Income and Corporate Tax Provisions of the 2001 Tax Act

By Mark H. Levin, Robert H. Colson, and Sidney Kess

In Brief

Sunset Provision Complicates Taxpayers’ Planning

Taxpayers and their advisors will be studying the provisions of the 2001 Tax Act to understand how it affects their current tax burden and future tax planning. For some, its effects will be limited to the rate reductions that phase in over the next few years. For others, there will be more complicated planning issues because of changes in retirement savings and education incentives.

The most disappointing aspect of the Act is its failure to lighten the burden of the alternative minimum tax (AMT). An increasing number of taxpayers in New York and other high–income tax states will see their regular income tax savings income reduced significantly by the AMT, especially after 2005.

The Act also provides for its own sunset at midnight on December 31, 2010, after which the tax law in effect before June 7, 2001, will become law once again. Veteran observers anticipate that Congress will revisit the tax act before the sunset date, and the White House has indicated that tax reform will be the focus of the 2004 reelection campaign.

On May 26, 2001, Congress passed the Economic Growth and Tax Relief Reconciliation Act of 2001 (Act). President Bush signed the bill into law on June 7, 2001. The popular and financial press has covered many aspects of the Act, from the repeal of the estate tax to the effect of the alternative minimum tax (AMT). Taxpayers can even estimate their new tax liability at several websites and contemplate how to spend the savings.

The Act reduces taxes over a 10-year period, but it is heavily back-loaded: many of its more significant tax reductions come into effect after 2006. In addition, the Act has a sunset provision that repeals all of the tax reductions as of January 1, 2011, unless Congress takes further action before then.

Additional uncertainty stems from increasing concern over whether the projected surplus that would fund the tax reduction will actually occur. The slowing economy could reduce federal tax collections and motivate Congress to rescind some of the recent tax cuts in order to avoid budget deficits. Congress has found it difficult to restrain its own spending and has initiated additional program expenditures that will also erode the projected surplus. In addition, the Medicare and Social Security surpluses have been effectively removed from current budgetary considerations. Although taxpayers will enjoy some immediate tax reductions, they should also be aware that future planned reductions still hinge upon budgetary considerations and political changes, such as the shift in the balance of power in the Senate.

Several features of the Act complicate tax planning for individuals at all income and wealth levels. The phase-in and sunset provisions for the estate tax repeal pose serious problems for planning wealth transfers. In addition, many of the tax reductions slated for the 2004–2006 period will not provide as much relief as expected because the AMT, which was not changed as dramatically, will affect many additional taxpayers. Tax plannners will have to consider all these changes plus their repeal in 2011.

The following is an exposition of the principal provisions of the Act for personal income and corporate tax planning purposes. The estate, gift, and generation-skipping transfer (GST) tax provisions are covered in a separate article on page 26.

Personal Income Tax

The Act creates new tax rates that are lower for all individual taxpayers, including a new 10% bracket that will be in effect for a portion of all taxpayers’ taxable income previously taxed at 15%. It applies to years after December 31, 2000, but will sunset after 2010. The 10% tax bracket applies as follows:

2001–2007
Single	first $6,000 of taxable income
Head of household	$10,000
Married filing jointly	$12,000

2008–2010
Single	first $7,000 of taxable income
Head of household	$12,000
Married filing jointly	$14,000

Rate Reduction Credit for 2001

The Act provides a rate reduction credit for 2001 to all individual taxpayers other than estates, trusts, nonresident aliens, or dependents as determined by their filing status on the 2001 tax return. Taxpayers are entitled to a credit for 2001 of 5% (the difference between the 15% rate and the 10% rate) of the amount of income that would have been subject to the new 10% rate. Taxpayers may not receive a credit larger than their income tax liability (determined after nonrefundable credits).

Most taxpayers will receive the credit in the form of a check issued by the Department of the Treasury. The amount of the check will be computed in the same manner as the credit, except that it will be based on tax returns filed for 2000 (instead of 2001). The Treasury anticipates that they will issue the checks before October 1, 2001, to taxpayers that filed timely tax returns in 2000. Taxpayers that filed late will receive their checks later in the fall.

The IRS is not authorized to issue any checks after December 2001. Taxpayers that have not filed their 2000 return in time for the advance refund to be mailed to them before January 1, 2002, may claim a credit, to the extent they qualify, on their 2001 return. Taxpayers that received an advance refund check will reconcile the amount of the credit with the amount they received on a worksheet on their 2001 tax return.

The amounts of the credit and the check will be the same for many taxpayers. If, however, the result is a positive, the taxpayer may claim that amount as a credit against the 2001 tax liability. If, on the other hand, the result is negative (because, for example, the taxpayer paid tax in 2000 but owes none in 2001), the taxpayer is not required to repay that amount to the Treasury.

The amount of the refund is not includable in federal gross income and does affect withholding. In addition, most states will not treat the credit as income. Under the IRC, the credit is treated as a reduction in a payment of tax for all purposes, including refund-offset provisions, such as those applicable to past-due child support.

The Treasury will process and mail the advance refunds according to the last two digits of the taxpayer’s Social Security number (for joint returns, the first Social Security number on the return):

SSN digits:	Check should arrive:
00–09	the week of July 23
10–19	July 30
20–29	Aug. 6
30–39	Aug. 13
40–49	Aug. 20
50–59	Aug. 27
60–69	Sept. 3
70–79	Sept. 10
80–89	Sept. 17
90–99	Sept. 24

Individual income tax rates. The Act reduces the rates for the 28%, the 31%, the 36%, and the 39.6% brackets according to a 10-year phase-in, as seen in

Exhibit 1.

Deductions and Personal Exemptions

Over five years, the Act phases in the repeal of itemized deduction and personal exemption phase-outs. The applicable limitations on itemized deductions and personal exemptions are reduced as follows:

2006, 2007	reduced by 1/3
2008, 2009	reduced by 2/3
2010	limitation repealed
2011 and after	limitation reinstated

These phase-outs, when fully effective, will decrease the tax rate for the highest taxpayers by an additional 3%.

Alternative Minimum Tax

The 2001 Act increases the AMT exemption amount during 2001–2004 from $45,000 to $49,000 for married couples filing a joint return and surviving spouses, from $33,750 to 35,750 for unmarried individuals (not surviving spouses), and from $22,500 to $24,500 for married individuals filing separately. In 2005, the AMT exemption reverts to the current amount of $45,000 for married couples filing a joint return and surviving spouses, $33,750 for unmarried taxpayers (not surviving spouses), and $22,500 for married taxpayers filing separately.

The AMT will prove particularly troublesome. The various substantial scheduled decreases in the regular tax, coupled with a temporary minimal decrease in the AMT, will increase the number of taxpayers subject to the AMT to 40 million in 2010. Unless corrective legislation is enacted, many taxpayers in states with a high state income tax (e.g., N.Y., N.J., Calif.) will find themselves subject to the AMT and not benefiting from the full tax reductions in the Act. The impact on the AMT can be seen in Exhibit 2.

Tax Benefits Related to Children

Child tax credit. The Act increases the child tax credit to $1,000 per child over 10 years, beginning in 2001:

2000	$500
2001–2004	$600
2005–2008	$700
2009	$800
2010	$1,000
2011 and after	$500

The Act makes the child credit refundable to the extent of 10% of a taxpayer’s earned income greater than $10,000. Beginning in 2002, the credit is indexed for inflation. Families with three or more children are allowed a refundable credit for the amount by which the taxpayer’s Social Security taxes exceed the taxpayer’s earned income credit, if that amount is greater than the refundable portion based on the taxpayer’s earned income in excess of $10,000.

The refundable portion of the child tax credit will no longer be reduced by the amount of the AMT. In addition, the child tax credit will be allowed to the extent of the full amount of the taxpayer’s regular income tax and AMT. Furthermore, the refundable portion of the credit will not constitute income and will not be treated as a resource for purposes of determining eligibility or benefits under any federal, state, or local program financed with federal funds. The existing AGI limits for the child care credit adjustment ($110,000 for married couples, $55,000 for singles) remain unchanged.

Dependent care tax credit. The Act increases the maximum amount of eligible employment-related dependent care expenses from $2,400 to $3,000, (from $4,800 to $6,000 if there is more than one qualifying individual) for taxable years after December 31, 2001. It also increases the maximum credit from 30% to 35% and raises the starting point of the credit’s phase-out from $10,000 to $15,000 of AGI.

Credit for child care facilities. The 2001 Act provides a new tax credit to employer-provided child care facilities, effective for taxable years beginning after December 31, 2001. This credit is equal to 25% of qualified expenses for child care and 10% of qualified expenses for child care resource and referral services. A taxpayer’s maximum credit cannot exceed $150,000 per taxable year.

To qualify as a child care facility, the principal use of the facility must be child care (unless it is the principal residence of the taxpayer), and the facility must meet all applicable state and local laws and regulations, including any licensing laws. A facility is not treated as a qualified child care facility unless—

• enrollment is open to the taxpayer’s employees;
• use of (or eligibility to use) the facility does not discriminate in favor of highly compensated employees [within the meaning of IRC section 414(q)]; and
• at least 30% of the children enrolled in the center are dependents of the taxpayer’s employees.

Qualified child care expenses include costs paid or incurred—

• to acquire, construct, rehabilitate, or expand property to be used for a qualified child care facility;
• for the operation of the taxpayer’s qualified child care facility, including certain costs of training and compensating employees of the child care facility, and scholarship programs; and
• under a contract with a qualified child care facility to provide child care services to the employees of the taxpayer.

Qualified child care resource and referral expenses are amounts paid or incurred under a contract to provide child care resource and referral services to the taxpayer’s employees. Qualified child care resource and referral expenditures must be provided (or eligible for use) in a way that does not discriminate in favor of highly compensated employees of the taxpayer [within the meaning of section 414(q)].

Any amounts for which the taxpayer may otherwise claim a deduction are reduced by the amount of these child care credits. Similarly, if the credits are taken for costs incurred in acquiring, constructing, rehabilitating, or expanding a facility, the taxpayer’s basis in the facility is reduced by that amount.

Adoption tax benefits. The Act permanently extends the adoption credit for children other than special needs children. The maximum credit is increased to $10,000 per eligible child, including special needs children. A $10,000 credit is provided in the year a special needs adoption is finalized regardless of whether the taxpayer has qualified adoption expenses. The starting point of the income phase-out range is raised to $150,000 of modified AGI. The credit is permanently allowed against the AMT.

The Act also permanently extends the exclusion from income for employer-provided adoption assistance. The maximum exclusion is increased to $10,000 per eligible child, including special needs children. In the case of a special needs adoption, the exclusion is provided regardless of whether the taxpayer has qualified adoption expenses. The starting point of the income phase-out range has been doubled, to $150,000 of modified AGI. The credit is permanently allowed against the AMT.

These provisions are generally effective for taxable years beginning after December 31, 2001. The provisions that extend the tax credit and exclusion from income for special needs adoptions regardless of qualified expenses are effective for taxable years beginning after December 31, 2002.

Marriage Penalty Provisions

Standard deduction relief. The Act increases the basic standard deduction for a married couple filing a joint return to twice that of the basic standard deduction for an unmarried individual filing a single return. For budgetary reasons, this increase is phased in over five years from 2005 to 2009. The following shows the basic standard deduction for a married couple filing a joint return as a percentage of the basic standard deduction for an unmarried individual filing a single return during the phase-in period:

2000–2004	164%
2005	174%
2006	184%
2007	187%
2008	190%
2009, 2010	200%
2011 and after	164%

When the changes become effective, they will eliminate the marriage penalty for filers in the 15% bracket that take the standard deduction. Married filers that do not itemize and are in higher tax brackets will receive some relief but will still not have a standard deduction that is twice that of individual taxpayers.

15% rate bracket. The Act increases the 15% regular income tax bracket for married couples filing a joint return to twice the size of the corresponding bracket for unmarried individuals filing a single return. The rise in the end point of the 15% bracket for joint returns as a percentage of the bracket for single returns is phased in from 2005 to 2008 as follows:

2000–2004	167%
2005	180%
2006	187%
2007	193%
2008–2010	200%
2011 and after	167%

Earned income credit. The Act increases the start and end of the earned income phase-out for married couples filing a joint return by the following amounts:

2002–2004	$1,000
2005–2007	$2,000
2008–2010	$3,000
2011 and after	$0

The $3,000 amount will be adjusted annually for inflation after 2008. The definition of earned income is simplified by excluding nontaxable employee compensation. The calculation of the earned income credit is simplified by using AGI instead of modified AGI. The present-law tie-breaking rules are simplified. In addition, the present-law provision that reduces the earned income credit by the amount of the AMT is repealed.

Beginning in 2004, the IRS is authorized to use math error authority to deny the earned income credit if the Federal Case Registry of Child Support Orders indicates that the taxpayer is the noncustodial parent of the child for whom the credit is claimed. The earned income credit provisions are effective for taxable years beginning after December 31, 2001.

Pension and Individual Retirement Arrangement Provisions

Contribution limits. The Act increases the limitation on the maximum annual dollar contribution for IRAs and 401(k), 403(b), and 457 plans as follows:

	IRA	401(k), 403(b), and 457 Plans
2000	$2,000	$10,500
2001	$2,000	$10,500
2002	$3,000	$11,000
2003	$3,000	$12,000
2004	$3,000	$13,000
2005	$4,000	$14,000
2006	$4,000	$15,000
2007	$4,000	$15,000*
2008	$5,000	$15,000*
2009	$5,000*	$15,000*
2010	$5,000*	$15,000*
2011 and after	$2,000	$10,500

* Indexed

Catch-up provisions. Individuals over age 50 may make additional contributions to their IRA, 401(k), 403(b), and 457 plans and salary reduction SEPs. Catch-up provisions for Roth 401(k) plans start in 2006. The maximum catch-up contributions increase along the following schedule:

2000–2001	N/A
2002	1,000
2003	$2,000
2004	$3,000
2005	$4,000
2006	$5,000
2007–2010	Indexed
2011 and after	N/A

Roth 401(k) and 403(b) option. The Act includes a provision allowing 401(k) and 403(b) plan participants to elect to have all or a portion of their elective deferrals treated as Roth contributions. The plan is required to establish a separate account and maintain separate record keeping for a participant’s Roth contributions (and earnings thereon).

SIMPLE plans. The Act increases the limitation on the maximum annual dollar contribution for SIMPLE IRA and 401(k) contributions as follows:

	Regular	Catch-Up
2000	$6,000	N/A
2001	$6,000	N/A
2002	$7,000	$500
2003	$8,000	$1,000
2004	$9,000	$1,500
2005	$10,000	$2,000
2006	Indexed	$2,500
2007–2010	Indexed	Indexed
2011 and after	$6,000	N/A

Credit for contributions to qualified plans. Congress designed this provision to encourage low–income tax payers to make contributions by means of a new tax credit for elective deferrals to 401(k) plans, 403(b) annuities, SIMPLE IRAs, 457 plans, salary reduction SEPs, and traditional and Roth IRAs. The Act provides a temporary nonrefundable credit for contributions made by eligible taxpayers to qualified plans for taxable years beginning after December 31, 2001, and before January 1, 2007. The maximum annual contribution eligible for the credit is $2,000. The amount of the credit depends on the taxpayer’s AGI, as seen in Exhibit 3. For example, if a single taxpayer with AGI of $24,000 in 2002 contributes $2,000 to an IRA, the credit would be $200, 10% of the IRA contribution of $2,000.

The credit offsets AMT liability as well as regular tax liability. The credit is in addition to any deduction or exclusion that would otherwise apply with respect to the contribution. The credit may be claimed by taxpayers 18 or older that are not full-time students and cannot be claimed as dependents on another tax return. The credit is available for 401(k), 403(b), 457, SIMPLE, SEP, traditional or Roth IRA, and voluntary contributions to a qualified retirement plan.

Waiver rollover rule. Effective for distributions made after December 31, 2001, the Treasury Secretary may waive the requirement that a rollover be completed within 60 days in order for it to qualify as nontaxable in cases of casualty, disaster, or events beyond reasonable control.

Defined benefit plans. Effective for years beginning after December 31, 2001, the Act increases the various annual benefit and contribution limits for qualified defined benefit plans. The $35,000 limit on annual additions to a defined contribution plan is increased to $40,000. The $140,000 annual benefit limit under a defined benefit plan is increased to $160,000. The limits will thenceforth be indexed in $1,000 increments. The limit is reduced for benefits commencing before age 62 and increased for benefits commencing after age 65, with additional increases until age 67.

Profit sharing or stock bonus plans. The Act increases the limit on the amount of compensation that may be contributed to a profit sharing or stock bonus plan from 15% to 25%. The increased limit also applies to money purchase pension plans.

Defined contribution plans. The Act increases the limit on annual additions to a defined contribution plan to 100% of a participant’s compensation.

Employer-provided retirement advice. The Act provides that qualified employer-provided retirement planning services constitute a fringe benefit that is excludable from income. Qualified retirement planning services are defined as any retirement planning services provided to an employee and spouse by an employer maintaining a qualified employer plan. Qualified employer plans include pension plans, government plans, 403(a) and 403(b) annuities, SEPs, and SIMPLE plans.

Credit for pension plan startup costs. The Act provides a nonrefundable credit to any small business that adopts a new qualified defined benefit or defined contribution plan [including a 401(k) plan], SIMPLE plan, or SEP after December 31, 2001. The tax credit is for 50% of the first $1,000 of administrative and education costs paid or incurred after adoption in each of the first three years of the plan.

The credit is available to an employer that did not have more than 100 employees with compensation of more than $5,000 in the preceding year. In order to qualify, the plan must cover at least one nonhighly compensated employee. In addition, if the credit is for the cost of a payroll deduction IRA arrangement, the arrangement must be made available to all employees with at least three months’ service.

The credit is a general business credit. The 50% of qualifying expenses that are effectively offset by the tax credit are not deductible; the other 50% (and other expenses) are deductible as permitted by the IRC.

Elimination of user-fees for IRS determination requests. The Act waives the user-fee charged by the IRS for a determination letter (currently $125 to $1,250, depending upon the scope of the request and the type of plan) if the requesting company has 100 or fewer employees and at least one nonhighly compensated employee is participating in the plan. The determination request must be made before the later of the last day of the fifth plan year or the end of any applicable remedial amendment period that begins before the end of the fifth plan year. The Act applies only to requests by employers after December 31, 2000, for determination letters concerning qualified retirement plans they maintain.

Expanded rollover option. The Act extends tax-free treatment to rollovers from IRAs to other eligible retirement plans, such as qualified plans, made after December 31, 2001, and not later than 60 days after the date on which the payment or distribution was made.

Surviving spouse rollover distributions. The Act provides that an employee’s surviving spouse can roll over eligible distributions after December 31, 2001, into any eligible retirement plan, just as if the spouse were the employee. Capital gains or special averaging treatment under 403(b) and 457 plans, however, is not available for amounts rolled over to the spouse under the above provision.

Education Incentives

Education IRAs. The Act increases the annual amount of deductible contributions to education IRAs from $500 to $2,000. It also expands the definition of qualified education expenses (which may be paid tax free from an education IRA) to include elementary and secondary school expenses. Qualified expenses include tutoring, computer equipment, room and board, uniforms, and extended day program costs. The Act also increases the phase-out range for married couples filing a joint return to twice that of single taxpayers (from $150,000–$160,000 AGI to $190,000–$220,000 AGI).

Beginning in 2002, corporations and other entities will be permitted to contribute to education IRAs, regardless of the income of the corporation during the year of the contribution. Contributions made before the deadline for filing the contributor’s tax return, not including extensions (April 15 of the following year for individuals), may be treated as made on the last day of the preceding year.

A taxpayer may claim a Hope or a Lifetime Learning credit for a taxable year and exclude from gross income a distribution (both the contributions and the earnings portion) from an education IRA on behalf of the same student as long as the distribution is not used for the same educational expenses for which the credit is claimed. The Act provides that the rule prohibiting contributions to an education IRA after the beneficiary attains 18 does not apply to special needs beneficiaries. The Act also repeals the excise tax on contributions made to an education IRA on behalf of a beneficiary during any taxable year in which any contributions were made to a qualified state tuition program on behalf of the same beneficiary. The education IRA provisions are effective for taxable years beginning after December 31, 2001.

College tuition deduction. The Act provides for an above-the-line deduction for qualified higher education expenses paid during the 2002, 2003, 2004, and 2005 tax years (see Exhibit 4). Qualified education expenses are defined in the same manner as the Hope credit. This deduction, however, cannot be claimed in the same year as a Hope or Lifetime Learning Credit is claimed for the same student.

Modifications to Student Loan Deduction

The Act increases the phase-out ranges for eligibility to deduct above-the-line interest on qualified educational loans (up to $2,000 for interest paid after December 31, 2001) from $40,000–$55,000 to $50,000–$65,000 for single taxpayers and from $60,000– $75,000 to $100,000–$130,000 for married taxpayers filing joint returns. The phase-out ranges will be adjusted for inflation after 2002. The 60-month limit for deducting student loan interest is repealed.

Exclusion for employer-provided educational assistance. The Act extends the exclusion for employer-provided educational assistance to include post-graduate education and makes the exclusion permanent after December 31, 2001.

Elimination of tax on awards. The Act provides that amounts received after December 31, 2001, under the National Health Service Corps Scholarship Program and the Armed Forces Scholarship Program are eligible for tax-free treatment as qualified scholarships under IRC section 117, without regard to any service obligation by the recipient. As with other qualified section 117 scholarships, the tax-free treatment does not apply to amounts received by students for regular living expenses, including room and board.

Private prepaid tuition programs. The Act expands the definition of qualified tuition program to include certain prepaid tuition programs established and maintained by one or more eligible institutions (which may be private) that satisfy the requirements of IRC section 529 (other than the state sponsorship rule). In the case of a qualified tuition program maintained by one or more private eligible educational institutions, persons could purchase tuition credits or certificates on behalf of a designated beneficiary but would not be able to contribute to a savings account plan. All assets placed in qualified tuition programs maintained by private institutions must be held in trust.

The definition of qualified higher education expenses is expanded to include the necessary expenses of a special needs beneficiary for enrollment or attendance at a qualified educational institution. The exclusion from gross income is provided for distributions from qualified tuition programs to the extent that the distribution is used to pay for qualified education expenses.

The transfer of credits (or other amounts) from one qualified tuition program for the benefit of a designated beneficiary to another qualified tuition program for the same beneficiary is not considered a distribution. This rollover treatment does not apply to more than one transfer within any 12-month period. The penalty for distributions not used for qualified education expenses is replaced by the same additional tax that applies to education IRAs.

These provisions go into effect for taxable years beginning after December 31, 2001, except that the provision regarding the income exclusion for qualified state tuition programs is effective for taxable years beginning after December 31, 2003.

Payments to Holocaust Victims

The Act provides that, for all IRC purposes, any excludable restitution payments (generally, any money or property received as a compensation for an individual’s persecution by the Nazis during the Holocaust) received after December 31, 1999, by eligible individuals, their heirs, or their estates are not includable in gross income. Nor are such payments taken into account for the purposes of applying any IRC provision that considers excludable income in computing adjusted gross income. Eligible individuals include anyone persecuted on the basis of race, religion, physical or mental disability, or sexual orientation by Nazi Germany, any other Axis regime, or any other Nazi-controlled or Nazi-occupied country.

Corporate Income Tax and Other Business Taxes

Payment of estimated taxes. The Act provides that the corporate estimated tax payment due on September 17, 2001, is not due until October 1, 2001. It also provides that 80% of the estimated tax payment due on September 15, 2004, should be paid by that date, with the remainder due October 1, 2004.

Personal holding company rate. The Act reduces the tax rate on a personal holding company’s undistributed income to the highest income tax rate imposed on single return filers, according to the following schedule:

2000	39.6%
2001 (blended rate)	39.1%
2002, 2003	38.6%
2004, 2005	37.6%
2006–2010	35.0%
2011 and after	39.6%

Accumulated earnings tax. The Act reduces the tax rate on a corporation’s accumulated earnings to the highest income tax rate imposed on single return filers; this reduction will follow the same rate schedule as that for a personal holding company’s undistributed income (see above).

Backup withholding rate. The Act reduces the backup withholding rate applied to payments of interest, dividends, and other items to the fourth-lowest income tax rate imposed on single return filers, according to the following schedule:

R

2000	31.0%
2001 (blended rate)	30.5%
2002, 2003	30.0%
2004, 2005	29.0%
2006–2010	28.0%
2011 and after	31.0%

Withholding on supplemental wages. The 2001 Act reduces the minimum withholding rate that an employer could apply to supplemental wages paid separately from regular wages under the flat rate method to the third-lowest income tax rate imposed on single return filers, according to the following schedule: