The Revenue Reconciliation Act of 1993 attacks the conversion of ordinary income to capital gain; additional changes are aimed at limiting benefits from capital gains.

• Author: Mason, Donald J.

The Revenue Reconciliation Act of 1993 (RRA) raised the top marginal tax rate on ordinary investment income for noncorporate taxpayers to 39.6%, while retaining the pre-RRA maximum tax rate of 28% on long-term capital gains. While the primary purpose of this increase in rates was to raise revenue, Congress was apparently concerned that the increased differential between the rates on ordinary income and capital gains might cause taxpayers to enter into certain transactions that would generate capital gains and take advantage of the lower rate. In response to this concern, the RRA adds new Sec. 1258 to prevent transactions, known as conversion transactions, that are designed to convert ordinary income into capital gain. The Act has also made changes to several existing provisions that will reduce the actual amount of capital gains recognized in certain transactions, make it more difficult to recognize capital gains or eliminate a related tax benefit from 'recognizing capital gains. These changes affect market discount bonds, stripped preferred stock, investment interest expense and the definition of substantially appreciated inventory of partnerships. Although these provisions were listed under the RRA's individual provisions, with the exception of the changes to the investment interest expense rules, they could also apply to corporate taxpayers. This article will analyze these changes and the significant complications that result.

Conversion Transactions--New Sec. 1258

* Overview

Sec. 12581 is a complex provision that adds new concepts that will require substantial guidance through regulations or other administrative pronouncements. Sec. 1258 generally requires a taxpayer to recharacterize a portion of recognized capital gain from a "conversion transaction" as ordinary income. The amount of the recharacterization is equal to an imputed rate of return on the taxpayer's net investment in the transaction. This recharacterization would apply to gain that, absent this provision, would otherwise be a long-term or short-term gain even though there is no rate differential between short-term capital gains and ordinary income. The recharacterization rules would also apply to corporations, even though there is no difference in the corporate tax rate on capital gains and ordinary income. It appears that the major hammer aimed at corporations is to prevent the circumvention of the restrictive capital loss rules. Although Sec. 1258 would recharacterize capital gain as ordinary income in specified situations, it does not create tax symmetry because it does not recharacterize capital loss as ordinary loss in "reverse" conversion transactions.(2) Sec. 1258 applies to conversion transactions entered into after Apr. 30, 1993.

* Conversion transaction

The Explanation of the Senate Finance Committee(3) describes a conversion transaction as one in which the taxpayer is in the economic position of a lender, i.e., "he has an expectation of a return from the transaction which in substance is in the nature of interest and he undertakes no significant risks other than those typical of a lender." Sec. 1258(c) defines a conversion transaction as any transaction in which "substantially all" of the taxpayer's expected return is attributable to the time value of the taxpayer's net investment in such transaction (lender-type transactions) and falls into one of the following four specified categories:

1. Transactions that consist of the acquisition of property by the taxpayer and a substantially contemporaneous agreement to sell the same or substantially identical property in the future.

2. An applicable straddle.

3. A transaction that was marketed or sold to the taxpayer on the basis that it would have the economic characteristics of a loan but the interest-like return would be taxed as capital gain.

4. Any other transaction described in regulations to be promulgated by the Treasury.

The statute creates immediate uncertainty by failing to define the term "substantially all." Absent a clear definition of substantially all, certain taxpayers may hesitate to enter into legitimate transactions while others, no doubt, will pursue arguably more questionable transactions. This type of uncertainty and resulting conflicting behavior undermines the effectiveness of the statute and tends to result in needless audit disputes and/or litigation. However, operational questions will still remain even if a clear definition of substantially all is provided by future administrative guidance.

Example 1: X purchases $200 of gold on jan. 1, 1994, and simultaneously agrees to sell on jan. 1, 1995 $100 of the gold for $106. Is this entire transaction a conversion transaction? Should it be divided into two transactions, i.e., $100 investment and $100 conversion transaction?

The statute and legislative history do not provide guidance for this simple scenario. Future guidance should not only define "substantially all" but also explain the treatment of transactions that are not entirely conversion transactions. Transactions that consist of the acquisition of property and the substantially contemporaneous entry into a contract to sell such property or substantially identical property: Further definitional guidance in this category is necessary. For example, what is substantially identical property?(4) When is a transaction considered to be "substantially" contemporaneous?(5)

"Applicable straddles:" For this purpose, Sec. 1258(d)(1) defines an applicable straddle as any straddle within the meaning of Sec. 1092(c), except that the term "personal property" includes stock. Sec. 1092(c)(1) defines a straddle as offsetting positions with respect to personal property. For Sec.

1258 purposes, personal property means any personal property of a type that is actively traded, including stock...