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The Taxpayer
Relief Act of 1997

By Steven C. Colburn and Ted D. Englebrecht

Whatever happened to tax simplification?

President Clinton signed the Taxpayer Relief Act of 1997 into law on August 5, 1997. This historic budget agreement has two ambitious goals: 1) eliminate the federal deficit by 2002, and 2) provide the first general tax cut in sixteen years. Over a five-year period, the agreement provides for $135 billion in gross tax cuts and $50 billion in new revenue for a net $85 billion in tax relief. It also calls for $250 billion in net spending cuts over the next 10 years.

Some of the major provisions of the Act include major changes in capital gains, a per child tax credit, education incentives, new savings incentives, and additional relief from estate and gift taxes. There are other provisions affecting both individuals and businesses. This article covers the highlights of some of the major provisions
of the new tax act and is
not intended to provide an exhaustive discussion of the provisions covered.

Capital Gains

Rate Changes. The Act reduces the maximum tax rate on net capital gains two ways. First, the top rate is reduced from 28% to 20% for net capital gains realized 1) between May 7, 1997, and July 28, 1997, on property held more than one year, and 2) after July 28, 1997, for property held more than 18 months. In addition, any portion of a gain that would normally be taxed at 15% will be taxed instead at 10%. Collectibles and property sold after July 28, 1997, held more than one year but less that 18 months does not qualify for the reduced capital gains rates. The maximum tax rates on such gains will remain at 28%. The reduced rates also do not apply to gains on the sale of qualified small business stock (discussed below).

Second, for property acquired by purchase after December 31, 2000, and held more than five years, the maximum tax rate for net capital gains is further reduced to 18%. Net capital gains meeting this new five-year requirement that would otherwise be taxed at 15% will instead be taxed at eight percent. For individuals in a 15% bracket, the asset may be acquired before December 31, 2000, and still qualify under the five-year rule. Individuals in a higher bracket must acquire the property after December 31, 2000, or make a special election (discussed below). For purposes of this provision, the holding period of assets acquired pursuant to the exercise of an option (or other right or obligation to acquire property) includes the period the option (or other right or obligation) is held.

A taxpayer (in a tax bracket higher than 15%) that acquired property before January 1, 2001 may still qualify for the reduced 18% rate on property held more than five years. To qualify, the taxpayer must elect to treat any eligible assets held on January 1, 2001, as having been sold and reacquired on that date. Qualifying assets are 1) any stock that is a) readily tradable, b) a capital asset, and c) is not sold before the next business day and 2) any other property or capital asset used in a trade or business. A readily tradable stock is any stock readily tradable on an established securities market or otherwise as of January 1, 2001.

If the election is made for any qualifying stock, the stock will be treated as having been sold and reacquired on the next business day for its closing market price. Other qualifying property for which the election is made will be treated as having been sold and reacquired for its fair market value on January 1, 2001. The taxpayer must recognize any gains resulting from the election. Losses are never recognized.

While reducing the capital gain rate on real property to as low as eight percent, the Act also changes the rate at which depreciation recapture on such assets is taxed to 25%. As a result, any part of a gain on the sale or exchange of such depreciable real property attributable to prior depreciation will be recaptured and taxed at a maximum rate of 25%. Any gain on the sale of such property in excess of prior depreciation will be taxed at the new lower capital gains rates of 20 (or 18) and 10 (or eight) %.

The lower 20 and 10% rates may also apply to capital gains recognized under the installment method on payments received after May 6, 1997. The holding period of the asset, not the sale date, will determine whether the installment gain qualifies for the 20 and 10% rates or the 28% rate.

As well as for purposes of the regular tax, the reduced capital gains rates also apply to the same extent for purposes of the alternative minimum tax.

Example: Diane Ross is single and has ordinary (not from capital gains) taxable income of $250,000 in 1998. In addition, she has a net capital gain of $150,000 from the sale of depreciable real property held more than 18 months. $100,000 of the net capital gain may be attributed to prior depreciation deductions. Diane's non-capital income of $250,000 is taxed as ordinary income with a top rate of 39.6%. Of her capital gain, the $100,000 traceable to her depreciation deductions is taxed at 25%, and the remaining $50,000 is taxed at a rate of 20%.

While providing relief for taxpayers with capital gains, the Act adds more complexity to the IRC. Gains earned by high-income taxpayers on capital assets may now be subject to four different rates as illustrated in Table 1.

Exclusion of Gain on Sale of Personal Residence. The new law repeals the rollover rules that allowed taxpayers to defer recognition of gain on the sale or exchange of a principal residence if the proceeds from the sale of the residence were reinvested in a new residence within two years. Also repealed is the once-in-a-lifetime $125,000 exclusion of gain on the sale of a principal residence for taxpayers 55 and older.

Instead, in certain cases, individuals may now exclude up to $250,000 ($500,000 for a married couple filing jointly) of gain realized on the sale or exchange of a principal residence after May 6, 1977. This exclusion does not apply to any gain attributable to depreciation deductions taken with respect to the rental or business use of the property for periods after May 6, 1997.

To qualify for the exclusion, the taxpayer must have owned and used the property as a principal residence for at least two of the five years ending on the date of sale or exchange. Generally, the exclusion is allowed only once every two years. However, a taxpayer may be allowed a pro rata portion of the exclusion amount for a sale or exchange before the end of the qualifying two-year period due to a change in 1) place of employment, 2) health, or 3) other unforeseen circumstances. The amount of the exclusion is the amount of the gain times the period of time the taxpayer owned and used the property over two years.

Example: In 1998, Scott Overmyer bought a home in Old Town, Maine in which he and his family lived. His employer relocated Mr. Overmyer to Delaware exactly six months later. The Overmyers sold their home for a gain of $100,000. The Overmyers only lived in the residence for one-quarter of the required two-year period. As a result, they will be able to exclude only one-quarter of the amount otherwise allowed, or $25,000.

The $500,000 exclusion is available to married couples filing a joint return if--either spouse meets the ownership requirement; both spouses meet the use requirement; and neither spouse has sold a residence qualifying for the exclusion in the preceding two years.

If a married couple files a joint return but does not share a principal residence, each is entitled to a $250,000 exclusion. A single person who marries a person who has used the exclusion within the two-year period before the marriage may qualify for an exclusion of up to $250,000. Both spouses must satisfy the eligibility requirements and two years must have passed since the last exclusion for the couple to qualify for the full $500,000 exclusion for the next sale or exchange of their principal residence.

While the new exclusion is effective for sales or exchanges occurring after May 6, 1997, a taxpayer may elect to apply the old rules (i.e., the rollover and/or $125,000 exclusion) under certain circumstances:

* The sale or exchange occurred before August 5, 1997;

* The sale or exchange takes place after August 5, 1997, but is pursuant to a binding contract in effect on that date;

* Under the rollover rules of the prior law, no gain would be recognized on the sale because a replacement residence was acquired on or before August 5, 1997 (or pursuant to a binding contract in effect on that date).

If the taxpayer's current residence was acquired in a transaction that qualified under the prior rollover rules, the period of ownership and use of the prior residence are considered when determining ownership and use of the current

A transition rule applies to taxpayers that own qualifying property on August 5, 1997, and sell the property before August 5, 1999, but who fail to meet the ownership and use requirements. Such taxpayers may qualify for a pro rata exclusion based on the period of time they owned and used the property.

For taxpayers with special circumstances--

* if certain rules are met, some or all of the period of time a person resides in a nursing home due to physical or mental incapacity would count as part of the two-year use requirement.

* the period of time a deceased spouse owned and used a residence may be used by the surviving spouse to meet the ownership and use requirements.

* an individual is treated as using property as his or her principal residence during any ownership period in which the individual's spouse or former spouse is granted use of the property under an instrument of divorce or separation.

* if an individual holds stock as a tenant in a cooperative housing corporation, the period of time the stock is held applies to the ownership requirement and the use requirement is applied to the house or apartment the stockholder is entitled to occupy.

For certain taxpayers who qualify under the transition rules, it may be more advantageous to elect to be taxed under the old rollover rules than to take the $250,000 or $500,000 exclusion under the new law. Likely candidates would be individuals whose new residence cost more than the exclusion amount.

Example: Bob and Kristen Strong sell their house after May 6, 1997, but prior to August 5, 1997, for $2 million. They had bought the house 30 years ago for $200,000. Applying the new law, the Strongs would pay tax on a gain of $1,300,000 ($2 million less $200,000 less $500,000). However, if the Strongs replace their old residence with a new residence costing more than $700,000, they would be better off electing to be taxed under the old rules. They can postpone being taxed on all of the gain by purchasing a new residence for at least $2 million.

Investments in Small Business Stock. While reducing the tax rate on most net capital gains, Congress did not reduce the maximum rate on capital gains on qualified small business stock. As under the old rules, taxpayers may exclude 50% of capital gains realized on the sale of such stock, and the remaining capital gain is still taxed at a maximum rate of 28%. As a result, the maximum tax on such gains remains at 14%.

For purposes of the alternative minimum tax, the minimum tax preference on the gain from the sale of qualified newly issued small business stock held at least five years declines from 50% of the excluded gain to 42% of such gain. This provision is
effective for sales after August 5, 1997.

Individuals realizing a gain on the sale of qualifying small business stock held more than six months may elect to roll over the gain tax free if they use the proceeds to acquire other qualified small business stock within 60 days of the sale. Gain on such a sale is recognized only to the extent the sales price exceeds the cost of the new stock purchased (less any portion of the cost previously taken into account under this rule). Any gain treated as ordinary income will not qualify under this provision. The basis of the stock purchased is reduced by the amount of the gain not recognized. Except for purposes of determining whether the six-month holding period is met, the holding period of the stock purchased generally includes the holding period of the stock sold.

Child Tax Credit

Beginning with the 1998 tax year, taxpayers may claim a credit for each qualifying child who is under age 17 as of the close of the tax year. The amount of the credit is $400 for 1998 and $500 for each year thereafter. A qualifying child is the taxpayer's child, stepchild, grandchild, or eligible foster child who is a U.S. citizen and is claimed by the taxpayer as a dependent.

Phaseout rules reduce the taxpayer's total child credit by $50 for every $1,000 increment (or fraction thereof) by which the taxpayer's modified AGI (AGI before the exclusion for the foreign earned income and foreign housing costs) exceeds $110,000 for joint filers. (For singles and those filing as head of household, the threshold is $75,000; $55,000 for married persons filing separately.) As a result, the credit is not available to married taxpayers filing jointly with AGI in excess of $119,000. Except for certain low-income taxpayers, the credit is not refundable. Generally, a taxpayer may not use the child credit to reduce the taxpayer's regular income tax liability below the sum of the taxpayer's tentative minimum tax liability and any allowed earned income tax credit.

Taxpayers with three or more qualifying children may be entitled to an additional credit. Also, taxpayers qualifying for the child tax credit may qualify for a refundable credit called the supplemental credit.

Education Incentives

The Act provides two income tax credits for qualified tuition and related expenses (the Hope Scholarship credit and the Lifetime Learning credit) and an education income exclusion for education expenses. Tuition and fees qualify as related expenses, but not books or room and board. This is a departure from the normal scholarship rules that allow amounts spent on books to be excluded from taxable income.

The Hope Scholarship Credit is nonrefundable and may be used for up to 100% of the first $1,000 and 50% of the second $1,000 of qualified tuition and related expenses paid during the taxable year. The credit is available for qualified education expenses incurred during the first two years of post-secondary education for the taxpayer, the taxpayer's spouse, or dependents of the taxpayer. Beginning in 2002, the $1,000 amounts will be adjusted annually for inflation. Students must be enrolled at least half time and carry at least one-half the workload of a full-time student. The credit is available for expenses paid after 1997.

The Lifetime Learning Credit is available for students enrolled at both the undergraduate and graduate level of post-secondary education as well as for students enrolled at a qualified education institution to acquire or improve job skills. Like the Hope credit, the Lifetime Learning credit may be used for qualified tuition and related expenses (not room and board). The credit equals 20% of up to $5,000 of qualified expenses paid after June 30, 1998 ($10,000 after 2002). Thus, the maximum credit is $1,000 ($2,000 after 2002). Unlike the Hope Scholarship Credit, this credit is not adjusted for inflation.

Generally, expenses paid with tax-exempt education assistance (i.e., grants and scholarships) do not qualify for either credit. However, qualified expenses paid with loan proceeds are eligible. A dependent student may not claim either credit if the credit is claimed by a taxpayer other than the student (e.g., a parent or guardian), and the taxpayer is treated as having paid all the eligible expenses for the tax year for credit purposes. Both credits are phased out for joint return filers with modified AGI (AGI increased by income earned outside the U.S.) between $80,000 and $100,000 ($40,000 to $50,000 for single filers). Beginning in 2001, the phase-out range will be adjusted annually for inflation. Both credits may be claimed for eligible education expenses of the taxpayer and the taxpayer's spouse and dependents. However, a taxpayer may claim only one of the credits (not both) for a specific student in any given year. In addition, the $1,500 maximum Hope credit is allowed per student, while the maximum Lifetime Learning credit is calculated per taxpayer and does not vary depending upon the number of students in the taxpayer's family. Married taxpayers must file jointly to claim the credits.

Education IRAs. Rather than using the Hope or Lifetime Learning credits, taxpayers may elect to exclude from taxable income amounts withdrawn from Education IRAs and spent on qualified education expenses for the taxpayer, the taxpayer's spouse, or a dependent. In addition to tuition, fees, supplies, and equipment, withdrawals from Education IRAs may be used for certain room and board and book expenses. The exclusion is available for both undergraduate and graduate-level coursework. Unlike the Hope and Lifetime Learning credits, Education IRA's are available to students enrolled less than half time at an eligible educational institution. However, students enrolled less than half-time may not treat room and board expenses as qualified education expenses for purposes of the Education IRA income exclusion. As with the credits, expenses paid with tax-exempt education assistance do not qualify as education expenses. However, expenses paid with loan proceeds do qualify. The income exclusion is not available in any tax year the HOPE Scholarship or Lifetime Learning credit is elected with respect to a student.

Education Individual Retirement Accounts are special trust accounts established for the sole purpose of paying qualified education expenses. For tax years beginning after 1997, taxpayers may contribute up to $500 a year for each child under 18. Although contributions are not deductible, earnings grow tax-free and withdrawals used to pay qualifying education expenses (including room and board) may generally be made free of tax. Distributions are deemed to be paid from both contributions and earnings. If aggregate distributions do not exceed qualified expenses for the year, all of the distribution will be free of tax. If aggregate distributions exceed qualified expenses, a portion of the earnings will be included in gross income. A phase out provision applies to taxpayers with modified AGI between $95,000 and $110,000 ($150,000 and $160,000 for joint filers).

According to the conference report, if a beneficiary reaches age 30 and has not used all of the IRA for qualified education purposes, the balance of the IRA must be distributed to the beneficiary. If this occurs, the earnings in the account will be taxed and subject to a 10% penalty (because they have not been used for education purposes). To avoid this result, the account balance may be rolled over to another Education IRA for another beneficiary before the original beneficiary turns 30. The new beneficiary must be a member of the family of the prior beneficiary. To accomplish this result, a technical correction to the law may be necessary.

Contributions to an Education IRA qualify for the annual $10,000 gift tax exclusion and will be exempt from the generation-skipping transfer tax if within the annual exclusion amount. However, such contributions will not qualify for the gift tax exclusion applicable to tuition payments made directly to educational organizations.

Which Alternative? The HOPE credit and the education income exclusion are available for expenses paid after 1997. The Lifetime Learning credit may be used for expenses paid after June 30, 1998. The applicable academic periods must begin after those dates. Students convicted of a felony for possession or distribution of a controlled substance may not claim the credits or exclusion. The most advantageous of the three alternatives will depend upon the amount of qualified education expenses incurred and paid during the tax year.

Example: Taxpayer Bill contributes a total of $7,000 (over 14 years) to an education IRA for his daughter, Chelsea's, educational expenses. The total value of the education IRA in the first year Chelsea attends college is $14,000. Bill makes a withdrawal of $8,000 from the IRA to pay for Chelsea's qualified education expenses of $8,000. Fifty percent ($7,000/14,000) of the withdrawal ($4,000) is attributable to untaxed earnings. Bill claims a $1,500 HOPE Scholarship credit for Chelsea's qualified education expenses for the year of distribution, making the income exclusion unavailable. Because Bill claimed the credit for the Hope Scholarship, Chelsea may not exclude the $4,000 distribution attributable to untaxed earnings from her income. If Bill had not claimed the credit, the entire $8,000 distribution would have been excluded from income.

Example: The facts are the same as above, except Bill uses $6,000 of the distribution for Chelsea's qualified expenses and elects the exclusion instead of the credit. One half of the distribution still consists of return of contributions. The amount of earnings excludable from Chelsea's income is $7,000 [$4,000 + ($6,000/8,000 x $4,000)]. She must include $1,000 ($8,000­$7,000) in gross income.

A Qualified State Tuition Program (QTP) is a program established by a state to help taxpayers finance college costs. Contributions to a QTP are not deductible, but earnings grow tax free. The earnings withdrawn from a QTP must be included in the taxpayer's income. However, the taxpayer may claim a HOPE Scholarship or Lifetime Learning credit in the year of withdrawal provided the withdrawn funds are used to pay qualified higher education costs and the modified AGI phaseout for the credits does not apply. Under the new law the definition of qualified higher education costs has been expanded to include room and board if the student is enrolled in a degree program at least half time.

Contributions to QTPs qualify for the yearly $10,000 gift tax exclusion. Furthermore, for purposes of the annual $10,000 gift tax exclusion, a donor may elect to treat a contribution to a QTP as if made over a five-year period. This election may allow the taxpayer to take full advantage of the gift tax exclusion if the amount contributed to a QTP in any one year exceeds $10,000.

Example: In 1998, Ted transfers $50,000 to a qualified state tuition program maintained by his alma mater to benefit his nephew J.W. during his schooling from 1998 through 2002. The transfer qualifies as a gift from Ted to J.W., qualifying for the annual $10,000 gift tax exclusion. Under the regular gift tax rules, the remaining $40,000 would not be excluded. To take maximum advantage of the annual gift tax exclusion, Ted may elect to treat the gift as if it were made over five years. As a result, Ted will be deemed to have made a gift to J.W. of $10,000 ($50,000/5) per year for 1998 through 2002.

Depending upon the family relationship and ages of the different beneficiaries, a taxable gift may result if the beneficiary of a QTP or an Education IRA is changed. Upon the death of a beneficiary, the value of the beneficiary's account is includable in his or her taxable estate. However, under no circumstances will the amount be included in the taxable estate of another person.

Withdrawals from Regular IRAs for Education Expenses. Taxpayers may make penalty free withdrawals from regular IRAs after 1997 for qualified education expenses (tuition, fees, books, supplies and equipment), including graduate school, paid for academic periods beginning after 1997. The amount of qualified education expenses is reduced by scholarships and other education assistance excludable from gross income. The 10% penalty that normally applies to withdrawals made before the taxpayer reaches age 59 Qs will not apply if the distribution is used for higher education expenses of the taxpayer, or the spouse, children, or grandchildren of the taxpayer. (Note: Except for the normal gift tax rules, none of the other provisions discussed allow exclusions or credits for amounts paid for educational assistance for grandchildren).

Deduction for Interest Paid on Student Loans. Beginning in 1998, taxpayers may take an annual deduction above the line (for AGI) for interest paid on qualified education loans. The deduction may not exceed $1,000 in 1998, $1,500 in 1999, $2,000 in 2000, and $2,500 for 2001 and beyond. The deduction applies to any loan during the first 60 months interest payments are required (not counting months in which the loan is in forbearance or deferral). A taxpayer may claim the interest deduction for a particular year only if not claimed as a dependent in that year by another taxpayer. As a result, students who are claimed as dependents by their parents may not deduct interest they (the student) pay on a student loan. However, the student's parents may take the interest deduction if they take out the loan and pay the interest. The deduction is phased out for single filers and those filing as heads of households with modified AGI between $40,000 and $55,000 ($60,000 and $75,000 for joint return
ilers). Beginning in 2003, the phase-
out range will be adjusted for inflation.

A qualified education loan is any indebtedness incurred to pay the qualified higher education expenses of the taxpayer, spouse, or a dependent attending 1) post-secondary educational institutions, 2) certain vocational institutions, or 3) other institutions conducting internship or residency programs. Qualified educational expenses are tuition, fees, and room and board, and related expenses (i.e., books and supplies) and must be reduced by any tax-free educational benefit (e.g., scholarships).

Employer-Provided Educational Assistance. The act retroactively reinstates and extends the income exclusion for employees receiving educational assistance from their employers. The exclusion for coursework begun after June 30, 1997, had expired. The maximum annual exclusion is still $5,250 and applies to tax years beginning after 1996 for undergraduate-level coursework begun before June 1, 2000. As long as coursework begins before June 1, 2000, payments received after that date may still qualify for the exclusion.

Forgiveness of Student Loans. After August 5, 1997, student loans may be forgiven in exchange for public service under the direction of a charitable organization or governmental entity. The student must work in an occupation or area with unmet needs. The student may exclude from gross income the amount of the loan forgiven by a tax-exempt charitable organization, such as an educational organization or private foundation, if the loan proceeds were used to pay to attend an educational institution or to refinance other outstanding student loans. The student must not be employed by the lender organization.

Savings Incentives

Roth IRAs. Effective for tax years beginning after 1997, taxpayers may take advantage of a new retirement savings vehicle, the Roth IRA. No tax deduction is provided for the year of contribution, but qualified distributions come out free of tax rather than tax deferred. Taxpayers may contribute up to $2,000 per year (apparently for each spouse), and contributions may be made even after age 70Qs. The $2,000 contribution limit is phased out for single taxpayers with AGI between $95,000 and $105,000 and for joint filers with AGI between $150,000 and $160,000. If the taxpayer also contributes to a regular IRA, the $2,000 limit is reduced by that amount. Except where expressly noted, the regular IRA rules will apply to the Roth IRA.

The taxpayer must have had a Roth IRA for at least five years before making a qualified distribution. The following types of distributions are considered to be qualified distributions:

* Those made after age 59 Qs;

* A distribution made by reason of death or disability of the taxpayer;

* A distribution that qualifies as a first-time homebuyer distribution, subject to a lifetime limit of $10,000. A first-time homebuyer is generally defined as a taxpayer who has not owned a principal residence for two years. The distribution must be used to acquire a principal residence of the taxpayer, or the taxpayer's spouse, child, grandchild, or ancestor.

Distributions are considered to have come from contributions first. Thus, for a nonqualified distribution, no portion of the distribution is considered to come from earnings or is includable in gross income until the total of all distributions from the Roth IRA exceeds the amount of contributions.

Unlike a regular IRA, minimum distributions from a Roth IRA are not required. That is, distributions need not start at age 70 Qs. Upon the death of the taxpayer, there are three options:

* The account balance must be distributed to the beneficiary within five years; or

* An annuity must be purchased within one year of death; or

* Distributions must be continued to the beneficiary at the same (or greater) rate as before the taxpayer's death.

Qualifying taxpayers may convert existing IRAs into Roth IRAs. To qualify, the taxpayer's AGI must not exceed $100,000 and the taxpayer must not be married filing separately.

If a rollover from an ordinary IRA to a Roth IRA is made before 1999, the amount that would have been included in income if the taxpayer had taken a distribution is included in income and the tax must be paid ratably over four years. However, such conversions are not subject to the 10% early distributions tax. Taxpayers may find the Roth IRA to be a better retirement vehicle than a regular IRA because earnings on the Roth IRA are tax-free, rather than tax-deferred.

Regular (Deductible) IRAs. Two changes in the law will entitle more taxpayers to deductions for regular IRAs. Effective for the 1998 tax year, the active participation of a taxpayer's spouse in an employer's retirement plan will not affect the deductibility of the taxpayer's IRA contribution. However, the deduction for a spouse of an active participant is
phased out for AGI between $150,000 and $160,000.

The AGI threshold for full deductibility of an IRA contribution by a taxpayer covered by a retirement plan at work is also increased. The threshold for joint filers gradually increases from $50,000 in 1998 to $80,000 by 2007. For single filers, the threshold increases from $30,000 in 1998 to $50,000 by 2005. Beginning in 2007, the phaseout range increases for joint filers from $10,000 to $20,000. As a result, in 2007 a taxpayer filing jointly with AGI of $100,000 or more who is covered by a retirement plan at work will not qualify for the IRA deduction.

As described earlier, taxpayers may now withdraw amounts from IRAs before age 59Qs without penalty to pay certain education expenses. Also, under the Act, qualified first-time homebuyers may make early withdrawals from their IRAs without penalty starting in 1998. The withdrawals are subject to a lifetime limit of $10,000 and must be used to acquire a principal residence of the taxpayer, a spouse, child, grandchild, or ancestor of the taxpayer. Generally, the distribution is available if the taxpayer has not owned a principal residence during the two years preceding the date of purchase.

Estate and Gift Taxes

The Act makes major changes to the rules affecting estate and gift taxes. While the tax rates are not reduced, special provisions substantially increase the amount that may be excluded from a taxable estate and other provisions provide relief for family-owned businesses and farms.

Increase in the Unified Credit. Beginning in 1998, the unified credit gradually increases from the current level of $192,800 to $345,800 after 2005. By 2006, this will allow taxpayers to transfer a total of $1 million by gift and at death, rather than $600,000 under the old law. Table 2 shows the phase-in of the credit from 1998 through 2006. In addition, filing requirements are also adjusted so
that estates valued at less than the
applicable exclusion amount will not be required to file.

Qualified Family-Owned Businesses. The Act allows a maximum exclusion from taxable estates of up to $1.3 million for "qualified family-owned business interests" less the applicable exclusion amount. Thus, for a decedent dying in 1998 with a gross estate of $625,000, an exclusion of $675,000 could be taken for a family-owned business. This provision applies to estates of decedents dying after 1997. Qualifying business interests include a sole proprietor's interest in a trade or business and an interest held by a family in a trade or business that is owned 1) at least 50% by one family, 2) 70% by two families, or 3) 90% by three families. If the trade or business is held by more than one family, the decedent's family must own at least 30%.

The stock of the business entity must not have been publicly traded within three years of the date of death, and the principal place of business must be located in the United States. If the business holds passive assets (stock in a publicly traded corporation), excess cash, or marketable securities, the value of the family business must be reduced to the extent of such assets.

The following requirements must be met to qualify for the exclusion:

* The decedent must have been a U.S. citizen or resident;

* A liquidity test must be satisfied;

* The decedent or a family member must have owned and materially participated in the trade or business for at least five of the eight years preceding the date of death;

* During the ten years following the date of death, each qualified heir, or a family member of that qualified heir, must materially participate in the trade or business for at least five years during a period of eight years; and

* The aggregate value of the decedent's qualified family-owned business interests passed to qualified heirs must exceed 50% of the decedent's adjusted gross estate.

Other Provisions. In the case of gifts made or decedents dying after 1998, the following estate and gift tax provisions will be indexed for inflation:

* The annual gift tax exclusion of $10,000 per donee ($20,000 in the case of gift splitting with a spouse);

* The maximum reduction in value allowed under the special use valuation provisions of $750,000 for certain property that is part of a decedent's estate
and is used in farming or a trade or business;

* The $1 million exemption allowed each taxpayer for transfers otherwise subject to the generation-skipping transfer tax; and

* The limitation of $1 million that qualifies for the special two percent interest rate applied against estate taxes paid in installments attributable to the value of a closely-held business included in a decedent's gross estate.

Effective for tax years beginning after August 5, 1997, a decedent's estate may elect to treat distributions made within 65 days after the close of its tax year as if they were made on the last day of the tax year. As a result, this rule now applies to estates as well as to trusts.

The throwback rules, applicable to trusts, have been repealed. These rules provided that distributions that were previously accumulated in a trust must be included in the income of a trust beneficiary if the beneficiary's top average marginal tax rate during the previous five years was higher than that of the trust. Another rule was also repealed. This rule required that any gain on the sale of appreciated property contributed to a trust be taxed at the contributor's marginal tax rates if the property were sold by the trust within two years of its contribution. The relatively high tax rates applicable to trust income (39.6% for income in excess of $8,100 for 1997) make it less desirable for trust beneficiaries to try to shift income to the trust and away from themselves.

Other Provisions Affecting

Charitable Contributions of Stock to Private Foundations. The Act retroactively reinstated an expired provision allowing donors of qualified stock to private foundations to deduct the full fair market value of the contributed stock. The provision applies to contributions made between June 1, 1997, and June 30, 1998. Qualified appreciated stock is generally publicly traded stock that has increased in value and has been held long term (i.e., more than one year). This deduction does not apply
to the extent that total family contributions to private foundations do not exceed 10% of the outstanding stock of a corporation.

A good tax planning strategy using this provision would be to contribute substantially appreciated stock to a private foundation, take the charitable deduction for the full value of the stock, and use the tax savings to acquire new shares at the current market price. This strategy would allow the taxpayer to gain a tax deduction while effectively getting a step up in basis for the shares.

Estimated Taxes. The threshold for incurring a penalty for underpayment of taxes has been increased from $500 to $1,000 effective for tax years beginning in 1998. For individuals with AGI in excess of $150,000, the percentage of the preceding year's tax that will have to be paid to avoid the underpayment penalty has been adjusted. Under prior law such individuals could avoid the penalty by paying in the lesser of 90% of the current year's tax or 110% of
their prior year's tax liability. The
new law changes the 110% safe harbor rule as follows:

These percentages are obviously not indexed for inflation, and may be related to revenue expectations for the each year. Future adjustments are likely.

Some taxpayers may find they will owe more taxes when they file their 1997 returns than they had anticipated (e.g., possibly because of increased capital gains taxes due to sales of capital assets to take advantage of the lower rates). The act provides relief for such taxpayers by waiving estimated tax penalties with respect to any underpayment of an estimated tax installment required to be paid before January 16, 1998. The payment must relate to the tax liability through December 31, 1997, and the underpayment must have been created or increased by provisions in the new tax law.

Health Insurance Premiums for the Self-Employed. Self-employed taxpayers may deduct for AGI 40% of the premiums they pay for health insurance to cover themselves and their families. This percentage was scheduled to gradually increase to 80% by 2006. Instead, it will rise to 100% by 2007. The following
table gives the applicable percentages for each tax year:

Home Office Deduction. Effective for tax years beginning after 1998, the new law will enable more taxpayers to satisfy the principal place of business requirement and qualify for the home office deduction. An office in a taxpayer's home may qualify as the taxpayer's principal place of business if the office is used regularly and exclusively by the taxpayer to conduct management and administrative activities of a trade or business. In addition, the taxpayer must not conduct substantial administrative or management activities of the business at any other fixed location. Essentially, this new rule overturns the Supreme Court's decision in Soliman.

This rule will not prevent a taxpayer from claiming the home office deduction in cases where administrative or management activities are performed occasionally in locations that are not fixed (i.e., hotel rooms, construction sites, etc.). Furthermore, a taxpayer may perform a minimal amount of office work at another fixed location of the business without losing the home office deduction. Also, a taxpayer may claim the deduction even if the taxpayer has a fixed business location away from home where office work could be, but is not, performed.

Employees must still satisfy the requirement that the office in the home must be maintained for the convenience of the employer to qualify for the home office deduction. If the employee chooses to perform administrative or managerial activities at home rather than in an office provided by the employer, the employee may have difficulty demonstrating the home office is being used for the convenience of the employer.

Foreign Earned Income Exclusion. Beginning in 1998, the foreign earned income exclusion (currently $70,000) will increase in increments of $2,000 per year until it reaches $80,000 in 2002. For tax years beginning after 2007, the exclusion will be indexed for inflation.

Provisions Affecting Business

For tax years beginning after 1997, small business corporations will be exempt from the corporate alternative minimum tax (AMT). To qualify as a small business corporation, the business must have had average gross receipts of less than $5 million for the three-year period beginning after 1994. If a corporation satisfies the gross receipts test, it will continue to remain exempt from the AMT as long as its average gross receipts do not exceed $7.5 million.

Effective for tax years beginning after 1997, the carryback period for general business credits will change from three years to one year. The carryover period increases from 15 to 20 years.

For net operating losses (NOLs), the carryback period is reduced from three years to two years. The carryover period increases from 15 to 20 years. These changes are effective for NOLs generated in tax years beginning after the enactment date, August 5, 1997.

For purposes of the AMT depreciation adjustment, the recovery periods for property placed in service after 1998 are conformed to the recovery periods used for depreciation under the regular tax.

The research tax credit has been extended retroactively from June 1, 1997, to June 30, 1998. The Work Opportunity Tax Credit is extended from October 1, 1997, to June 30, 1998. A new category of Supplemental Security Income recipients has been added to the group of workers eligible for the credit.

A new Welfare to Work Credit is now available for employers who hire qualified long-term family assistance (AFDC) recipients. The amount of the credit is 35% of the first $10,000 of eligible wages paid or incurred in the first year of employment and 50% of the first $10,000 of eligible wages in the second year. The credit applies to qualified workers who begin employment between January 1, 1998, and May 1, 1999.

The temporary surtax of 0.2% on federal unemployment taxes scheduled to expire in 1998 has been extended through 2007. The penalty has been lifted for companies that were required to convert to the Electronic Federal Tax Payment System, because their federal deposits exceeded $50,000 in 1995, but did not use the system between July 1, 1997, and June 30, 1998.

Beginning in 1998, the deductible percentage of business meals has been increased for certain employees from 50% to 80%. Eligible employees are
certain airline employees, truckers, railroad employees, and sailors who consume meals away from home during
the time their work hours are subject
to limits by the U.S. Department of

Steven C. Colburn, PhD, CPA, is an associate professor at the University of Maine. Ted D. Englebrecht, PhD, CPA, is Eminent Scholar at Old Dominion University.

In Brief

Something for everyone.

The Taxpayer Relief Act of 1997 has something in it for just about everyone: capital gains cuts, credits for college expenses, exclusion of gain on sale of a personal residence, tax credits for families with children, new IRAs, tax relief for small businesses, and so on. Low to moderate income families and those with substantial capital gains appear to be the big winners.

Unfortunately, along with the increase in tax breaks comes a substantial increase in complexity. There are different transition rules and effective dates that apply to the many provisions of the Act. In addition, phaseout rules will reduce or eliminate many of the benefits for higher income taxpayers.

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