Tax Newsletter 1998
Taxpayer Relief Act of 1997
I want to tear the income tax out by its roots, said Bill Archer, House Ways & Means Committee Chair, as he last ran for office. Now we know what he meant.
Tax Cuts are good political currency. Tax Simplification is not. The Taxpayer Relief Act of 1997 (TRA97), passed by a republican Congress and signed by democratic President Clinton, cut taxes more than since 1981. Politicians are already promising more tax cuts for 1998 to spend the huge tax revenue of the booming economy. TRA97 is the biggest and most complex tax overhaul since at least 1986, with over 800 tax changes. Internal IRS reform will wait for 1998, when Washington promises to implement the 1998 Taxpayer Bill of Rights 3, which the House has already passed. This new law should be the biggest internal IRS restructuring in 50 years.
TRA97 increased complexity enormously, adding weight to the demands and true need for tax reform (see page 2). Complex restrictions increasingly deny tax cuts to higher and middle income taxpayers. Alternative Minimum Tax (AMT) is growing, and will surprise many more people every year. Over 20 phaseouts will reduce the tax benefit for many higher income Californians. Most of the new laws take effect in 1998, and planning is more important than ever.
20% 10%, 25%, 18%, 8%, and 14% are the new capital gains rates
on investments (not collectibles) for both regular tax and AMT, effective
May 7, 1997. Capital gains planning is once again hot, as these rates are
so much less than the maximum 39.6% ordinary rate. These new rates and holding
periods are so complex that Schedule D tripled in size, and IRS cannot program
its computers in time for filing season. It will delay processing Schedule
Ds and refunds until at least mid-February. Capital gains reporting this
year will be a challenge because Congress promises a 1998 retroactive technical
corrections act, and IRS will not revise most capital gains forms until
Homeowners pay no capital gains tax on sale of their homes (phaseout $500,000-$250,000), effective May 7, 1997. There are many planning opportunities to take advantage of this great benefit. For example, amend a return (within 3 years) if you sold a home and might still benefit from the old $125,000 one-time over-55 exclusion. Or, escape capital gains tax on existing property by converting vacation homes and rentals into principal residences, then selling each two years. This conversion benefit seems too good to be true.
Investors can avoid the normal December mutual fund capital gain distributions by timing purchases and sales. Defer capital gains by instructing your broker in writing to sell commingled shares with the highest basis and longest holding period. Avoid capital gains and take a charitable deduction for the fair market value of appreciated stock you give to charity, including your own private foundation (but not for California).
IRAs are all new and all complicated. Congress changed IRAs to subsidize worthy activities, such as relieving the troubled Social Security system. More people will be able to contribute to IRAs with increased phaseout limits ($50,000-$30,000 in 1998) that will more than double over ten years. But California income is just too high, and most of my clients will not qualify. Contribute even though your spouse is an active participant at work (phaseout $150,000). Distributions for education and for first time homebuyers escape the 10% early withdrawal penalty.
Convert existing IRAs to Roth IRAs (phaseout $100,000). While not deductible now, any income is not taxable, ever, not when you earn it inside the IRA, nor when you take the income distribution. The $2,000 annual contributions limit is the same as regular IRAs, with no phaseout limit. The hot planning opportunity is to convert existing IRAs during 1998 and pay tax on any income, spread over 4 years. Advantages include paying lower tax (if you are in a temporary lower tax bracket), eliminating the distribution requirement after age 70, and eliminating the double estate and income taxation at death.
Post secondary education leading to a degree is highly favored and highly complex in 1998. If you can afford to pay a professional to explain and plan for these benefits, you probably will be phased out of them. Choose one of the these three benefits each year:
HOPE tax credit to $1,500 per student for the first two yearsí education. (phaseout $80,000-$40,000).
Lifetime Learning tax credit to $5,000 per taxpayer (also available for students who are acquiring or improving their job skills) (phaseout $80,000-$40,000).
Deductions to pay education expenses from a child's education savings account, Take a double deduction when you contribute up to $500 per year per student, (phaseout $150,000-$95,000).
Student loan interest for higher education for you and your dependents is deductible to $1,000 per year (increasing to $2,500 per year in 2001) for the first 60 months (phaseout $60,000-$40,000).
Child tax credits for dependents to 16 years old are $400 in 1998, $500 thereafter (phaseout $100,000-$75,000). Congress limited this credit unconscionably, considering the low/middle income taxpayers it is designed to help. This credit is one of the biggest tax subsidies in the new law.
Estate/Gift tax Lifetime exemption will increase by 2006 to $1,000,000 from $600,000 per person. Closely held business exemptions are $1,300,000, but eligibility requirements are complex and so stiff that few Estates will qualify.
Home Office deductions again allow administrative and managerial use of your home, if you have no other place to conduct these activities. Congress rewrote the law after IRS and the Supreme Court angered many voters by applying the previous law consistently. Effective 1999
Self employed health insurance deductions increase by 2007 to 100% from 40% (but not for California).
Airfare excise taxes are back, with a vengeance. Congress reinstated the 10% tax, and reduced it in stages to 7.5% by 1999. The big increase is a $2.25 user fee per ticket for each flight segment.
It's time we got real and did something
Complexity is an underlying cause of many, if not all, of the most
serious problems encountered by taxpayers.
The IRS is not doing the job I think it should be. It is a troubled
agency, with widespread serious problemsÖthat is losing the confidence
of the American people because it all too frequently acts as if it were
above the law. At a minimum, the cases brought to our attention paint a
picture of an unresponsive agency with some employees who do not care about
the taxpayers they serve. At the worst, our investigation has uncovered
an agency in which a subculture of fear and intimidation has been allowed
to flourish, both in the internal treatment of employees and in the treatment
of some taxpayers.
If the true incidence of taxpayer abuse were known, the public would
be appalled. If the public ever knew the number of abuses covered up by
the IRS, there would be a tax revolt.
TRA97 is Washington's idea of tax reform: cut taxes, and make the law much more complex. Special interests influence politicians by donating to and helping assure their re-election. We could use public funds to reelect politicians, but we would retain our entrenched political ruling class. Better, we citizens should enact term limits, to encourage citizen politicians, who will come from real life experiences and return to real life after serving their country.
We desperately need true Tax Reform to remake the dysfunctional IRS, and to simplify the unworkably complex tax law. If we do not truly reform taxes, US taxpayers will continue their slide from voluntary compliance, and the US income tax system as we know it will end.
Voluntary compliance is the key to the current US income tax system. Most countries cannot rely on voluntary compliance to collect income taxes. These countries use easier taxes, such as the European value added tax. When the US income tax system as we know it ends, we, too, will use a value-added tax, which is another name for a sales tax.
The Alternative Minimum Tax (AMT) is Washingtonís flat tax version of tax reform. But AMT is very complex, much more so than the already complex regular income tax system. Congressí answer to many tax controversies over the last quarter century has been to allow disputed items for regular tax, but to disallow them for AMT. There are dozens of income and expense items disallowed for AMT, with many separate phaseout limits and other restrictions. 6.3% of taxpayers will pay AMT (vs. .5% now) by 2006, according to Congressí Joint Tax Committee. Many times these numbers must deal with AMT because they are close to the AMT limit, or have AMT credit carryforwards.
Bill of Rights 3
The 1998 Taxpayer Bill of Rights will be the third in almost as many years. Congressional hearings made big news in exposing IRS abuses and setting the stage for the Bill of Rights, which should be the biggest internal IRS regulation in 50 years. This Bill of Rights is expected to:
Congressional hearings uncovered chronic abuses, that IRS:
Immediately after the Congressional hearings, an embarrassed IRS promised a few internal reforms, such as elimination of District quotas, top management review of recent complaints, and special problem solving days. IRS just does not get it.
Make sure to save all your 1099s and 1098s, which are multiplying as rabbits. IRS relies increasingly on computers to audit more people, and on these information reporting forms to feed its computers. Information reporting by businesses will expand to include payments to attorneys, payments which attorneys make from their trust accounts, education credits, and education saving accounts. 1099/1098 mismatches prompt IRS computers to write letters asking for additional tax. Most of these computer-generated letters are wrong, at least in part.
Beware of tax avoidance schemes using Trusts. Trusts have their rightful place, but are abused by tax protesters and fringe advisors to avoid normal taxes. IRS is cracking down.
Send your return via private delivery service (UPS, FedEx, DHL, and Airborne). IRS will accept your mailing date for timely filing, just as it does from the Post Office. California will not. But IRS wants to receive payments at its post office boxes, which the private services cannot use.
Watch for IRS to accept credit cards, which Congress now allows IRS to do. But IRS cannot pay the usual merchantís discount. The banks have not figured how to charge for their service, nor how to keep taxpayers from discharging previous tax debts in bankruptcy. No banks have signed up yet.
It's immoral to punish taxpayers simply because they are married, says Speaker of the House Newt Gingrich. President Clinton says it is just too expensive to end the marriage penalty, which affects 21 million couples. The War Widows of America and other groups lobbied hard, and Congress started marriage distortion when it introduced joint tax returns in 1948. In 1969 Congress increased the marriage penalty. Half of married couples now save taxes by splitting income with the lower earning spouse. The other half pay more, such as increasing numbers of dual income couples, and low-income taxpayers limited from taking the earned income tax credit. IRS refused to release a worksheet to calculate withholding accurately for two earner couples because of complaints the worksheet was so complicated.
California filing is complex and expensive because California insists on being different. We are always in a state of partial conformity to Federal law. Major California changes this year followed the major Federal changes, including major mistakes. California will pass its own major technical corrections act in 1998, possibly retroactively. Major individual differences from Federal law include no special capital gains rates, different definitions of deductible club dues and lobbying, different estimated tax rules, no earned income credit, none of the education and IRA credits and deductions. Business differences include depreciation and AMT rates, no real estate professional status, and lower self employed health insurance deductions.
December 14, 1997 © William M West This Newsletter is an overview of the year's tax news, and is not tax or legal advice. You should consult a professional to determine how these new and rapidly changing topics affect you and your situation. You may use any material herein if you credit me by name, telephone, address, and issue date; and send me a full copy of your publication.
William M West Certified Public Accountant
1905 Park Avenue, Suite 100
San Jose, CA 95126
Last Updated 1-12-01