What Are the Tax Provisions of PL 101-239?

Public Law 101-239, the Omnibus Budget Reconciliation Act of 1989 (OBRA ’89), was a significant piece of federal legislation enacted to address the national budget deficit. Signed into law on December 19, 1989, its primary objective was to achieve deficit reduction targets for the 1990 fiscal year. While the legislation implemented widespread changes, a substantial portion under Title VII was dedicated to revenue-raising provisions that amended the Internal Revenue Code. These tax changes affected corporations, individual taxpayers, and employers, and this analysis focuses on its most durable tax provisions.

Significant Corporate Tax Adjustments

The Omnibus Budget Reconciliation Act of 1989 involved major adjustments to corporate income tax rules, largely in response to the wave of leveraged buyouts (LBOs) that characterized the 1980s. Congress became concerned that the tax code was subsidizing these debt-financed acquisitions through the full deductibility of interest payments on high-yield debt instruments.

The law introduced rules to limit interest deductions on certain debt, targeting what the law defined as an “applicable high-yield discount obligation,” or AHYDO. For a debt instrument to be classified as an AHYDO, it must have a maturity term of more than five years, its yield to maturity must be at least five percentage points higher than the applicable federal rate (AFR), and it must have “significant original issue discount” (OID).

The law bifurcated the interest on such bonds. The portion of the interest that is not OID is deductible only when paid in cash. The “disqualified portion” of the yield, which is the part of the interest return that exceeds the AFR plus six percentage points, is completely non-deductible.

OBRA ’89 also modified the rules for utilizing net operating loss (NOL) carrybacks. The corporate equity reduction transaction (CERT) rules limited a corporation’s ability to carry back NOLs to offset past income when those losses were generated by interest expenses related to major corporate acquisitions.

Reforming Taxpayer Penalties and Compliance

One of the lasting reforms within OBRA ’89 was the creation of the Improved Penalty Administration and Compliance Tax Act, known as IMPACT. This subtitle of the law overhauled the civil tax penalty structure within the Internal Revenue Code, simplifying a complex system into a more coordinated one.

The centerpiece of IMPACT was the consolidation of several penalties into a single “accuracy-related penalty.” This new structure took effect for tax returns due after December 31, 1989, and applied a uniform rate of 20% of the portion of the tax underpayment attributable to certain specified behaviors.

The accuracy-related penalty applies to underpayments resulting from several issues, including:

• Negligence or disregard of rules or regulations.
• A substantial understatement of income tax, which applies when the understated amount exceeds the greater of 10% of the tax required to be shown on the return or $5,000 for individuals ($10,000 for most corporations).
• Substantial valuation misstatements.
• Substantial overstatements of pension liabilities.

The law established an exception to the accuracy-related penalty if a taxpayer can demonstrate that there was “reasonable cause” for the underpayment and that they acted in “good faith.”

Key Revisions to Employee Benefit Plans

The Omnibus Budget Reconciliation Act of 1989 brought substantial changes to employee benefit plans, most notably by repealing Section 89 of the Internal Revenue Code. These rules had established a highly intricate series of nondiscrimination tests for health and welfare benefit plans. The compliance burden proved expensive and administratively overwhelming for many businesses, which led Congress to repeal Section 89 retroactively.

Another area of revision involved Employee Stock Ownership Plans (ESOPs), as the law tightened tax incentives created to encourage these plans. One change was a restriction on the partial interest exclusion available to commercial lenders that made loans to an ESOP. OBRA ’89 limited this 50% interest income exclusion to loans where the ESOP owned more than 50% of the employer’s stock immediately after the acquisition.

Furthermore, the act curtailed an estate tax incentive related to ESOPs. Prior law had allowed an estate to deduct 50% of the proceeds from the sale of employer securities to an ESOP. OBRA ’89 repealed this deduction for sales occurring after its enactment.

Impact on Estate and Gift Taxes

The tax provisions within OBRA ’89 also extended to wealth transfer taxes, introducing targeted changes to estate and gift tax rules. The law took aim at specific estate planning techniques that were perceived as allowing wealthy individuals to transfer assets to the next generation at artificially low tax values. A primary focus of these reforms was to curtail the use of estate valuation freezes.

An estate valuation freeze was a technique where a business owner would recapitalize their company into two classes of stock: preferred and common. The owner would retain the preferred stock, which had a fixed value, and gift the common stock, which held the potential for future appreciation, to their heirs. This effectively “froze” the value of the business in the owner’s estate.

OBRA ’89 enacted Chapter 14 of the Internal Revenue Code, which included new valuation rules that severely restricted this practice. These rules established that for gift tax purposes, the value of the retained interest would be treated as zero unless it met specific, stringent requirements, such as providing for qualified fixed payments. This change forced a much higher valuation on the gifted common stock, resulting in a higher immediate gift tax.