1996 Federal Tax Law Changes

By Constance J. Crawford and Corinne L. Crawford

Major changes were made to the IRC. They were not made through a major "tax bill" but were contained in three different pieces of legislation passed by Congress and signed by President
Clinton.

During 1996, President Clinton signed into law three major pieces of legislation, the Small Business Job Protection Act, the Health Coverage Availability and Affordability Act, and the Taxpayer Bill of Rights 2. In drafting this legislation, the 104th Congress strove to preserve small businesses from the consequences of a 90¢ minimum wage increase, make health care accessible to all citizens, and empower the taxpayer in some battles against the IRS. All three pieces of legislation contain tax provisions that will affect individuals, corporations, and the economy as a whole for many years to come.

The tax aspects of this legislation are quite pervasive. They range from revamping Subchapter S of the IRC to providing a tax credit for adoption of children. Certain provisions relating to pension simplification are covered in a separate article in this issue, Pension Simplification Provisions of the Small Business Job Protection Act. The following is an analysis of other pivotal tax provisions contained in each of the three bills.

Small Business Job Protection Act
of 1996

Congress passed the Small Business Job Protection Act of 1996 to provide tax relief for small businesses, to protect jobs, create opportunities, and increase workers' take-home pay. To achieve these goals, S corporations were made more flexible, provisions were added to the tax code to make it easier for a small business to establish a qualified pension plan, and IRC section 179 depreciation deductions were increased.

Section 179 Depreciation. The legislation increases the allowable IRC section 179 depreciation deduction, as shown in Exhibit 1.

Charitable Risk Pools. IRC section 501, which currently provides for exemption from tax for certain corporations and trusts, is amended by this legislation to exempt certain charitable risk pools. A qualified charitable risk pool is defined as an entity organized and operated solely to pool insurable risks of its members (other than risks related to medical malpractice), and to provide information to its members with respect to loss control and risk management. A qualified charitable risk pool shall be treated as an organization organized and operated exclusively for charitable purposes.

To qualify, an organization must meet the following criteria:

* The risk pool must be qualified as a nonprofit organization under state law provisions authorizing risk pooling arrangements for charitable organizations.

* The risk pool must be exempt from any income tax imposed by a state.

* The risk pool must have obtained at least $1,000,000 in start up capital from nonmember charitable organizations.

* The risk pool must be controlled by a board of directors elected by its
members.

* The organizational documents must fulfill certain requirements.

The effective date of this legislation is January 1, 1997.

Work Opportunity Tax Credit. The Targeted Jobs Tax Credit has been extended, amended, and renamed the Work Opportunity Credit. The amount of the credit has been reduced from 40% to 35% of qualified wages. The legislation redefines the members of the targeted group as follows:

* Any individual who is a member of a family receiving assistance under a IV-A program for at least nine months.

* A qualified veteran.

* A qualified ex-felon.

* A high-risk youth.

* A vocational rehabilitation referral.

* A qualified summer youth.

The minimum employment period has been amended. No wages shall be taken into account for credit calculation unless the employee has worked 180 days or 500 hours or, in the case of a summer youth employee, 20 days or 120 hours.

The credit calculation for a qualified summer youth employee has also been amended. The eligibility period for the credit formerly was any 90-day period between May 1 and September 15. This eligibility period has been amended to the one-year period beginning with the day the individual begins work for the employer. The wage credit base for qualified summer youth employees has been reduced from eligible wages of $6,000 to $3,000.

The revised credit will be applicable to employees who begin working after September 30, 1996 and before October 1, 1997. The legislation does not reinstate the Targeted Jobs Tax Credit, thus no jobs related tax credit is available for the period January 1, 1995, through September 30, 1996.

Research and Development Tax Credit. The research and development tax credit is reinstated for the 11-month period July 1, 1996, through May 31, 1997. The credit was not reinstated retroactively, so there is a gap in the credit's availability for research and development expenditures paid or incurred between June 30, 1995, and July 1, 1996.

The new legislation provides an elective alternative incremental research credit. This alternative credit primarily is intended to benefit taxpayers who incur significant research and development expenditures but are unable to claim the reinstated credit because their current research and development expenditures are lower than during the credit base period 1984-1988.

Under the alternative incremental research credit, the following graduated credit rates apply to the extent the taxpayer's current-year expenditures exceed a specified percentage of a base amount that is its average gross receipts for the prior four years as follows:

Qualified Research Credit Rate

Expenditures Percentage

Less than 1% 0%

More than 1% 1.65

More than 1.5% 2.20

More than 2% 2.75

If elected, the alternative credit applies to the taxpayer's first taxable year beginning after June 30, 1996. An electing calendar-year taxpayer would apply the alternative credit with respect to qualified expenses incurred from January 1, 1997, to November 30, 1997.

Reinstatement of the Orphan Drug Credit. The orphan drug credit for the testing of certain drugs for rare diseases has been reinstated from July 1, 1996, through May 31, 1997.

Adoption Credit, Exclusion. Individuals may claim a nonrefundable income tax credit of up to $5,000 for qualified adoption expenses. Similarly, employees may exclude from income up to $5,000 for qualified adoption expenses paid or reimbursed by their employer. The per-child limits in the case of special needs children is generally $6,000. The credit and exclusion begin to be phased out for taxpayers with adjusted gross income above $75,000 and are fully phased out for taxpayers with adjusted gross income of $115,000 or more.

Reinstatement of Fair Market Value Deduction. The fair market value deduction for contributions of qualified appreciated stock to private nonoperating foundations has been reinstated from July 1, 1996, through May 31, 1997.

Educational Assistance Programs. The legislation extends the time frame for deductibility for certain employer provided educational assistance programs from December 31, 1994, to December 31, 1996. However, deductibility for educational programs will be limited to education below the graduate level.

S Corporations. One major change for S corporations is the number of permissible shareholders has been increased from 35 to 75. In addition, tax-exempt pension trusts and charitable organizations may now be shareholders. Certain trusts that "spray" income among family members and testamentary trusts for a two-year period also may be shareholders.

The legislation provides remedies for inadvertent terminations and invalid elections. The legislation provides that if a corporation prepares an invalid election or inadvertently terminates the corporation election, it will still be considered a valid S corporation during the period it failed to meet the S corporation rules. This waiver will apply if the Secretary of the Treasury determines that the circumstances resulting in such ineffectiveness or termination were inadvertent and the problem is corrected within a reasonable period after its discovery. All shareholders must agree to the adjustments necessary to cure the ineffective election or inadvertent termination.

The legislation also granted the Secretary of the Treasury the power to treat a late election as timely filed, if the Secretary determines there is reasonable cause for the failure to make a timely election.

The legislation repealed the "Special Audit Provisions" for Subchapter S items and added a new subsection that requires shareholders' returns be consistent with the corporation's return. The Secretary must be notified of all inconsistencies between the shareholders' return and the corporate return. A shareholder will be treated as having complied with this requirement if the shareholder can demonstrate that he or she received incorrect information from the corporation. If the shareholder fails to notify the Secretary of any inconsistency, the inconsistency will be treated as a clerical or mathematical error and the shareholder will be billed
accordingly.

IRC section 1361(b) has been amended and S corporations have been granted permission to hold subsidiaries. If the subsidiary is an S corporation, 100% of the qualified S subsidiary's stock must be held by the parent S corporation. To achieve a flow through of the subsidiary's income, the parent must elect to treat the subsidiary as a qualified subchapter S subsidiary. A qualified S subsidiary is not treated as a separate corporation; all the assets, liabilities, and items of income and deduction are treated as the assets, liabilities, and such items of the S corporation parent. If any corporation that was a qualified S subsidiary ceases to meet the requirements, such corporation will be treated as a new corporation acquiring all of its assets and assuming all of its liabilities immediately before such cessation from the S corporation in exchange for its stock.

The new legislation amended the treatment of certain dividends. If an S corporation holds 80% or more of the voting power and value of a C corporation, the term passive income shall not include dividends from such C corporation to the extent such dividends are attributable to the earnings and profits of such C corporation derived from the active conduct of a trade or business.

The treatment of distributions during loss years for S corporations has been changed. In calculating the amount of distributions made during any taxable year, the amount in the accumulated adjustments account as of the close of any taxable year shall be determined without regard to any net negative adjustments for such taxable year. Net negative adjustments are defined as the excess of the reductions in the account for the taxable year (other than distributions) over the increase in the account for the year. This amendment allows the corporation to disregard the loss for the current year when calculating distributions, as they will be calculated before the loss for the current year is taken into account.

The new legislation eliminates certain earnings and profits. All corporations that elected S status prior to January 1, 1983, must adjust their accumulated adjustments account in its first taxable year beginning after December 31, 1996, to eliminate such portion of the earnings and profits accumulated before January 1, 1983.

Except as otherwise noted, the amendments to Subchapter S are effective for tax years beginning after December 31, 1996.

Revenue Offsets to The Small
Business Job Protection Act

The following provisions were included in the Small Business Job Protection Act to raise revenue to pay for the other provisions of the legislation.

Possessions Tax Credit Phase-Out. The act repeals the IRC section 936 tax credit for U.S. business operations in Puerto Rico and other U.S. possessions, effective for taxable years beginning after 1995. A 10-year grandfather period is provided for existing credit claimants.

Income Forecast Accounting. The calculation of depreciation under the income forecast method is modified for motion picture films, television films and taped shows, video games, and certain other property, generally effective for property placed into service after September 13, 1995. The legislation makes changes in the income required to be included in the depreciation calculation, limits included with costs to items that satisfy the economic performance standard, and implements a look-back calculation to correct errors as a result of using estimates in the calculation.

Treatment of Damages. The exclusion from income of damages received on account of personal injury or sickness will no longer apply to punitive damages. Also, the exclusion does not apply to damages--other than for medical expenses-- received for emotional distress unless attributable to a physical injury or sickness. This treatment applies to amounts received after August 20, 1996, unless received under a written agreement, court decree, or mediation award in effect or issued on or before September 13, 1995.

The Health Coverage Availability and Affordability Act of 1996

The intent of this legislation is to improve the portability and continuity of health insurance coverage in the group and individual markets; to combat waste, fraud, and abuse in health insurance and health-care delivery; to promote the use of medical savings accounts; to improve access to long-term care service and coverage; and simplify the administration of health insurance.

Medical Savings Account. Congress is testing the concept of "Medical Savings Accounts," or MSAs, which in the new legislation allow individuals covered by a high deductible health plan to make tax deductible contributions to an MSA. Only an employee working for an employer who has employed on average no more than 50 employees during the preceding or second preceding year will be eligible for participation. An employer may also make contributions to an employee's medical savings account. These contributions are excluded from income if made by the employer of an eligible individual. Additionally, earnings on the accounts are not currently taxable. Distributions for medical expenses are also not taxable. Distributions not used for medical expenses, however, are included in income, and will be subject to an additional 15% tax unless the distribution is made after age 65 or on account of death or disability. No deduction is allowed for expenses paid from these accounts.

MSAs will be available on a limited basis as part of a four-year pilot program beginning in 1997.

Application of COBRA Sanctions. Currently, COBRA requires employers to offer qualified beneficiaries the opportunity to continue in the employer's group health plan after termination of the employee. A fine of $100 per day to a maximum of $50,000 is imposed if the employer fails to satisfy this requirement. The new legislation expands portability of coverage, and contains limitations on exclusions of preexisting conditions and prohibitions on excluding individuals from coverage based on their health status. This legislation becomes effective January 1, 1998.

Deductions for Health Insurance Expenses of Self-Employed Individuals. Currently, self-employed individuals are entitled to deduct 30% of the amount paid for health insurance. The new legislation will increase the deduction, as shown in Exhibit 2.

Treatment of Long-Term-Care Insurance and Services. Under present law, a taxpayer is entitled to include in itemized deductions an amount equal to unreimbursed medical expenses to the extent they exceed 7.5% of adjusted gross income. To encourage taxpayers to take financial responsibility for their long-term care needs, favorable tax treatment with respect to long-term insurance contracts is provided in the new legislation. The new legislation provides that taxpayers will be allowed to exclude from income amounts received from long-term care contracts of up to $175 per day or $63,875 annually, on per diem contracts only. If the taxpayer receives more than the exclusion limitation, the excess is excluded to the extent the taxpayer has incurred actual expenses for long-term care services. A long-term-care insurance contract is defined as any insurance contract that provides only for coverage of long-term care services. The contract must be guaranteed to be renewable. The contract cannot provide for a cash surrender value or other money that can be pledged, borrowed, paid, or assigned. Refunds or dividends under the contract may only be used to reduce future premiums or increase future benefits. It cannot pay or reimburse expenses reimbursable under Medicare.

Unreimbursed expenses for qualified long-term care are treated as medical expenses in calculating a taxpayer's itemized deductions. Therefore, amounts received under long-term care insurance are to be treated as reimbursements for expenses incurred.

The insurance premiums paid for long-term care services are treated as medical expenses on the itemized deduction schedule based on the following
limitations:

Age Limitation-Premiums

Not more than 40 $ 200

More than 40 but not more

than 50 375

More than 50 but not more

than 60 750

More than 60 but not more

than 70 2,000

More than 70 2,500

These provisions are effective beginning after December 31, 1996.

Tax Treatment of Accelerated Death Benefits Under Life Insurance Contracts. Presently, amounts received under a life insurance contract are included in the gross income of the recipient to the extent the cash value exceeds the taxpayer's investment. The new legislation provides an exclusion from gross income for life insurance proceeds paid by reason of death of the insured or for amounts received for the sale or assignment of a life insurance contract to a qualified viatical settlement provider due to the terminal or chronic illness of the insured. This provision applies to amounts received after December 31, 1996.

Exemption from Income Tax for State Sponsored Organizations Providing Health Coverage for High-Risk Individuals. This provision will eliminate the uncertainty surrounding the eligibility of certain state health insurance risk pools for tax exempt status. This will assist states in providing medical coverage for uninsured high-risk individuals. The bill provides for tax exempt status for any membership organization established by a state exclusively to provide coverage for medical care on a nonprofit basis to certain high-risk individuals. This provision is effective for taxable years beginning after December 31, 1996.

Revenue Offsets to the Health
Coverage Act

The Healthcare Coverage, Availability, and Affordability Act contains the following revenue offsets to provide funding for its legislation.

Treatment of Bad Debt Deductions of Thrift Institutions. Thrift institutions may currently use the reserve method of accounting for bad debts. This is a more favorable tax treatment than afforded other taxpayers. Mismeasurement of economic income in the accounting for bad debts was a negative result of the reserve method in some instances. This legislation repeals the bad debt reserve method of accounting effective for taxable years beginning after December 31, 1995. To not penalize thrift institutions, the amount of excess reserves shall be taken into income ratably over a six-year period.

Earned Income Credit Restrictions. Congress believes individuals not authorized to work in the U.S. should not be entitled to claim the earned income credit. Taxpayers will not be eligible to claim the earned income credit if they do not include their taxpayer identification number on the tax form. If the taxpayer fails to provide the correct Social Security number, the omission will be treated as a math or clerical error. The IRS will assess additional tax due without sending the taxpayer a notice of deficiency and allowing the taxpayer to petition the Tax Court. This provision is effective for taxable years beginning after December 31, 1995.

Revision of Expatriate Tax Rules. This provision addresses situations where taxpayers relinquish their U.S. citizenship for the principal purpose of avoiding U.S. tax. An individual who relinquishes his or her citizenship with a principal purpose of avoiding U.S. tax is subject to an alternative method of income taxation for 10 years after expatriation under IRC section 877. The new provision generally subjects former citizens to the expatriate tax provisions without inquiry as to their motive for losing their U.S. citizenship. However, the legislation allows certain individuals to request a ruling from the Secretary of the Treasury as to whether the loss of citizenship had a principal purpose of tax avoidance. The new legislation is applicable when U.S. citizens give up their citizenship on or after February 6, 1995.

Taxpayer Bill of Rights 2

The Taxpayer Bill of Rights 2 contains over 40 pro-taxpayer procedural rights that Congress hopes will help to "balance the playing field" for taxpayers.

Taxpayer Advocate. The first provision of the legislation replaces the taxpayer ombudsman with a taxpayer advocate. This new position has been empowered to assist taxpayers in resolving problems with the IRS. The advocate will concentrate on identifying problem areas within the IRS and designing solutions for these problem areas.

Modification and Appeal of Installment Agreement Provisions. The new legislation requires the IRS to notify taxpayers 30 days before modifying or terminating any installment agreement in all cases except when tax collection is in jeopardy. The IRS is required by this legislation to establish procedures for an independent administrative review of terminations for taxpayers who request a review.

Expansion of Authority to Rebate Interest. The legislation enables the IRS to rebate interest with respect to any unreasonable error or delay resulting from managerial or administrative problems on the part of the IRS. For example, if the IRS loses a taxpayer's records or an IRS employee is on an extended leave that results in the accrual of interest, the IRS now has the authority to abate this interest.

Extension of Interest Free Period for the Payment of Tax. The interest-free period for the payment of tax has been extended from 10 days to 10 business days (21 calendar days if the total tax liability is less than $100,000). The interest-free period is applicable to payment of taxes, penalties, and additions to tax on which interest is computed. This provision is effective after December 31, 1996.

Abatement of Payroll Deposit Penalty. The new legislation has given the IRS the power to abate the penalty on failure to deposit payroll taxes under certain circumstances. To qualify, the company must be a small business and the failure to timely deposit must take place in the first quarter deposits were required. Additionally, the employment tax return must have been timely filed. The IRS also has the power to abate penalties if a first-time depositor inadvertently sends the deposits to the IRS instead of the required government depository.

Joint Return May Be Made After Separate Returns Without Full Payment of Tax. For tax years beginning after 1996, the new legislation repeals the requirement of payment of tax as a prerequisite to altering filing status. Under prior law, taxpayers filing separate returns would be unable to alter their status to joint filing status without first paying the tax due on the joint return. Taxpayers will now be allowed to amend their separate returns and elect joint filing status without first paying the tax due on the joint return

Collection Disclosure for Joint Filers. If a taxpayer filed a joint tax return that resulted in a tax deficiency, and the taxpayers are now divorced or not living together, the IRS will now be required to state in writing whether it has attempted collection from the other joint filer, the nature of the collection activities, and the amount collected. This procedure will be activated once a written request is received from one of the joint filers.

Modification of Liens and Levies. The new legislation allows the IRS to withdraw a public notice of tax lien and return the property before payment is received in full. Prior to this legislation, once the IRS had filed a notice of lien it could not be withdrawn unless the notice had been erroneously filed or the judgment had been satisfied. The revision states that the IRS can withdraw the lien if the notice was filed prematurely, the notice was not in accord with administrative procedure, the taxpayer enters into an installment agreement to satisfy the agreement, the withdrawal of the lien would enhance the collection of the tax liability, or the Taxpayer Advocate determines the withdrawal of the lien would be in the best interest of the taxpayer. The IRS will now be required to make a reasonable effort to give notice of withdrawal to the lien creditors, credit reporting agencies, and financial institutions specified by the taxpayer.

Offers-in-Compromise. If a taxpayer is unable to pay a tax liability in full, and there is doubt as to the collection or to the liability itself, the IRS will now be able to accept an offer-in-compromise for amounts over $500 up to $50,000. Prior to the enactment of this law, the IRS could only accept offers-in-compromise if the reasons for the acceptance were documented in detail and supported by an opinion of the IRS chief counsel.

Third Party Damages for False Information Returns. A taxpayer who is injured because a fraudulent information return has been filed with the IRS asserting payment has been made, may now bring a civil action for damages against the person filing the return. The amount of recoverable damages is limited to the greater of $5,000 or the actual damages plus attorney's fees. In addition, injured parties who cooperate with the IRS may be relieved of the IRS's presumption of correctness of 1099s and W-2s, and the IRS would have the burden of producing reasonable information on the deficiency in addition to the information return itself.

IRS Must Prove Position Was Substantially Justified. The new legislation provides that the burden of proof rests with the IRS in an action for litigation and attorney's fees. The act establishes a rebuttable presumption that the IRS was not substantially justified if it did not follow in administrative proceedings, its published regulations, revenue rulings, revenue procedures, information releases, notices or announcements, or a private letter ruling, determination letter, or TAM issued to the taxpayer.

Increased Limit on Attorney's Fees. A taxpayer can now recover litigation costs and attorney's fees at the rate of $110 per hour. The previous rate was $75 per hour. Further, any failure to agree to an extension of the statute of limitations cannot be taken into account for purposes of determining whether a taxpayer has exhausted all administrative remedies for purposes of being eligible for attorney's fees. Failure to exhaust all administrative remedies in a suit for damages for unauthorized collection activities is no longer an absolute bar to awarding litigation costs; it is now up to the court's discretion.

Increase in Limit on Recovery of Civil Damages. The new legislation allows a taxpayer to sue the government for up to $1 million of damages caused by an officer or employee of the IRS who recklessly or intentionally disregards the provisions of the IRC or regulations in collecting tax from the taxpayer. The prior ceiling was $100,000.

Responsible Person Penalty Rules Modified. The IRS will now be required to issue a notice to an individual who is deemed to be a responsible person at least 60 days prior to the issuing of a notice and demand for penalty. The statute of limitations would not expire before 90 days after the date the notice was mailed. The IRS must also notify all responsible parties to a tax deficiency, the identity of all other responsible parties. The IRS will also be responsible to develop materials to inform board members of tax-exempt organizations that they can be determined to be responsible persons, even if serving on a volunteer or honorary basis.

Enrolled Agents as Third-Party Recordkeepers. Before the IRS can issue a summons requiring third-party recordkeepers to provide information regarding a taxpayer, they must follow special procedures. The taxpayer must now be notified of the summons served to an accountant or attorney and given the opportunity to challenge it.

Annual Reminders to Delinquent Taxpayers. The IRS will now be required to send annual reminders of outstanding tax liabilities beginning in 1996. The liability will not be affected, however, by the failure to receive the notice.

Phone Numbers on Information Returns. To help taxpayers resolve problems on information returns, returns must now contain the phone number of the information contact of the payer. This will be required for all 1996 information returns.

Missing Information on Payment Now Requires IRS Notification. The IRS must make every reasonable effort to contact a taxpayer within 60 days of receipt of a payment they cannot associate with the taxpayer.

Taxpayer Can Sue IRS for "Deal" with Tax Professional. If an employee of the IRS entices a tax professional to disclose information about a client in exchange for favorable tax treatment of taxes of the professional, the taxpayer will have the right to sue the IRS for the lesser of $50,000 or actual damages.

Disclosure of Cash Transaction Returns Broadened. The reporting of cash transactions on Form 8300 for amounts in excess of $10,000 may be disclosed to other Federal agencies, as well as state, local, and foreign agencies. Disclosure would not be permitted for purposes of tax administration.

Private Delivery Services Qualify Under Timely Filing Ruling. The new legislation will allow taxpayers to use private delivery services such as Federal Express to prove timely filing of returns under the timely-filing rule.

Restriction on Retroactive Regulations. The new legislation generally precludes the IRS from issuing regulations that apply retroactively unless the regulations are issued within 18 months of enactment of the tax law change to which the rules relate. The provision is effective for Treasury regulations relating to tax legislation enacted on or after July 30, 1996; it does not apply to current or future tax regulations relating to previously enacted legislation. *

Constance J. Crawford, CPA, is a professor at Ramapo College of New Jersey. Corinne L. Crawford, CPA, is a senior manager at Price Waterhouse LLP.