Congressional Research Service
7-5700
www.crs.gov
RL32656
Summary
Health care Flexible Spending Accounts (FSAs) are benefit plans established by employers to reimburse employees for health care expenses such as deductibles and copayments. FSAs are usually funded by employees through salary reduction agreements, although employers are permitted to contribute as well. The contributions to and withdrawals from FSAs are tax-exempt.
Historically, health care FSA contributions were forfeited if not used by the end of the year. However, in 2005 the Internal Revenue Service (IRS) formally determined that employers may extend the deadline for using unspent balances up to 2 1/2 months after the end of the plan year (i.e, until March 15 for most plans). The Tax Relief and Health Care Act of 2006 (P.L. 109-432) allows individuals to make limited, one-time rollovers from balances in their health care FSAs to Health Savings Accounts. In the 110 th Congress, as in previous Congresses, legislation has been introduced to permit part or all of remaining balances to be rolled over to accounts next year or to qualified retirement accounts.
According to the Bureau of Labor Statistics National Compensation Survey, 33% of all workers in 2007 had access to a health care flexible spending account. When viewed by firm size, 51% of workers in firms with more than 100 workers had access to a health care FSA. The accounts were not as common for workers in small businesses. In establishments with fewer than 100 employees, 17% of the workers could choose to participate in an FSA. The average employee participation rate for FSAs has been very stable over the past decade. According to a 2008 Mercer Survey, 22% of employees participated in an FSA in 2008 (compared to 21% the prior year). In 2003, FSAs became available to federal employees for the first time. In September 2008, about 240,000 federal employees had health care FSAs.
These other points might be noted about health care FSAs:
FSAs are limited to employees and former employees.
The IRS imposes no dollar limit on health care FSA contributions, but employers generally do.
FSAs generally can be used only for unreimbursed medical expenses that would be deductible under the Internal Revenue Code, but not for health insurance or long-term care insurance premiums.
Employers may impose additional restrictions.
In the 111 th Congress two legislative proposals regarding health care FSAs have been introduced as of the date of this report. H.R. 544 allows up to $500 of unused FSA funds to be either carried forward to next year or contributed to a health savings account or a qualified retirement plan. H.R. 1495 includes a provision to permit up to $500 of unused health FSA funds to be carried over to the next year or to be paid as employee compensation. Health care FSAs are different from Health Savings Accounts (HSAs), Health Reimbursement Accounts (HRAs), and Archer Medical Savings Accounts (MSAs). See CRS Report RS21573, Tax-Advantaged Accounts for Health Care Expenses: Side-by-Side Comparison , by Bob Lyke and Chris L. Peterson.
This report will be updated for new data or as legislative activity occurs.
Contents
Background
Basis for Tax Treatment
Data on Access and Participation
Principal Rules Regarding FSAs
Eligibility
Contributions
Qualifying Expenses
Nonqualified Withdrawals
Carryover of Unused Funds
Interaction with Other Health Accounts
Current Legislation
Contacts
Author Contact Information
Additional Author Information
Health care Flexible Spending Accounts (FSAs) are employer-established benefit plans to reimburse employees for specified health care expenses as they are incurred. They arose in the 1970s as a way to provide employees with a flexible benefit at a time when the cost of health care was a growing concern. In contrast to traditional insurance plans, FSAs generally allow employees to vary benefit amounts in accordance with their anticipated health care needs. FSAs can be used for unreimbursed medical expenses, and contributions to FSAs have tax advantages. However, FSA contributions are generally forfeited if not used by the end of the year, although employers may extend the deadline for using unspent balances up to 2 1/2 months after the end of the plan year (i.e., March 15 for most plans).
This report 1 describes FSAs, the basis for their tax treatment, and data on their use. 2 The report concludes with a brief discussion of recent legislative proposals affecting FSAs.
Background
FSAs are employer-established benefit plans that reimburse employees for specified expenses as they are incurred. They usually are funded through salary reduction arrangements under which employees receive less take-home pay in exchange for contributions to their accounts. Employees each year choose how much to put in their accounts, which they may use for dependent care, adoption assistance, or for medical and dental expenses. However, there must be separate accounts for these three purposes, and amounts unused at the end of the year must be forfeited to the employer. If FSAs meet these and other rules, contributions are not subject to either income or employment taxes. The focus of this report is on the FSAs devoted to health care.
To illustrate the tax savings, consider a health care FSA funded for an employee through a salary reduction arrangement. Before the start of the year, the employee elects to reduce his salary by $75 a month in exchange for contributions of that amount to the FSA. Other employees might choose to contribute more or less than $75. Throughout the year, as the employee incurs medical and dental expenses not covered by insurance or other payments, he may use funds in the account to pay them. His total draw, which must be available at the start of the year, is limited to $900 (the sum of his monthly contributions for the year). If all $900 is used the first nine months, for example, he cannot replenish the account until the next year. Any amount that remains unspent at the end of the year (or after the 2 1/2 month extension, if available) is forfeited to the employer. 3 If the FSA was funded by the employer, as sometimes is the case, the employee's draw must similarly be available at the start of the year. It is possible for FSAs to be funded both by salary reductions and employer contributions.
If the employee were in the 25% tax bracket, the federal income tax savings from the $900 salary reduction used to fund the account generally would be $225 (i.e., $900 0.25); in addition, the employee could save $69 in Social Security and Medicare taxes (i.e., $900 .0765). 4 There could be state income tax savings as well. If the employee were in the 15% tax bracket, the federal income tax savings would be $135, three-fifths as large, while if he were in the top 35% bracket they would be commensurately greater, $315). 5
The employer would also save $69 in employment taxes from the $900 salary reduction. Employers often use these savings to help pay the expenses of administering an FSA.
Tax savings can exceed losses due to forfeiture of a remaining balance at the end of the year; thus, not all of an account must be used for employees to come out ahead financially. Since tax savings are greater in the higher tax brackets, higher income employees may be less concerned about forfeitures (assuming they recognize they could still be better off) than lower income employees. 6
The tax savings associated with a health care FSA are not unlike those for traditional comprehensive health insurance, which also allows employer payments to be excluded from the income and employment taxes of the employees as well as from the employment taxes of the employer.
Basis for Tax Treatment
FSAs are one way that employment benefits can be varied to meet the needs of individual employees without loss of favorable tax treatment. Flexible benefit arrangements generally qualify for tax advantages as "cafeteria plans," under which employees choose between cash (typically take-home pay) and certain nontaxable benefits (in this case, reimbursements for health care expenses) without paying taxes if they select the benefits. The general rule is that when taxpayers have an option of receiving cash or nontaxable benefits they are taxed even if they select the benefits; they are deemed to be in constructive receipt of the cash since it is made available to them. Section 125 of the Internal Revenue Code provides an express exception to this rule when certain nontaxable benefits are chosen under a cafeteria plan. 7
FSAs and cafeteria plans are closely related, but not all cafeteria plans have FSAs and not all FSAs are part of cafeteria plans. FSAs are considered part of a cafeteria plan when they are funded through voluntary salary reductions ; this exempts the employee's choice between cash (the salary subject to reduction) and normally nontaxable benefits (such as health care) from the constructive receipt rule and permits the latter to be received free of tax. 8 Thus, instead of receiving a full salary (for example, $30,000), the employee can receive a reduced salary of $29,100 with a $900 FSA contribution and will need to treat only $29,100 as taxable income.
However, if FSAs are funded by nonelective employer contributions then their tax treatment is not governed by the cafeteria plan provisions in Section 125; in this situation, the employee does not have a choice between receiving cash and a normally nontaxable benefit. Instead, the benefits are nontaxable since they are directly excludable under some other provision of the Code. For example, nonelective employer-funded FSAs for dependent care are tax-exempt under Section 129, while nonelective employer-funded FSAs for health care are tax-exempt under Sections 105 and 106.
Regardless of how they are funded, rules regarding FSAs are not spelled out in the Internal Revenue Code; 9 rather, they were included in proposed regulations that the Internal Revenue Service (IRS) issued for cafeteria plans in 1984 and 1989. 10 Final rules regarding circumstances in which employers may allow employees to change elections during a plan year were issued in March 2000 and January 2001. 11 To be exempt from the constructive receipt rule, participants must not have cash or taxable benefits become "currently available"; they must elect specific benefits before the start of the plan year and be unable to change these elections except under specified circumstances. With respect to health care FSAs,
the maximum amount of reimbursement (reduced by any benefits paid for covered expenses) must be available throughout the coverage period;
coverage periods generally must be 12 months (to prevent employees from contributing just when they anticipate having expenses);
reimbursements must be only for medical expenses allowable as deductions under Section 213 of the Code;
claims must be substantiated by an independent third party;
expenses must be incurred during the period of coverage;
after year-end forfeitures, any "experience gains" (the excess of total plan contributions and earnings over total reimbursements and other costs) may at the employer's discretion be returned to participants or used to reduce future contributions, provided individual refunds are not based on participants' claims; 12 and
health care FSAs must exhibit the risk-shifting and risk-distribution characteristics of insurance. 13
The effect of the IRS rules is to allow only forfeitable FSAs under which employees lose whatever they do not spend each year. The rules disallow three other types of FSAs that had started to spread before 1984: benefit banks , which refunded unused balances as taxable compensation at the end of each year; ZEBRAs , or zero-based reimbursement accounts, under which reimbursements were subtracted from salaries each month (thus reducing taxable compensation at the time it was paid); and ultimate ZEBRAs , under which salaries already paid were recharacterized at the end of the year into reimbursements and taxable compensation. Neither ZEBRAs nor ultimate ZEBRAs had accounts that were funded, and they were criticized as abusive arrangements.
In August 2007, the IRS issued new proposed rules for cafeteria plans that will generally be effective on January 1, 2010, though taxpayers may adopt them sooner. The proposed rules generally preserve rules set out in regulations from 1984 and 1989 that were never finalized. The new rules also reflect changes in tax law from the last 20 years. One key area of the proposed rules are detailed requirements for nondiscrimination testing. Nondiscrimination testing measures whether a plan disproportionately favors highly compensated employees. All cafeteria plans will have to comply with these rules even those that currently do not undertake such testing. The August 2007 proposed rule, however, has not yet been finalized. 14
The IRS rules lay out what is permissible with respect to FSA plans, but employers may add their own requirements. For example, the IRS does not limit the amount that an employee can be reimbursed through a health care FSA, but employers may establish their own ceiling. 15 (One reason they might do so is to limit the financial risk that employees might resign having received reimbursements that exceed their contributions.) Similarly, employers may exclude certain elective expenses from their plans.
FSAs can provide tax savings for the first dollars of health care expenditures that people have each year, similar to the tax savings associated with comprehensive insurance plans having negligible deductibles and copayments. However, taxpayers normally are allowed to deduct out-of-pocket medical expenses only to the extent they exceed 7 1/2 % of adjusted gross income, and then only if the taxpayer itemizes deductions. The more favorable treatment for FSAs might be justified since participants generally assume additional financial risk for their health care. Some might question, however, whether the savings are proportional to the risk and whether they are equitable among people of similar incomes.
Data on Access and Participation
Few surveys ask about FSAs, and those that do obtain only limited information. The two surveys that are available report different measures of access. The first survey from the Bureau of Labor Statistics (BLS) reports the percent of workers who have access to health care FSAs. According to the BLS survey, 33% of all workers in 2007 had access to a health care flexible spending account. When viewed by firm size, 51% of workers in firms with more than 100 workers had access to one. The accounts were not as common for workers in small businesses. In establishments with fewer than 100 employees, 17% of the workers had access to a health FSA. 16 The second survey from Mercer reports the share of employers offering FSAs . According to the Mercer Employer Benefit Survey, more than four-fifths of large employers (83%) offered a health care FSA to their employees in 2008. Among small employers (those with less than 500 employees), 26% offered a health care FSA.
The federal government began to offer FSAs to its employees in July 2003. As of September 2008, there were about 240,000 federal health care FSAs. 17
Despite high percentage of employers offering FSAs, the average participation rate among employees has been much lower. According to a 2008 Mercer Survey, 22% of employees of large firms participated in an FSA in 2008 (compared to 21% the prior year). The average annual contribution was $1,380. 18
Reasons for low FSA participation include employee perceptions of complexity, concerns about end-of-year forfeitures, and limited employer encouragement. Younger employees, particularly if single, may not have enough health care expenses to make participation worthwhile. For lower income employees, the tax savings may be inconsequential.
The modest participation levels suggest that early concerns about the extent to which FSAs would reduce tax revenue may have been exaggerated. In 1985, a congressionally mandated study concluded that forfeitable FSAs would increase health expenditures by approximately 4% and 6%, depending on an employee's health plan, and that revenue loss would be $7 billion (in 1983 dollars). 19 However, the study assumed that all employees with employment-based health insurance would eventually have FSAs. Moreover, the revenue estimate did not reflect any reduction in health care use from additional cost-sharing requirements that employers sometimes impose when implementing FSAs. These reductions would partially offset increases in health care use due to funding FSAs with pre-tax dollars. 20
Principal Rules Regarding FSAs
Eligibility
Eligibility for FSAs is limited to employees whose employers offer plans; people who are self-employed or unemployed generally cannot participate. However, former employees can be eligible provided the plan is not established predominantly for their benefit. 21 Employers may set additional conditions for eligibility.
FSAs allow coverage of a spouse and dependents. FSAs do not have to be linked with any particular type of insurance, though it is said some employers establish FSAs in order to win employee acceptance of greater cost-sharing in plans with higher deductibles.
Contributions
FSA contributions may be made by employers (through nonelective payments), employees (through salary reduction plans), or both. FSA contributions occur during the plan year, which is usually a calendar year. Since most FSAs are funded through salary reductions, contributions typically occur pro-rata throughout the year.
The IRS imposes no specific dollar limit on health care FSA contributions, though plans typically have a dollar or percentage maximum for elective contributions made through salary reductions. 22 Employers set limits to reduce losses from employees who quit or die when their withdrawals (which might total the year's allowable draw) exceed their contributions from salary reductions. For 2008, each federal employee may contribute up to $5,000 to his or her health care FSA.
Qualifying Expenses
Under IRS guidelines, health care FSAs can be used for any unreimbursed (and unreimbursable) medical expense that is deductible under Section 213 of the Internal Revenue Code, with several important exceptions. 23 One exception disallows their use for long-term care and for other health insurance coverage, including premiums for any employer plan. A second exception is that FSAs may cover nonprescription drugs. Employers may add their own limitations.
The restriction against paying health insurance premiums can be circumvented if the employer offers a separate premium conversion plan. This arrangement allows employees to pay their premiums through what are deemed to be pre-tax salary reductions. For example, if employees pay $600 a year for health insurance (with their employer paying the balance), their payment can be considered to be made directly by their employer (and so exempt from income and employment taxes) instead of included in their wages (and so taxable). Premium conversion plans are common among businesses that offer health insurance, particularly among large companies. The federal government implemented a premium conversion plan in October 2000.
Nonqualified Withdrawals
FSA funds may be used only for qualifying expenses, as defined above; they generally cannot be withdrawn for other purposes. To ensure compliance, reimbursement claims must be accompanied by a written statement from an independent third party (e.g., a receipt from a health care provider).
One exception to the rule prohibiting nonqualified withdrawals is that military reservists called to active duty for at least 179 days or for an indefinite period may receive some or all of the unused funds in their account. Employers are permitted but not required to allow these withdrawals.
Carryover of Unused Funds
Historically, FSA balances unused at the end of the year were forfeited to the employer; they could not be carried over. 24 On August 23, 2004, Senator Grassley, then chairman of the Senate Committee on Finance, requested the Treasury Department to assess whether it had the authority to modify the "use or lose it" rule without a directive from the legislative branch. On December 23, 2004, Treasury Secretary John W. Snow responded by letter that Congress had effectively ratified the rule and that changes would require legislative action.
Nonetheless, on May 18, 2005, the IRS issued a notice that employers may extend the deadline for using unspent balances up to 2 1/2 months after the end of the plan year (i.e, until March 15 for most plans). 25 FSAs are still subject to the "use it or lose it" rule; however, the notice allows employers to offer access to the FSAs for up 14 1/2 months instead of 12 months.
The rationale for the new notice is based on other benefits covered under the section of the Internal Revenue Code dealing with cafeteria plans, Section 125. Cafeteria plans may not include a benefit that defers compensation, which is the basis of the "use it or lose it" rule. However, according to the new notice, payment from a plan is not considered deferred compensation even if the payment occurs after the end of the plan year if that payment occurs within "a short, limited period" after the end of the plan year. The notice cites other regulations and rulings stating that benefits are not considered deferred if they "are received by the employee on or before the fifteenth day of the third calendar month after the end of the employer's taxable year [that is, March 15].... Consistent with these other areas of tax law, Treasury and the IRS believe it is appropriate to modify the current prohibition on deferred compensation in the proposed regulations under § 125 to permit a grace period after the end of the plan year during which unused benefits or contributions may be used."
The employer has the option to offer this 2 1/2 -month grace period but is not required to do so. For implementation, the cafeteria plan document must be amended to include a grace period, and the period must apply to all participants in the plan. The IRS notice does not alter other features of FSAs, so at the end of the applicable grace period, unused balances still must be forfeited to the employer.
Employers' initial reaction to the rule change has been mixed, with some welcoming the added flexibility but others concerned about additional administrative burdens and exposure to increased financial risk.
The Tax Relief and Health Care Act of 2006 (P.L. 109-432) provided that individuals may make limited, one-time rollovers from balances in their FSAs to Health Savings Accounts. IRS guidance issued in February 2007 provides details about the conditions under which these transfers can occur. Among other things, employees must elect to make "qualified HSA distributions" by the last day of the plan year, no reimbursements can be made to employees after that last day, and the HSA distribution cannot exceed the lesser of the balance in the FSA on (1) September 21, 2006, or (2) the date of the distribution. 26
Interaction with Other Health Accounts
It is possible for individuals to have a health care FSA along with other tax-advantaged health accounts --Health Savings Accounts (HSAs) and Health Reimbursement Accounts (HRAs). 27 However, employers must coordinate how multiple accounts are used so that the eligibility requirements are not violated.
Health care FSAs cannot be used to pay the deductible of an HSA's qualifying high deductible health insurance. As a result, the FSA for those with an HSA must be either a "limited purpose FSA" or a "post-deductible FSA." A limited purpose FSA is one that pays only for preventive care and for medical care not covered by the HSA's qualifying health insurance (for example, vision and dental care). A post-deductible FSA is one that does not pay or reimburse any medical expense until the deductible of the HSA's qualifying health insurance has been met.
For those enrolled in an HRA and FSA at the same time, the accounts cannot pay for the same expenditures. Amounts in the HRA must be exhausted before reimbursements may be made from the FSA, except for qualifying expenses not covered by the HRA. When a person is enrolled in an HRA and an FSA, there is no federal requirement that the FSA be limited in purpose or post-deductible. However, the employer has the authority to implement such policies, as well as to require that the FSA be exhausted if the HRA must also be exhausted before the arrangement's health insurance begins.
HSAs and HRAs are offered to federal employees and annuitants through the Federal Employees Health Benefit Program (FEHBP). A federal health care FSA is also available to federal employees, though not to annuitants. For 2005, the U.S. Office of Personnel Management (OPM) prohibited enrollees in FEHBP's HSA or HRA options from enrolling in a health care FSA. Starting in 2006, however, a health care FSA limited to vision and dental care became available for enrollees with the HSA option. Starting in 2007, federal enrollees can purchase separate vision and dental insurance as well.
Health care FSAs can conflict with the objectives of HSAs and HRAs. People with FSAs receive tax advantages for the first dollars of health care expenditures without assuming the additional risk associated with the high deductible insurance that is required of HSAs and that usually accompanies HRAs. While they cannot carry over FSA balances for use in later years, this might not make much difference to those who would not be building up HSA or HRA balances anyway. As a consequence, those who believe that enrollment in high deductible health insurance should be encouraged might oppose further incentives for FSAs.
Current Legislation
In the 111 th Congress, two legislative proposals have been introduced. H.R. 544 (Royce) allows up to $500 of unused FSA funds to be either carried forward to next year or contributed to a health savings account or a qualified retirement plan. H.R. 1495 (Paul) includes a provision to permit up to $500 of unused health FSA funds to be carried over to the next year or to be paid to the employee as compensation.
CRS Report RL33505, Tax Benefits for Health Insurance and Expenses: Overview of Current Law and Legislation , by Bob Lyke and Julie M. Whittaker, may have more recent information about these and other relevant bills.
The 111 th Congress may consider legislation to expand health insurance coverage to people who are uninsured. Possibly comprehensive health care reforms will also be considered. What role FSAs might play in these initiatives is likely to a be of interest to employers and employees alike.
Author Contact Information
Bob Lyke
Janemarie Mulvey
Specialist in Aging Policy
jmulvey@crs.loc.gov, 7-6928
Additional Author Information
Bob Lyke, an author of this report, currently works as a contractor for CRS. He can be reached at rlyke@crs.loc.gov, or extension 7-7355.
1 Chris L. Peterson, CRS Specialist in Health Care Financing, contributed to portions of this report.
2 FSAs are different from the three other types of tax-advantaged health care accounts: Health Savings Accounts, Health Reimbursement Accounts, and Archer Medical Savings Accounts. For a comparison of all these accounts, see another CRS Report RS21573, Tax-Advantaged Accounts for Health Care Expenses: Side-by-Side Comparison , by Bob Lyke and Chris L. Peterson. Also see Internal Revenue Service publication number 969, Health Savings Accounts and Other Tax-Favored Plans , which is available through the IRS website, http://www.irs.gov.
3 The Tax Relief and Health Care Act of 2006 (P.L. 109-432) provided that individuals may make limited, one-time rollovers from balances in their FSAs to Health Savings Accounts.
4 If the employee's earnings exceeded the Social Security wage base ($102,000 in 2008), the only savings would be $13 from Medicare taxes (i.e., $900 .0145). Reductions in Social Security taxes due to FSA salary reductions could affect the Social Security benefits that the worker later receives, though not by much.
5 In 2009, the 15% bracket for single filers applies to taxable income (that is, after exemptions and deductions are subtracted) of over $8,350 to $33,950; for married couples filing jointly, the bracket extends from over $16,700 to $67,900. The 25% brackets for these taxpayers are from over $33,950 to $82,250 and from over $67,900 to $137,050, respectively.
6 The breakeven point for an employee in the 25% bracket who contributes $900 would generally be $606 (i.e., $900 minus income tax savings of $225 and employment tax savings of $69). The employee comes out ahead if unreimbursed expenses exceed that amount, assuming they would have been incurred in the absence of the FSA. If expenses would not have been incurred except for the FSA, then the breakeven point generally would be higher since the employee presumably values the obtained services at less than the market price.
7 In addition, cafeteria plans may include some taxable benefits; like cash, these are taxable if the employee selects them.
8 For a critical discussion of the Internal Revenue Service's interpretation of constructive receipt with respect to employee benefit plans and Section 125, see Leon E. Irish, "Cafeteria Plans in Transition," Tax Notes , December 17, 1984, pp. 1135-1136.
9 For many years, the Code had no explicit reference to FSAs. The Health Insurance Portability and Accountability Act of 1996 (P.L. 104-191) added a definition in subsection 106(c)(2) when it disallowed coverage of long-term care services through such accounts.
10 49 Federal Register 19321, May 7, 1984, 49 Federal Register 50733, December 31, 1984 and 54 Federal Register 9460, March 7, 1989. The proposed regulations were not finalized, but they remained the position of the IRS. (With the August 2007 proposed rules cited earlier in this CRS report, the IRS formally withdrew these proposed regulations.) The rules cover both FSAs funded by salary reductions and FSAs funded by nonelective employer contributions. Although employers generally do not permit annual reimbursements from FSAs to exceed the amount slated for contribution during the year, the proposed regulations do not require this. The proposed regulations allow a maximum annual reimbursement of up to 500% of the total annual contribution, or "premium" (including both employer-paid and employee-paid portions of the contribution to the FSA). An FSA operating in this way would be more similar to typical health insurance in that the maximum benefit is not limited to the year's contribution total. However, such an FSA would still differ from typical health insurance in that the maximum benefit is relatively low.
11 65 Federal Register 15548, March 23, 2000 and 66 Federal Register 1837, January 10, 2001. The rules apply to cafeteria plans generally, not just FSAs. The rules allow mid-year election changes for changes in status (marital status, number of dependents, employment status, place of residence) and significant changes in cost or coverage; however, mid-year election changes for health care FSAs are not allowed for cost or coverage changes since the plans must exhibit the risk-shifting and risk-distributions characteristics of insurance. These rules only permit employers to allow mid-year changes, they do not require them.
12 Thus an employer might refund the same dollar amount to every participant, even though some used all their benefits while others forfeited unused amounts.
13 54 Federal Register 9460, Q and A 7. Some of the seven requirements listed in the text had been issued in 1984.
14 72 Federal Register 43938, August 6, 2007.
15 A $5,000 limit applies to dependent care FSAs. The latter are governed by Section 129, which includes that limit.
16 Bureau of Labor Statistics, Table 24. Pretax benefits: Access, private industry workers, National Compensation Survey, March 2007.
17 Office of Personnel Management, incremental summary for 2008 benefit period.
18 Mercer Human Resources Consulting, National Survey of Employer-Sponsored Health Plans 2008.
19 U.S. Department of Health and Human Services, Office of the Assistant Secretary for Planning and Evaluation. A Study of Cafeteria and Flexible Spending Accounts, July 1985, pp. 18 and 20. The study was mandated by Section 531(b)(6) of the Deficit Reduction Act of 1984 (P.L. 98-369). The three prototype health plans on which the study was based had deductibles of $0/$0, $150/$300 and $150/$300 for individuals and families, respectively; 15% coinsurance; and cost-sharing maximums of $150/$300, $500/$1,000, and no limit.
20 For a critical review of the congressionally mandated study, see Daniel C. Schaffer and Daniel M. Fox, "Tax Law as Health Policy: A History of Cafeteria Plans 1978-1985," The American Journal of Tax Policy , v. 8, spring 1989, p. 47.
21 49 Federal Register 19321, Q and A 4.
22 Limits are applied to adoption assistance and dependent care FSAs, based upon the statutory provisions for these benefits.
23 Allowable expenses are discussed in IRS publication number 502, Medical and Dental Expenses , available through the IRS website at http://www.irs.gov.
24 Since employees control how much is contributed through salary reduction plans, in effect they can "carry over" amounts they do not anticipate using by not putting them into the account in the first place.
25 IRS Notice 2005-42, available through the IRS website at http://www.irs.gov.
26 IRS Notice 2007-22.
27 Archer Medical Savings Accounts (MSAs) could also be added to this list, but since they have largely been replaced by HSAs, they were not included in this discussion. More detailed descriptions of these accounts appear in CRS Report RS21573, Tax-Advantaged Accounts for Health Care Expenses: Side-by-Side Comparison , by Bob Lyke and Chris L. Peterson.
Congressional Research Service Report for Congress --Tax Issues Relating to Charitable Contributions and Organizations, April 6, 2009
April 16, 2009
111th Congress
Tax Issues Relating to Charitable Contributions and Organizations
Jane G. Gravelle
Senior Specialist in Economic Policy
April 6, 2009
Congressional Research Service
7-5700
www.crs.gov
RL34608
Summary
The value of tax benefits for charitable contributions and organizations is estimated to be around $100 billion per year. About half of this cost arises from the deductions for charitable contributions, and about half from exemptions of earnings of non-profits.
While revisions to the treatment of charitable contributions and tax-exempt organizations that receive contributions have been made in the past few years, several issues may be considered in future legislation. Of most immediate concern are the provisions that, as a part of the "extenders," expire at the end of 2009, and may be considered for extension. Other issues that may arise reflect concerns about donor-advised funds and supporting organizations (now under study at the Treasury Department), nonprofit hospitals' provision of charity care, and educational institutions' use of growing endowments. While no current proposals are under consideration, charitable contribution floors and extensions to non-itemizers were included in the President's Advisory Panels' tax proposals and in the Congressional Budget Office's budget options study. President Obama's FY2010 Budget proposed to create a reserve fund for health care financed in part by limiting the value of itemized deductions (which would include charitable contributions) to 28% of each dollar. The Senate Budget Resolution, S.Con.Res. 13 includes a clause to prevent tax changes that reduce itemized deductions for charitable contributions.
Most of the charitable extenders were contained in legislation first introduced in 2001. Some provisions were enacted temporarily in 2005; further provisions and extensions occurred in 2006, in the Pension Protection Act (P.L. 109-280). These extenders include an individual retirement account (IRA) rollover, liberalized treatment of certain gifts of inventory and conservation property, and two more technical provisions. (One of these technical provisions relates to the treatment of corporations that elect to be taxed as partnerships, and the other to the definition of unrelated business income of tax-exempt organizations, which is subject to tax.) These "extenders" are being considered currently in various bills.
Legislation, primarily in the Pension Protection Act, also imposed restrictions on contributions and charitable organizations to address abuses. The Act made changes relating to donor-advised funds and supporting organizations, which receive charitable contributions for further donation. That legislation also commissioned the Treasury Department to study this issue and make recommendations, including whether minimum distributions should be required. In addition, some of the same concerns about whether funds were being paid out at a high enough rate were also directed at university and college endowments, where a combination of high returns and relatively low payout rates has led to rapid growth. Issues have also been raised about whether non-profit hospitals provide enough charity care. The Senate Finance Committee has, in the past, investigated potential abuses raised by the Internal Revenue Service or reported in the media. These investigations have sometimes led to self-correction and sometimes led to legislation.
This report will be updated to reflect legislative and other changes.
Contents
Current Tax Benefits
Charitable Contributions
Tax Exemption of Earnings
Expanding Benefits for Charitable Contributions and Organizations
Provisions Considered But Not Adopted
Deduction for Non-Itemizers
Reducing the Foundation Investment Income Excise Tax
Raising the Corporate Charitable Deductions Cap
Unrelated Business Income of Charitable Remainder Trusts
Disaster Provisions Enacted on a Temporary Basis
Provisions Now Part of the Extenders
Contributions of Conservation Property
IRA Rollover Provision
Extending the Deduction for Food Inventory to all Businesses
Contributions of Scientific and Computer Property
Contributions of Book Inventory
Basis of S Corporation Stock for Charitable Contributions
Unrelated Business Income: Related Party Payments
Permanent Reduction in Excise Tax Reduction for Blood Collector Organizations
Recent Restrictions on Charitable Donations and Organizations
Restrictions on Charitable Contributions
Vehicle Donations and Gifts of Intellectual Property
Contributions of Historical Conservation Easements
Contributions of Taxidermy Property
Recapture of Tax Benefit if Not Used for Exempt Purpose
Deductions for Contributions of Clothing and Household Items
Recordkeeping Requirements
Contributions of Fractional Interests
Penalties on Overstatements of Valuations
Restrictions on Tax-Exempt Organizations
Terrorist Activities
Leasing Activities
Penalties for Tax-Exempt Organizations in Prohibited Tax Shelters
Life Insurance
Penalties and Penalty Taxes
Credit Counseling Agencies
Expanding the Base for Imposing Foundation Excise Taxes
Defining Conventions or Association of Churches
Information Reporting: Organizations Not Filing Annual Returns
Disclosure to State Officials
Disclosure of the Unrelated Business Income Tax Return
Donor-Advised Funds and Supporting Organizations
Current Issues Surrounding Charitable Deductions and Organizations
The Extenders
The Proposed 28% Cap on Itemized Deductions
Donor Advised Funds and Supporting Organizations
Non-Profit Hospitals
University and College Endowments
Specific Sectors Including Media-Based Ministries
Tables
Table 1. Charitable Provisions Among the Extenders
Contacts
Author Contact Information
The value of tax benefits for charitable contributions and organizations is estimated to be around $100 billion per year. While revisions to the treatment of charitable contributions and tax-exempt organizations that receive these contributions have been made in the 108 th , 109 th , and 110 th Congresses, a number of issues remain unresolved. Several liberalizations of tax benefits for charitable contributions, including an individual retirement account (IRA) rollover, liberalized treatment of certain gifts of inventory, and some other revisions expire at the end of 2009. These "extenders" will likely be considered during the 111 th Congress. Certain issues relating to donor-advised funds and supporting organizations, which receive charitable contributions for further donation, were addressed in 2006. The legislation also included a directive to the Treasury Department to study this issue and make recommendations. In addition, some of the same concerns about whether funds were being paid out at a high enough rate were also directed at university and college endowments, where a combination of high returns and relatively low payout rates has led to rapid growth. Issues have also been raised about whether non-profit hospitals provide enough charity care.
More recently, President Obama's FY2010 Budget proposed to create a reserve fund for health care financed in part by limiting the value of itemized deductions (which would include charitable contributions) to 28% of each dollar. The Senate budget resolution, S.Con.Res. 13 includes a clause to prevent tax changes that reduce itemized deductions for charitable contributions, although such a restriction is not in the House budget resolution..
This report reviews those issues, beginning with a discussion of current tax benefits, a review of legislative changes in the past four years, and a discussion of potential future legislative issues. It focuses on deductions for charitable contributions, and on institutions that are generally eligible for deductible charitable contributions, such as social welfare organizations, educational institutions, non-profit hospitals, and churches, along with conduits to those institutions such as private foundations, donor-advised funds, and supporting organizations.
Current Tax Benefits
The tax system provides a series of benefits for tax-exempt and charitable organizations. The most widely estimated and discussed is the deduction for charitable contributions, which is estimated in FY2008 to reduce federal revenue by about $46 billion. 1
Another important benefit is the exemption of earnings on assets from the income tax. As discussed below, while this benefit is difficult to estimate, it appears to be as large, in the neighborhood of $50 billion per year for the same period. For universities and colleges, these benefits are several times as large as the savings by donors from deducting charitable contributions. The value is likely, however, to fall temporarily given the reduction in earnings yields during the current slowdown.
Charitable Contributions
Not all tax-exempt organizations can receive tax deductible donations, but religious, educational, social welfare, health, animal protection, and similar organizations are eligible. Over the past several years, several revisions to the treatment of charitable deductions have been made, both to expand benefits and address potential abuses. Some of the provisions that expand benefits have become part of the "extenders," provisions that expire or have expired but are seen as likely to be extended or reinstated.
While charitable deductions are available to all taxpayers, individuals who take the standard deduction do not have a marginal tax incentive to give. (The standard deduction does not impose a penalty, as it is an option that can be used when it is greater than the total sum of itemized deductions.) Slightly over one-third of taxpayers itemize; about 30% deduct charitable contributions. Individuals' contributions are, in general, limited to 50% of income for most charities, but are restricted to 30% for certain non-profits, including non-operating foundations and institutions set up for the benefit of members (such as fraternal lodges). Individuals can contribute property as well as cash, and the contribution of appreciated assets has particularly beneficial treatment, since the value of most appreciated assets can be deducted without including the capital gains in income. (Some contributions of property are limited to the smaller of basis or fair market value, such as business inventory). For that reason, gifts of appreciated property are limited to 30% of income for most general charitable organizations, and to 20% for organizations with more restricted giving limits, such as non-operating private foundations. Corporate contributions are limited to 10% of taxable income. Individuals can also deduct costs of volunteering for charitable purposes, including out-of-pocket expenditures, costs of using a vehicle, and travel costs when there is no significant personal element.
The treatment of charitable contributions has been of legislative interest. A series of proposals to expand charitable benefits were made, beginning with President Bush's 2000 presidential campaign, and followed by a series of bills introduced in Congress (referred to as the Community Solutions Act and the CARE Act). The centerpiece of the initial proposal was to allow charitable deductions for non-itemizers. This provision, which was relatively costly compared to other proposals, was scaled back with ceilings and floors, and ultimately not adopted. A number of more limited proposals were considered and some were adopted, largely on a temporary basis. These temporary provisions are now part of the extenders; they expire at the end of 2009.
Proposals and enacted legislation placing restrictions on charitable contributions were largely motivated by potential abuses, which led to some changes in the law. These included the lack of documentation of cash contributions, but largely focused on gifts of property, where the valuation of the property or even the existence of a true gift may be questioned. Broad reform proposals have also suggested restricting charitable deductions in order to make incentives more efficient, both from an economic and administrative perspective, by only allowing charitable deductions in excess of a floor.
Tax Exemption of Earnings
A less visible, but nevertheless important, benefit is that tax exemption allows organizations to accumulate assets without paying tax on earnings, 2 and estimates discussed below suggest that the revenue loss from this tax benefit is even larger than that associated with charitable contributions deductions. If charitable contributions were spent quickly, this benefit would be minimal. If contributions are held as assets and invested, tax exemption may confer significant benefits. There are several ways in which donations are invested rather than spent. Some types of active tax-exempt organizations maintain assets in the form of endowments, particularly educational institutions. Private foundations are often originally funded with a large donation and pay out a small share of assets (required to be at least 5%, however). Two other types of institutions are similar to private foundations in that they do not directly engage in activities and accumulate assets from which they make payments: supporting organizations and donor-advised funds. All of these types of asset accumulating institutions have been the subject of legislative interest.
The revenue loss of this latter benefit has likely increased substantially with the growth of educational institution endowments, particularly by some educational institutions where earnings have been substantial relative to pay-out rates. If university endowment earnings alone were subject to the corporate tax, the revenue gain is roughly estimated at over $25 billion per year for FY2007 (which ended, for most of these institutions, in June 2007). It is more than three times as large as the revenue loss for charitable donations to all educational institutions, which total around $7 billion. While the ratio of revenue cost of the asset earnings to charitable contributions is probably smaller for other types of non-profits, the cost for all non profits would probably be around $50 billion, about the same size as the cost of the charitable deduction. 3
Note that this revenue loss will fluctuate as returns to assets fluctuate, so that it is likely to fall, perhaps significantly, during the current slow down. This fall would be expected to be temporary.
Congress also addressed some issues associated with tax-exempt organizations themselves. Some of this concern was directed at circumstances where tax deductible donations are made to organizations that act as conduits and do not have charitable activities. Private non-operating foundations, recipients of donations that make grants to active organizations, are required to pay out 5% of assets. Donor advised funds and supporting organizations, however, had no payout requirements. These organizations were the subject of legislative interest, not only because of concerns about payout rates, but also about the possibilities of using these organizations, which were not subject to self-dealing rules as restrictive as foundations, for private benefit. Some changes for these organizations were adopted, but major changes, such as pay-out requirements, were not in all cases; instead, Congress has authorized Treasury studies.
Although legislation has not been introduced, the tax-writing committees, especially the Senate Finance Committee, have been examining the status of some other tax-exempt organizations through hearings and studies. These include nonprofit hospitals where issues about the amount of charity care provided have been raised. The Senate Finance Committee has also focused on the growing endowments of universities and colleges. Because these educational institutions are considered active operations, there are no payout requirements. Low payout rates relative to earnings, however, have led to a rapid growth of endowments, at the same time that tuition rates have risen faster than inflation.
Expanding Benefits for Charitable Contributions and Organizations
Legislative proposals involving expanded tax incentives for charity began in the 107 th Congress with the Community Solutions Act of 2001 (H.R. 7). This bill, passed in 2001 by the House, had eight new tax provisions designed to benefit charitable giving including a capped deduction for non-itemizers. The President had proposed three of these tax provisions in his original 2001 tax proposal, but these provisions were not included in the 2001 tax cut (P.L. 107-16). Senate consideration also began in the 107 th Congress with S. 1924, introduced by Senators Lieberman and Santorum, which would have provided a temporary non-itemizers deduction with a higher cap along with other provisions. The Senate Finance Committee reported this bill, the CARE Act of 2002, with a temporary non-itemizers deduction with both a floor and ceiling, but it was not considered on the floor, containing some other provisions of H.R. 7. In the 108 th Congress, similar bill, S. 476, was passed by the Senate on April 9, 2003. S. 476 included some provisions that also would restrict charitable organizations, aimed at concerns about abuse. A new version of H.R. 7 passed the House in 2003. No further action occurred in that Congress.
A 109 th Congress bill, S. 7, included charitable provisions. Some limited provisions, largely aimed at disasters, including the Tsunami Relief Act of 2005 (P.L. 109-1), the Katrina Emergency Relief Act of 2005 (P.L. 109-73), and the Gulf Opportunity Zone Act of 2005 (P.L. 109-135), provided additional benefits. The Senate continued to propose some of these charitable provisions along with revenue raisers, which were enacted in 2006 in The Pension Protection Act (P.L. 109-280).
This section summarizes the tax proposals liberalizing charitable contributions and briefly reviews the issues in most cases. It is followed by a section summarizing the tax proposals restricting charitable contributions and organizations. Each proposal considered in this section is identified as not adopted, temporary (adopted as a temporary provision without expectation of extension), extender (adopted with an expiration date as part of the extenders proposals), or permanent. Note that further details of provisions enacted are contained in the Joint Tax Committee's "Blue Books," that summarize legislation. 4
Provisions Considered But Not Adopted
Four provisions were included in various proposals, but ultimately not adopted: a deduction for non-itemizers, a reduction in the foundation excise tax, an increase in the income limit on corporate deductions, and a proposal to replace the disallowance of tax-exempt status for unrelated business income in a charitable remainder trust with an excise tax.
Deduction for Non-Itemizers
The most significant charitable contributions proposal, in scope and revenue, considered in the last three Congresses was a deduction for non-itemizers, which was directed at encouraging charitable contributions. Under current law a taxpayer can either itemize deductions (the major deductions are charitable contributions, excess medical expenses, mortgage interest, and state and local income and property taxes) or choose the standard deduction. The standard deduction is advantageous if that amount is larger than total itemized deductions. (A limited deduction for non-itemizers was formerly available for 1981-1986, enacted as part of the Economic Recovery Tax Act of 1981 (P.L. 97-34).)
Proposals for extending the deduction to non-itemizers were considered under various proposals, in some cases including caps and floors. President Bush's initial proposal would have extended the deduction to itemizers with no restrictions that differed from those of itemizers. The first version of the House bill in the 107 th Congress (2001) would have imposed a cap on the deduction, with a phased in increase to $200 for married couples and $100 for singles. The initial Lieberman-Santorum plan, S. 1924, would have provided a larger cap of $600 and $400; the Senate Finance Committee reported a version of S. 1924 (as a substitute for H.R. 7) with a temporary non-itemizers deduction with floor and a ceiling ($250/$500 for singles and $500/$1,000 for joint returns). This provision with a floor and a ceiling was also in the 108 th Congress bills.
In its most recent Budget Options study, the Congressional Budget Office estimated that a non-itemizer's deduction with a $200/$100 cap would cost $3.4 billion over five years and $7.9 billion over ten years, while a $500/$250 cap would cost $14.7 billion and $38.7 billion respectively. 5
While no further proposals in this area were considered in Congress in 2005, the President's advisory group proposing overall tax reform included in their plans an extension of the deduction to non-itemizers, but added a floor of 1% of income, for both itemizers and non-itemizers. 6 The Congressional Budget Office also discussed a 2% floor as a separate provision in their budget options report, indicating that such a floor would gain revenue of about $20 billion per year in the first year, $100 billion over five years, and $250 billion over ten years. 7
The main objective of this extension of the deduction to non-itemizers was to increase charitable giving. Charitable provisions were, however, considered after the 2001 tax cuts which involved considerable revenue costs. Caps were seen as a means to constrain the revenue loss. At the same time, while the deduction for non-itemizers may increase giving, its effects would be limited because of the cap, and the dollars of charitable giving induced per dollar of revenue loss would be smaller, particularly with a small cap. In addition, the provision would increase complexity for taxpayers who do not itemize.
Floors also limit the revenue cost, but increase effectiveness per dollar of revenue lost (relative to a provision without a floor) and simplify the tax code because taxpayers with small amounts of contributions would not qualify. Even without a cap, the deduction may not induce additional giving as large as the revenue loss because the responsiveness of taxpayers, particularly lower and moderate income taxpayers, to incentives may be small. 8
Reducing the Foundation Investment Income Excise Tax
Current law imposes a 1% tax on investment income of foundations, and an additional 1% if the foundation does not make a certain minimum distribution (based on average distribution rate over the previous five years), or has been subject to a tax for failure to distribute in the previous five years. The House considered several bills that would have eliminated the extra 1% tax. This provision accounted for a $2.3 billion revenue cost over 10 years when last considered in 2003. The proposal was not included in the Senate bills under consideration at this time.
Private foundations, whose contributors (or their families) retain the right to direct the distribution of funds, have always been subject to greater scrutiny, in part because of the possibility of the donor (or family) obtaining a private benefit. Foundations are required to distribute 5% of their assets each year (or pay a penalty), but the tax is credited against that distribution.
If the foundation is just making the minimum distribution, every dollar of tax reduction should be funneled into distributions because the tax is credited against the deduction. Since the tax and the actual distribution sum to a fixed amount, a fall in the tax will result in a rise in the amount distributed to other organizations. Moreover, the moving average rule which imposes the additional 1% tax if the foundation does not distribute at the average rate of the last five years discourages a large contribution in a particular year because it increases the hurdle for future avoidance of the tax. The reduction in the investment tax should also make private foundations more attractive to givers in general, although that increased attractiveness might in part induce more contributions, and in part replace contributions that might have gone to other charities. The effects should be small, however, because the tax is small.
Proponents of reducing the tax also argued that it should be reduced because it brings in revenue that is in excess of IRS audit costs, which they indicate was the original purpose of the tax (which was introduced in 1969). The revenue stream from this tax has, however, been quite variable recently because it is heavily affected by the stock market. In any case, a reading of the legislative history indicates that while the Senate characterized the tax as an audit fee, the House referred more generally to the notion that private foundations should bear part of the cost of government generally because of their ability to pay (as well as viewing it in part as a user fee), and both objectives were cited in the bill's final explanation. It was reduced twice (in 1978 and 1984) based on the argument regarding costs of audit versus revenue.
Another argument made for eliminating the additional tax is the additional complication arising from it. At the same time, simplification does not require reduction in the tax; it could be converted to a larger flat fee.
The 2003 House proposal added a new provision that limited the counting of administrative costs as part of a foundation's minimum distribution requirement. Foundations are required to make a minimum distribution of 5%, but that 5% can currently include administrative costs (which currently have to be "reasonable"). As originally introduced earlier in 2003, the provision would have disallowed any administrative costs, but the proposal as reported allowed deductions for most administrative costs, with some exceptions.
The provisions affecting foundations were not adopted. 9 Moreover, concerns about abuse ultimately led to some increases in taxes and penalties including those on foundations, which are described below.
Raising the Corporate Charitable Deductions Cap
Under current law corporations can deduct charitable contributions of up to 10% of income; the 2003 House proposals would have gradually raised the cap to 20% (by one percentage point each year beginning in 2004, reaching 15% in 2008-11, and 20% thereafter). The initial (107 th Congress) provision would have raised the limit to 15%. This provision was not in the Senate bill. This provision is relatively small, and most corporate giving already falls well under the cap; the average giving is less than 2% of income.
Some question the appropriateness of corporate charity, since shareholders could make their own decisions about charitable giving. Allowing the deduction at the firm level is, however, more beneficial to the donor since both the corporate and individual taxes are eliminated. In some views, charitable giving by corporations is another management perk that might be excessive because of monitoring problems by shareholders (this problem is also called an agency cost problem). Others argue that corporations should be encouraged to give to charity and to be socially responsible. Economists have studied models in which charitable giving is part of the firm's profit maximizing behavior (e.g., by gaining the firm good will). Evidence on the effectiveness of the deduction is mixed, with time series studies showing a positive effect and cross section results not finding an effect. 10
Unrelated Business Income of Charitable Remainder Trusts
Current law provides tax deductions for some portion of a trust and income tax exemption on the earnings, if a remainder of the assets is left to charity (while paying income to a non-charitable donee, usually a spouse or other relative during an interim period). The trust's income is, however, no longer exempt from tax if the trust has unrelated business income. There have been congressional proposals to liberalize the rule by providing for a 100% excise tax on any unrelated business income rather than loss of all tax exemption. This provision would have accounted for a negligible cost.
Disaster Provisions Enacted on a Temporary Basis
Several provisions were enacted in 2005 in response to disasters. The Tsunami Relief Act of 2005, P.L. 109-1 allowed contributions made in January 2005 to be treated as made in the previous year (and therefore deductible on 2004 tax returns) to encourage giving for relief from the Tsunami that struck in 2004. The Hurricane Katrina Emergency Relief Act of 2005 adopted several provisions, effective through 2005, to encourage giving to Katrina victims. It allowed unlimited cash contributions for individuals (normally restricted to 50% of income). It also allowed unlimited contributions for corporations (normally restricted to 10% of taxable income) if contributions were made to aid Katrina victims. Charitable contributions made after the disaster were not subject to the phase out of itemized deductions. Mileage rates for deducting costs of using a vehicle for charitable purposes to aid Katrina victims were increased from 14 cents to 70% of the business rate of 48.5 cents. Reimbursements for these costs in excess of the mileage allowance were not included in income if the activity was for the aid of Katrina victims. The Gulf Opportunity Zone Act P.L. 109-135 extended the benefits of higher limits to contributions to Hurricanes Rita and Wilma.
Provisions Now Part of the Extenders
Seven provisions were enacted with expiration dates; they will expire at the end of 2009. One provision, relating to donation of conservation property, was last extended by P.L. 110-234. Six others, including the IRA rollover provision, three provisions relating to donations of business inventory, a provision regarding the effect of a charitable donation on the basis of stock of small corporations that elect to be taxed as partnerships, and a provision eliminating the unrelated business income tax on arms-length rental payments to tax-exempt organizations from a related entity were extended by P.L. 110-343.
Contributions of Conservation Property
Another important set of provisions, originated in the Senate, expanded benefits for contributions for conservation purposes by lifting the cap on contributions as a percent of income. Gifts of appreciated property are deductible at the fair market value, but, for individuals, have lower limits (30% of income) than ordinary gifts such as cash (50% of income). The Pension Protection Act (P.L. 109-280) increased the limit for appreciated property contributed for conservation purposes to 50% for individuals. The provision increased the limit to 100% for farmers and ranchers, including individuals and for corporations that are not publicly traded. To qualify, land used or available to be used for agricultural or livestock production must remain available for such purposes. This provision expired at the end of 2007, but was extended for an additional two years in the Food, Conservation, and Energy Act of 2008, P.L. 110-234. As noted above, lower income limits for gifts of appreciated property reflect concerns about the overstatement of fair market value and the deduction of amounts that have not been included in income.
IRA Rollover Provision
All of the proposed charitable contribution proposals considered in Congress included a provision to allow tax free distributions from individual retirement accounts to charities by individuals aged 70 and 1/2 or older. This provision was adopted on a temporary basis in the Pension Protection Act in 2006 but expired at the end of 2007, and is now extended through 2009. The treatment benefits non-itemizers, who would not otherwise be able to take a deduction, although in the President's original proposals nonitemizers would be allowed a deduction in any case.
While this treatment may appear no different, for itemizers, from simply including the amounts in adjusted gross income and then deducting them as itemized deductions, it can provide several types of benefits even to those who itemize. This treatment reduces adjusted gross income which can trigger a variety of phase-outs and phase-ins, including the phase-in of taxation of Social Security benefits. There are also income limits on charitable contributions: individuals can contribute no more than 50% of income in cash and no more than 30% in appreciated property. Since IRAs tend to be held by higher income individuals, the taxpayers might be somewhat more sensitive to the incentive to give; however, the law does not specify why this particular group of taxpayers was targeted for an expansion of charitable giving provisions. This provision was adopted in P.L. 109-280 with a $100,000 annual limit. It was originally projected to cost $238 million in the first year, and $856 million over ten years.
Extending the Deduction for Food Inventory to all Businesses
Corporations that donate inventory to charity in general get a deduction for the cost (not the market value). A special rule allows businesses paying the corporate tax to also exclude half the appreciation (half the difference between market value and cost of production) if the inventory is given to an organization that directly passes it on to the ill, the needy, or infants, as long as the total deduction is no more than twice the cost. An important category of donations is food. There have been disputes between taxpayers and the IRS about how to measure the fair market value of food. 11 The charitable contributions proposals would have allowed unincorporated businesses (or businesses that are incorporated but do not pay the corporate tax) the additional deduction, and the fair market value of wholesome food would be considered the price at which the firm is currently selling the item (or sold it in the past), although this deduction would be limited to the corporate percentage cap on deductions in general. This provision's cost was relatively small.
The provision's objective was to create more equity among different types of taxpayers and resolve disputes (largely in the taxpayer's favor). However, as with the deduction of appreciated property, these rules allow firms to deduct amounts that have not been included in income. While the provision is limited by allowing only one half the appreciation, these products, if sold, would be taxed at full rates (rather than the lower rates imposed on individual capital gains). In addition, as with gifts of capital gain property, an important concern is the potential overstatement of market value. Firms may only be able to sell donated inventory at a much lower price because the product is damaged in appearance, is older, or has other characteristics that would require deep discounting to sell. Moreover, a firm with market power may not wish to sell all of its inventory because increasing supply will drive the price down more for a sale than a donation. It is possible that a provision that is extended to non-corporate businesses, which are smaller and more numerous, will be more difficult to monitor for compliance.
For inventory that cannot be practically sold, the barrier to a donation by the firm is the extra costs encountered in distributing the product. Thus, there is a tradeoff between creating an incentive and providing a windfall for the firm.
The Katrina Emergency Relief Act of 2005 (P.L. 109-73) provided treatment to unincorporated firms (not to exceed 10% of business income) through 2005 but did not make the other changes. The Pension Protection Act of 2006 (P.L. 109-280) extended the provision through 2007, and the Emergency Economic Stabilization Act of 2008 (P.L. 110-343) extended it through 2009.
Contributions of Scientific and Computer Property
Certain special treatment (similar to that for food inventory) is allowed for certain scientific property used for research and for contributions of computer technology and equipment, provided the property is constructed by the taxpayer. In concrete terms, this rule requires that no more than 50% of the cost is due to parts purchased elsewhere. The issues surrounding this provision are the same as those related to other contributions of inventory, such as food inventory. This provision expired in 2003. The proposals would have allowed property assembled, as well as constructed, to be eligible and make the provision permanent, although the Senate proposal involved an extension. The Working Families Tax Relief Act of 2004 (P.L. 108-311) extended the existing provisions through 2005 and The Tax Relief and Health Care (P.L. 109-432) extended the provision, including the expansion to assembled property, through 2007. The Emergency Economic Stabilization Act of 2008 (P.L. 110-343) extended it through 2009.
Contributions of Book Inventory
A provision that originated in the Senate extended the treatment of food inventories to book inventories donated to public elementary and secondary schools. As with all contributions of property, valuation may be an issue. Book publishers who have printed too many books may only be able to sell them at a discount, and perhaps a potentially deep one. This provision was enacted in the Katrina Emergency Relief Act of 2005 (P.L. 109-73) through 2005. The Pension Protection Act of 2006 (P.L. 109-280) extended the provision through 2007, and the Emergency Economic Stabilization Act of 2008 (P.L. 110-343) extended it through 2009.
Basis of S Corporation Stock for Charitable Contributions
Under current law, a shareholder in a Subchapter S corporation (a corporation treated as a partnership) is allowed to deduct his or her pro rata share of any corporate contribution. At the same time, the taxpayer must decrease the basis of stock by that amount (which is a way of reflecting the effect on the shareholder's asset position). The Congressional proposals on charitable contributions provided that the taxpayer would not have to reduce basis in the stock to the extent a deduction is taken in excess of adjusted basis of the donated property (e.g., cost). This provision appears to be consistent with allowing a deduction for the market value of appreciated property without including the appreciation in income (a special benefit generally available to taxpayers). This provision's cost was relatively small. The Pension Protection Act of 2006 (P.L. 109-280) included this provision effective through 2007, and the Emergency Economic Stabilization Act of 2008 (P.L. 110-343) extended it through 2009.
Unrelated Business Income: Related Party Payments
Charities are subject to a tax on unrelated business income. Rents, royalties and annuities are excluded from income subject to the tax except when received by a majority owned subsidiary. Among provisions included in the 108 th Congress version of charity proposals was one to exclude certain items (such as rent) received by a subsidiary from a tax on unrelated business income except for the excess over an arms-length price. As with other provisions, however, the determination of arms-length rents is not always straightforward when there are not closely comparable properties. This provision was adopted in the Pension Protection Act (P.L. 109-280), and applied to payments through 2007. The Emergency Economic Stabilization Act of 2008 (P.L. 110-343) extended it through 2009.
Permanent Reduction in Excise Tax Reduction for Blood Collector Organizations
The Pension Protection Act of 2006 (P.L. 109-280) included a provision exempting qualified blood collectors from a variety of excise taxes, including communications taxes and taxes relating to fuels and vehicles. This provision is directed at the Red Cross.
Recent Restrictions on Charitable Donations and Organizations
Congress has considered many provisions over the last three Congresses aimed at preventing potential abuse, with many problematic areas identified by the Internal Revenue Service. 12 The Senate Finance Committee, and Senator Grassley, currently the ranking member, have investigated many compliance issues. 13 In 2004 and 2005, the Senate Finance Committee held hearings on the subject. Also, early in 2005, the Joint Committee on Taxation published an study on options to improve tax compliance that included a number of provisions relating to charitable contributions and tax-exempt organizations. 14
The concerns expressed in these hearings and studies focused on potential abuses of charitable organizations, on the valuation of gifts of property, and on certain types of organizations, including donor-advised funds and supporting organizations. These two types of organizations, like private foundations, permit contributions to build up an account without necessarily making a contribution. Private foundations, however, are subject to a 5% pay-out requirement and a number of special restrictions to prevent funds from being used for the benefit of the donor. Donor-advised funds are funds where the donor contributes to an account in an institution and the institution subsequently makes contributions, advised by the donor. Supporting organizations do not have a direct charitable purpose, but support organizations that do. 15
More broad ranging proposals to make the charitable contributions deduction more effective and less subject to claims of small undocumented deductions would have introduced a floor. Earlier proposals associated with expansions of the deductions to non-itemizers proposed dollar floors, but these proposals tended to focus on floors as a percent of income. The President's Advisory Panel on Tax Reform proposed a floor equal to 1% of income. 16 The Congressional Budget Office included a budget option for a floor of 2%, 17 with an estimated revenue gain of about $20 billion in the first year, $99 billion over five years, and $250 billion over ten years.
Some changes were enacted in 2003 and 2004, but most of the restrictive provisions that were adjusted were part of the Pension Protection Act of 2006.
Restrictions on Charitable Contributions
A series of restrictions on charitable donations, aimed at reducing abuse, were adopted. Most of these provisions related to gifts of appreciated property, where the gift is deducted at fair market value. These gifts account for about 25% of all donations, and for much larger shares of donations of higher income taxpayers. For taxpayers with incomes above $10 million, gifts of property account for 50% of contributions. Taxpayers with incomes above $1 million account for 18% of cash gifts, but 40% of property gifts. 18 This provision is especially beneficial to the donor because a deduction is allowed for the full value, while the appreciation is not taxed. While the valuation of contributions such as publicly traded stock is straightforward, the valuation of gifts where value is not easily assigned presents some issues for tax compliance. If the taxpayer can value donated property at an excessive value, it is even possible to benefit privately from making a contribution rather than by selling the property.
The President's Advisory Commission on Tax Reform proposed in 2005 that individuals be allowed to sell appreciated property and donate the proceeds without paying the capital gains tax, to address the valuation problem. 19
During the debate on the treatment of gifts of appreciated property, some broad changes were discussed. For example, the Joint Committee on Taxation presented an option in its study to allow only the basis to be deducted for gifts of property that were not publicly traded. A Senate staff discussion paper, among a broad array of options discussed, considered "baseball arbitration," where the court can only find for the taxpayer's original value or the IRS value, which would create an incentive to limit any overstatement of value. 20 Although these provisions were not adopted, a number of changes were, as detailed below.
Vehicle Donations and Gifts of Intellectual Property
Growing concerns about the abuse of donations of used vehicles and of patents and other intellectual property led to several revisions in the American Jobs Creation Act of 2004 (P.L. 108-357). According to IRS data, in 2003, $2.3 billion of deductions associated with vehicles was deducted, for those taxpayers who had non-cash contributions of $500 or more. 21 Often charities resold vehicles at a much smaller value than the value deducted by the taxpayer. 22 The revision required that, for vehicles with a value of $500 or more, the deduction is restricted to the value of resale, if the vehicle is resold rather than used or refurbished by the charity. The act also extended to corporations the requirement of an appraisal for a donation of property (other than readily valued property such as cash, inventory, and publicly traded securities) of $5,000. This appraisal is not required in the case of resale of a vehicle by an organization. It also required appraisals to be attached to tax returns for gifts valued at $500,000 or more. Finally the law restricted the donation of intellectual property, which could be valued at fair market value, to the lesser of basis (roughly cost of developing or purchasing) or market value.
Contributions of Historical Conservation Easements
As a general rule, a taxpayer cannot take a deduction for a partial interest in a property. However, gifts of conservation or historical easements (where the taxpayer restricts the use of property) may be made. Their value is the reduction in the value of the property due to the easement. One concern that arose was that taxpayers were making gifts of easements on historical facades (the front of the building), which involve an agreement not to change the facade, when the regulations in the historical district already imposed this restriction. Thus there could be no effect on property values. A provision in the Pension Protection Act required these easement to be limited to buildings but to apply to the entire exterior (not just the facade), and that an appraisal be supplied.
Contributions of Taxidermy Property
Press reports suggested that individuals involved in big game hunting were receiving deductions for contributing their mounted trophies at inflated prices which were often resold at a lower price. 23 In addition to the revenue effects, concern was expressed by environmental and animal rights groups. The Pension Protection Act restricted the deduction to the cost of mounting the trophy; thus, cost does not include the cost of hunting trips.
Recapture of Tax Benefit if Not Used for Exempt Purpose
The Pension Protection Act requires individuals who give gifts of appreciated property to be subject to a recapture tax if the property is not used by the organization for its exempt purposes and is sold within three years. If the property is sold in the same year, the donor generally deducts basis (cost); if sold after that year, the donor must include in income the difference between fair market value claimed and the basis.
Deductions for Contributions of Clothing and Household Items
Contributions of used clothing and household items present difficulties because these items are difficult and time intensive to value and audit. They are significant in value, however. In 2003, these contributions were estimated at $8.6 billion for those with $500 or more of non-cash contributions; clothing accounted for two thirds of the total. 24 The amounts would be larger if taxpayers with contributions of less than $500 in cash were included. The Pension Protection Act disallows the deduction for items not in good used condition or better and provides the Internal Revenue Service with broad authority to disallow deductions. Items valued more than $500 may be deducted if not in good used condition or better if accompanied by an appraisal. Household items do not include items such food, art, antiques, jewels and gems, and collections.
Recordkeeping Requirements
The Pension Protection Act changed the rule that allowed substantiation of small cash contributions by a written record or log. All cash contributions must be substantiated by a bank record (e.g., cancelled check) or receipt from the organization.
Contributions of Fractional Interests
Taxpayers could deduct contributions of fractional interests in art although they could not deduct a contribution of a future right to the art. 25 For example the taxpayer could contribute a 10% interest in an art work to a museum, and receive a deduction for 10% of the value of the art. The museum would have the right to possess the art for 10% of the year. There were several concerns about this tax treatment. First, a court decision (Winokur v. Commissioner) settled in 1988 found that physical possession was not required to make a fractional interest donation, only the right to physical possession. 26 The Internal Revenue Service challenged this case, but the court found for the taxpayer. As a result, individuals could keep art work in their possession, perhaps through their lifetimes, or even pass the property on to their heirs, while still securing a charitable contribution deduction. The second is a concern that the possession or display of the art by the museum itself enhances the market value of the work, effectively increasing the value of the art work, and the value of future deductions or sales compared to an outright gift. Another set of issues relates to estate taxes. Estate taxes can be reduced by a reduction in value due to minority discounts --the view taken by the courts that an ownership of a minority interest in an asset loses some value because of lack of control. The minority ownership does not, however, affect the value of the charitable deduction for income or estate tax purposes. The Pension Protection Act requires physical possession by the donee, requires the gift to be completed within 10 years or at the donor's death, whichever comes first, disallows fractional donation of a property that is not wholly owned by the donor, or the donor and donee for later gifts, (the Secretary of the Treasury can make an exception if multiple owners donate similar fractional shares), and requires that subsequent fractional shares are limited to market value at the time of the original donation. If these restrictions are not met the tax savings from the deduction are recaptured with interest and a 10% penalty.
Penalties on Overstatements of Valuations
This provision lowered the thresholds for imposing penalties for overstatements of value for the income tax and understatement for the estate tax. It also established a separate penalty structure for appraisers.
Restrictions on Tax-Exempt Organizations
A few provisions were enacted during the 108 th Congress that applied to tax-exempt organizations, but most provisions were enacted in the 109 th Congress, primarily in the Pension Protection Act in 2006. Some of these provisions affect organizations that are tax exempt but are not charitable organizations.
Terrorist Activities
The Military Family Tax Relief Act of 2003 (P.L. 108-121) provided for automatic suspension of the tax-exempt status of organizations placed on the designated list of terrorist organizations or supporters of terrorism. Normally, suspension of tax-exempt status requires or permits administrative and judicial proceedings.
Leasing Activities
In a provision not directly affecting contributions or tax-exempt status, but which nevertheless might have consequences for tax-exempt organizations, the American Jobs Creation Act of 2004 also restricted the ability of parties leasing arrangements to obtain favorable tax treatment. 27
Penalties for Tax-Exempt Organizations in Prohibited Tax Shelters
Some tax shelter operations require participation of a tax-exempt entity. This provision imposed penalties on exempt organizations that are a party in a prohibited tax shelter transaction. It was enacted in the Tax Increase Prevention and Reconciliation Act (P.L. 109-222) in 2006.
Life Insurance
Investments in life insurance are subject to beneficial tax treatment, including exemptions when assets are paid at death and deferral of tax on investment earnings. State laws restrict the holding of an interest in life insurance if there is no insurable interest (e.g., a relationship with the insured). Some states exempt charities from the insurable interest and some allow insurable interests for private investors if there is also a charitable organization involved. The Pension Protection Act does not directly affect these relationships but requires temporary reporting on life insurance arrangements by exempt organizations (for two years) and mandates a study of this issue by the Treasury Department.
Penalties and Penalty Taxes
A series of penalties applies to certain actions of charitable and tax-exempt organizations. The most punitive penalty for an inappropriate action, in general, is to revoke the exempt status. There are a series of intermediate sanctions that generally impose monetary penalties. An excess benefit tax applies to transactions of charitable welfare organizations (other than private foundations) and social welfare organizations. Private foundations are subject to taxes and/or penalties for selfdealing, failure to distribute income, on excess business holdings, for investments that jeopardize the charitable purposes, and for taxable expenditures (such as lobbying or making open-ended grants to institutions other than charities). The Pension Protection Act increased those taxes and penalties.
Credit Counseling Agencies
Non-profit credit counseling agencies obtained tax-exempt status because their purpose was largely to educate and counsel consumers, and perhaps offer some tailored debt management plans as well. A rapid growth of tax-exempt credit counseling agencies occurred in the 1990s. Press reports and investigations suggested that there was widespread abuse and that these new firms were not primarily being used for educational purposes but were used to enroll individuals into payment plans. The Internal Revenue Service performed audits and revoked tax-exempt status for some agencies. The Pension Protection Act established a series of standards and requirements for exempt credit counseling agencies and treated debt management plans as an unrelated business, with earnings subject to the unrelated business income tax.
Expanding the Base for Imposing Foundation Excise Taxes
As discussed above, foundations are subject to excise taxes on investment income. The Pension Protection Act expanded the base to include additional types of income-such as income from financial contracts, annuities, and certain capital gains.
Defining Conventions or Association of Churches
A convention or association of churches is not required to file an information return and is subject to provisions generally applicable to churches. The Pension Protection Act specified that a convention or association of churches would not fail to qualify because there are individual members.
Information Reporting: Organizations Not Filing Annual Returns
While exempt organizations are required generally to file information returns, certain organizations are exempt (these include small organizations, certain religious organizations and certain government related organizations). The Pension Protection Act, requires these organizations to report contact information to the Internal Revenue Service (i.e., organizational title, address).
Disclosure to State Officials
The Secretary of the Treasury is required to notify the appropriate State officer of a refusal to recognize an organization as a charitable one that may receive tax deductible contributions, revocation of that status, and the mailing of a notice of deficiency for certain taxes. Returns and records relating to this disclosure must be made available for inspection. This provision in the Pension Protection Act revises the rules for disclosure of tax information to state authorities, including the disclosure, upon request, of a notice of proposed refusal to recognize, revoke, or issue a deficiency, names and addresses of applicants, and associated returns.
Disclosure of the Unrelated Business Income Tax Return
Organizations are required to make information and application materials available for public inspection. The Pension Protection Act requires disclosure to be applied to the return reporting unrelated business income.
Donor-Advised Funds and Supporting Organizations
The Pension Protection Act authorized Treasury Department studies of donor advised funds and supporting organizations and made other changes to their status. 28 Donor advised funds are funds where donors make contributions and the institution holding the accounts makes contributions to charitable organizations with the advice of the donor. While the donor has no legal control, in practice the donor's wishes are likely to be respected. Supporting organizations do not actively engage in charitable activities but support organizations that do by contributing funds to them. Supporting organizations fall into three types: Type I controlled by the charitable organizations, Type II, controlled by the same entity controlling the charitable organization and Type III, related to the charitable organization. Type III organizations may support many charitable organizations.
These types of organizations had many features in common with private foundations, but were not subject to self dealing rules and other restrictions (meant to prevent the donor from receiving a private benefit) or payout requires (meant to keep the organization from accumulating funds without paying out some amount for charitable purposes). There was some evidence that abuses were occurring and that, in some cases, little was being paid out. In addition to the mandated studies, other changes, including the following, were made.
Donor-advised funds eligible for charitable contributions were specifically defined in the law. They were prohibited from providing benefits to the donors, they were required to have a governance structure if grants were made to individuals (such as a scholarship fund), and contributions of closely held businesses had to be sold within a short period of time.
Supporting organizations must indicate which type they are and certain Type III organizations will eventually be subject to a minimum payout (with the Treasury Secretary making such a determination through issuance of regulations). In August 2007, the Treasury issued proposed regulations and invited comment, indicating the same minimum distribution rule applying to foundations (5% of assets) is expected to be applied. 29
In general, the Pension Protection Act prohibits supporting organizations from making grants or loans, or paying compensation, to substantial contributors. Supporting organizations cannot receive contributions from persons who control the organization, and from private foundations if the supporting organization is controlled by significant persons at the foundation. They are not eligible for the rollover treatment for individual retirement accounts (IRAs). Type III organizations must also file additional information and cannot support foreign non-profits.
Current Issues Surrounding Charitable Deductions and Organizations
As indicated in the discussion above, two issues of current legislative interest are the extenders, and any potential legislation arising from the Treasury studies of donor advised funds and supporting organizations. More recently, President Obama's FY2010 Budget proposed to create a reserve fund for health care financed in part by limiting the value of itemized deductions (which would include charitable contributions) to 28% of each dollar. The Senate Budget Resolution, S.Con.Res. 13 includes a clause to prevent tax changes that reduce itemized deductions for charitable contributions. In addition, there is interest, as indicated by hearings and by activities of the Senate Finance Committee in the tax-exempt status of non-profit hospitals and in university endowments. The Finance Committee has also in the past examined specific areas of the charitable giving and tax-exempt charitable world, including specific tax-exempt organizations. These examinations were spurred by studies and by media reports. Most recently, Senator Grassley has inquired of the finances of media related ministries. Finally, there remains a possibility that a floor could be imposed on charitable giving as part of a broad tax reform, given the recommendations of the President's Advisory Panel and the inclusion of that provision in the Congressional Budget Office options paper.
The Extenders
Table 1 reports the expected revenue cost of extending each of the six provisions that expired at the end of 2007 (and were subsequently extended through 2009) for one year. There are two issues associated with these charitable benefits "extenders:" whether they are effective or appropriate provisions, and, if so, whether they should be temporary when most of the provisions of the tax code are permanent. The specific issues associated with each of these provisions was discussed earlier.
Table 1. Charitable Provisions Among the Extenders
_____________________________________________________________________________________
Provision Revenue Cost
(Millions of
Dollars)
_____________________________________________________________________________________
Individual Retirement Account Rollover $465
Extending Food Inventory Provision $71
Contributions of Scientific and Technological Property $260
Contribution of Books $32
Modifying the Basis of S Corporation Stock $62
Unrelated Business Income of Related Parties $35
_____________________________________________________________________________________
Source: Joint Committee on Taxation, JCX26-08 http://www.jct.gov/x-46-08.pdf.
The contributions of conservation property, which has already been extended two years, was estimated to cost $54 billion for a one year extension in an earlier estimate, JCX 107-07 http://www.jct.gov/x-105-07.pdf.
One criticism that could be made of using temporary provisions for charitable purposes is that although the budgetary cost is smaller for a provision extended only a year at a time, the intention is to continue the provision. This practice causes the official projected budget deficits to be smaller than they will likely be, takes up the time of the Congress with considering the extenders, and creates some uncertainty for taxpayers.
On the other hand, an argument that could be made in favor of temporary provisions is that a temporary provision makes reconsideration of the merits and design of the provisions more likely. Evidence suggests, however, that relatively few temporary provisions have been revised. Only one extender of dozens allowed since the first extender was enacted in 1981 has been allowed to lapse. Most provisions are not revised either, although the R&D tax credit has been the subject of some major revisions. Nevertheless, it could be argued that the temporary nature of these provisions is conducive to better tax policy because provisions are reconsidered even though they are rarely revised.
The issues surrounding the specific charitable extenders are discussed above. History suggests they are likely to be enacted, however. 30
The Proposed 28% Cap on Itemized Deductions
President Obama's FY2010 Budget proposed to create a reserve fund for health care financed in part by limiting the value of itemized deductions (which would include charitable contributions) to 28% of each dollar. 31 Thus, under the proposal, taxpayers in the top brackets (currently 33% and 35%, rising to 36% and 39.6% in 2011) would have each dollar of deductions reduced by 28 cents on the dollar rather a reduction based on their marginal tax rate (for example, 33 cents). The Senate budget resolution, S.Con.Res. 13 includes a clause to prevent tax changes that reduce itemized deductions for charitable contributions; the House budget resolution does not.
Although there has been concern expressed about the effect on charitable giving, especially during difficult economics times, the provision would not affect giving today because it does not go into effect until 2011; in fact, enactment today of a future change would be expected to increase contributions as taxpayers seek to make contributions before the cap is imposed. Estimates of permanent effects on charitable giving suggest the effects would be relatively small, generally around 1%. 32
The itemized deduction cap overall is projected to raise about $30 billion in FY2012 when fully in effect, rising over time. The cost in the first five years (FY2010-FY2014) is projected at $110 billion while the cost over ten years (FY2010-FY2019) is projected at $317 billion. Internal Revenue Service statistics suggest that charitable contributions account for about a quarter of itemized deductions at higher income levels.
Donor Advised Funds and Supporting Organizations
The two basic issues associated with donor-advised funds and supporting organizations were possibilities of receiving private benefit by donors and pay-out rates. As noted above, while some changes were enacted, others remain possible. Although payout requirements are planned (administratively) for Type III supporting organizations, there are no payout requirements for donor-advised funds and for other supporting organizations. These issues might be revisited when Treasury completes its studies. 33
The Treasury was directed to study specific issues: whether deductions for contributions to donor-advised funds and supporting organizations are appropriate given the use of the assets or benefits to the donor, whether donor-advised funds should have a distribution requirement, whether the retention of rights by donors means that the gift is not completed, and whether these issues apply to other charities or charitable donors. Thus, it is possible that results of the studies could also have implications for charities in general.
Non-Profit Hospitals
The tax writing committees, and especially Senator Grassley, have also been interested in non-profit hospitals. A major concern is the degree of charity care and whether non-profit hospitals are providing benefits that justify their charitable and tax-exempt status. The Congressional Budget Office released a study in 2006 that found that non-profit hospitals overall provided only slightly more charity care than for profit hospitals. 34 The Senate Finance Committee held hearings on the topic "Taking the Pulse of Charitable Care and Community Benefits at Non-Profit Hospitals," on September 13, 2006 and the House Ways and Means Committee held hearings on "The Tax Exempt Hospital Sector," on May 26, 2005.
In a staff discussion draft released July 18, 2007 by Senator Grassley, the following concerns were raised about non-profit hospitals: establishing and publicizing charity care, the amount of charity care and community benefits provided, conversion of nonprofit assets for use by for-profits, ensuring an exempt purpose for joint ventures with for-profits, governance, and billing and collection practices. 35 Subsequently, on October 24, 2007, Senator Grassley authorized a round-table to discuss the draft. Also in July 2007, the IRS released an interim report on non-profit hospitals, where they found that the median share of revenues spent on charity care was 3.9% and almost half of hospitals spent 3% or less. The average was 7.4%. 36
One of the concerns expressed in the staff discussion draft was that, since 1969, with a revenue ruling issued by the Internal Revenue Service, non-profit hospitals were not required to demonstrate specific standards for charity to qualify for exempt status (and in some cases to be eligible to receive tax deductible charitable contributions); rather they must meet a community benefit standard that is not quantitatively defined. 37
University and College Endowments
Universities and colleges are classified as charitable organizations eligible to receive deductible contributions, and, also, as tax-exempt entities, do not pay tax on their investments. As indicated above, the benefit of exempting endowment income of colleges and universities from taxes is estimated at around $25 billion, more than three times the benefit of charitable deductions to all educational institutions. IN the past few years, endowments have been growing rapidly because of very high yields, coupled with relatively low payout rates. For the fiscal year that ended June 2007, endowments were $411 billion and the average rate of return was 21.5%. The payout rate was 4.6%. As a result of those relationships along with contributions, endowments grew 18.4% between FY2006 and FY2007 (about thee and a half times the growth rate of the economy), continuing an on-going trend from recent years. This growth may slow or reverse in FY2008 and after, given the performance of the economy, but the trend in high earnings has persisted for longer periods of time inclusive of business cycles. 38
The Senate Finance Committee received testimony on college endowments in connection with hearings held on offshore funds in 2007. Marge university endowments are invested in, among other assets, offshore hedge funds, and one issue discussed during the hearing was whether these investments were being used to avoid the unrelated business income tax. The witnesses discussed the growth of endowments and also addressed the relationship between endowments and affordability, showing that a very small increase in payout of universities and colleges with the largest endowments could obviate the need for tuition increases and could fund significant increases in student aid. 39 The Senate Finance Committee also sent a survey to colleges with endowments of more than $500 million to obtain more details about their endowments and payouts. 40 Senator Grassley, ranking member of the Finance Committee, recently discussed his concern that, in exchange for tax exemption, colleges were expected to provide affordable education, and why colleges were not spending more of their endowment funds for this purpose. 41
Specific Sectors Including Media-Based Ministries
Over a period of time the Senate Finance Committee has examined specific charitable organizations or groups as well as specific charitable donation practices. Some of these investigations were spurred by media reports and some by IRS studies; they have led to both legislation and self correction by entities involved. Some of these examples are mentioned in a summary of Senator Grassley's oversight available on the Senate Finance Committee's web page; they include in addition to issues associated with some of the provisions enacted in the Pension Protection Act and other bills, the Red Cross, the Nature Conservancy, and the Smithsonian. 42
Recently, Senator Grassley has sent inquiries to several media based ministries for information on their finances. Religious organizations do not have to file the information (990) forms that other tax-exempt organizations have to file, so that it is difficult to obtain information. The issues of concern and status of this investigation, which relate to issues such as governance and compliance with tax withholding laws, are contained in a recent press release. 43
Author Contact Information
Jane G. Gravelle
Senior Specialist in Economic Policy
jgravelle@crs.loc.gov, 7-7829
1 Joint Committee on Taxation, Estimates of Federal Tax Expenditures for Fiscal Years 2007-2011 , JCS-3-07, September 24, 2007. The categories for education and health are estimated separately at $7 billion and $5.2 billion respectively. Of overall charitable contributions, not all of which are deductible because they are made by non-itemizers, about a third are to religious organizations,14% are to education, 10% each to private foundations and human services, around 7% each to health and public society benefit, about 4% each to arts, culture and humanities and international, and about 2% to environment and animals, with the remaining 8% unclassified. See Giving USA 2006, distribution posted at http://sforce.benevon.com/images/GivingUSA2007.htm.
2 The unrelated business income tax, or UBIT, is imposed on business activities unrelated to the charitable purpose, but it does not apply to investment earnings such as dividends and interest.
3 For FY2007 (ending in June of 2007) endowments of universities totaled $411 billion, and earned a return of 21.5% according to the National Association of College and University Business Officers (posted at http://www.nacubo.org/x2376.xml). At a 35% tax rate, this amount totals to $31 billion ($411 billion times 0.215 times 0.35). Based on the allocation of assets (about 60% to 70% in equity investments), standard shares in capital gains (60%) and shares of gains unrealized (50%), about 20% would be unrealized capital gains. The total loss would be about $25 billion ($31 billion times 0.80). The only other readily available data source of assets and earnings of specific charities is in the survey of large charitable institutions in the Chronicle of Philanthropy ( "Special Report: Jitters Among Strong Returns," pp. 6-11, June 24, 2008). Adding the assets of institutions outside of education indicated that these large non-educational institutions had endowments about 40% the size of all educational institutions, with about three quarters attributable to foundations, implying an additional revenue cost of around $10 billion, for a total of $35 billion. This estimate is incomplete, however, as only a limited number of charities are included and not all income is from endowments. For a more comprehensive number, some estimates of passive income are included in the national income accounts. Earnings for educational institutions for FY2006, a year with comparable data, were $52 billion. Although the income concepts are not precisely the same, in calendar year 2005 (which ended approximately six months earlier) total rents, dividends and interest reported in the National Income and Product Accounts ascribed to non-profits and retained were $64 billion (Mark Ledbetter, Comparison of BEA Estimates of Personal Income with IRS Estimates of AGI, Survey of Current Business, November 2008, p. 38) and, if the share of capital gains were assumed to be the same as endowment investments, total income would be $106 billion, with the total for all nonprofits roughly twice the amount of educational institution endowment earnings. Hence, the total revenue cost would be about twice as large as the loss from exempting endowments, or about $50 billion.
4 These documents can be found on the Joint Committee's website http://www.jct.gov/. The legislation discussed in this report is summarized in two volumes: General Explanation of Tax Legislation Enacted in the 108 th Congress , JCS-105, and General Explanation of Tax Legislation Enacted in the 109 th Congress , JCS-1-07
5 Congressional Budget Office, Budget Options , February 2007, p. 273.
6 President's Advisory Panel on Federal Tax Reform, Simple, Fair and Pro-Growth,: Proposals to Fix America's Tax System , Washington, DC, U.S. Government Printing Office, November 2005.
7 Congressional Budget Office, Budget Options , February 2007, p. 272.
8 See CRS Report RL31108, Economic Analysis of the Charitable Contribution Deduction for Non-Itemizers , by Jane G. Gravelle. The effects of alternative approaches on revenues and charitable giving were also addressed in Congressional Budget Office, Effects of Allowing Nonitemizers to Deduct Charitable Contributions , December 2002.
9 CRS Report RS21603, Minimum Distribution Requirements for Foundations: Proposal to Disallow Administrative Costs , by Jane G. Gravelle.
10 See James R. Boatsman and Sanjay Gupta, "Taxes and Corporate Charity: Empirical Evidence from Micro-Level Panel Data," National Tax Journal , Vol. 49, June 1996, pp. 193-213.
11 See CRS Report RL31097, Charitable Contributions of Food Inventory: Proposals for Change , by Pamela J. Jackson.
12 See, for example, testimony of Mark Everson, Commissioner of Internal Revenue, Statement on Exempt Organizations, Enforcement Problems, Accomplishments and Future Directions before the Senate Finance Committee, April 5, 2005: http://finance.senate.gov/hearings/testimony/2005test/metest040505.pdf.
13 Summary of Senator Chuck Grassley's Non-Profit Oversight, November 20, 2007: http://www.senate.gov/%7Efinance/press/Gpress/2007/prg112007a.pdf.
14 Joint Committee on Taxation, Options to Improve Tax Compliance and Reform Tax Expenditures. JCS-2-05, January 27, 2005, posted at http://www.jct.gov/s-2-05.pdf.
15 Issues surrounding supporting organizations and donor-advised funds, as well as gifts of appreciated property, are discussed in the testimony of Jane G. Gravelle, on Charities and Charitable Giving: Proposals for Reform, before the Senate Finance Committee, April 5, 2005, posted at: http://finance.senate.gov/hearings/testimony/2005test/jgtest040505.pdf
16 President's Advisory Panel on Federal Tax Reform, Simple, Fair and Pro-Growth,: Proposals to Fix America's Tax System , Washington, DC, U.S. Government Printing Office, November 2005.
17 Congressional Budget Office, Budget Options , February 2007.
18 These data are reported in the testimony of Jane G. Gravelle, on Charities and Charitable Giving: Proposals for Reform , before the Senate Finance Committee, April 5, 2005, posted at: http://finance.senate.gov/hearings/testimony/2005test/jgtest040505.pdf.
19 President's Advisory Panel on Federal Tax Reform, Simple, Fair and Pro-Growth,: Proposals to Fix America's Tax System , Washington, DC, U.S. Government Printing Office, November 2005.
20 For a discussion, see the testimony of Jane G. Gravelle, on Charities and Charitable Giving: Proposals for Reform, before the Senate Finance Committee, April 5, 2005, posted at: http://finance.senate.gov/hearings/testimony/2005test/jgtest040505.pdf.
21 Janette Wilson and Michael Strudler, "Individual Non-Cash Charitable Contributions 2003," Internal Revenue Service, Statistics of Income Bulletin , Spring 2006, p. 59.
22 See, for example, the report by the GAO, Vehicle Donation: Benefits to Charities and Donors but Limited Program Oversight , GAO-04-73, November 2003, at: [http://www.gao.gov/new.items/d0473.pdf}.
23 See Zachary A. Goldfarb, "Pension Bill Also Curbs Hunter's Breaks," Washington Post , August 5, 2006.
24 Janette Wilson and Michael Strudler, "Individual Non-Cash Charitable Contributions 2003," Internal Revenue Service, Statistics of Income Bulletin , Spring 2006, p.59.
25 The magnitude of these donations is difficult to determine as is the degree of potential abuse. Certain museums that had wealthy patrons using this process could lose significant donations, although these art works may not necessarily be exhibited constantly because of fractional ownership. According to a news report, the San Francisco Museum of Modern Art received 48% of donations in fractional giving in the fiscal year ending in 2001, although the share fell to 10% the next year and has recently climbed to 20% (See Sarah Duxbury, "SFMOMA Turns 'Timeshare' Gifts into an Art Form," San Francisco Business Times , August 19, 2005). In general, most discussions of fractional giving in the news seem to suggest that having the donor keep the art is not uncommon. (See Rachel Emma Silverman, "Joint Custody for your Monet," Wall Street Journal Online , July 7, 2007). A law journal article, in discussing the proposal to require physical possession stated: "This would effectively put an end to fractional gifts of large sculptures that are difficult and expensive to move every year. It will also substantially curtail fractional gifts of paintings since it is usually not the best idea to constantly move a fragile painting every year." This discussion also suggests that physical possession is an important issue. See Ralph E. Lerner, "Fractional Gifts of Art." New York Law Journal , April 24, 2006. A New York Times article stated "in practice, many museums have waived their right to possess pieces at all except when they needed them for exhibitions." Jeremy Kahn, "Museums Fear Tax Law Changes on Some Donations," New York Times , September 13, 2006.
26 Winokur v. Commissioner, 90 T.C. 733 (1988). James Winokur contributed fractional interests in paintings to the Carnegie Museum, and the museum had a right to possess the paintings but never did. This case is summarized in Marylynne Pitz, "Fractional Donations Require Close Look at the Law," Pittsburgh Post-Gazette, July 24, 2005: http://www.postgazette.com/pg/05205/541620.stm.
27 A discussion of this issue can be found in CRS Report RL32479, Tax Implications of SILOs, QTEs, and Other Leasing Transactions with Tax-Exempt Entities , by Maxim Shvedov.
28 The proposed regulation can be found at http://a257.g.akamaitech.net/7/257/2422/01jan20071800/edocket.access.gpo.gov/2007/pdf/E7-14925.pdf.
29 The proposed regulation can be found at: [http://a257.g.akamaitech.net/7/257/2422/01jan20071800/edocket.access.gpo.gov/2007/pdf/E7-14925.pdf].
30 See CRS Report RL32367, Certain Temporary Tax Provisions ( "Extenders" ) Expired in 2007 , by Pamela J. Jackson and Jennifer Teefy.
31 A New Era of Responsibility: Renewing America's Promise, Office of Management and Budget, Washington, D.C., U.S. Government Printing Office, 2009.
32 Paul N. Van de Water, Proposal to Cap Deductions for High Income Households Would Reduce Charitable Deductions by Only About 1%, Center on Budget Policy and Priorities. http://www.cbpp.org/cms/index.cfm?fa=view&id=2700. "How Changes in Tax Rates Might Affect Itemized Charitable Giving, by Deb Partha and Mark O. Wilhelm, The Center on Philanthropy at Indiana University found a reduction of less than 1%. [http://www.philanthropy.iupui.edu/docs/2009/2009_TaxChangeProposal_WhitePaper.pdf]
33 See Nick Tarlson, "Donor Advised Funds: Prepare for Closer Scrutiny," Journal of Accountancy , 2008: [http://www.aicpa.org/pubs/jofa/jan2008/donor_advised_funds.htm].
34 Congressional Budget Office, Nonprofit Hospitals and the Provision of Community Benefits , December 2006.
35 Tax Exempt Hospitals: Discussion Draft , at: [http://finance.senate.gov/press/Gpress/2007/prg071907a.pdf]
36 Internal Revenue Service, Hospital Compliance Program Interim Report , at: [http://www.irs.gov/pub/irs-tege/eo_interim_hospital_report_072007.pdf].
37 See CRS Report RL34605, Tax-Exempt Section 501(c)(3) Hospitals: Community Benefit Standard and Schedule H , by Erika K. Lunder and Edward C. Liu for further discussion of the legal issues involved in defining community benefit.
38 See "Special Report: Jitters Amid Strong Returns," Chronicle of Philanthropy , July 24, 2008, pp. 6-11. There was a similar period of slow growth during the 2001 recession, but funds still averaged high returns over the five year period that included the recession. See memorandum by Jane G. Gravelle. Congressional Research Service, analyzing endowment earnings, payouts, and uses that formed the basis for testimony, at: [http://finance.senate.gov/press/Gpress/2008/prg011408b.pdf].
39 See testimony of Jane G. Gravelle, Congressional Research Service and testimony of Lynn Munson, Center for College Affordibility and Productivity, before the Senate Finance Committee, September 26, 2007: [http://finance.senate.gov/hearings/testimony/2007test/092607testjg.pdf] [http://finance.senate.gov/hearings/testimony/2007test/092607testlm.pdf]. Also see the memorandum by Jane G. Gravelle. Congressional Research Service, analyzing endowment earnings, payouts, and uses that formed the basis for testimony, at: [http://finance.senate.gov/press/Gpress/2008/prg011408b.pdf].
40 Senate Finance Committee Press Release, "Baucus, Grassley Write to 136 Colleges, Seek Details of Endowment Pay-Outs, Student Aid." : [http://finance.senate.gov/press/Gpress/2008/prg012408f.pdf].
41 Charles E. Grassley, "Wealthy Colleges Must Make Themselves More Affordable," Chronicle of Higher Education, May 29, 2008: [http://finance.senate.gov/press/Gpress/2008/prg052908d.pdf].
42 Summary of Senator Chuck Grassley's Non-Profit Oversight, November 20, 2007: [http://www.senate.gov/%7Efinance/press/Gpress/2007/prg112007a.pdf].
43 [http://finance.senate.gov/press/Gpress/2008/prg070708.pdf].
Labels: 2009, Congressional Research Service Reports April 8
posted by Return Preparer Tax Law @ Thursday, April 16, 2009
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