The Revenue Reconciliation Act of 1993: who wins and who loses? (Cover Story)by Johnson, Janice M.
By a two-vote margin in the House and a one-vote margin in the Senate, President Clinton saw his first tax package squeak through Congress. On August 10, 1993, he signed it into law. Now tax practitioners, financial planners, businesses, and the American public at large have the onerous task of sorting out the numerous tax changes contained in the package.
While the Revenue Reconciliation Act of 1993 ("the Act") does little to increase the tax burden of average Americans, certain urban residents who would not view themselves as wealthy will find their taxes significantly increased due to the tax rate cut-offs in the legislation intended to apply to the most affluent of our society. In addition, more individual taxpayers than ever are likely to find themselves subject to the alternative minimum tax due to increases in the rate of that tax. Whatever the scenario, it is imperative to factor the impact of the new law into year-end tax planning.
Software vendors have already factored the new rates and cut-offs into their tax planning software. The November issue of The CPA Journal will review several such packages and provide information on where to obtain.
Changes in Individual Rates
Individuals-Regular Tax. To the surprise of many, the Act increased tax rates retroactively to the beginning of 1993. For 1993 and 1994, a 36% tax bracket will apply to taxable income of individuals in excess of the following thresholds:
$140,000 for married filing jointly and surviving spouses;
$115,000 for singles;
$70,000 for married filing separately;
$127,500 for heads of households; and
$5,500 for estates and trusts.
The 36% bracket will be indexed for inflation for tax years beginning after December 31, 1994.
In addition, a 10% surtax is imposed for tax years beginning after December 31, 1992, on taxable income in excess of $250,000. Thus, the maximum tax rate imposed on taxable income over $250,000 will be 39.6% (36% + 3.6%). Married individuals filing separate returns will be subject to the surtax on taxable income in excess of $125,000, and it will apply to taxable income of estates and trusts in excess of $7,500. The surtax will also be indexed for inflation in taxable years beginning after December 31, 1994.
Capital gains will remain taxed at a rate of no higher than 28%. The larger differential between the highest individual rate and capital gains will now cause many taxpayers to seek to convert ordinary income to capital gains. Congress has tried to anticipate these maneuvers, and enacted several provisions to quash them, such as the loss of an investment interest deduction as explained later.
Taxpayers may elect to pay the additional taxes due as a result of either of these two individual tax rate increases in three equal yearly installments. The first payment must be made on or before the due date for the taxpayer's tax return for the tax year beginning in calendar year 1993 (generally April 15, 1994, for individuals). This election is not available to trusts and estates.
Additional 1993 taxes are computed as the excess of the net tax liability determined after application of the new 36% rate and the surtax over the net tax liability that would have been determined without them. Net tax is computed after the application of any credit other than the credits for wage withholding, special fuel uses, and estimated tax payments.
For example, assume Lucy and Ricky are a married couple with $350,000 in taxable income in 1993. $110,000 of this amount would be subject to an additional 5% tax rate (new 36% rate -- old 31% rate on taxable income between $140,000 and $250,000), for an additional tax of $5,500. Another $100,000 of the taxable income would be subject to an additional 8.6% rate (the 39.6% rate applicable to taxable income over $250,000 compared to last year's 31% rate), for an additional tax of $8,600. The total additional tax due to rate increases, $14,100 ($5,500 + $8,600), can be paid in three installments of $4,700 each on April 15, 1994, April 17, 1995, and April 15, 1996.
If a taxpayer does not pay any installment by the required date or if the IRS believes collection of the tax deferred under this election is in jeopardy, the IRS can terminate the installment payment election. The entire amount of the unpaid tax becomes payable immediately upon notice and demand.
Individuals-Alternative Minimum Tax. For tax years beginning after December 31, 1992, there is a two-tiered, graduated rate schedule for alternative minimum tax (AMT) applicable to non-corporate taxpayers. A 26% rate applies to the first $175,000 of a taxpayer's alternative minimum taxable income (AMTI) above the exemption amount, and a 28% rate applies to AMTI that is more than $175,000 above the exemption amount. For those who are married filing separately, the 26% rate applies to the first $87,500 in AMTI above the exemption amount and the 28% rate applies to AMTI that is more than $87,500 above the exemption amount.
The exemption amounts have been increased under the new law to $45,000 for those who are married filing a joint return, $33,750 for single taxpayers, and $22,500 for married individuals filing separately and for estates and trusts.
Example: Assume Sally is single and has $250,000 in AMTI in 1993. Initially, she would be entitled to an exemption amount of $33,750, but she loses all of this exemption amount because of the exemption phase- out provisions of IRC Sec. 55(d)(3)(B). Her $33,750 exemption would be less than the phase-out amount required (|$250,000-$112,500 x .25 = $34,375) so she would receive no exemption. Thus, the first $175,000 in AMTI would be taxed at 26% for a tax of $45,500 and the $75,000 balance of the AMTI would be taxed at 28% for a tax of $21,000, or a total tentative AMT liability of $66,500 ($45,500 + $21,000).
Estate and Gift Tax Rates. The top two estate and gift tax rates that expired December 31, 1992, have been reinstated permanently for decedents dying after December 31, 1992, and for gifts and generation- skipping transfers occurring after that date. This means that for taxable transfers over $2.5 million but not over $3 million, the estate and gift tax rate is 53%, and for taxable transfers over $3 million, it is 55%. The 5% surtax imposed to phase out the benefit of the graduated rates and unified credit applies with respect to cumulative taxable transfers between $10 million and $21,040,000.
Additionally, since the generation-skipping transfer tax is computed by reference to the maximum Federal estate tax rate, the rate of tax on generation-skipping transfers is 55%.
Additional "Back-Door" Rate Increases for Individuals
The limitation on certain itemized deductions for taxpayers with adjusted gross income (AGI) in excess of $100,000 ($50,000 for those who are married filing separately), which was set to expire after 1995, has been made permanent. Thus, the total amount of all itemized deductions other than medical expenses, casualty, theft and excess wagering losses, and investment interest will remain reduced by 3% of AGI in excess of $100,000. However, total otherwise allowable deductions (aside from medical, casualty, theft, wagering and investment interest) will not be reduced by more than 80%.
Under the new law, the phase-out of personal exemptions, originally slated to expire after 1996, has also been made permanent. For 1993, the deduction for personal exemptions is phased out as a taxpayer's AGI exceeds $108,450 for single filers, $162,700 for joint returns, $135,600 for heads of household, and $81,350 for those married filing separately. Each 1993 exemption of $2,350 is phased out by 2% for each $2,500 (or fraction thereof) by which the taxpayer's AGI exceeds the threshold amount. For a married person filing a separate return, the phaseout rate is 4%. This formula still serves to disallow all personal exemption deductions for those with AGI of $122,500 in excess of the threshold amounts.
Taxation of Social Security Benefits
Under prior law, the amount of a taxpayer's Social Security benefits that must be included in taxable income was the lesser of one-half of the annual benefits received or one-half of the excess of a taxpayer's modified adjusted gross income (AGI) plus one-half of the Social Security benefits over $32,000, if married filing jointly, and $25,000 for singles. Generally, modified AGI is the taxpayer's AGI plus any tax- exempt interest.
The new law provides that after 1993, prior law inclusion rules continue to apply for married taxpayers filing jointly with modified AGI combined with 50% of Social Security benefits which does not exceed $44,000 and $34,000 for singles. For taxpayers with totals above these new thresholds, gross income includes the lesser of 85% of the taxpayer's Social Security benefit or the sum of 85% of the taxpayer's provisional income (modified AGI plus one-half of the Social Security benefit) over the applicable new threshold amounts ($44,000 for marrieds and $34,000 for singles) plus the smaller of--
1. the amount included under present law; or
2. $6,000 for married taxpayers filing jointly ($4,500 for singles).
Example: Assume Fred and Ethel are married filing jointly and receive $20,000 in Social Security benefits. They have $40,000 in taxable interest and dividends, $10,000 in tax-exempt interest income, and $20,000 in pension income, so that their modified AGI equals $70,000. Their provisional income, therefore, equals $80,000 ($70,000 + $10,000 |one-half their Social Security benefits). Eighty-five percent of their Social Security benefits equals $17,000. Eighty-five percent of the excess of their provisional income of $80,000 over the new $44,000 threshold equals $30,600 (85% x $36,000), which must then be added to $6,000 (the smaller of the amount included under present law--$15,000-- or $6,000), a total of 36,600. Therefore the amount included in Fred and Ethel's taxable income is $17,000, 85% of their Social Security benefits, which is less than the $36,600 amount.
Repeal of the Medicare Earnings Cap
Beginning in 1994, the $135,000 limit on amounts subject to Medicare hospital insurance tax is eliminated. The tax will be imposed at a rate of 1.45% on the employer and 1.45% on the employee on every dollar of wages paid (no matter how high the amount) and at a rate of 2.9% on earnings from self-employment. This is a substantial tax increase when added to the 5% and 3.6% income tax rate increases.
Other Changes Have Far-Reaching Effects
Individual Estimated Tax Payments. One of the most welcome provisions of the Act concerns the revision in the estimated tax rules governing individuals. For tax years beginning after December 31, 1993, individuals whose AGI for the preceding tax year is not over $150,000 ($75,000 for marrieds filing separately) will be able to make estimated tax payments equal to the lesser of 1) 90% of the tax shown on the return for the current year, or 2) 100% of the tax shown on the return for the preceding year. Those with AGI over $150,000 for the preceding year will also be able to take advantage of a safe harbor in computing their estimated tax liability by paying 110% of the preceding year's tax.
Charitable Contributions of Appreciated Property. A very attractive provision for both individual and corporate taxpayers allows gifts of appreciated long-term capital-gain property to charities with no alternative minimum tax (AMT) consequences. The appreciation element of such gifts was an item of tax preference under the old law. The Act provides that for contributions of tangible personal property made after June 30, 1992, and contributions of other property made after December 31, 1992, there will be no preference item for gifts made by individuals nor will corporations have to make any adjustment in earnings and profits in computing their adjusted current earnings component of the corporate AMT.
Thus, if in 1993 Jose gives his college AT&T stock that he has held for many years and the value of that stock at the date of the gift is $12,000, he will receive a full charitable contribution deduction of $12,000 (assuming he does not exceed any of the other limitations on charitable giving). Furthermore, there will be no element of inclusion for purposes of computing his AMT. If Jose's basis in the AT&T stock is only $2,000, his college is much better off than giving the appreciated stock rather than his selling it, paying a tax on the long- term capital gain of $2,800, as well as additional state and, perhaps, local taxes, and then donating the net amount to the college. If Jose had made a pledge to his college to give $12,000, he would have to make up the difference from other funds.
Charitable Contributions. After December 31, 1993, a deduction for charitable contributions of $250 or more will be disallowed unless the donor has written substantiation from the charity (including a good faith estimate of the value of any goods or services provided by the charity in exchange for the contribution). The substantiation must be obtained by the donor prior to filing his or her return and on or before the extended due date for the return. The law places the responsibility on the taxpayer who claims an itemized deduction for a contribution of $250 or more to request (and maintain) substantiation from the charity. Taxpayers will not be allowed to rely solely on a canceled check as substantiation for a donation of $250 or more.
A charity that receives a payment exceeding $75 made partly as a contribution and partly for goods or services provided by the organization (a "quid pro quo" contribution) is required to provide a written statement, either with the charitable solicitation or upon receipt of the donation. The statement must inform the donor that the deductible amount of the contribution is limited to the excess of the contribution amount over the value of goods or services provided by the organization. The statement must also provide the donor with a good faith estimate of the value of goods or services furnished. Excepted from the reporting provision are de minimis, token goods or services given to a donor. This provision, too, is effective January 1, 1994.
Penalties of $10 per contribution, capped at $5,000 per particular fund- raising event or mailing, may be imposed upon charities that fail to make the required disclosure, unless the failure was due to reasonable cause. The penalties will apply if a charity either fails to make any disclosure in connection with a quid pro quo contribution or makes a disclosure that is incomplete or inaccurate.
Limitation or Elimination of Deductions
Business Meals and Entertainment. Beginning January 1, 1994, the business deduction for meal and entertainment expenses is reduced from 80% to 50%. This is a provision that will be likely to cause many businesses to reexamine their meal and entertainment policies.
To try to cushion the effect of this provision on restaurants, the Act provides a business tax credit to food and beverage establishments for the amount equal to the employer's FICA obligation (7.65%) attributable to reported tips in excess of those treated as wages for purposes of satisfying the minimum wage provisions of the Fair Labor Standards Act (FLSA). Under the FLSA tip income is treated as being paid by the employer to the extent it does not exceed one-half of the minimum wage. An employer is prohibited from taking a deduction for any amount for which he or she receives a FICA credit. This provision is effective for taxes paid after December 31, 1993.
Club Dues. Under prior law an 80% deduction was available for club dues and fees directly related to the business use of the club, as long as the club, overall, was used more than 50% for business purposes. After 1993, however, no deduction will be allowed for club dues, including those for business, social, athletic, luncheon, sporting, airline, and hotel clubs.
One planning opportunity is to pay any business-related club dues prior to 1994 to obtain a 1993 deduction to the extent allowed by the IRS. It remains unclear whether deductions for membership in civic clubs such as the Rotary will be disallowed--or whether such expenditures will simply be reclassified by certain businesses as business development. Furthermore, expenses of business meals, etc., at a club will be 50% deductible if they meet the substantiation requirements. Many clubs may restructure their pricing to reduce dues and increase the costs of meals and entertainment.
Spousal Travel. Prior to the 1993 Act, a deduction was allowed for the travel expenses of a spouse or dependent if they were accompanying the taxpayer for a business purpose. Effective for 1994 this deduction is eliminated unless the accompanying spouse or dependent is an employee of the person paying the expenses.
Moving Expenses. Formerly the law provided an itemized deduction for certain moving expenses incurred in connection with a new job if the job was located at least 35 miles farther from the individual's former residence than his or her former job. Expenses for moving household goods, traveling to the new location (including meals and lodging), house-hunting trips, temporary living expenses and expenses related to the sale and purchase of residences (or of leasing residences) were deductible. However, expenses for house hunting, temporary living, and real estate sales, purchases or leases were limited to $3,000, with no more than $1,500 to consist of house hunting and temporary living expenses.
After 1993, taxpayers may no longer deduct the cost of selling, or settling an unexpired lease on, their former residence or the cost of buying or acquiring a lease on a new residence. The cost of meals consumed while traveling and while living in temporary quarters near the new workplace are also not deductible. Only the reasonable cost of moving household goods and personal effects from the former residence to the new residence and traveling, including lodging during the period of travel, from the former residence to the new place of residence will be deductible. No longer will the cost of pre-move househunting trips be deductible nor will the cost of temporary living expenses for up to 30 days in the general location of the new job.
The new law increases the mileage limit from 35 to 50 miles. To the taxpayer's advantage, it provides that moving expenses paid or reimbursed by the taxpayer's employer that would otherwise be deductible by the employee are excludable from the employee's gross income. Moving expenses that are not paid or reimbursed by the employer are allowable as a deduction to the employee in computing adjusted gross income.
Lobbying Expenses. Lobbying expenses paid or incurred after 1993 will no longer be deductible as ordinary and necessary business deductions. Lobbying expenses include amounts paid in connection with influencing legislation; participation in any political campaign on behalf of, or in opposition to, any candidate for public office; any attempt to influence the general public, or segments of the public, with respect to elections, legislative matters or referendums; or any direct communication with certain executive branch officials in an attempt to influence the official's actions or positions. Lobbying expenses also include amounts paid or incurred for research for, or preparation, planning or coordination of, any activity related to lobbying activities. If a taxpayer or tax-exempt entity monitors legislation and subsequently attempts to influence the same or similar legislation, the monitoring costs will constitute lobbying expenses.
Under the law, influencing legislation consists of communication with any member or employee of a legislative body or with any government official or employee who may participate in the formulation of legislation. Legislation includes any action with respect to acts, bills, resolutions or similar items by the Congress, a state legislature, or similar governing body, or by the public in a referendum, initiative or similar procedure. There is, however, an exception provided for communications with respect to local legislation.
A de minimis rule is provided where in-house lobbying expenditures do not exceed $2,000. As a result, as long as a taxpayer's in-house lobbying expenditures do not exceed $2,000, such expenditures (along with allocable overhead) will not be subject to the lobbying expense disallowance rule. However, payments made to third party lobbyists and dues payments allocable to lobbying are subject to the disallowance rules, regardless of whether the taxpayer's in-house expenses are exempted under the de minimis rule.
The deduction limitation does not apply to the expenses incurred by taxpayers engaged in the trade or business of lobbying, but it does apply to the amounts paid by those hiring the professional lobbyist.
Tax-exempt organizations (other than Sec. 501(c)(3) charitable organizations) must include on any return claiming a trade or business deduction the total nondeductible lobbying expenses for the tax year and the total amount of the dues payments that are allocable to such expenditures. Furthermore, when dues are assessed by the organization, it must provide to each person making dues payments a notice containing a reasonable estimate of the portion of the dues allocable to nondeductible lobbying activities.
Limitation on Executive Compensation. For tax years beginning after 1993, a publicly held corporation will not be able to deduct certain compensation in excess of $1 million per tax year paid to either the chief operating officer or the four highest compensated officers whose total compensation is required to be reported to shareholders under the Securities Exchange Act of 1934. A publicly held corporation is any corporation issuing any class of securities required to be registered under Sec. 12 of the Securities Exchange Act of 1934.
This generally includes a corporation whose securities are listed on a national securities exchange or which has $5 million or more of assets and 500 or more shareholders.
Compensation covered by the rule includes any cash and noncash benefits other than:
1. Income from pensions, annuities, etc.;
2. Any benefit reasonably anticipated to be tax free under the IRC;
3. Specified commissions;
4. Compensation based on performance goals; and
5. Income payable under a written binding contract in effect on February 17, 1993.
The limitation applies when the deduction would otherwise be taken so that in the case of a nonqualified stock option, an employee who is a covered employee when an option is granted but is not a covered employee when it is exercised, will not be subject to the limitation. This is because the deduction is normally taken in the year the option is exercised, even though the option was granted for services performed in a prior year.
Commissions based solely on the income generated by the individual performance of the employee are not covered. Additionally, compensation based on the attainment of performance goals is not covered if the goals are established by a compensation committee of the board of directors that is comprised solely of two or more outside directors; the material terms of the compensation, including the performance goals, are disclosed to shareholders and approved by majority vote in a separate shareholder vote before the compensation is paid; and, before the compensation is paid, the compensation committee certifies that the performance goals and other material terms are satisfied.
Qualified Plan Compensation Limitation Decreased. The maximum amount of annual compensation that can be taken into account for qualified retirement plan purposes has been reduced under the Act from $235,840 for 1993 to $150,000 for 1994. After 1994, this amount will be adjusted for inflation, but the amount will be rounded down to the next lowest multiple of $10,000. Thus, if the adjustment is $4,000 for the year, no change in the annual amount will be made, but if the adjustment is $11,000, the $150,000 amount would then be moved up to $160,000. This provision generally applies to benefits accruing in plan years beginning after December 31, 1993, but there are special transition rules for governmental plans and plans maintained under collective bargaining agreements.
Small Business Provisions
Exclusion for Gain on Small Business Stock. Noncorporate investors who hold qualified small business stock issued after August 10, 1993, for at least five years would be permitted to exclude 50% of certain gains realized on the disposition of their stock. The amount of gain eligible for the 50% exclusion is limited to the greater of 10 times the taxpayer's basis in the stock or $10 million.
A qualified small business is a C corporation with less than $50 million in cash and aggregate adjusted bases of other property held by the corporation through the date the taxpayer acquires stock in the corporation. DISCs, former DISCs, Sec. 936 corporations, regulated investment companies, real estate investment trusts, real estate mortgage investment conduits, and cooperatives cannot be qualified small businesses. Also, the corporation generally cannot own real property whose value exceeds 10% of its total assets, or portfolio stock or securities where the value exceeds 10% of its excess of total assets over total liabilities. At least 80% of the assets of the corporation must be used in the active conduct of a trade or business.
A qualified trade or business is any trade or business other than those involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any other trade or business where the principal asset of the business is the reputation or skill of one or more of its employees. Also excluded are any banking, insurance, leasing, financing, investing, or similar business, any farming business (including the business of raising or harvesting trees), any business involving the production or extraction of products of a character for which percentage depletion is allowable, or any business of operating a hotel, motel, restaurant, or similar business.
One half of any excluded gain is to be treated as a preference item for purposes of the alternative minimum tax.
Specialized Small Business Investment Companies. Any corporation or individual may elect to roll over without payment of tax certain capital gains realized upon the sale of publicly traded securities after August 10, 1993, where the corporation or individual uses the proceeds from the sale to purchase common stock or a partnership interest in a specialized small business investment company (SSBIC) within 60 days of the sale of the securities.
An SSBIC is defined as any partnership or corporation licensed by the Small Business Administration under Sec. 301(D) of the Small Business Investment Act of 1958, as in effect on May 13, 1993.
The amount of capital gain which may be rolled over without payment of tax is limited for an individual. It is the lesser of $50,000 annually or $500,000 reduced by the gain previously excluded under this provision. For corporations, these limits are $250,000 and $1,000,000. Estates, trusts, S corporations and partnerships are not eligible to make the election to roll over gains.
Expensing Election. When the dust settled, the 1993 Act contained no investment tax credit provisions. All that remained to encourage business to invest in new depreciable property was an expanded expensing election. For property placed in service after December 31, 1992, a taxpayer may elect to currently deduct, rather than depreciate, up to $17,500 of the cost of Sec. 179 property. The dollar amount continues to be reduced by the amount by which qualifying property placed in service during the taxable year exceeds $200,000. Furthermore, the amount expensed for a taxable year may not exceed the taxable income derived from the active conduct of a trade or business, but any disallowed amount may be carried forward to succeeding taxable years.
Anti-Conversion Provisions. For transactions entered into after April 30, 1993, capital gain from any "conversion transaction" is recharacterized as ordinary (but not interest) income to the extent that interest would have accrued on the taxpayer's net investment in the position for the relevant period at a yield equal to 120% of the applicable Federal rate.
A conversion transaction places the taxpayer in the economic position of a lender. It occurs when a taxpayer holds two or more positions with respect to the same or similar property, and substantially all the return is attributable to the time value of the net investment in the transaction. The arrangement must also be one of the following:
1. A transaction in which the taxpayer agrees to buy property and on a substantially contemporaneous basis enters into a contract to sell that property or substantially identical property for a set price;
2. A straddle;
3. A transaction that is marketed or sold as one producing capital gains; or
4. A transaction the IRS specifies in regulations.
Transactions of options dealers and commodities traders in the normal course of their business will generally not be treated as conversion transactions.
The amount of a taxpayer's ordinary income from a conversion transaction is not to exceed the "applicable imputed income amount," which is equal to the amount of interest which would have accrued on the taxpayer's net investment in the conversion transaction for the period ending on the date of disposition, reduced by the amount of ordinary income that was recognized under the anti-conversion rules with respect to any prior dispositions of property that was held as part of the conversion transaction.
Market Discount Bonds. For bonds purchased after April 30, 1993, the market discount rule has been extended to all tax-exempt bonds and to all market discount bonds, regardless of when such bonds were issued. Under the market discount rule, gain on the disposition of a bond acquired for a price less than the principal amount of the bond is treated as ordinary income to the extent of the accrued market discount.
Stripped Preferred Stock. As of April 30, 1993, stripped preferred stock is treated for income tax purposes in generally the same manner as a stripped bond under the original issue discount (OID) rules. Thus, the difference between issue price and redemption price is generally the OID. A portion of this OID is required to be accrued and included in the holder's gross income on an annual basis.
Stripped preferred stock is any stock where the ownership of the stock has been separated from the right to receive dividends that have not yet become payable.
Investment Interest Limits. For tax years beginning after December 31, 1992, in computing the limit for the deduction on investment interest, net capital gain from the disposition of investment property is generally excluded from investment income. Thus, a taxpayer could not use income from the sale of property as an item of investment income to get a higher deduction for investment interest. However, taxpayers may elect to include any amount of their net capital gain in their investment income when computing their allowable investment interest deduction if they correspondingly reduce the amount of TABULAR DATA OMITTED their capital gains otherwise eligible for the maximum 28% tax rate.
Taxpayers who choose to exclude their net long-term capital gains income from determining their net investment income will simply defer the time at which they can use their investment interest expense. Any investment interest that is limited as a result of the investment income limitation will carry forward and can be used in a later year when sufficient income is generated.
To the extent a taxpayer tries to avoid this new limitation, he or she will be forced to use alternate financing arrangements, such as home equity loans, that are more expensive than borrowing against securities. This may be detrimental to the securities industry. It will also allow taxpayers who use alternate financing arrangements to circumvent the margin requirements.
The provision may also discourage long-term investment in small capitalization stocks since these usually generate no investment income other than long-term capital gains. This is certainly contrary to the small-capitalization-companies provisions in the Act.
Real Estate Provisions
Passive Losses. Where more than 50% of an individual's personal services during the tax year are performed in real property trades or businesses in which the individual materially participates, and the individual performs more than 750 hours of service in these businesses, the income will no longer be subject to the passive activity rules. However, the personal services of an employee will not be treated as performed in a real property trade or business unless the employee is a five percent owner in the employer. A closely held C corporation will also be exempted from the passive activity rules if, during the year, more than 50% of the gross receipts of the corporation were derived from real property trades or businesses in which the corporation materially participated.
A real-property trade or business is defined as any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing or brokerage trade or business. For purposes of computing modified adjusted gross income in excess of $100,000 to reduce the $25,000 of passive activity losses allowed against nonpassive income for taxpayers who only actively participate in rental real estate activities, losses allowed under the new rules cannot be used.
These rules are effective for taxable years beginning after 1993. However, suspended losses from any rental property activity that is treated as not passive by the new law are treated as losses from a former passive activity. Thus, such suspended losses are limited to income from the activity and are not allowed to offset other income. When the taxpayer disposes of his entire interest in the activity in a fully taxable transaction with an unrelated party, any remaining suspended losses allocable to the activity are allowed in full.
Nonresidential Real Property Depreciation. For property placed in service generally after May 12, 1993, the recovery period for depreciating nonresidential real property is increased to 39 years and to 40 years for the alternative minimum tax.
Discharge of Real Property Business Debt. Most discharge of indebtedness results in income for the debtor. Discharges under a Title 11 bankruptcy case or where the debtor is insolvent, along with certain farm indebtedness, are exceptions to this rule. However, for discharges of indebtedness after 1992, individuals and entities other than C corporations may elect to exclude from income some or all of the income from discharge of their qualified real property business indebtedness. Basis in the property is reduced by the amount of excluded income.
The amount excluded cannot exceed the excess of the outstanding principal amount of the debt before the discharge over the aggregate fair market value (net of other qualified real property indebtedness) of all the business real property securing the debt. Furthermore, it cannot exceed the aggregate adjusted basis of the depreciable real property held by the debtor immediately before the discharge and after any other reductions to the basis of such property for any other excluded discharge of indebtedness income.
Example: Nancy owns a building on July 1, 1993, worth $150,000, which is used in her trade or business. It is subject to a first mortgage of $110,000 securing one of her debts, and to a second mortgage of $90,000 securing another of her debts. Nancy is neither bankrupt nor insolvent. If Nancy agrees with the second mortgagee to reduce the second mortgage debt to $30,000, resulting in a discharge of indebtedness of $60,000, she can elect to exclude $50,000 of that discharge from gross income. This is because the principal amount of the discharged debt immediately before the discharge (i.e., $90,000) exceeds the fair market value of the property securing it ($150,000 of free and clear value less $110,000 of other qualified business real property debt or $40,000) by $50,000. The remaining $10,000 of discharge is included in gross income.
Extension of Credit and Deduction Provisions
President Clinton had originally proposed that many credit provisions which sunsetted at June 30, 1992, be permanently extended. However, when the revenue calculators got down to the nitty-gritty, it became apparent that fairly large chunks of revenue could be gained to make the Act revenue neutral by extending the provisions for lesser periods. Thus, although it is likely these provisions will continue to be reenacted, almost all of them have sunset dates attached in the Act.
Self-Employed Health Insurance Deduction. The deduction available for 25% of health insurance premiums paid by a self-employed individual on behalf of him- or herself, a spouse, and dependents is extended retroactively from July 1, 1992, through December 31, 1993. For tax years beginning after 1992, the determination of whether self-employed individuals or their spouses are eligible for employer-paid health benefits is to be made on a calendar month basis. Where such eligibility exists, a self-employed individual is not entitled to take a deduction for premiums he or she pays.
Employer-Provided Educational Assistance. Up to $5,250 of employer- provided educational assistance that meets the requirements of IRC Sec. 127 remains excludable from gross income and wages. This exclusion is retroactive to July 1, 1992, and remains in effect through December 31, 1994. Educational assistance that does not satisfy the IRC Sec. 127 requirements may still be excluded from income if it qualifies as a working-condition fringe benefit under IRC Sec. 132; i.e., if the cost of the education is a job-related deductible expense.
Because of the number of returns (employer, employee, and payroll) affected by this provision, the Secretary of the Treasury has been directed to use his existing authority to alleviate the administrative problems caused by the retroactivity of the new law.
The tax credit for employers who hire those identified as members of certain disadvantaged groups has been extended retroactively from June 30, 1992, to December 31, 1994. The 50% credit for expenses of certain qualified clinical drug tests is also extended from June 30, 1992, through December 31, 1994.
Extended from June 30, 1992, through December 31, 1995, was the 20% credit for increased qualified research expenses and basic research payments to universities and other qualified organizations. For tax years beginning after 1993, the fixed base percentage used to compute a start-up company's base amount for the research credit has been modified.
The low income housing credit was the only credit provision to be permanently extended by the Act. This extension, too, was retroactive to June 30, 1992. With the possible exception of the employer-provided educational assistance provisions, all of these other "extenders" may require amendment of 1992 returns already filed.
Corporate Tax Rates. For corporate taxable income over $10 million, the tax rate has increased from 34 to 35% for tax years beginning on or after January 1, 1993. Additionally, the benefit of lower corporate tax brackets is phased out for certain corporations with very high taxable income. A three percent tax is imposed on taxable income over $15 million, up to a maximum of $100,000 in additional tax.
Corporate Estimated Tax. For tax years beginning after 1993, any corporation that does not use the safe harbor of 100% of last year's tax must base its tax on 100% of the amount of tax shown on its current year's return. Large corporations (those with taxable income of $1 million or more in any of the three preceding tax years) may continue to compute first quarter estimated tax payments based on the preceding year's tax liability.
New optional annualized income periods for computing corporate estimated tax are also provided in the Act.
Corporate AMT Depreciation. The adjusted current earnings (ACE) depreciation adjustment is eliminated for property placed in service after December 31, 1993. Thus, for ACE purposes corporations will use the 150-percent declining balance method over the class life of tangible personal property, just as they do for AMT purposes generally.
Luxury Excise Tax
The luxury excise tax on jewelry, furs, boats and aircraft was repealed effective January 1, 1993. It does, however, still remain in effect on luxury automobiles, at a rate of 10% of the retail price in excess of $30,000. Contrary to initial reports, although this $30,000 amount will be indexed, it remains at $30,000 for all of 1993. Even though Conferees on the tax bill agreed to index the threshold for inflation, raising it to $32,000 this year on sales on or after August 10, 1993, the actual wording of the Act itself left the 1993 threshold unchanged.
Compliance and Tax Administration
The Act provides that for returns due after 1993, adequate disclosure under the 20% accuracy-related penalty will not be sufficient to avoid the penalty unless there is also a reasonable basis for the taxpayer's treatment of the disclosed item. Also, the IRS will not pay interest on a refund arising from any type of original tax return for returns filed after 1993 if the refund is issued within 45 days after the later of the due date of the return (determined without regard to extensions) or the date the return is filed. Prior to the Act, the 45-day grace period applied only to refunds of income taxes.
There are many other provisions, affecting a wide range of taxpayer situations. Amortization of intangibles will be discussed in depth in the next issue of The CPA Journal. A number of measures were enacted to try to collect additional tax revenues from businesses operating internationally. The Act also contains provisions to eliminate some of the inclusion in unrelated business taxable income of certain real estate transactions engaged in by tax-exempt entities as well as certain securities transactions engaged in by them.
The Act contains provisions governing complete liquidation of partnership interests and inventory distributions from partnerships. It extends the replacement period for certain property involuntarily converted as a result of a Presidentially declared disaster to four years after the close of the first taxable year in which any part of the gain upon conversion is realized. It also increases and expands the availability of the earned income credit for tax years after 1993.
Numerous tax accounting provisions are also in the Act. For tax years after 1993, securities dealers are required to recognize gain or loss based on the fair market value of any inventory they hold at year end (the "mark-to-market" rule). In another area, the Act specifies that in determining losses on bad debts, any Federal Savings and Loan Insurance Corporation (FSLIC) assistance must be taken into account. Yet another change provides that for stock transferred after December 31, 1994, in satisfaction of any indebtedness, the stock-for-debt exception for the rules on cancellation of indebtedness income for insolvent corporations and for corporations bankrupt under Title 11 of the U.S. Code is repealed.
The authority of state and local governments to issue qualified mortgage bonds and qualified small-issue bonds has been made permanent, retroactive to June 30, 1992. In an additional attempt to provide economic stimulus to certain areas of the country, special tax incentives will be provided for up to nine empowerment zones and 95 enterprise communities to be designated during 1994 and 1995.
Finally, in a much-publicized, and hotly debated change, the per-gallon excise taxes to which all fuels used in transportation are subject are increased by 4.3 cents.
Rethinking and Decisions Will be Required
Because of the highest rate differential between C corporations and individuals, the Act is going to cause a re-evaluation of whether a business should operate in C versus S corporation form. It is also likely that many residents of high cost urban areas with high taxable incomes may take another look at whether the costs of their life style (including the increased tax burden of the Act) outweigh the benefits they are enjoying. We may see another move by certain people back to a simpler, less costly, more rural lifestyle.
There are also tax planning opportunities for those whose taxable portion of Social Security will increase in 1994. Now may be the time to recognize capital gains and certain interest income if it will serve to create less taxable income in 1994.
It may be attractive to shift bonuses and other payments into 1993 to avoid the medicare tax of 1.45% which will apply to all such payments after 1993. This may be particularly attractive given the ability to spread the additional tax due over a three-payment period with no interest.
Tax professionals must study this new law carefully to familiarize themselves with the numerous and varied provisions it contains.
Janice M. Johnson, JD, CPA, is Director of Tax Policy of the NYSSCPA and Technical Editor (Taxes) of The CPA Journal. Ms. Johnson is a frequent lecturer on tax issues and contributor to accounting and tax journals.
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