Something exciting happened in Washington recently and, amazingly, it didn't involve anyone named Monica or Ken. A year after the famous "Tax Payers' Relief Act of 1997" (TRA '97), the kinks are finally being worked out by the newest tax act known as "The Internal Revenue Service Restructuring and Reform Act of 1998" (the Act). In addition, Massachusetts passed some long-awaited tax legislation.
While TRA '97 brought long-awaited "tax relief," it also left a number of uncertainties which the Act has attempted to correct. The following article contains highlights of some of the technical corrections to TRA '97.
Qualified Family Owned Business Deduction
As we reported last year, TRA '97 brought an additional estate tax exemption of $700,000 for a "qualified family owned business," allowing certain "qualified" estates a total estate tax exemption of $1.3 million. Note, however, that under the original structure of the exemption, as the unified credit increased each year, the amount of the exemption decreased. In other words, in 2006, when the unified credit equivalent is $1,000,000, the exclusion for an estate with a family business is $300,000, for a total exemption of $1.3 million.
The effect of this is that estates of equal size would pay more in taxes in 2006 than they would in 1998, because the unified credit reduces the estate at the lower estate tax brackets, while the exclusion reduces taxes at the highest marginal level.
The Act remedied this first by changing the exemption to a deduction. The executor may also make an election to utilize a maximum qualified business deduction of $675,000, regardless of the year in which the decedent dies. The deduction, combined with the unified credit in effect for the year of death, still cannot exceed $1.3 million. However, the idea is for the estate to be able to allocate more of the deduction and less of the unified credit if it so chooses. The result is that more of the estate is being "exempted" at a higher marginal rate.
As a practical point, since the stringent ownership and material participation requirements have not changed, an election should be made to use the deduction only to the extent that there are other assets with which to fund the unified credit share. However, if the business assets can only be insulated from estate taxes through the family business deduction, then, by all means, the deduction should be used.
The Act also clarified other issues with respect to the "qualified family owned business" provisions, such as the definition of "qualified heirs." Since we now have a deduction as opposed to an exemption, the property is included in the gross estate, yielding the step up in basis. The deduction applies only to estates and not to lifetime gifts, and a trust now constitutes a "qualified heir."
Capital Gain Holding Period
The Act eliminates the 18-month holding period for long-term capital gain treatment which was instituted by TRA '97. The new 12-month holding period applies to tax years ending after December 31, 1997.
Under TRA '97, gains on the sale of a principal residence are tax free up to $250,000 for individuals, or $500,000 for married couples. To qualify, the taxpayer must have owned and occupied the residence as a principal residence for an aggregate of at least two of the previous five years prior to the sale. This provision was only available to taxpayers for one sale every two years. Under the new Act, taxpayers who have owned a home for less than two years may utilize a portion of the exclusion equal to the time that they have resided in the house. For example, a single taxpayer who has owned a residence for a year may exclude the lesser of his actual gain or $125,000 (= of the $250,000 single-person exclusion).
In our last newsletter, we discussed the idiosyncrasies of the Roth IRA and expressed our hope that they would be addressed in a technical corrections act. Well, lo and behold, our questions have been answered. By virtue of the Act, we now know that:
1. When converting to a Roth IRA, the taxpayer's AGI could not exceed $100,000. The Act clarified that the conversion amount does not count towards the income limitation.
2. If a taxpayer converted an existing IRA to a Roth IRA in 1998, the amount includible in the taxpayer's income would be allocated over four years. The Act closes a loophole that existed by now mandating that withdrawal of any converted amounts, prior to the end of the four-year period, will be included in income, along with that year's prorated share of the conversion amount. In other words, the inclusion amount is accelerated. This is probably best illustrated by example.
In 1998, a taxpayer converts a $100,000 IRA to a Roth IRA. For the next four years, he must report $25,000 of income on his return as a result of the conversion. In 2000, he makes a withdrawal of $10,000 from the Roth IRA. For that taxable year, he will report $35,000 of income (the $25,000 from the conversion plus the additional $10,000 withdrawal). However, in 2001, the final year of reporting the conversion, he will report only $15,000, since the $10,000 withdrawal caused an acceleration of the tax. The taxpayer is still taxed on the original $100,000; however, the withdrawal caused some of the income to be taxed in a different year.
3. The five-year holding period for converted IRAs will not be extended for a subsequent conversion. The five-year holding period will begin when a contribution is first made to a Roth IRA, and a subsequent conversion will not start the running of a new five-year period.
The 1998 Act was entitled "The Internal Revenue Service Restructuring and Reform Act" and dealt with more than just technical corrections of TRA '97. You may recall congressional hearings earlier this year concerning the way in which the IRS conducts its business. New protections were enacted for the taxpayer, including the shifting of the burden of proof from the taxpayer to the IRS in tax litigation cases, and provisions providing greater protection for "innocent spouses." In addition, a taxpayer may collect up to $100,000 in damages against an IRS employee who negligently disregards the tax law. However, a detailed discussion of the reforms is a subject for another day.
Massachusetts Tax Law Changes
1. Massachusetts income tax law now conforms to the federal law with respect to Roth IRAs and the capital gains exemption for the sale of a personal residence, for tax years beginning January 1, 1998. This means that if you had been holding off from converting to a Roth IRA because of the uncertainty of the Massachusetts tax ramifications, you can now rest easy.
2. The tax on unearned income (interest and dividends) has been reduced from 12% to 5.95% for tax years beginning January 1, 1999.
3. The personal exemption will increase for tax years 1998 and 1999.
This is only a brief overview of some of the highlights of the new legislation, both federal and state. We will periodically address other areas of the new law which affect our clients.