Pub L 98 369: Key Tax and Spending Changes Explained

Public Law 98-369, the Deficit Reduction Act of 1984, was a package of tax increases and spending cuts designed to address growing federal budget deficits. Signed into law on July 18, 1984, it was separated into two parts. Division A, the Tax Reform Act of 1984, contained numerous changes to the Internal Revenue Code, while Division B, the Spending Reduction Act of 1984, focused on curtailing government expenditures.

Major Tax Provisions Affecting Individuals

The act introduced rules under Internal Revenue Code Section 7872 to address below-market interest rate loans, preventing tax avoidance on loans with artificially low or no interest. Through a concept called “imputed interest,” the IRS treats the transaction as if a market-rate interest was paid by the borrower to the lender and then transferred back. This imputed transfer is then characterized based on the relationship, such as a gift, dividend, or compensation.

For gift loans between family members, the forgone interest is treated as a taxable gift. In compensation-related loans from an employer to an employee, the imputed interest is considered taxable wages. For corporation-shareholder loans, the forgone interest is treated as a taxable dividend paid by the corporation to the shareholder.

The act also altered the tax treatment of alimony and separate maintenance payments, establishing a more objective set of criteria. Prior to 1984, the rules were often subjective and led to disputes. To be considered alimony, payments had to meet several conditions:

• Payments had to be made in cash under a divorce or separation instrument.
• The instrument could not designate the payment as non-alimony.
• The spouses could not be members of the same household.
• The payor’s liability for payments had to cease upon the death of the recipient.

For decades, these rules allowed payors to deduct the payments and required recipients to include them in taxable income, though this tax treatment was eliminated for divorce agreements executed after 2018.

Rules for children of divorced or separated parents were also changed to resolve conflicts over which parent could claim a child for tax benefits. The law awarded the right to claim the child to the custodial parent—the one with custody for the greater part of the year. The noncustodial parent could claim the child only if the custodial parent formally released their right. While the dependency exemption was later suspended, this “custodial parent” standard remains a rule for determining who may claim various child-related tax benefits.

Key Corporate and Business Tax Reforms

The act changed the Accelerated Cost Recovery System (ACRS), which governed depreciation deductions. To slow the rate at which businesses could write off buildings, the act increased the minimum recovery period for most real property from 15 to 18 years. This extension reduced annual deduction amounts, thereby increasing taxable income for businesses and generating more tax revenue.

The taxation of export profits also saw a structural change. The act phased out the Domestic International Sales Corporation (DISC) regime and created the Foreign Sales Corporation (FSC) provisions in its place. An FSC was a foreign-chartered corporation that could exempt a portion of its export-related income from U.S. taxation if it met certain foreign presence requirements, a design intended to comply with international trade rules.

The act introduced the “luxury automobile” depreciation limits in response to businesses purchasing expensive cars for executives and taking large depreciation deductions. The new rules placed a dollar cap on the annual depreciation that could be claimed for a passenger automobile used in a business. For vehicles placed in service in 1984 and after, the investment tax credit was limited and annual depreciation deductions were capped.

Significant Financial Instrument and Transaction Rules

The act codified the “time value of money” concept, which recognizes that a dollar today is worth more than a dollar in the future. This was implemented through an expansion of the Original Issue Discount (OID) rules. OID arises when a debt instrument, like a bond, is issued for a price less than its redemption price at maturity, with the discount functioning as interest.

Previously, OID rules were limited, allowing taxpayers to defer interest income. The new law broadened their application to more debt instruments, including those issued by individuals or not publicly traded. It required both the issuer and holder to include a portion of the OID in their taxable income each year, regardless of whether cash interest was paid, ensuring interest income was reported systematically.

Related to OID were new imputed interest provisions for seller-financed property sales, governed by Internal Revenue Code Sections 1274 and 483. These rules apply when a seller provides a loan to a buyer with a below-market interest rate. If a contract did not state an adequate interest rate, a portion of the principal would be recharacterized as interest, preventing sellers from converting interest income into capital gains. These rules established a minimum interest rate, the Applicable Federal Rate (AFR) published monthly by the IRS, that must be used in most seller-financed sales to avoid interest imputation.

Life Insurance and Employee Benefit Provisions

The act overhauled the federal income taxation of life insurance companies. The previous system was a complex, three-phase structure that allowed for significant tax deferral. The act replaced it with a simpler, single-phase structure that taxed life insurance companies more like other corporations, based on their taxable income with deductions for additions to reserves.

The act also introduced tax incentives to encourage the use of Employee Stock Ownership Plans (ESOPs), which are benefit plans that invest primarily in the stock of the sponsoring employer. One provision allowed a shareholder of a privately held company to defer capital gains tax on the sale of stock to an ESOP if the proceeds were reinvested in other U.S. corporate securities. Another incentive allowed the sponsoring corporation to deduct cash dividends paid on stock held by an ESOP if the dividends were paid to employees or used to repay an ESOP loan.

Spending Reductions and Other Notable Changes

In addition to tax reforms, the act’s Division B, the Spending Reduction Act of 1984, implemented cuts and modifications to federal programs. These changes were aimed at slowing the growth of government expenditures and were a part of the law’s deficit-cutting mission.

One strategy was the implementation of freezes and delays in cost-of-living adjustments (COLAs) for various federal entitlement programs. By postponing or limiting these automatic increases, the law curtailed the projected growth in spending for programs that would have otherwise expanded with inflation.

The act also made changes to the Medicare program to control its rising costs. It modified payment structures for hospitals and physicians, introducing new reimbursement methods to promote efficiency. For instance, the law refined the prospective payment system for hospitals and adjusted how physicians were paid for services provided to Medicare beneficiaries.