As I am sure you are aware, a number of significant changes have been made to the tax laws in recent years. For example, 1996 saw the adoption and implementation of The Taxpayer Bill of Rights 2; The Personal Responsibility and Work Opportunity Reconciliation Act of 1996, The Small Business Job Protection Act of 1996 ("Small Business Act"), and The Health Insurance Portability and Accountability Act of 1996. The Taxpayer Relief Act of 1997 ("1997 Tax Act") was signed on August 5, 1997 and included a number of change that impact tax years that began after December 31, 1997. Most recently, the IRS Restructuring and Reform Act of 1998 ("Restructuring and Reform Act"), signed by the President in July 1998, corrected several provisions included in the 1997 Tax Act and implemented a number of changes relating to taxpayer protections and rights. The purpose of this letter is to brief you on some of the more important changes that may impact your personal and business-related tax planning.
A. General Changes in Rules Affecting Business Activities
1. Check-the-Box Regulations
Beginning in 1997, the Internal Revenue Service ("IRS") established new guidelines and regulations for determining whether an entity will be taxed as a partnership or a corporation. Previously, an entity like a limited liability company or a limited partnership was taxed as a partnership only if it lacked certain corporate characteristics. The new rules essentially allow an entity other than a per se corporation to choose how it will be classified for tax purposes. These rules are referred to as "check-the-box" rules and are intended to simplify the classification process.
Once a classification has been chosen, an entity may change the classification (generally once every five years). However, there may be a tax consequence for such a conversion. If an entity fails to elect a particular classification, it will be classified under a default system based not on corporate characteristics but on various other factors, such as the number of members, where the organization is formed (i.e., domestic or foreign), and, for foreign entities, whether its members have limited liability.
One important byproduct of these changes has been the rising popularity of single-member limited liability companies, which can be treated as sole proprietorships for tax purposes while providing the owner with limited liability for non-tax purposes.
2. S Corporations
The Small Business Act included a number of changes in the rules for forming and operating S corporations, including the following:
- The maximum number of S corporation shareholders was increased from 35 to 75.
- Electing small business trusts, which are certain trusts where all the beneficiaries are individuals or estates eligible for S corporation shareholder status, may now be S corporation shareholders, and the income and gains from the S corporation stock held by the trust will be subject to tax at the maximum rates applicable to trusts and estates.
- S corporations may now own more than 80% of the stock of a C corporation, thereby allowing S corporations to divide their activities into separate subsidiaries for liability purposes without any change to the tax treatment of the parent corporation.
- Effective January 1, 1998, certain tax-exempt organizations may be shareholders of an S corporation.
Unless otherwise noted, the aforementioned changes became effective for tax years beginning after December 31, 1996.
3. SIMPLE Savings Plans for Small Employers
Effective January 1, 1997, so-called "SIMPLE" ("Savings Incentive Matching Plan for Employees") savings plans became available to qualifying "small employers" as a replacement for salary reduction simplified employee pensions. SIMPLE plans, authorized under the Small Business Act, permit small employers, defined as employers with no more than 100 employees who receive at least $5,000 in compensation from the employer in the preceding year, to offer employees a retirement plan that is not burdened by the complicated paperwork requirements and discrimination tests traditionally associated with pension plans. An employer offering a SIMPLE plan may not simultaneously maintain any other form of qualified retirement plan for employees. Self-employed persons can also participate in a SIMPLE plan.
Employees or self-employed persons covered by a SIMPLE plan may make pretax contributions of a percentage of compensation up to $6,000 (indexed) annually. As a general rule, employers must match employee contributions dollar-for-dollar up to 3% of compensation; however, in no more than two out of five years, an employer may, with notice to the employees, reduce the matching percentage to as low as 1% of compensation. Alternatively, employers may simply make an unrestricted contribution of 2% of the compensation paid to all participants in the plan. Employees are eligible to participate in a SIMPLE plan only after they have earned at least $5,000 in the two preceding years in which they have been employed and are reasonably expected to earn $5,000 of compensation during the current year.
Account balances for a SIMPLE plan are similar to IRA balances, which means that distributions are subject to income tax at withdrawal and penalties are imposed for early withdrawals (25% penalty for early withdrawal of funds from the plan during the first two years of participation and 10% penalty thereafter).
The Small Business Act also provided an opportunity for employers of any size to avoid the complex nondiscriminatory requirements historically associated with 401(k) plans by modifying the terms of their 401(k) plans to comply with the employee contribution and employer-matching conditions established for SIMPLE plans.
4. Home Office Deduction
Effective after December 31, 1998, the definition of "principal place of business" will be expanded, effectively reinstating the home office deduction for some taxpayers. However, it will still be necessary to show regular, frequent and exclusive business use of the area in order for the deduction to be available.
5. Other Business-Related Changes
A variety of other business-related changes in the tax laws have been implemented in the recent tax legislation, including:
- Increase in the maximum amount which may be expensed annually for purchases of tangible equipment ($18,000 beginning in 1997 and rising to $25,000 in 2003 and thereafter).
- Implementation of a tax credit for employers who hire certified members of target groups (35% of up to $6,000 of qualified new worker's first-year wages).
- Reinstatement of 20% research tax credit, but only for the period beginning July 1, 1996 and ending May 31, 1997.
- Elimination of five-year forward averaging of lump-sum distributions from pension plans for lump-sum distributions made after December 31, 1999.
- Modification of various rules and definitions relating to "highly compensation employees," which is a key concept in determining whether retirement plans satisfy nondiscrimination tests.
- The health insurance deduction for self-employed persons was 40% in 1997, increased to 45% in 1998, and will continue to increase gradually to 100% by 2007.
- The 1997 Tax Act extended the existing program for employer-provided education assistance to May 31, 2000. The exclusion is limited to $5,250 in any calendar year, and graduate-level courses leading to an advanced degree do not qualify for the exclusion.
B. Capital Gains
1. Changes in 1997 Tax Act
The 1997 Tax Act changed the rules relating to taxation of capital gains by creating three kinds of capital gains for assets sold on or after July 29, 1997: short-term (assets held 12 months or less), mid-term (assets held more than 12 months, but not more than 18 months), and long-term (assets held more than 18 months). Short-term gains are taxed at ordinary rates; mid-term gains are subject to a maximum rate of 28%; and long-term capital gains are subject to a maximum rate of 20% (10% for taxpayer with a marginal tax rate of 15%). A phase-in provision for property sold between May 6 and July 29, 1997, treated assets held for more than one year on the date of sale as long-term and therefore eligible for the maximum tax rate of 20% (10% for taxpayers in lowest tax bracket). The changes did not apply to collectibles, which are to be taxed either at short-term rates for assets held 12 months or less or at mid-term rates for assets hold more than 12 months.
The 1997 Tax Act also established a 25% tax rate applicable to the lesser of (1) capital gains realized on the disposition of certain depreciable real property held for more than 18 months, or (2) depreciation taken on the disposed property.
And, the 1997 Tax Act provided that assets sold after December 31, 2000, which have been held for more than five years at the time of sale would be subject to a maximum rate of 18% (8% for taxpayers in the lowest tax bracket).
2. Further Changes in Restructuring and Reform Act
The Restructuring and Reform Act reduced the "long-term" holding period for property to qualify for the 20% (or 10%) rate (or the 25% rate on certain real property gains) from more than 18 month to more than 12 months. This new one-year holding period applies to gains properly taken into account on or after January 1, 1998.
The Restructuring and Reform Act also addressed an omission in the 1997 Tax Act relating to how an individual's capital gains and losses are to be netted. The new rules generally provide that capital losses are first applied against capital gains taxed at the 28% maximum rate, then against capital gains taxed at 25%, and then against capital gains taxed at 20%.
C. IRAs and Medical Savings Accounts
1. Increase in Income Limits
Beginning January 1, 1997, the spousal IRA limit was raised from $250 to $2,000. Beginning in 1998, phaseouts begin at $30,000 AGI for individuals, $50,000 for couples, up from $25,000 and $35,000 respectively. Phaseouts will gradually rise in subsequent years to $50,000 AGI for individuals and $80,000 for couples.
2. Revision of Non-Deductible IRA Rules
Contributions to a non-deductible IRA, commonly referred to as a "Roth IRA," cannot be deducted; however, interest and capital gains will accumulate tax-free. Beginning in 1998, the maximum amount of non-deductible contributions that can be made was increased to $2,000 for each individual. Investors are permitted to withdraw, penalty free, up to an amount equal to their original contribution. In addition, there is no requirement for distributions to begin at age 70 1/2. After five-year period there is no penalty for distributions up to $10,000 for certain qualified special purposes, including down-payments for first-time home buyers. Phaseout begins at $ 150,000 AGI for couples and $95,000 for individuals.
3. Education IRA Accounts
The 1997 Tax Act created Education IRA Accounts that permit up to $500 per year non- deductible contributions for beneficiaries under age 18. Phaseout begins at $150,000 for couples, $95,000 for individuals. Distributions exceeding expenses incur 10% penalty. Unused balance is distributed and taxed to beneficiary at age 30.
4. IRA Withdrawals for Medical Expenses
Certain penalty free withdrawals from an IRA account may now be made for medical expenses. Specifically, individuals who have received unemployment compensation for at least 12 weeks may withdraw IRA funds without being subject to the usual 10% penalty if the funds are used to pay medical insurance premiums or to pay medical expenses in excess of 7.5% of AGI.
5. Medical Savings Accounts
A pilot plan for the creation of Medical Savings Accounts ("MSAs") has been launched and will continue through 2000. Under the plan, small businesses with 50 or fewer employees and self-employed workers whose coverage is limited to catastrophic health insurance may be permitted to make contributions to MSAs if certain eligibility conditions are satisfied. Eligibility is determined on a monthly basis, and the deductible amount for the catastrophic health insurance must be between $1,500 and $2,250 for an individual, and between $3,000 and $4,500 for a family. Contributions limits have been established at 65% of the deductible for individuals and 75% of the deductible for policies covering family members. MSA contributions that are made by a small business are not taxable income to the employee and are not subject to payroll taxes, and contributions made by self-employed workers are above-the-line deductions.
Distributions from MSA will be tax-free to the extent they are used for qualified medical expenses, long-term care insurance, COBRA insurance premiums, and medical insurance premiums paid which the person is receiving unemployment insurance. On the other hand, distributions from an MSA which are used for other purposes are not tax-free and are subject to a 15% withdrawal penalty in addition to the ordinary income tax. Earnings on funds in an MSA accrue tax-free, and penalty-free withdrawals may be made for any reason after the person reaches age 65, dies, or become disabled (although such penalty-free withdrawals may still be subject to income tax unless used for one of the purposes listed above).
D. Taxpayer Protections and Rights
1. Taxpayer Bill of Rights
The Taxpayer Bill of Rights was adopted to afford new rights and protections to taxpayers in their efforts to comply with the Internal Revenue Code and deal with the Internal Revenue Service ("IRS"). Among other things, a Taxpayer Advocate Office was created within the IRS, installment agreement procedures were modified, and changes were made with respect to taxpayer rights relating to abatement of interest and penalties and filing of joint tax returns. The legislation also included changes in the rules relating to liens, levies, and offers of compromise.
2. Restructuring and Reform Act
Many of the changes adopted in the Restructuring and Reform Act focused on taxpayer rights, especially the rights of individual taxpayers who have encountered difficulties with the way the IRS conducts tax examinations, enforces tax collection, or otherwise requires compliance with the tax laws. Several of the changes are summarized below; however, you should be aware that the legislation also included changes relating to "interest netting" in cases where a business has overlapping underpayments and overpayments, interest charges and other penalties, jurisdiction of the Tax Court, and protection for "innocent spouses."
a. Confidentiality of Communications With Tax Advisers
One important change deals with the question of privileged communications and non- attorney tax advisers. Historically, there has been no federally recognized privilege between taxpayers and non-attorney professionals authorized to practice before the IRS, such as certified public accountants or enrolled agents. The Restructuring and Reform Act changes this by extending, with certain exceptions the attorney-client privilege to confidential communications made between a client and its federally authorized tax practitioner providing tax advice.
b. Burden of Proof
The Restructuring and Reform Act also includes significant changes with respect to the burden of proof in disputes regarding an IRS determination of tax liability. Until the Act became law, the determination of the IRS was presumed to be correct and individual and small business taxpayers were often at a disadvantage in overcoming the burden of proof in tax litigation. The Act shifts to the IRS the burden of proof in any court proceeding with respect to factual issues if the taxpayer introduces "credible evidence" about the issue relevant to determining the tax liability. In order to successfully shift the burden of proof, four conditions must be met:
- The taxpayer must substantiate the item.
- The taxpayer must maintain records.
- The taxpayer must cooperate with reasonable IRS requests for witnesses, information, documents, meetings, and interviews, and must exhaust the available administrative remedies (which does not mean that the taxpayer is required to extend the statute of limitations).
- The taxpayer, if not an individual, must have a net worth of no more than $7 million and no more than 500 employees.
These new provisions shift the burden of proof to the IRS in court proceedings arising out of tax audits beginning after July 22, 1998. In court proceedings involving a matter where there was no tax examination, the new burden of proof provisions apply in court proceedings relating to tax periods beginning (or events occurring) after July 22 1998.
c. IRS Audit and Collection Activities
The Restructuring and Reform Act provides a variety of taxpayer rights for individuals and some businesses subject to IRS audit and collection activities:
- No financial status or economic reality audits can be conducted for unreported income, unless there are reasonable indications that unreported income is likely.
- IRS must rewrite its Publication 1 (Your Rights as a Taxpayer) to advise taxpayers more clearly of their rights under examination and to provide information about the examination selection process.
- The IRS generally will be required to accept an eligible taxpayer's request to enter into n installment agreement if the tax liability is $ 10,000 or less (excluding interest and penalties). In addition, the IRS must now furnish the taxpayer with an annual statement that indicates the amounts still owed under the installment agreement.
- Establishes formal procedures for IRS notice and provides an opportunity for IRS Appeals hearing after the IRS files a notice of tax lien or a notice of intent to levy. Levy is prohibited during the appeals process and judicial review of the determination during the appeal is available.
- Seizure of the principal residence of either the taxpayer, the taxpayer's spouse or former spouse, or the taxpayer's minor child is prohibited without prior judicial approval.
- The 10 percent early-withdrawal penalty normally applicable to a distribution from a retirement plan or IRA will not apply in cases where the distribution is forced by an IRS levy.
E. Other Changes Affecting Individual Taxpayers
1. Sale of Personal Residence
For sales of a personal residence on or after May 7, 1997, married couples are entitled to exclude from tax the first $500,000 of gain (the exclusion for singles is $250,000). The exclusion is reusable every two years, and can be used even if the taxpayer has previously used the previous $125,000 exclusion. However, the exclusion will only be available for sales of property that the taxpayer has used as a home for a total of two years during the five years immediately preceding the sale. The maximum tax rate on recapture of Section 1250 depreciation has been set at 25%.
2. Child Tax Credit for Children Under Age 17
The 1997 Tax Act created a $400 per child tax credit beginning in 1998, with an increase to $500 per child in 1999. Credit applies to children 16 and under, and phaseout begins at $ 110,000 AGI for couples, $95,000 for individuals. The credit is partially refundable for low-income families with three or more children. Credit refund interacts with the Earned Income Credit.
3. Long-Term Care Insurance and Expenses
The Health Insurance Act included various provisions relating to long-term care insurance contracts and long-term care expenses. Specifically, long-term care insurance contracts are now treated for income tax purposes the same as health and accident insurance plans, which means that proceeds received under a long-term insurance contract will be tax-free to recipients up to a specified daily limit that is indexed for health care inflation. Also, premiums for long-term care insurance will be deductible as a medical expense for taxpayers who itemize deductions subject to limitations determined by reference to the age of the taxpayer at the end of the tax year. Long- term care coverage provided by employers will be a tax-free fringe benefit.
In addition, unreimbursed long-term care medical expenses will be treated as medical expenses provided that certain conditions are satisfied. In order to qualify, the expenses must be necessary diagnostic, preventive, therapeutic, curing, treating, mitigating, and rehabilitative services, or maintenance or personal services, which are required by a chronically ill person and are provided pursuant to a plan of care prescribed by a licensed heal care practitioner. A "chronically ill person" is someone who is unable to perform certain basic activities of daily living for at lest 90 days due to a loss of functional capacity or someone requiring substantial supervision to protect the individual from threats to health and safety due to severe cognitive impairment.
These provisions generally became effective for long-term care insurance contracts issued and expenses incurred for tax years beginning with 1997.
4. Post-Secondary Education Credit
The 1997 Tax Act created the Hope Scholarship and Lifetime Learning Credit for payments relating to post-secondary education. Beginning in 1998, payment made for the first two years of college may qualify for a 100% credit for the first $1,000 of expenses per year for each dependent student under 24 years, and a 50% credit for the next $ 1,000. At least half-time enrollment for one academic period required.
The "Lifetime Learning Credit" is available for payments relating to the third and fourth year of college and for education to improve job skills. The credit applies only to payments that are made after July 1, 1998, and is equal to 20% of first $5,000 of expenses, per student.
Credit phaseout begins at $80,000 AGI for couples, $50,000 for individuals. With respect to divorced parents, only the parent who makes the payment may claim the credit.
5. Education Interest Deduction
The 1997 Tax Act created a $1,000 maximum student loan interest deduction in 1998, increasing an additional $500 each year thereafter until the maximum of $2,500 is reached in 2001. The deduction is available for those who do not itemize, and phaseout begins at $60,000 AGI for couples, $40,000 for individuals.
6. Estate and Gift Taxes
The 1997 Tax Act increased the estate and gift tax exemption to $625,000 in 1998, and provided for further gradual increases up to $1,000,000 in 2006. The annual exclusion of $10,000 per donee for gift tax purposes has been indexed for inflation, effective for gifts made after December 31, 1998. And, the 1997 Tax Act included several changes calculated to ease the potential estate burden when a substantial portion of the decedent's estates consists of an interest in a closely held family business.
7. Miscellaneous Items
- Accelerated life insurance death benefits, including proceeds from the sale of a life insurance policy to a licensed viatical settlement company, received by a terminally ill person after 1996 may be exempt from income tax.
- The $5,000 exclusion from income for employee death benefits has been repealed for decedents dying after August 20, 1996.
- Expenses relating to the adoption of eligible adoptees may be eligible for up to a $5,000 credit ($6,000 in the case of special needs children) if paid or incurred after 1996 and on or before December 31, 2001, subject to a phaseout as modified AGI rises from $75,000 to $115,000.
- Punitive damages resulting from personal injury or physical illness are now subject to tax, as are damages received due to emotional distress that exceed the amount paid for resulting care.