Studying the Tax Law Changes Is Not for the Weak at Heart

The Clinton administration's 1997 budget package includes many provisions that were included in the administration's previous proposals; however, there are some new ideas.

Though it is difficult to predict how the legislative process will ultimately end, there are two key observations to keep in mind.

  • Government cannot seem to resist the temptation to tinker with the tax law every few years. Because the last major tax legislation was in 1993, we are probably overdue for some changes.
  • Changes that are ultimately enacted generally percolate in proposal form for some time. Accordingly, the best indicators of the end product are the "on-the-table" proposals.

The prospects for short-term enactment of these Clinton proposals are tied to the efforts of lawmakers to resume negotiations on a broad deficit-reduction plan. A new plan would likely include fewer tax cuts than Congress desires. It is possible that lawmakers may consider spending provisions and tax provisions on separate tracks, with tax cuts taken up only after locking in spending reductions. However, it is not at all clear that Congress and the White House can reach agreement on a budget plan in this election year.

Tax-Cut Proposals
Below is a list of tax-cut proposals in the Clinton budget. The first five proposals would be subject to triggers that would curtail the tax benefits if federal deficit-reduction targets were not met.

Tax Credit for Dependent Children. A nonrefundable tax credit for each dependent child under age 13 would phase in at $300 for 1996, 1997, and 1998, and $500 thereafter.

Education and Job Training Tax Deduction. Taxpayers could deduct qualified educational expenses for the education or training of themselves, their spouses, or their dependents. In 1996, 1997, and 1998, the maximum deduction would be $5,000. Thereafter, it would increase to $10,000, with likely phase-outs at certain income levels.

Expanded Individual Retirement Accounts (IRAs). The income thresholds and phase-out ranges for deductible IRAs would double in two stages (in 1996 and in 1999). Individuals eligible for traditional deductible IRAs would have the option of contributing either to deductible IRAs or to new "special IRAs." Contributions to the special IRAs would not be tax deductible, but distribution of the contributions would be tax-free.

Self-Employed Insurance Deduction. A self-employed individual's health insurance deduction would increase in stages from 35 percent in 1996 to 50 percent in 2000.

Small-Business Expenses. An increase in tax-deductible expenses for small businesses would phase in, rising in stages from $19,000 in 1996 to $25,000 in 2002.

Closely Held Business Estate Tax Extension. An increased cap on the special low-interest rate would apply to the deferred tax on $2.5 million of value of closely held businesses. The 4 percent rate would be cut in half, and the rate on values greater than $2.5 million would decline to 45 percent of the usual IRS rate on tax underpayments.

Retirement Plan for Small Businesses. Employers with 100 or fewer employees could adopt a new simple retirement plan, the National Employee Savings Trust. All employee and employer contributions would be 100 percent vested immediately and would be fully portable.

Pension Simplification. The Clinton budget for fiscal 1997 includes a number of pension-simplification provisions.

Empowerment Zone and Enterprise Community Expansion. The bill would authorize additional zones and communities.

Tax-Increase Proposals
The following are revenue-raising proposals included in the Clinton budget.

Securities Sales. Taxpayers selling stocks, notes, bonds, or derivative financial instruments would determine their basis in substantially identical securities using the average of all their holdings in the securities (rather than by specific identification or by using a first-in, first-out or last-in, first-out presumption).

Distributions that Constitute Disposition of Business. This proposal largely eliminates the long-standing ability to split up a corporate business into two or more segments in tax-free spin-off transactions and exacts a toll on the formerly nontaxable event when no cash is generated to pay the tax.

Sales of Stock to a Related Corporation. The government would treat sales to related corporations as the payment of a dividend by the purchaser, subject to certain limitations for foreign-controlled domestic corporations.

Extinguished Treatment. Gain or loss attributable to the termination of any right or obligation regarding property that is or would be a capital asset in the hands of the taxpayer would be treated as capital gain or loss (instead of ordinary gain or loss).

Corporate-Owned Life Insurance Plans. No deduction would be allowed for interest paid or accrued on any indebtedness regarding life insurance, endowment, or annuity contracts covering individuals who are officers or employees of-or financially interested in-any trade or business carried on by the taxpayer, regardless of the amount of debt.

Dividends-Received Deduction Reduction. The dividends-received deduction available to corporations owning less than 20 percent of the stock of a U.S. corporation would decline from 70 percent to 50 percent of the dividends received. The provision also includes holding-period restrictions.

Tax-Exempt Interest Expenses. Corporations investing in tax-exempt obligations would not be able to deduct a portion of their interest expense equal to the portion of their total assets comprising tax-exempt investments.

Short Transactions. Taxpayers would have to recognize gain (but not loss) upon entering into a constructive sale of any appreciated position in stocks, debt instruments, or partnership interests.

Preferred Stock as Boot. Certain preferred stock would be treated as boot, subject to exceptions.

Section 1374 Repeal. A C-to-S corporation conversion (whether by S-corporation election or merger) would be treated as a liquidation of the C corporation followed by a contribution of the assets to an S corporation by the recipient shareholders. This would require immediate gain recognition by both the corporation and its shareholders.

Inventory Accounting Methods. Both the lower-of-cost-or-market and the components-of-cost inventory accounting methods would end.

Involuntary Conversions. When a taxpayer acquires a controlling interest in the stock of a corporation as replacement property after an involuntary conversion, the corporation will generally have to reduce its adjusted bases in its assets by the same amount the taxpayer reduces its bases in the stock.

Failure to File Information Returns. The general penalty amount would increase to the greater of $50 per return or 5 percent of the total amount required reported.

Payments to Attorneys. Any person making a payment to a lawyer in the course of a trade or business would have to report the payment to the IRS.

Bruce Bulloch, CPA, and Julie M. Hardnock, CPA

Bruce Bulloch, CPA, a tax partner with Ernst & Young/Kenneth Leventhal Real Estate Group, serves many of the firm's real estate development, home-building, and REIT clients in the Baltimore/Washington, D.C., area. Julie M. Hardnock, CPA, is a tax manager with Ernst & Young/Kenneth Leventhal Real Estate Group based in Baltimore.