Though not constituting a sea change in the tax law, the Revenue Reconciliation Act of 1993 nevertheless deviates substantially from the tax course charted by the Tax Reform Act of 1986.
President Clinton has apparently kept his promise of not raising income taxes of the middle class, as new tax rates of 36 percent and 39.6 percent will affect only taxpayers who are at least modestly affluent. Thus, for married taxpayers (filing jointly) whose taxable income is less than $140,000, the top marginal income tax rate will remain at 31%. Married taxpayers filing jointly whose taxable income does not exceed $250,000 will see their taxable income in excess of $140,000 being taxed at a new rate of 36 percent. Finally, a 39.6 percent tax rate (termed the “high income surtax”) will apply to taxable income in excess of $250,000. Taxpayers who wish may pay additional 1993 taxes attributable to the rate increases in three equal installments over the next three tax years. Since this provision in effect constitutes an interest-free loan from the government, it may be enticing to those who qualify.
Low-income taxpayers will benefit from the expansion of the earned income tax credit, which consists of a refundable credit available to qualifying persons whose income does not exceed a threshold amount. For the first time, this credit may also be claimed by taxpayers without children.
Of immediate interest to most taxpayers is the new 4.3 cents per gallon additional excise tax on all transportation fuels, effective October 1, 1993. The unpopular excise tax on luxury items has been repealed with respect to boats, aircraft, jewelry and furs, but persists with respect to automobiles. However, the threshold amount for automobiles is now indexed for inflation, retroactive to 1991, so the 10 percent excise tax will now operate by imposing a tax of 10 percent on that part of the purchase price in excess of $32,000.
The phase-out of the personal exemption for high-income taxpayers, which had been scheduled to expire in 1997, has now been made permanent. Similarly, the limitation on itemized deductions for high-income taxpayers, set to expire in 1996, has also been made permanent. Under this provision, taxpayers having adjusted gross income above a threshold amount are required to reduce itemized deductions by up to 80 percent.
Significantly, the 1993 Act made no change in the 28 percent rate of tax imposed on capital gains. As a result, the rate differential of 11.6 percent between the top marginal ordinary income tax rates (i.e., 39.6 percent) and the 28 percent capital gains tax rate makes the flight to capital gains extremely attractive to many taxpayers.
The new tax law grants even more favorable capital gains tax treatment to the disposition of certain small business stock. Thus, a noncorporate taxpayer who holds “qualified” small business stock for more than 5 years may exclude 50 percent of the gain on the sale or exchange of the stock. This translates to an effective capital gains tax of only 14 percent. Any business whose principal asset is the reputation or skill of its employees (e.g., health or law) will not constitute a qualified trade or business.
Recognizing that the 11.6 percent differential in capital and ordinary tax rates may invite abuse, two new Code provisions seek to prevent the “conversion” of ordinary income to capital gains, and to impede “rate arbitrage” involving the investment interest deduction.
The first of these provisions denies the 28 percent capital gain tax rate to gains that have a decidedly ordinary-income flavor. Thus, new Code Sec. 1258 taxes as ordinary income “capital gains” arising from an investment where “substantially all of the taxpayer’s return is attributable to the time value of the taxpayer’s net investment in the transaction.” The rationale for this provision is that the investment return above actually constitutes disguised interest, which, like other interest, should be taxed at the higher ordinary income rates. This provision is effective for “conversion” transactions entered into after April 30, 1993.
The second anti-abuse provision seeks to prevent “rate arbitrage” with respect to capital gains and the investment income deduction. Generally speaking, the Code permits a deduction from ordinary income for interest expenses attributable to investments. Congress had, even before the 1993 Act, limited the scope of the investment interest deduction to “net investment income.” Net investment income is the excess of “investment income” over “investment expenses.”
The 1993 Act has excluded certain items from “investment income,” with the result that “net investment income” (which in turn defines the upper limit of the investment interest deduction), is reduced. Specifically, investment income no longer includes net capital gain from the disposition of investment property. Since gains attributable to property held for investment will no longer generate ordinary income deductions, rate arbitrage will no longer be possible.
Four changes in the tax law are of particular import with respect to retirment planning. First, for married taxpayers with “provisional” income (i.e., modified adjusted gross income plus one-half of the social security benefit) of $44,000 or more, up to 85 percent of the taxpayer’s social security benefit may now be includible in gross income. Second, a new limit has been placed on the amount of annual compensation that may be taken into account under qualified retirement plans. The new ceiling is $150,000, reduced from $200,000. This means that less of the taxpayer’s money can escape current taxation at the higher marginal rates. Third, for self-employed individuals, the 25 percent deduction for health insurance has been retroactively extended from July 1, 1992 through December 31, 1993. Fourth, effective January 1, 1994, the 1.45 percent Medicare portion of the Social Security tax will, for the first time, also be imposed on income in excess of $135,000.
With the new higher tax rates, charitable contributions will again become more attractive as tax shelters. Charitable contributions in excess of $250 must, under the new law, be substantiated with a “contemporaneous acknowledgment” furnished by the donee organization, which includes the value of any property the taxpayer received from the organization in consideration for the contribution.
Donee organizations must also now furnish every taxpayer who makes a “quid pro quo” contribution (i.e., a contribution in which the taxpayer receives something of value from the charitable organization) with a statement advising the donor that only the net contribution is deductible for federal income tax purposes. On the bright side, contributions of appreciated property will no longer constitute a tax “preference” for alternative minimum tax purposes.
The 1993 Act also eliminates a complicated and unpopular provision which denied the use of a safe harbor for individuals making estimated tax payments. Under the new provision, estimated taxes may be based on the lesser of (1) 90 percent of the tax shown on the return for the taxable year, or (2) 100 percent of the tax shown on the previous year’s return (110 percent if the previous year’s return showed an adjusted gross income of more than $150,000).
Important changes have also been made with respect to taxpayer disclosure and the penalty for substantial understatement of income tax. A penalty tax of 20 percent is imposed on the amount of any understatement, but it is reduced to the extent that the taxpayer’s position is adequately disclosed on the return. The new law redefines the meaning of “adequate.” While under prior law a nonfrivolous position was deemed adequate, a disclosure now must be reasonable to be considered adequate for purposes of avoiding the 20 percent penalty for understatements.
The 1993 Act seeks to impose a larger share of the tax burden on businesses and corporations. Thus, effective in 1994, the corporate tax rate for taxable income in excess of $10 million will be increased to 35 percent, from 34 percent. Also effective in 1994, corporations will no longer be permitted to deduct executive compensation in excess of $1 million, subject to a few narrow exceptions. Nor will business executives be permitted the present 80 percent business meal deduction: Effective December 31, 1993, the deductible portion of otherwise allowable business meals will be reduced to 50 percent. Club dues of any kind will also cease to be deductible as of that date.
Another important new tax provision will permit businesses to amortize the cost of many intangibles, including goodwill and going concern value, neither of which had been previously amortizable. Under new Code Sec. 197, qualifying intangible property will become amortizable (i.e., deductible) ratably over a 15-year period, irrespective of the actual useful life of the property.
Many rental real estate operations will also fare considerably better under the 1993 Act. The passive activity loss rules had been especially restrictive with respect to rental real estate, since developers had been denied the right to net losses from real estate operations with other active income. Provided certain participation standards are met, the new law permits losses from rental real estate to offset nonpassive income of the taxpayer. This change is effective for tax years after 1993.
Small businesses will enjoy an increased Section 179 deduction under the 1993 Act. Effective December 31, 1992, the dollar limitation on Section 179 property that may be expensed rather than depreciated is increased to $17,500, from $10,000. This entitlement is rapidly phased out once property placed in service during the taxable year exceeds $200,000.
The 1993 Act did not materially affect the imposition of gift and estate taxes. However, a scheduled reduction in the top transfer tax rate to 50 percent was retroactively aborted; that rate remains at 55 percent for transfers in excess of $3 million. Speculated reductions in both the $10,000 annual exclusion and the $600,000 lifetime exemption from transfer taxes both failed to materialize. Given the comparatively small amount of revenue estate and gift taxes produce, Mr. Clinton might conclude that an attempt to reduce these entitlements, which seem to genuinely offend few, is either not warranted, or is not worth the contentious debate that such an attempt would engender.