Although entitled the "IRS Restructuring and Reform Act of 1998," it is the act's provisions unrelated to IRS restructuring that will have the most significant impact on the majority of taxpayers. Many of the technical provisions listed in the Reform Act of 1998 will have a tremendous impact on tax planning. The Tax Reform Act of 1997 (TRA '97) was one of the most significant pieces of legislation made over the last decade for the average taxpayer. The legislation, however, added a great deal of complexity to the already tedious and complicated tax code.
Technical reforms usually do not emerge until several years after the underlying legislation has passed. However, many of the technical provisions of TRA '97 have such a significant impact on tax planning and tax return preparation that there was a sense of urgency to promptly execute these reforms.
The major provisions of TRA 1997 that were modified by the Reform Act of 1998 include the child tax credit, education incentives, individual retirement accounts, capital gains, estate and gift taxes, and the alternative minimum tax. Throughout this article, readers should keep in mind that corrections made by the Reform Act of 1998 do not make any attempt to solve the complexities ingrained in many of the provisions.
What the IRS is interested in accomplishing in the 1998 legislation is clarifying the scope of many of those provisions. What I am trying to do is make the reader aware of the planning opportunities that emerge from these complex tax laws.
Changes affecting individuals
- Principal residence. The law says that an individual may elect to exclude up to $250,000 of gain on the sale or exchange of a principal residence. The individual must own and occupy the house for at least two of the five years before the sale or exchange of it. (The exclusion rises to $500,000 for married filing jointly).
The $250,000 or $500,000 exclusion, not the realized gain, is prorated for a taxpayer who does not meet the two-year ownership and use requirement in the case of a sale or exchange due to a change in place of employment, health or unforeseen circumstances. The change was put in place for the 1997 tax returns that we all filed. Therefore, affected taxpayers need not file an amended return for 1997.
- Transportation fringe benefits and travel expenses. In tax years beginning in 1999 and thereafter, the base amount for the maximum exclusion for qualified parking benefits paid by employers for employees has been increased from $155 to $175. Other qualified transportation benefits such as van pooling and transit passes increased from $60 to $65.
Notice that for tax years beginning after 1997, employers who provide any qualified transportation fringe benefits for their employees may offer employees the choice between cash and one or more qualified transportation benefits without causing the employees to lose the exclusion from income for noncash transportation fringe benefits. This means that the employee can receive the cash and not report it as taxable income. Thus, no amount is included in an employee's income or wages merely because the employee is offered a choice among qualified transportation benefits.
- Roth IRAs. The provision of TRA '97 that put a smile on taxpayers' faces has become even more taxpayer-friendly after the changes imposed by the Reform Act of 1998. The mandatory provision of TRA '97 that stated taxpayers had to spread income taxes due upon conversion of a regular IRA to a Roth IRA is now elective. Those taxpayers that would like to take advantage of spreading their income over a longer period can still do so, while other taxpayers who anticipate a higher tax bracket in the future can elect to pay the whole amount of income taxes due in the year of election. However, this option is only available for taxpayers converting in 1998.
The second key provision is aimed at those taxpayers who miscalculate income above the $100,000 threshold. In this case, taxpayers are allowed to convert back to their traditional IRA by the due date of the return.
The third change in the Roth IRA has to do with the deductibility of IRA contributions. The IRS Restructuring and Reform Act of 1998 makes it clear that if the phase-out rule applies to an individual merely because his or her spouse is an active participant in an employer-sponsored plan, the $2,000 maximum deductible IRA contribution for the individual, but not for the active participant spouse, will be phased out between $150,000 to $160,000. For active participants, the phase-out range is $50,000 to $60,000.
Estate and gift tax changes
- Qualified family-owned business deduction. The QFOB exclusion is converted to a deduction. This means that instead of excluding the qualified amounts, the amounts must be included in the gross estate and then deducted.
The ownership and material participation requirements that must be met in order to be eligible for the QFOB deduction remain the same: 50% of the equity of the business must be owned by members of the decedent's family, or 70% equity of the business must be owned by members of two families, or 90% of the equity of the business must be owned by members of three families. If two or more families own an interest, more than 30% must be owned by the decedent or members of the decedent's family. "Material participation" is defined as five out of eight years before the decedent's death and five out of eight in the 10 years succeeding the decedent's death.
- Generation-skipping transfer tax. For families gifting to a generation below the next one, i.e., grandfather to grandson (skip the father), the generation-skipping transfer tax is applied.
There are three basic types of transfers: direct skips, taxable terminations and taxable distributions. The amount of the GSTT is the taxable amount multiplied by the "applicable rate." The IRS Reform Act of 1998 clarifies that indexing the generation- skipping transfer tax exemption is applicable to direct skips, taxable terminations and taxable distributions made after 1998. The exemption is currently set at $1 million.
Business and investment changes
- Elimination of the 18-month holding period. The most significant change made by the 1998 Tax Act regards the tax treatment of capital gains. The 18-month holding period has been eliminated for tax years ending after Dec. 31, 1997. The explanation in the past for increasing the long-term capital gains holding period from 12 months to 18 months was the significantly reduced percentage for taxing such gains. The new legislation provides that the 10%, 20% and/or 25% long-term rates apply to most capital assets held for more than 12 months.
This new change should encourage individuals to develop tax strategies and planning over a 12-month time period so that capital gains will be granted. Remember, tax rates on ordinary income are almost double the capital gains rate.
- Small-business stock (rollover of gain by partnerships and S corporations). An individual may elect to roll over any gain realized from the sale of qualified business stock if the stock is held by the individual for more than six months. This means that all income taxes on such transactions are deferred to a future year. The gain may be rolled over into other small-business stocks, provided that such stock is purchased by the individual during the 60-day period that begins on the date of the sale of the original small-business stock. The Reform Act of 1998 changes the word "individual" stated above to a "taxpayer other than a corporation," making it clear that the rollover provisions now include partnerships as well as S corporations. This is good news for all closely held businesses.
The benefit of a tax-free rollover with respect to the sale of small-business stock by a partnership will flow through to a partner (that is not a corporation) if the partner held its partnership interest at all times the partnership held the small-business stock. A similar treatment exists for S corporations.