There has been much discussion around the country concerning the new tax law changes enacted by congress in August 1997. What do all these changes mean to you? The 824 changes made to an already complex tax code serve to both help and confuse the average taxpayer. As with any tax law changes there are "winners" and "losers". The tax act, also dubbed the "CPA Relief Act" probably assures that many taxpayers will be running to professional tax preparers for assistance not only in preparing their returns but in the relevant tax planning concerns. It was reported that H & R Block’s stock surged nearly 40% upon the news of the tax "reform". Despite the demands of the people to simplify the tax code, the congress made it even more complicated. Complication is not necessarily a bad thing. Of course, the new tax act contains the usual bizarre, targeted (a good Washington word for "favored") tax benefits for limited classes of taxpayers. For example, Sheriffs in Mississippi will receive a special tax deduction for certain business expenses. Additionally, Microsoft, which has a mere $11 billion in revenues will benefit from a provision that lets software companies avoid paying taxes on part of the income earned from licensing software to be made or sold abroad (got all that?). The tax break for the software companies will cost us humbler taxpayers approximately $2 billion during the next 10 years. However.....if an average taxpayer is able to "structure" their tax lives in conjunction with the new complexity, significant new savings can be realized.

The "winners" under the new tax laws appear to be large families with lots of kids, parents with children in college and people who own stock. In specific instances, additional "winners" are gay and lesbian couples (and non-married heterosexual couples). Please see the discussion concerning Roth IRAs.

The "losers" under the new tax laws appear to be single people (with the exception of the Roth IRA). Corporate America did not experience any broad based tax relief under the new rules.

Adding to the complications of the new tax code is the fact that not all the changes happen at the same time. Furthermore, there are still many unresolved "mechanical" issues related to the actual reporting. These changes will most likely be handled in the usual manner. Congress will issue what they call "technical corrections". So much for simplification. Forget it folks!

Although there were many changes to the tax laws, below find listed the most relevant ones to the average taxpayer. The most important changes were in the areas of:

1. IRAs
2. Educational Tax Credits
3. Capital Gains
4. Sale of Personal
5. Child Tax Credits
6. Self Employed

Please, before implementing any strategy discussed here, please discuss it with us or your CPA. There are many details which are not being discussed here which could affect your tax strategy.

Previous Law:

Taxpayers could make up to a $2,000 contribution and deduct it on their taxes assuming that they were not involved in a company pension plan. Penalties for withdrawal existed (10%) and virtually no exceptions to the penalty were allowed. The $2,000 deductible contribution was further restricted if the taxpayer earned over $25,000 (for singles). If ineligible to make a deductible IRA contribution, a taxpayer could elect to make a nondeductible contribution but still receive the tax deferred advantage. Of course, the taxpayer was still taxed on the earnings portion of any distributions.

New Law for Standard IRA deductions (assuming you already have a pension):

The income thresholds for allowing deductible IRA contributions will gradually go up from the current $25,000 (singles) to $40,000. The change will occur gradually over time. Also, under the old law, even if one spouse was in a employer type plan, both spouses were stuck with the income threshold limitations which severely limited their ability to take the IRA deduction. Under the new law, effective in 1998, one spouse can deduct his or her account contributions (assuming they are not in an employer sponsored plan) even if the other spouse participates in their employer sponsored plan.

In addition, taxpayers are allowed to withdraw money, effective January 1, 1998, from an IRA, without penalty (of course it will still be taxed as income), for qualified higher educational expenses (including graduate level courses). Furthermore, no penalty will attach (but the distribution is still taxed as income) if the withdrawal is used for the purchase of a first home. The lifetime limit on these withdrawals, without incurring the penalties, is $10,000.

Effective Date:

First changes occurs in 1998. The income threshold moves up to $30,000 (for singles), $50,000 (married, filing jointly).

Previous Law:

Did not exist.

New Law:

The "Roth" IRA, named for Senator Roth allows taxpayers to make nondeductible IRA contributions. What makes this an attractive option is the fact that the distributions are tax free assuming that the taxpayer holds the IRA for at least 5 years. So, whereas the tax savings for a regular IRA are realized up front with a deduction on the tax return, a Roth IRA provides tax savings upon the distribution (principal as well as interest) after 5 years. The taxpayer still needs to be 59 ½ years old in order for the 5 year holding period to apply and to receive the tax savings. There are several other provisions related to this "liberalized" IRA worth mentioning.

First, you can make a contribution to a Roth IRA even if you are involved in an employer sponsored plan. Please always bear in mind that the maximum contribution to any IRA (deductible or nondeductible) is limited to $2,000. You are eligible to make a Roth IRA contribution if your adjusted gross income is under $95,000 (singles), $150,000 (married, filing jointly). Above those income thresholds, contributions are "phased-out" until adjusted gross income reaches $110,000 for individuals ($160,000 for married, filing jointly).

Another advantage of the Roth IRA is that the amounts accumulated in the IRA do not have to be distributed at age 70 ½ (a standard IRA requires a distribution of part of the IRA funds each year after age 70 1/2). Furthermore, contributions can continue to be made indefinitely.

Of special interest is the ability to "rollover" an existing IRA into a Roth IRA. Although no penalty will be imposed, the taxpayer will have to pay the normal taxes on the distribution. Also, the taxpayer cannot have an adjusted gross income in excess of $100,000 in the year of the rollover. If this "rollover" takes place in 1998, the tax law will allow the taxpayer to spread the income & tax effects of the distribution over a four year period.

Additionally, the new Roth IRA rules allow the taxpayer to withdraw money, tax & penalty free (assuming the 5 year holding period has been met) if the distributions are due to the disability of the taxpayer or for first-time home buyers. An example of the complexity of the rules--a "first-time" home buyer is defined according to the legislation as "anyone who had no ownership interest in a principal residence during the two-year period ending on the date of acquisition of the home for which the IRA assets are being used." Be careful. Although there are specific rules to abide by, overall the guidelines have been greatly "liberalized" in favor of the taxpayer.

Tax Strategies

Who should create a Roth IRA? The answer is really simple, just about everyone who qualifies. Of course, individual situations need to be assessed. The tax savings upon distribution will probably be substantial. For example, if the taxpayer is under 40, there will be an opportunity for the Roth IRA to accumulate, tax free, interest for at least 20 years! Giving up a relatively small deduction now to receive a large distribution, tax free, in the future makes sense. Another bit of good news. Distributions from a Roth IRA will not cause taxation of your social security benefits!

Special Tax Strategy for Gay & Lesbian Couples

Under the current IRA laws any inheritance of a life partner’s IRA account is subject to taxation. For example, if partner A dies and leaves an IRA account balance of $50,000 to partner B, the entire amount is taxable to partner B in the year of distribution. The new Roth IRA will be tax FREE to the beneficiary regardless of marital status! The other elements of the Roth IRA must still be satisfied (5 year holding rule). If partner A died before the 5 year holding period was satisfied, partner B could elect to leave the funds where they are until the holding period is met. This is reason alone to convert all IRAs to Roth IRAs. Sure you will pay some taxes now but compared to the savings on the accumulated earnings in 20+ years it will probably be well worth it.

Effective Dates & Other Comments

A taxpayer is eligible to establish a Roth IRA in 1997. If a rollover of an existing IRA is necessary it would make more sense to establish a Roth IRA in 1998 in order to take advantage of the ability to spread the income distribution over a four year period. Also noteworthy to mention, given the fact that the accumulations in a Roth IRA can be significant, is that the old 15% excise tax on excess withdrawals, over $160,000 from a retirement plan, has been repealed.

This is an unusual opportunity being afforded the average taxpayer to accumulate tax free savings as well as not being taxed on the distributions! Please consider acting on this, especially if you have been making nondeductible IRA contributions.

Previous Law:

Did not exist.

New Law:

This IRA is part of a more broad based set of tax incentives to encourage savings for college tuition for children. Specifically, the new laws allow single taxpayers to create an Educational IRA in the amount of $500 per child, per year. The single taxpayer can establish an Educational IRA as long as their adjusted gross income does not exceed $95,000 ($150,000 for married filing jointly). Above these income levels the allowable contributions are "phased-out" (limited). The distributions are tax free if used for higher education expenses. Contributions cannot be made once the beneficiary (child or grandchild) reaches age 18. Also, this contribution will be disallowed, if, in the same year, a contribution is made to a qualified state tuition program on behalf of the same beneficiary.

Tax Strategies:

Establish an educational IRA immediately for all children. Between the tax deferred nature of the earnings on the contributions and the tax free distributions make this an exceptionally attractive method for saving for colleges. Traditional tax deferred annuities grow tax free but the taxpayer is taxed in the year of receipt. With an Educational IRA, the distribution is tax free (assuming the proceeds are used for higher educational expenses). There are some minor cautions to be aware of (see discussion under "Educational Expenses") but nothing that should prevent most people from participating.

Effective Dates:

The Educational IRA may be established beginning on January 1, 1998.

Previous Law:

No such credits existed. It was previously possible to deduct educational expenses as a miscellaneous itemized deduction (subject to the 2% floor) as long as the educational expenses were undertaken to maintain or improve a skill(s) required of the individual in the context of the individual’s employment or if they were incurred to meet the express requirements of the individual’s employer.

New Law:

The new law allows for several credits to be taken. The Hope Scholarship Credit allows taxpayers to claim a credit for up to $1,500 per student, per year, for qualified tuition and fees paid during the year, for higher education (college) on behalf of the student. A "student" can be the taxpayer, the taxpayer’s spouse or dependent. The "student" must be enrolled on at least a half time basis. The credit is per student and it can be claimed for the first 2 years of undergraduate education. As is becoming a resounding theme in the new tax laws, the ability to claim this credit is dependent upon the adjusted gross income of the taxpayer. For the single taxpayer, the credit starts "phasing-out" after adjusted gross income exceeds $40,000 and is gone completely when adjusted gross income reaches $50,000 (married, filing jointly, the phase-out starts at $80,000 and ends at $100,000).

Effective Date:

Individual taxpayers are allowed to claim this credit, against federal income taxes. The credit is equal to 20% of the tuition and fees paid during the year. The maximum credit is $1,000 per year, per taxpayer. The good news is that after 2005, the credit increases to $2,000 per year. It is important to point out that this credit is also available to those taxpayers who are taking educational classes in order to acquire or improve job skills. The credit is computed on a per taxpayer return basis. This means that the amount of the credit is limited whether there is one student or several. It can, however, be claimed for an unlimited number of years. This credit is subject to the same income phase-out rules as the Hope Credit discussed above.

Effective Date:

The Lifetime Learning Credit is available for expenses paid after June 30, 1998 for academic periods which begin after that date.

Of the three new tax items concerning education (The Hope Credit, The Lifetime Learning Credit and the Educational IRA), you can only elect one for each student in a given year.

Tax Strategy:

Given the tax free accumulations and the tax free distributions (for educational expenses only), it would seem prudent to fund the Educational IRA. Also, given the higher adjusted gross income limitations, it might be a taxpayer’s only choice. It would appear that since a taxpayer is limited to choosing one of the tax advantaged items per year, taking the Hope Credit, while it is available (first 2 years of undergraduate education), then taking either the Lifetime Learning Credit or distributing the Educational IRA. It would depend on which has the greater value. Please recall that if the Educational IRA is not used for educational expenses, it is not tax free upon distribution. Essentially, the taxpayer would have to assess if the paying the tax on the distribution is more advantaged then taking the Lifetime Learning Credit. In most cases, it probably makes sense to distribute the Educational IRA. Any remaining expenses, in future years can still qualify for the Lifetime Learning Credit.

Previous Law:

No deduction has been allowed for student loan interest.

New Law:

Student loan interest may be claimed as an "above the line" deduction which means it will be deducted before calculating adjusted gross income. The allowable deduction will be "phased-in" over a four year period. The deduction will only be allowed for taxpayers with an adjusted gross income of less then $40,000 for single taxpayers (with the deduction "phased-out" at $55,000 for singles), likewise for married, filing jointly, the deduction will only be allowed if adjusted gross income is less then $60,000 (with the deduction "phased-out") at $75,000.

Effective Date:

A maximum of $1,000 in interest expense may be claimed for interest paid on or after January 1, 1998. This maximum will be gradually be raised over a "phase-in" period of 4 years, a maximum of $2,500 in interest expense will be allowed as a deduction. Interest can only be claimed if the interest expense is related to the first five years of the loan repayment period.

Previous Law:

No such provision existed.

New Law:

Beginning January 1, 1998, penalty free withdrawals can be made from a standard IRAs for qualified higher educational expenses. The withdrawal, however, is not tax free and is subject to tax at the taxpayers regular tax rate.

Effective Date:

The IRA withdrawal is not subject to penalty as long as the expenses are for academic periods starting on or after January 1, 1998. There are no income "phase-outs"

The long awaited capital gains reductions have arrived. The new tax laws provide for a significant reduction in taxes on capital gains for assets held over 18 months. Additionally, there will be a further reduction in the capital gains rate effective for tax periods beginning January 1, 2006.

The maximum capital gains rate for individuals has been reduced to 20% from 28%, effective retroactively to May 7, 1997. For qualified assets purchased after January 1, 2000 and held more than five years, the top rate will be 18%. Of interesting consequence is the fact that congress also made a provision for individuals in the 15% tax bracket. The maximum capital gains rate (assuming the same holding periods) is 10% and, for qualified assets purchased after January 1, 2000 and held more than five years, the top rate will be 8%.

What makes these new capital gains rules confusing are the effective dates and holding periods. Below find a table summarizing these changes.

Stocks or Assets Holding Period	New Maximum Capital Gains Rates	Old Maximum Capital Gains Rates
12 months or less	39.6%	39.6%
More than 12 months, but less than 18 months	28% (see note 1 below)	28%
More than 18 months	20% (see note 2 below	28%
More than 60 months (and acquired AFTER January 1, 2000	18% (see note 3 below)	28%

Note 1:

There is a "phase-in" period for the new capital gains rates to be effective. Since, prior to the new tax laws, 12 months was considered "long term", congress made a provision for this. Therefore, for assets held more than 12 months, but not more than 18 months (assuming the assets were sold between May 7 and July 29, 1997) the new 20% rate would apply. If an asset were sold, for example, on August 7, 1997 and only held 15 months, the 28% rate would be applicable. If that same asset were sold, however on July 27, 1997, the 20% rate would apply. The new tax law requires an 18 month holding period, except as noted during the "phase-in" period of May 7 - July 29, 1997.

Note 2:

For assets sold on or after May 7, 1997. If an asset were sold prior to this date, the old rules are in effect.

Note 3:

The earliest date that this rate can be claimed, given a 60 month holding period, is January 1, 2006. For assets held on January 1, 2001, the new tax laws allow the ability to "mark to market" which will effectively treat the assets as sold and subsequently repurchased thereby making them eligible for the new 5 year holding period for lower capital gains rate treatment (18%). Be aware that any appreciation is immediately recognized as gain and taxed accordingly (20% rate). Since it is subsequently "repurchased" effectively, the new cost basis is increased. Losses, due to this "marking" will not be allowed.

Tax Stategy:

Careful documentation is necessary in order to determine which rate applies. As for "marking to market" in order to save an additional 2% off the tax, the general opinion is that it is not a good idea in most cases. The idea of paying tax on an "unrealized gain" in 2001 to save a scant 2% in 5 years probably does not bear itself out as a solid tax planning strategy. Every opinion, however, has its exceptions and this idea should be at least reviewed at the appropriate time (after January 1, 2001).

Previous Law:

Under the old tax laws, taxpayers could exclude the gain on the sale of a principal residence by "rolling over" into a home of equal or greater value within a 2 year time period. In addition, if the taxpayer was over age 55, up to $125,000 of any calculated gain could have been excluded (a one time opportunity).

New Law:

The new tax laws allow up to $250,000 of gain ($500,000 for married filing jointly) from the sale of a principal residence to be excluded from income. The basic rules require that the residence be occupied by the taxpayer for at least 2 of the past 5 years prior to the sale.

Effective Dates:

The new rules were made effective retroactively to May 7, 1997. If you sold a home before this date (January 1-May 6, 1997) the old rules of rollover etc. apply. If you sold the home between May 7 and August 4, 1997, the taxpayer can elect to choose the rollover or to be treated under the new tax laws. On or after August 5, 1997, the new rules apply.

Tax Strategy:

Please bear in mind that these new rules do not eliminate the need to keep accurate records. The new rules, concerning the non-taxability of a gain (up to the limits discussed above), do not apply to rental property (or if the property is not held the required period). A separate discussion concerning rental property appears below. If the taxpayer enjoys buying and fixing up homes for sale, this can be a great method of generating nontaxable income. The new laws will allow a taxpayer to sell their home as often as every two years.

Previous Law:

Generally the same rules that applied to the old capital gains applied here.

New Law:

Upon the sale of rental property, there is a special 25% rate on the portion of the capital gains related to the amount of depreciation taken over the years. Any remaining amount of the capital gains is taxed at 20%. For example, assume the following:

Selling price of rental property $100,000

Cost of rental property 70,000

Total depreciation taken on the property 10,000

The gain on the sale, therefore, is $40,000 ($100,000-(70,000-10,000)). Please be reminded that the depreciation is deducted from the original cost of the rental property.

The taxes would be computed as follows (assuming the holding periods were met):

The $40,000 gain has two components which are tax differently:

1) $10,000 related to the depreciation is taxed at 25%

Tax would equal $2,500

2) $30,000 remaining gain is taxed at 20%

Tax would equal $6,000

Therefore the total taxes arising from this transaction would equal $8,500. It is therefore still very necessary to keep accurate records concerning original costs (settlement sheet) and improvements.

The new Schedule D is expected to now be three pages long. Also, at issue, is the proper "netting" of all the different holding period gains and losses. A technical correction can be expected prior to year end which will address these issues.

Investors, who invest in mutual funds, might want to review this strategy with their brokers. Although taxes should "not be the tail that wags the dog", a taxpayer should be aware that a fund with significant capital gains on fund assets held less than 18 months could produce income subject to the higher rates.

The new capital gains rules provide opportunities for tax reduction but prudent planning should be performed to ensure that the maximum advantages are being realized.

No tax credit was available.

New Law:

The $500 tax credit will be available for each qualifying dependent of a taxpayer under age 17. Credits will be "phased-out" for single filers with an adjusted gross income over $75,000 ($110,000 for married, filing jointly).

Effective Date:

The credit of $400 per dependent will be allowed starting in 1998. The amount of the credit increases to $500 in 1999 and beyond. The tax credit will be indexed to inflation starting in 2000.

The credit is reduced by $50 for every $1,000 of adjusted gross income over the income thresholds discussed above. For example, if a single taxpayer has an adjusted gross income of $80,000, in 1998, and has one dependent, the tax credit is reduced in 1998 from $400 to $150 ($50 reduction per $1,000-since adjusted gross income was $5,000 over the threshold, $250 is disallowed).

Tax Strategy:

This tax credit is independent of the earned income credit (EIC). Prior to the new law, low income taxpayers could take the EIC to reduce their taxes often resulting in having zero taxes due. The new child credit can be added on top of EIC which will send many tax returns into negative numbers. The federal government will send a refund for the difference.

Previous Law:

Prior to 1997, only 30% of health insurance was deductible as an adjustment to gross income for the self employed taxpayer. Declaring a home office deduction is extremely difficult under the previous rules.

New Law:

In 1997 the self employed health insurance deduction increases to 40%. Gradually, the amount allowable for this deduction will increase to 100% by 2007.

Starting in 1999, more liberalized rules will exist for claiming a home office deduction. Essentially, anyone who uses a home office and doesn’t have an office anywhere else will be able to deduct the cost of the home office.

It makes more sense then ever to hire your significant other to work in your business. Health insurance, paid for an employee, is a nontaxable benefit to the employee and fully deductible to the employer. Although the new tax laws "liberalize" the health insurance deduction for the self employed, it still remains a deduction with limited benefit since it is deducted as an adjustment to gross income and not a reduction to self employment income (which would shield it from the double FICA tax). Ideally, both partners would have their own businesses and "cross employ" each other. This needs to be weighed against the increase in FICA tax but, dollar per dollar, it should make sense to do. Additionally, the "employer" can provide a pension plan to the "employee". Of course, the other partner can turn around and provide the same benefits. Furthermore, the ability to "income shift" from the higher earning partner to the lower earning partner should be considered. Close consultation with a CPA is highly recommended.

Tax reform, sounds simple enough but what we got was an additional level of complexity. What makes the tax laws especially complex are all the new "phase-in" and "phase-out" periods and levels of income. Pay extremely careful attention to the details, there a re many of them. Although many tax laws changed, many others did not. Careful planning is now, more then ever, truly necessary. The good news is that most of the changes occur after January 1, 1998, so we still have adequate time to plan.

As long as there is a congress which creates tax laws, continued changes are inevitable. Please do not expect something as simple as a "flat tax". Granted, the tax laws are riddled with special interests but this new tax bill should benefit the general economy by getting more spendable income into the system. Additionally, the college credits and other savings incentives should improve the nation’s sagging savings rate...always a good thing.

Of course, it would be nice if the new tax laws were a little more balanced. As it stands now they are very favorable towards the traditional married couple with lots of children (and if they are in college, so much the better). The single taxpayers and/or gay/lesbian couples continue to shoulder more of the tax burden although there is some "relief" in certain areas. Overall, however, the changes, as made by congress, are good ones. Far from the tax simplification that taxpayers wanted (or thought they wanted), there is much, however, to be happy about. Be mindful of the new complexity! Careful tax planning and investing will help to ensure that the maximum benefits allowed under the new laws will be realized.

The above represents a "smattering" or cross section of the tax law changes. It is not intended to be a complete statement on the subject. There are many details on the 824 changes (and indeed many of the changes themselves) which have not been presented. What is presented probably represents what most taxpayers would find interesting. You are urged to seek our more complete advice or the advice of your CPA before instituting any changes to your tax lives.

One final thought, the hard cider producers in Vermont and New York are also getting special tax breaks...makes you wonder what congress was drinking when they passed this "tax simplification" package!