TEFRA and DEFRA: Key Tax Rules and Provisions

In the early 1980s, the United States faced a growing budget deficit resulting from tax cuts and a difficult economy. Congress responded by passing two pieces of legislation: the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) and the Deficit Reduction Act of 1984 (DEFRA). These acts shifted fiscal policy by aiming to increase federal revenue and tax compliance without fully reversing prior tax rate reductions.

TEFRA was designed to generate revenue by closing tax loopholes and introducing stricter enforcement. At the time, it was the largest tax increase in U.S. history. Two years later, DEFRA continued this effort, refining the tax code to address areas where tax liabilities were being minimized in unintended ways. These laws reshaped federal taxation, with lasting effects on businesses, financial products, and individual taxpayers.

The TEFRA Partnership Audit Procedures

Before TEFRA, the Internal Revenue Service (IRS) faced administrative challenges when auditing partnerships. The law required the IRS to open separate audit proceedings for each partner to adjust their share of partnership items. This fragmented approach was inefficient, often led to inconsistent outcomes, and made it difficult to examine complex partnerships.

TEFRA introduced unified audit rules that changed how partnerships were examined. These procedures allowed the IRS to conduct a single, consolidated audit at the partnership level. Adjustments to items of income, gain, loss, deduction, or credit were determined in this single proceeding and then passed through to individual partners, who were required to report the changes consistently.

A central figure in this process was the “Tax Matters Partner” (TMP), a general partner designated to act as the primary liaison with the IRS. The TMP had the authority to represent the partnership, receive notices, and negotiate with the IRS. While the TMP held this primary role, other partners, such as those with a significant interest, were entitled to receive notice of the audit proceedings. All partners had the right to participate in the partnership-level proceedings.

These TEFRA procedures have since been replaced. The Bipartisan Budget Act of 2015 repealed the rules for partnership tax years beginning after December 31, 2017. A new centralized partnership audit regime was instituted where the IRS assesses and collects tax adjustments at the partnership level.

DEFRA’s Definition of a Life Insurance Contract

Before DEFRA, the tax code lacked a specific definition of a life insurance contract. This ambiguity allowed for the creation of policies structured more like investment vehicles than insurance products. These policies emphasized tax-deferred growth of cash value while minimizing life insurance coverage, which sheltered investment income from taxes.

DEFRA introduced Internal Revenue Code Section 7702, which established a two-pronged test to qualify a contract as life insurance for tax purposes. If a policy meets these requirements, its cash value grows tax-deferred, and death benefits are received income-tax-free. Failure to meet these tests means the contract is treated as an investment, and the policyholder must pay income tax on the annual increase in cash value.

The first test is the Cash Value Accumulation Test (CVAT). This test ensures the cash surrender value of the policy does not become excessive in relation to the death benefit. The CVAT dictates that the cash value may not exceed the net single premium required to fund the future benefits, preventing the policy from being used as an investment funded by a large, upfront premium.

The second, alternative test is the Guideline Premium Test (GPT), which has two components: a premium limitation and a cash value corridor. The premium limitation restricts the total amount of premiums that can be paid into the contract based on either the single premium needed to fund the benefits or a level annual amount. The cash value corridor requires the death benefit to be at least a specified percentage of the cash surrender value, ensuring a minimum amount of pure insurance risk is always present.

For contracts issued on or after January 1, 2021, the rules were updated by the Consolidated Appropriations Act. This legislation amended the tests to replace the original fixed interest rates with dynamic rates that are updated annually. This change allows for higher premiums to be paid into a policy relative to its death benefit while still qualifying for the tax advantages of life insurance.

Pension and Retirement Plan Reforms

TEFRA introduced rules for “top-heavy” retirement plans to ensure that rank-and-file employees receive minimum benefits in plans that disproportionately favor a company’s owners and highest-paid employees. A plan is considered top-heavy for a year if the total value of benefits for “key employees” exceeds 60% of the total value for all employees.

A “key employee” includes an officer of the company, an individual who owns more than 5% of the business, or an employee who owns more than 1% of the business. For 2025, an officer is a key employee if their compensation exceeds $230,000. A 1% owner is a key employee if their compensation is over $150,000; this amount is not indexed for inflation. The 60% test is performed annually, so a plan can move in and out of top-heavy status.

When a plan is determined to be top-heavy, two requirements are activated to protect non-key employees. The first is an accelerated vesting schedule, so employees gain full ownership of employer contributions more quickly. A top-heavy plan must adopt either a three-year “cliff” vesting schedule, where an employee is 100% vested after three years, or a six-year “graded” schedule with incremental vesting from the second year.

The second requirement involves minimum contributions or benefits for non-key employees. For a defined contribution plan like a 401(k), the employer must contribute a minimum of 3% of compensation. For a defined benefit pension plan, the employer must provide a minimum benefit accrual, calculated as 2% of the employee’s average compensation per year of service, up to a 20% maximum. These rules ensure that when a plan heavily favors leadership, a baseline benefit is still provided to all other eligible workers.

Key Tax Accounting and Timing Rules

DEFRA introduced changes to tax accounting rules, focusing on the timing of income and deductions to prevent taxpayers from deferring income or accelerating deductions. A primary area affected was Original Issue Discount (OID), which occurs when a bond is issued for less than its redemption price at maturity. DEFRA’s rules require both the issuer and holder to account for the discount as interest over the life of the bond, rather than waiting until maturity.

The act also established rules for imputed interest on loans with below-market interest rates and on seller-financed property sales. If a loan or sales contract does not charge a sufficient rate of interest, the IRS can recharacterize a portion of the principal payments as interest. This prevents parties from disguising interest income as a capital gain. The rules require a minimum interest rate tied to the applicable federal rate (AFR).

Another change made by DEFRA involved depreciation. The act extended the cost recovery period for most real property to 18 years under the Accelerated Cost Recovery System (ACRS), but that system is no longer in effect. The Tax Reform Act of 1986 replaced ACRS with the Modified Accelerated Cost Recovery System (MACRS), which sets the cost recovery period at 27.5 years for residential rental property and 39 years for nonresidential real property.