Letter Regarding Conference Report to H.R. 4520

LETTER REGARDING CONFERENCE REPORT TO H.R. 4520 -- HON. WILLIAM M. THOMAS (Extensions of Remarks - October 11, 2004)

HON. WILLIAM M. THOMAS
OF CALIFORNIA
IN THE HOUSE OF REPRESENTATIVES

THURSDAY, OCTOBER 7, 2004

Mr. THOMAS. Mr. Speaker, I would like to insert in the RECORD, the following letter concerning the Conference Report to H.R. 4520, the "American Jobs Creation Act of 2004."

Department of the Treasury,
Internal Revenue Service,
Washington, DC, October 7, 2004.

Mr. GEORGE K. YIN,
Chief of Staff, Joint Committee on Taxation,
Washington, DC.

DEAR MR. YIN: Enclosed are the combined comments of the Internal Revenue Service and the Treasury Department on the new deduction relating to income attributable to domestic production activities contained in the Conference Committee Report on the "American Jobs Creation Act", that you identified for complexity analysis in your letter of October 6, 2004.

Our comments are based on the description of the provision provided in your letter, and the statutory language and description of this provision in the Chairman's Mark for the Conference Committee on H.R. 4520, dated October 4, 2004, as posted on the House Ways and Means Committee web site. Due to the short turnaround time, our comments are provisional and subject to change upon a more complete and in-depth analysis of the provision.

Overall, the conference report provides new tools that will assist the IRS in administering the tax laws. However, thus far in the appropriations process, I would note that Congress has not taken favorable action with regard to the request for incremental enforcement resources for the IRS in the President's FY 05 budget request. As noted in the attached analysis, IRS will face additional challenges and resource requirements in administering the proposed domestic production activities credit.

Sincerely,

Mark W. Everson,
Commissioner.

Enclosure.

COMPLEXITY ANALYSIS OF PROVISION FROM H.R. 4520, AMERICAN JOBS CREATION ACT OF 2004
DEDUCTION RELATING TO INCOME ATTRIBUTABLE TO DOMESTIC PRODUCTION ACTIVITIES

The provision provides a deduction from taxable income (or, in the case of an individual, adjusted gross income) that is equal to a portion of the taxpayer's qualified production activities income. For taxable years beginning after 2009, the deduction is equal to nine percent of the lesser of (i) the qualified production activities income of the taxpayer for the taxable year, or (ii) taxable income (determined without regard to this section) for the taxable year. For taxable years beginning in 2005 and 2006, the deduction is three percent of income and, for taxable years beginning in 2007, 2008 and 2009, the deduction is six percent of income. However, the deduction for a taxable year is limited to 50 percent of the W-2 wages paid by the taxpayer during the calendar year that ends in such taxable year.

For purposes of determining the deduction, qualified production activities income is equal to domestic production gross receipts, reduced by the sum of (a) cost of goods sold allocable to such receipts, (b) other deductions, expenses, or losses, directly allocable to such receipts, and (c) a ratable portion of deductions, expenses, and losses not directly allocable to such receipts or another class of income.

The provision is effective for taxable years beginning after 2004.

Administration, Compliance and Controversy

The new deduction for domestic production activities will require the promulgation of extensive, detailed new guidance, particularly in the form of regulations. We anticipate that guidance will be required to address:

1. Which activities constitute production activities;

2. The statutory exceptions to the definition of production activity;

3. The allocation of revenues between production and non-production activities;

4. The allocation of deductions between production and non-production activities;

5. The application of the provision when related and unrelated taxpayers perform parts of the production activity; and

6. Numerous other issues.

We expect that such guidance will be difficult to craft. By distinguishing "production" from other activities, the provision places considerable tension on defining terms and designing anti-abuse rules.
Many businesses, particularly small businesses, will find it difficult to understand and comply with these complex new rules, which will affect not only the computation of a taxpayer's regular tax liability but also its alternative minimum tax liability. It will be difficult, if not impossible, for the IRS to craft simplified provisions tailored to small businesses or other taxpayers.

Taxpayers will be required to devote substantial additional resources to meeting their tax responsibilities, including not only employees and outside tax advisers, but also recordkeeping and systems modification resources. The resulting costs will reduce significantly the benefits of the proposal. Some small businesses may find that the additional costs outweigh the benefits, particularly during the initial phase-in period.

It will be necessary to devote significant audit resources to administering the new deduction. This will be due not only to the novelty of the rule but also to the benefits that are provided to "production activities" over other aspects of a taxpayer's business. Taxpayers naturally will classify everything possible as production activities. Audits, particularly those involving integrated businesses, will have to focus on classification and the allocation of income and costs. Significant additional IRS resources will be needed to administer the provision to avoid diverting resources from other compliance issues (such as tax shelters).

Finally, for all of the reasons discussed above, we anticipate a significant increase in controversies between taxpayers and the IRS. This will increase the number of IRS appeals cases and litigated tax cases.

Tax Forms and Publications

The computation of the deduction relating to income attributable to domestic production activities would be figured on a new form for 2005 of at least 10 lines. The instructions for the new form would likely be at least 3 pages.

Two additional lines would have to be added to each 2005 form or schedule on which the deduction from the new form could be claimed. The deduction would be claimed on the following forms and schedules, among others.

1. Schedule C (Form 1040) (sole proprietors);

2. Schedule F (Form 1040) (farm businesses);

3. Form 1041 (estates and trusts);

4. Form 1065 (partnerships);

5. Form 1065-B (electing large partnerships);

6. Form 1120 (corporations);

7. Form 1120-A (short tax return for corporations);

8. Form 1120S (S corporations); and

9. Other Form 1120 series returns.

2005 Forms 4626, 6251, and Schedule I of Form 1041 would have to be revised to add a new line to reflect the difference between the regular tax deduction and alternative minimum tax deduction.

The instructions for all affected forms and schedules listed above would have to be revised to reflect the new deduction.

The tax forms and publications for 2007 and 2010 would have to be updated to reflect the increasing percentage of qualified production activities income taken into account beginning in those years.

Programming changes would be required to reflect the new 10 line form, the two additional lines on the above forms and schedules, and the changing percentages. Currently, the IRS tax computation programs are updated annually to incorporate mandated inflation adjustments. Any programming changes necessitated by the provision would be included during that process.

The following 2005 publications, among others, would have to be revised to cover the new deduction, adding 3 to 6 pages to each.

1. Publication 225 (farmers);

2. Publication 334 (small business tax guide);

3. Publication 541 (corporations);

4. Publication 542 (partnerships); and

5. Publication 535 (business expenses).

Training materials and the Internal Revenue Manual would have to be revised to reflect the new deduction.