duced and retained until 1969. The gradual increase of the alternative tax ceiling provided by the 1969 Tax Reform Act represented a Congressional response to public pressure to remove this provision which was of primary benefit to higher income taxpayers. Holding period requirements have fluctuated through the years. Throughout, there has been the intention to exclude speculative gains from the relief provisions. On the other hand, there have been objections to the "lock-in" effect which might result from longer holding periods. A summary of the historical evolution of the federal income tax treatment of capital gains and losses in the United States is attached as Appendix B to this statement. The importance of incentives for capital investments In the normal course of practice, Certified Public Accountants have broad experience in working with businesses and investors. Through this experience, we are in a position to judge the effectiveness and impact of taxation on the availability of capital for investment and the willingness of investors to accept the risks associated with investments. Much has been said and written about the needs of this nation for capital investment during the next few years, but this cannot be overemphasized. Some economists have estimated our capital needs to be at least $100 billion per year for the foreseeable future. If we are to meet the challenges of greatly increased competition from abroad (both in domestic and foreign markets) and also the needs to solve problems at homesocial, environmental and economic-we must continue a tax structure that will encourage citizens to accumulate capital and take the risks inherent in investing it. As an example of the problems faced by American business in competing in world-wide markets, a Fortune survey of our 500 largest industrial companies shows that the average amount of capital investment per employee has risen from approximately $16,400 in 1957 to $31,800 in 1971. Total assets for these companies increased over this period from roughly $190 billion to over $450 billion. In spite of this increase in capital investment, U.S. industry presently has the highest percentage of obsolete industrial facilities of any leading industrial nation. Furthermore, we are replacing facilities at a slower rate than other leading countries. As an example, fixed asset investment in relation to gross national product for Japan and West Germany is currently running about 27% and 20% respectively, while our percentage is less than 13. Rapidly changing technology and modernization of facilities will continue to require large amounts of capital. If preferential treatment for capital gains is eliminated, there are serious doubts as to the availability of the capital needed and the willingness of investors to take the risks. Impact of inflation Much has also been said about the severe impact of inflation on our economy. Changes in price levels affect all of us in many ways, but particularly acute problems arise where assets are held for relatively long periods of time. There are many indexes designed to measure inflation, but they all indicate the same picture. The United States Department of Labor Consumer and Wholesale Price Indexes, using 1967 as the base year, indicate the following changes: Expressed as a percentage increase, the Consumer Price Index has risen nearly 50% in the last 15 years, and about 25% in the last 5 years. If a taxpayer invested $100,000 in a corporate security in 1957 and sold it for $150,000 in 1972, he would have been approximately even in terms of purchasing power. However, even under our present capital gains tax structure, he probably would have incurred a tax of at least $12,500. This would have placed him in a worse position economically in 1972 than he would have been 15 years earlier. In effect, this represents a tax on capital and not a tax on income or real gain. By analogy, it represents a failure to distinguish between the tree and its fruit— a tax on the tree, rather than on the fruit. The combined effects of inflation and taxation have clearly eroded the amount of capital available for additional investment. If the present preferential treatment for capital gains were eliminated, the erosion of capital would be much greater, and in our judgment could create serious problems for our economy. Recommendations Preferential treatment for capital gains.—We believe that full taxation of capital gains will diminish the willingness of investors to risk capital in new ventures. Furthermore, high tax rates obviously discourage investors from selling appreciated assets. This leads to undersirable results. It tends to inhibit the flow of funds into other investments, thereby prolonging the life of certain entities or ventures that may have become comparatively less productive. And, if nothing else, it produces the so-called "lock-in” effect which severely restricts the free flow of capital. We believe that these counter incentives are not in the best interests of our free enterprise system which is basically responsible for the relatively high standard of living in the United States. Preferential treatment is also needed to relieve the financial hardships created by the bunching of income in a progressive tax system when there is a realization of substantial gains which have accrued over a long period of time. Without preferential treatment, such gains would be subjected to unfair and confiscatory taxation. While the present income averaging provisions provide some relief in this connection, this relief is too limited and inadequate under the circumstances. For these reasons we believe that preferential tax treatment for capital gains should be continued. Definition of capital assets.-While we favor the retention of some preferential treatment for capital gains, we recommend several modifications of the present law in this area. We believe these modifications would improve and simplify the capital gain and loss provisions of the Code and, at the same time, be responsive to public pressure for further legislative changes in this connection. At present, capital assets are defined negatively in Section 1221 of the Code. Under Section 1221, all assets are considered capital assets unless they are specifically excepted in the statute. We suggest a revision of Section 1221 to make it positive rather than negative. In addition, we would narrow the definition of a capital asset along the following lines: 1. The term "capital asset" means property which: (a) Is a corporate security or other "investment asset"; (b) Has been held by the taxpayer for more than 1 year; and (c) Is not held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business. 2. The term "investment asset" for this purpose means property other than a corporate security which consists of: (a) Real estate or tangible personal property the ownership and use of which does not constitute the conduct of a trade or business; or (b) An interest in a partnership, joint venture or other similar type of entity. We believe this more limited definition of a capital asset provides greater clarity, contributes to simplification of a very complicated section of the law and continues to provide an incentive for desirable captal accumulation and the assumption of risk essential for the growth, strength and prosperity of our free enterprise system. We are aware that our tax laws now contain special provisions which extend capital gain treatment to many items which would ordinarily not be considered capital assets. In our judgment, the general approach taken in the Mills-Ullman type of legislation introduced in the 92nd Congress, providing for a systematic and periodic Congressional review of all special provisions in order to determine the continuing justification for such special treatment, is an appropriate way to deal with these items. These special provisions should be evaluated on their merits, and more direct ways of providing desirable incentives should be considered. Extension of the holding period.-We believe that the present six-month holding period for long-term gain should be extended to a year. This would be responsive to the contention that quick profits contain an element of speculation which should not be rewarded by the law. A one-year holding period also corresponds to the period generally used to distinguish a capital expenditure from a current expense. Sliding scale for inclusion of capital gains.—In conjunction with the adoption of a longer holding period, we also recommend a return to the sliding scale of exlusions similar to those in effect during the period 1934 to 1937. Although we are not recommending a reestablishment of the 1934-1937 exclusion ratios, we do support the concept of ecouraging longer-term investments in our nation's productive facilities. Gains on assets held longer than one year could be excluded from income at the rate of 10% per year or at any other rate that Congress deems appropriate. Longterm losses.-Although we do not recommend unlimited deductibility of capital losses at this time, we do believe the present structure for the deduction of capital losses and carryovers should be improved. We suggest that a three-year carryback of capital losses on a basis similar to that already prescribed in the case of corporate taxpayers should be allowed. In our view, such carrybacks in the case of noncorporate taxpayers should be limited to previously realized capital gains. We feel that this three-year carryback is more appropriate and equitable, since gains are taxed as they occur and fairness would seem to indicate that losses which occur shortly afterward should be available to offset such gains. The deductibility of net capital losses from ordinary income has been arbitrarily limited to various amounts since 1934. In view of the fact that the present rules for allowance of a $1,000 per year write-off of excess capital losses against ordinary income dates back to 1942, we feel that an increase in this allowance may be warranted at this time. III. CAPITAL RECOVERY Your Committee has already heard testimony suggesting that the investment credit, accelerated depreciation (including the Asset Depreciation Range system) and other special amortization and depreciation provisions of the Code be further restricted, cut back or repealed. It is our view that the investment credit and the ADR system are beneficial and effective incentives to stimulate capital investment necessary to finance the continued growth, productivity and modernization of this nation's productive facilities. Particularly in these times of rapidly-advancing technology, it is vital to our national interest to remain competitive with foreign businesses-and these incentives seem desirable to better enable American businesses to so compete. In any event, considering the relatively short time that these provisions have been enacted into the Code, we suggest that they be tested longer in actual practice before they are again modified, suspended or discarded. IV. PRIVATE PENSION PLANS Last year the Institute testified before this Committee on H.R. 12272, an Administration-sponsored bill affecting private pension plans. While no formal action was taken on this bill by Congress, we feel that, with modification, it could provide a reasonable basis for reform of the private pension system. Since we feel that H.R. 12272 offered a practical beginning, our comments at this time will be limited generally to those provisions which were originally a part of that bill and which may directly affect self-employed individuals and their employees. Although members of our profession undoubtedly have individual opinions on proposals regarding funding and portability, we are not in a position at this time to present a consensus view as a "profession." Our comments cover proposed changes relating to (1) eligibility, (2) vesting and (3) contribution limitations-in the case of plans which cover one or more self-employed individuals—and the proposal for deductions for individual retirement savings. It is our general view that special restrictions or limitations on qualified retirement plans covering self-employed individuals should be imposed only where there is a clear and present need to establish rules which would not otherwise be satisfied by the general nondiscrimination provisions of the Code as they relate to employee benefit plans. We therefore urge that the goal of equal treatment in this respect be a key element in your consideration of this important area of tax legislation. Eligibility Present law. The Internal Revenue Code does not presently contain any specific requirements for qualified deferred compensation plans regarding eligibility conditions based on age or length of service, except that in the case of an unincorporated business in which an "owner-employee" participates, the plan cannot exclude an employee who has been employed for three or more years. Apart from this exception, existing administrative practice permits a plan to limit participation to employees who have attained a specified age (e.g., 40 years), who have been employed for a specified period of time (e.g., 5 years) or who are too close to retirement age at the time they would otherwise first become eligible to participate in the plan. 1972 Adminisration proposal.-Under H.R. 12272, a plan would not qualify if it required that an employee complete service with the employer for more than 3 years, have attained an age in excess of 30 years, or where, as of the time he is first eligible to participate, he has not attained an age greater than 5 years preceding normal retirement age under the plan. In the case of plans covering self-employed individuals who are "owner-employees," the eligibility conditions could not require the completion of more than three years of service if the employee's age is less than 30 years, more than 2 years of service if his age is 30 years or more but less than 35 years, or more than one year of service if his age is 35 years or more. Recommendation.-The institute agrees wth the underlying philosophy that qualification of private retirement plans should be permitted only where the eligibility conditions are not unduly restrictive as to age and service. It is, however, a matter of judgment whether an appropriate age qualification requirement should be established within a 30-to-35 range, or whether the service qualification requirement should be based on a 3-year formula. On the other hand, the Institute does not believe that there is any basic justification for imposing additional restrictions on the qualifying conditions for a plan which also benefits selfemployed individuals who are "owner-employees." We, therefore, oppose the "3-21" service and age eligibility tests proposed for such plans. The eligibility requirements for plans benefiting "owner-employees" should be no different than for plans established by corporate employers. Vesting Present law. The Internal Revenue Code does not presently specify vesting standards for qualificaton of employee retirement plans, but various standards have been applied administratively. Generally, the administratve standards applied for profit-sharing plans have been more restrictive than those for pension plans. In the former case, vesting usually has been required to begin within the first 5 years of participation, whereas in the latter case vesting may be deferred until retirement. 1972 Administration proposals.-H.R. 12272 provided the same standard for both pension and profit-sharing plans through the application of a "rule of 50" (or in plans which cover "owner-employees," a "rule of 35"). In addition, it would have authorized the promulgation of regulations setting forth vesting requirements in the case of certain other closely-controlled partnerships (and corporations) which do not include "owner-employees." In such circumstances, the regulations could impose vesting requirements which are more stringent than the "rule of 50", but not more stringent than the "rule of 35." The effect of these proposals would be to establish three levels of vesting standards: 1. The "rule of 50" as the general rule. 2. The "rule of 35" in the case of a plan covering a (10%) "owneremployee." 3. A third standard falling between the "rule of 50" and the "rule of 35" to be determined by regulations in the case of certain closely-controlled partnerships and corporations. Recommendations.-The Institute agrees with the basic philosophy that qualified retirement benefits should become fully vested prior to retirement. We also believe that vesting standards should now be legislatively prescribed and that the "rule of 50" could be an appropriate mechanical device to establish such requirements, if it is desirable to recognize age in addition to service as a factor in the vesting of retirement benefits. Furthermore, we wish to make it clear that while we believe that the "rule of 50" is a workable concept in providing for vesting requirements, we do not believe that it is the only acceptable proposal, and we are receptive to other suggestions which have been made before this Committee and the Pension Task Force of the House Committee on Education and Labor. While we accept the "rule of 50" as a suitable method for establishing uniform vesting standards, we do not agree with the variations of the rule which result in a three-tiered standard. In proposing its legislative changes last year, the Administration stressed the importance of eliminating artificial distinctions in the tax treatment of similar plans because such plans are sponsored by dfferent types of business entities. We now urge that Congress promote greater uniformity between and among qualified retirement plans by providing for no more than a two-tiered formula for vesting-with a rational basis for the more stringent second tier where the contributions or benefits are primarily for a limited group of participants who also have controlling ownership interests in a business entity. We suggest that this more restrictive vesting provision should apply irrespective of the form of business entity. With respect to implementing this proposal, we question the test included in H.R. 12272 as to what constitutes a plan primarily for the benefit of controlling ownership interests. H.R. 12272 proposed that a more than 5% ownership interest, or in the alternative, a more than 1% to 5% interest which, when combined with other such interests, represent more than 50% of the value of the business, is sufficiently large to justify a separate and more stringent vesting standard than the proposed general rule. We suggest that ownership interest of the business is not the only factor which should be considered. Rather, the extent of benefits (whether or not vested) under the plan for those who represent the controlling ownership interests should also be considered in determining whether a more stringent vesting standard should be imposed. We propose, therefore, that the second standard for vesting (which should be no more restrictive than the "rule of 35") should apply in any case where the controlling ownership interests of those who participate in the plan aggregate more than 50% of the value (or vote) of the business entity (partnership or corporation), and their aggregate interest in employer contributions exceeds 50% of the total employer contributions under the plan. We urge that this second vesting standard be required by legislation, rather than be the subject of regulatory authority. The administrative aspects of this proposal, such as the future treatment in instances where the ownership interests change, could properly be the subject of Treasury Department regulations. Deduction for retirement savings 1972 Administration proposal.—H.R. 12272 provided a method whereby an employee (or a self-employed individual) may establish a personal retirement plan to provide for his own retirement benefits and secure a limited deduction for federal income tax purposes. In general, the amount deductible would be limited to 20% of the first $7,500 of earned income, subject to further reduction for (1) amounts contributed on his behalf under another qualified plan of his employer, or (2) for the equivalent amount of tax that would be imposed on the employee under FICA in the case of an employee who is not covered by the social security system. Recommendations.-The Institute urges the incorporation of this provision in any legislation that may be proposed because we believe that the individual retirement plan provisions will be beneficial to employees of many business entities which do not now have employer-sponsored retirement plans. We suggest, however, that appropriate provision be made for a simple method of annual reporting by individuals. The benefits of individual retirement savings plans should not be eroded by placing onerous reporting burdens on relatively unsophisticated taxpayers who choose to adopt such plans. The desirability of a simplified reporting procedure could be described in accompanying committee reports. Contributions on behalf of self-employed individuals Present law.-The Code now provides a distinction between plans covering only employees and those which also cover self-employed persons. In the latter case, $2,500 is the maximum allowable deduction for contributions on behalf of such a self-employed person. |