Internal Revenue Service Restructuring & Reform Act of 1998

Congress passed another new tax law called the Internal Revenue Service Restructuring and Reform Act of 1998. The new law addresses taxpayer rights, IRS governance, and tax procedure. The new law also contains important changes to the rules as to how your taxes are computed. The following are highlights of the legislation:

Capital Gains Holding Period | Retroactive to January 1, 1998, property held more than 12 months can qualify for the lowest capital gains rates-generally 20% (10% for taxpayers in the 15% bracket for ordinary income). The 1997 law had reduced the maximum rate from 28% to 20%, but required a holding period of 18 months.

Note, the maximum rate on certain gains will continue to be higher than 20% despite the reduced holding period. For example, depreciationrecapture on real estate will be at a 25% rate, collectibles at a 28% rate.

Gain on Sale of a Principal Residence | The 1997 law allows individuals to exclude up to $250,000 of gain on the sale of a principal residence from income. The exclusion doubles to $500,000 for married couples filing a joint return. The exclusion may be claimed once every two years. To be eligible for the exclusion you must have owned the residence and used it as a principal residence for at least two of the five years prior to sale. If you fail to meet these requirements due to a change in employment, health problems, or other unforseen circumstances described in the regulations, a partial exclusion is available.

The new law clarifies that the partial exclusion is based on a fraction of the maximum exclusion amount, not a fraction of the gain. If, for example, an unmarried person owns and uses a residence for one year (half the required period) and then changes jobs, sells at a gain of $50,000, the entire gain may be excluded since it is less than one half of the maximum exclusion (one-half of allowable $250,000 exclusion = $125,000 which is greater than the $50,000 gain).

Roth IRAs | The 1997 law created the Roth IRA. Annual contributions are not deductible but the earnings build up tax-free so that there is no tax when the money is withdrawn.

An existing IRA may be converted to a Roth if adjusted gross income doesn't exceed $100,000. The converted amount is not included in determining the $100,000. There is a price; however, the converted amount is taxed. For 1998 conversions, a special four-year averaging rule allows you to include only one-fourth of the income each year from 1998 to 2001.

The new law allows you to elect not to apply the four-year rule and instead take the entire amount into income in 1998. The new law also clarifies that if you choose the four-year averaging and later withdraw any amount during that four-year period, the withdrawn amount is included in income, together with the amount that was includible for that year under the four-year averaging rule. Thus, some of the benefit will be lost.

The new law adds a rule that if you die during the four-year period, any as-yet untaxed amounts are included in income in the year of death. But if the IRA passes to your surviving spouse, he or she may elect to continue reporting under the four-year averaging method.

Limits on Roth IRA Contributions | The maximum that you can contribute to a Roth IRA in any year (other than a rollover contribution) is the lesser of $2,000 or your earned income. This amount is reduced by any amount contributed to a regular IRA for the same year.

The amount is also reduced if the adjusted gross income exceeds $95,000 for single filers and$150,000 for joint returns. There is no contribution if adjusted gross income exceeds $110,000 for singles or $160,000 for joint returns and $10,000 for married individuals filing separately.

The new law clarifies that contributions to a Simple or SEP IRA do not reduce the amount that can be contributed to a Roth IRA.

Education IRA Provisions | The 1997 Act allowed nondeductible contributions of up to $500 a year to an Education IRA to pay for higher education expenses of a designated beneficiary. Earnings on the Education IRA will not be taxed if used to pay higher education expenses. Distributed earnings not used to pay higher education expenses are taxable and subject to a 10% penalty.

The new law provides that any balance remaining in an Education IRA is treated as being distributed within 30 days after the date the beneficiary reaches age 30 or dies, whichever occurs first. As a result, that balance is taxed and subject to a 10% penalty. However, the Education IRA may be rolled over to another beneficiary who is a "member of the family" as long as the new child beneficiary is under age 30. A "member of the family" is defined as lineal ancestors and descendants, and their spouses.

Note that a contingent beneficiary may be named to receive any remaining assets upon death of the original child beneficiary. Furthermore, the new beneficiary, if a member of the family, may do a tax-free rollover of the assets into their own Education IRA.

Student Loan Interest | A deduction will be allowable for a limited amount of student loan interest due and paid after 1997. For 1998, the maximum deduction is $1,000, with this amount increasing in increments to $2,500 in 2001 and later years. It is only the person who is required to make interest payments under the terms of the loan who may claim the deduction.

A qualified education loan includes debt incurred solely to pay
qualified higher education expenses. Therefore, a revolving line of credit generally would not qualify unless the borrower agreed to use it only to pay higher education expenses.

IRS Restructuring and Reform | The Act calls for the creation of an IRS Oversight Board to oversee the IRS and its role in executing and applying the tax law. The Board will be composed of nine members, including six from the private sector.

The IRS Commissioner is directed to restructure the IRS by eliminating or substantially modifying the present geographic structure into units serving particular groups of taxpayers with similar needs. The plan must also ensure an independent appeals function within the IRS.

Taxpayer Protection Rights | The Act shifts the burden of proof to the IRS in any court proceeding beginning after July 22, 1998, with respect to a factual issue if the taxpayer introduces credible evidence, complies with any substantiation requirements, maintains adequate records, cooperates with the IRS and, if the taxpayer is not an individual, doesn't have a net worth that exceeds $7 million. You must also be able to walk on water!

The attorney-client privilege of confidentiality is extended to
communications between a taxpayer and any individual authorized to practice before the IRS, including CPA's, with respect to tax advice. This applies only to noncriminal tax matters. This also does not apply if the matter involves a tax shelter.

The Act makes "innocent spouse" relief easier to obtain for tax
liabilities on joint returns, by, among other things, providing a
separate liability election for a taxpayer who is divorced, legally
separated, or living apart from the person with whom the taxpayer filed a joint return.

The Act imposes fair collection practices on the IRS. For example, the IRS can't call you after 9:00 p.m., or otherwise harass or abuse you.

Because of the complexity of some of the provisions, you may want to call us for specific advice as to how a provision may impact your personal, investment, or business activities.