The Taxpayer Relief Act of 1997
Provisions Affecting Individuals

Taxation Advisory - August 22, 1997 Issue

On August 5, 1997, President Clinton signed the Taxpayer Relief Act of 1997 (the "Act"), which implements a number of tax cuts and tax simplification proposals. Unfortunately, many of the new tax benefits are not available to high income taxpayers. The major features of the bill affecting individuals are summarized below.

Individual Income Tax

Capital Gains Tax. The capital gains tax rate has been reduced from 28% to 20% effective for sales after May 6, 1997. The new 20% rate applies to property held for more than 18 months. Property held for more than 12 months but not more than 18 months will qualify for the 28% tax rate. The capital gains tax rate will be further reduced to 18% for assets purchased after December 31, 2000 and held for at least 5 years. This change increases the incentive for taxpayers to structure their portfolios for more capital gain income and less ordinary income.

Taxpayers who sold capital assets between May 7 and July 28, 1997 will qualify for the 20% tax rate if they held the assets for the 12-month holding period. The 18-month period will not apply to those sales because Congress had announced the May 7 effective date of the tax cut but not the new 18-month holding period as part of the original capital gain tax cut proposal.

The capital gains tax rate for taxpayers in the 15% tax bracket has been reduced to 10% for assets held over 18 months and will be reduced to 8% for capital gains recognized after December 31, 2005 on assets held for more than five years. Gifts of stock to children may be used to take advantage of these lower rates.

An amendment was made to the alternative minimum tax to ensure that individuals subject to AMT will benefit from the reduced capital gains tax rate.

Tax on Sale of Residence. For home sales occurring after May 6, 1997, there is no tax imposed on the first $500,000 of gain from the sale of a principal residence ($250,000 for single individuals), if the residence has been owned and used as a principal residence for at least 2 of the 5 years prior to the sale. The rollover of gain from one principal residence to another and the one-time $125,000 exclusion for taxpayers over age 55 are no longer available.

For individuals selling a principal residence with more than $500,000 of gain and purchasing a new residence for the same or greater price, the new law will result in additional taxes. Therefore, individuals who anticipate that they may have more than $500,000 of gain on the sale of their residence should continue to keep records of cost and capital improvements.

Individuals who sold their homes or had signed binding contracts to sell their homes before August 5, 1997 may elect to apply the rollover and exclusion provisions of prior law if they have more than $500,000 of gain. This election is also available to taxpayers who had purchased replacement homes (or signed binding contracts to do so) before August 5, 1997 and would have been able to apply the old rollover provision when they later sold their principal residence (i.e., for a sale after August 5 and within 2 years after the purchase of the replacement home).

Because the new exclusion does not require reinvestment of the sale proceeds in a new home, there are some new planning opportunities. For example, taxpayers with second homes may benefit doubly by selling their principal residence tax free (or partially tax free), moving into their second home and eventually selling the second home tax-free (or partially tax free) as a principal residence.

Individual Retirement Accounts ("IRAs"). The rules relating to IRA contributions were liberalized, effective in 1998, to permit deductible contributions of up to $2,000 by nonworking spouses of persons covered by employer retirement plans, provided that family adjusted gross income ("AGI") is less than $150,000. The deduction phases out between $150,000 and $160,000 of AGI.

The income thresholds above which deductible contributions cannot be made by persons participating in employer plans will be increased over the next ten years. Beginning in 1998, the threshold will gradually increase from current levels to $100,000 of AGI for married taxpayers and $60,000 for single taxpayers

Beginning in 1998, a new back-loaded IRA (referred to as the "Roth IRA") will permit nondeductible contributions of up to $2,000 to be made and then withdrawn tax-free after 5 years if the taxpayer is at least age 59‡. Eligibility to contribute to a Roth IRA phases out for married taxpayers with AGI over $150,000 ($95,000 for singles) and is lost when AGI reaches $160,000 ($110,000 for singles). For individuals who cannot make deductible contributions to an IRA because they participate in an employer plan, the new Roth IRA offers a better alternative than making a nondeductible contribution to a traditional IRA.

The $2,000 limitation for contributions to IRAs applies to all IRAs. Thus, one cannot contribute $2,000 to a Roth IRA and a regular IRA, but must choose how much of the aggregate $2,000 amount to contribute to each type of IRA.

Short-Against-the-Box Sales. Taxpayers who sell securities short-against-the-box ("SATB") (or enter into other "constructive sales") will generally be required to recognize gain on the securities held as if they had sold the underlying securities. This rule will not apply to taxpayers who close the short position within 30 days after the end of the tax year in which it was established and who continue to own the long position for 60 days after closing the short position. This permits gains to be deferred from one year to the next.

Although short positions entered into before June 9, 1997 are grandfathered, taxpayers who maintain such positions will not receive a step-up in the basis of the securities upon death if the short position (i) remained open for two years or more, and (ii) was in effect at any time within three years of the date of death. This can be avoided by closing out the SATB position before September 4, 1997.

Taxpayers who have grandfathered SATB positions that have been in effect for two years or more should consider closing such positions before September 4, 1997, because the loss of basis step up generally will cost a taxpayer more than will be saved by maintaining the SATB trade. Grandfathered SATB positions that have not been open for two years need not be closed before September 4, but should be closed before they are open for two years, or the taxpayer will run the risk of dying within 3 years after closing the position and losing the basis step up.

Although the short-against-the-box strategy was an important tax deferral strategy used by taxpayers who had appreciated securities, there are other similar strategies that may still be used to hedge appreciated securities positions. Taxpayers who are forced to unwind SATB positions should investigate these alternatives. Treasury regulations to be issued under the Act will likely place further limitations on deferral strategies, but those regulations will apply prospectively.

Charitable Gifts of Appreciated Securities. A tax deduction will continue to be permitted for the full value of appreciated securities donated to a private foundation. This provision had expired on May 31, 1997, but was extended retroactively through June 30, 1998.

Self-Employed Health Insurance Deduction. The deduction for health insurance premiums available to self-employed individuals, which is presently limited to 40%, and was scheduled to increase to 80%, will now gradually increase to 100% between 1997 and 2007.

Education Tax Breaks. The Act implemented a number of education tax breaks, including the HOPE Scholarship Tax Credit, Lifetime Learning Tax Credit, education savings accounts, and deduction of student loan interest. These benefits are not available to high income taxpayers due to phase outs based on various levels of modified AGI.

Child Tax Credit. The child tax credit of $500 per child is not available for taxpayers with modified AGI in excess of $85,000 for single taxpayers and $110,000 for married taxpayers.

Foreign Earned Income Exclusion. The foreign earned income exclusion will gradually increase in $2,000 increments per year from its current level of $70,000 to $80,000, beginning in 1998.

Estate and Gift Tax

Increased Unified Credit. Beginning in 1998, the unified credit will increase from its current level of $600,000 per person to $1 million in 2006. This will permit married taxpayers to transfer up to $2 million of assets free of estate and gift tax. If your present will has the typical formula credit shelter clause, this increased credit will be automatically provided for by the formula and no change will be required to your will.

Protection for Family-Owned Businesses. The Act added a new family owned business exclusion that will permit a limited amount of the value of a qualifying business to be excluded from estate tax, beginning in 1998. The amount of the exclusion will be $675,000 in 1998 and will decrease thereafter. The combination of the exclusion and the unified credit will permit closely-held business owners to transfer $1.3 million free of estate or gift taxes ($2.6 million for married couples). A family-owned business must be at least 50% of the estate to qualify, and family members must participate in the business for at least 10 years after the decedent's death. Small business owners may need to revise their estate plans to ensure full utilization of the new exclusion.

Estate taxes attributable to closely held businesses may be paid in installments over 14 years, with 2% interest (reduced from 4% under prior law) paid on the first $1 million in value. The interest rate on the excess value will be 45% of the regular federal interest rate. However, interest paid on installments will no longer be deductible against the estate tax.

Increase in Annual Gift Tax Exclusion. The $10,000 annual gift tax exclusion will be increased for inflation beginning in 1999.

Revaluations of Gifts. Effective for gifts made after 1997, gifts made before death will no longer be subject to revaluation for estate tax purposes once the statute of limitations has expired for the gift tax return filed with respect to the gift. Under old law the IRS could revalue gifts at the time they examined the decedent's estate tax return. This change will make it more important that timely gift tax returns be filed when any asset subject to revaluation is transferred. The Act also provides, however, that the statute of limitations will not run on an inadequately disclosed gift, regardless of whether a taxpayer has filed a gift tax return for other transfers made during the same year.

Other Changes

Repeal of Excess Distribution Tax. The 15% tax on excess distributions from, and accumulations in, retirement plans has been permanently repealed. This tax had previously been repealed with respect to excess distributions only for 1997-99. The elimination of this tax removes a disincentive to retirement savings and will simplify estate planning for individuals with substantial retirement plan benefits.

Estimated Tax Payments. The estimated tax payment safe harbor based on prior year tax currently requires that taxpayers pay at least 110% of their prior year liability to avoid a penalty. The Act has modified this safe harbor to require payments equal to 100% of prior year tax in 1998, 105% in 1999 to 2001, 112% in 2002, and 110% in 2003 and later years. This confusing change will require taxpayers to pay close attention to which threshold is in effect in each tax year.

Payment of Tax by Credit Card. Beginning May 5, 1998, the IRS will be permitted to accept any commercially accepted means of payment authorized by the Treasury Department, including electronic funds transfers, credit cards, and debit cards.

For more information about how the Taxpayer Relief Act of 1997 may affect you, contact Kirk H. O'Ferrall or Stephen B. Katz via phone at: 212-818-9200.