By Vernon K. Jacobs, CPA, CLU, FLMI email vkj@rpifs.com [http://www.rpifs.com/vjcpa.htm] (C) Vernon K. Jacobs, 1997. All rights Reserved. Distributed by Financial Services Online [http://www.fsonline.com]

Late in 1995, the Congress passed an extensive tax bill but President Clinton vetoed it. To get something that could be passed by the Congress and signed by the President during an election year, the Congressional leaders drafted four separate bills with significant tax provisions that were generally regarded as being politically non-controversial. Most likely you’ve already heard or read something about them. A summary of these new laws by Commerce Clearing House is about 150 pages - so report will only highlight the provisions that have some effect on your client’s 1996 tax returns. The purpose of this report is only to provide a reminder of some changes that may require immediate attention by your clients or their tax preparers.

These are the four bills that were passed in 1996. Except for the Taxpayer Bill of Rights 2, these bills were enacted into law on August 20, 1996.

1. The Taxpayer Bill of Rights 2.

2. The Small Business Job Protection Act. (SBJPA)

3. The Health Insurance Portability and Accountability Act. (HIPAA)

4. The Personal Responsibility and Work Opportunity Reconciliation Act. (PRWORA)

This report doesn’t include any comment on the Taxpayer Bill of Rights 2. (You can obtain some information about that bill at [http://www.rpifs.com/vjcpa.htm]. )

The following changes in the 1996 tax bills will affect the 1996 tax returns of your clients and may require immediate attention if you are involved in helping any of your clients with their tax returns or if you suspect your client’s tax preparer might not be aware of these items.

Small Business Tax Issues

CLAMP DOWN ON CORPORATE INTEREST DEDUCTION FOR LARGE POLICY LOANS: It was probably a nice “loophole” while it lasted but now the IRS has the weapons to prohibit corporations from taking big deductions for policy loans on life, endowment or annuity policies on the life of officers, employees or those who have a “financial interest” in the company. Apparently, some companies were taking out tax free loans on policies covering rank and file employees, while the cash values were accumulating tax free. Then they were deducting the interest on the loans. The new rules apply to interest on loans of more than $50,000 after October 13, 1995, but the change includes some complex transitional rules. [HIPAA Sec. 501; IRC Sec. 264]

EXTENSION & REVISION OF VARIOUS BUSINESS TAX CREDITS: The former targeted jobs tax credit has been replaced with a “new” “Work Opportunity Credit” and has been extended through September 30, 1997. The credit for increased research expenses has been extended through May 31, 1997. The Puerto Rico and Possession tax credit has been repealed but qualified corporations will continue to receive a limited credit during a transition period. The orphan drug testing credit has also been extended through May 31, 1997. [SBJPA Sec. 1201, 110, 1204, 1702, 1601 and 1205]

AN OPPORTUNITY TO RESTORE PRIOR S CORPORATION STATUS: Major changes were made in the rules applicable to S corporations for tax years after 1996. However, one of the provisions in that part of the new law provides an opportunity for corporations that were denied reinstatement of their terminated S corporation status by the IRS for the five years from August 20, 1991 through August 19, 1996. The prior law didn’t give the IRS the authority to make waivers - but now they can, back to 8/20/91. [SBJPA Sec. 1305(a); IRC Sec. 1362]

Changes In Income Exemptions

REPEAL OF EXEMPTION FOR $5,000 DEATH BENEFIT EXCLUSION: The estates or beneficiaries of employees who die after August 20, 1996 will no longer be able to exclude up to $5,000 of benefits paid to the estate or beneficiary of a deceased employee by an employer of the deceased. [SBJPA Sec. 1402; IRC Sec. 101, 406(e), 407(e) and 7701(a)(20)]

EDUCATIONAL ASSISTANCE REIMBURSEMENT WAS EXTENDED: An exclusion from income for reimbursements by employers for up to $5,250 per year of educational expenses, per employee, expired after 1994. It’s been reinstated retroactive to the end of 1994 and extended through June 30, 1997. The exclusion isn’t available for post graduate educational expenses incurred after June 30, 1996. [SBJPA Sec. 1202; IRC Sec. 127]

Personal Deductions & Credits

I.D. NUMBERS REQUIRED FOR DEPENDENTS: For calendar year tax returns for 1996 and later years, taxpayers will be required to have a correct taxpayer identification number (TIN) for dependents’ deductions or the dependent care credit. Incorrect or missing numbers will result in an automatic tax assessment by the IRS. A missing TIN is also likely to preclude filing as a head-of-household. No TIN is required for 1996 for children born after November 30, 1996. [SBJPA, Sec. 1615(a)]

NEW LIMITS ON TAX EXEMPTIONS FOR PUNITIVE DAMAGES: Punitive damages have generally been tax exempt to the recipient. The 1996 law makes an assortment of changes that depend on the nature of the damages. Thus, any clients who did receive any punitive damage awards after August 20, 1996 will need to review these new rules. [SBJPA Section 1605(a) & IRC Section 104]

DEDUCTION EXTENDED FOR CONTRIBUTIONS OF STOCK TO PRIVATE FOUNDATION: A “temporary” rule allowed taxpayers to deduct the value of appreciated stock that was donated to a private foundation - rather than the adjusted cost (basis) of such stock. That rule expired at the end of 1994, but has now been reinstated from July 1, 1996 through May 31, 1997. [SBJPA Sec. 1206(a); IRC Sec. 170(e)(5)(D)]

Foreign Tax Issues

HARSH NEW RULES APPLY TO TAX MOTIVATED EXPATRIATES: Because of some publicity about a few very wealthy U.S. citizens and long term resident aliens who gave up their citizenship (or residency) for the ostensible purpose of saving taxes, the Congress reacted with some very harsh new rules to deter U.S. persons from leaving the country in order to save taxes. The rules are effective for those who gave up their citizenship or residency after February 5, 1995. One of the provisions of the bill provides that any U.S. citizen or resident with a net worth of $500,000 or more will be presumed to have a tax avoidance motive and will be subject to these new rules. To add insult to injury, the 1997 Budget Bill included a provision to prohibit these people from returning to the U.S. (Further details about this will be published in special reports of OFFSHORE and at [http://www.rpifs.com/vjcpa.htm]. )

FOREIGN TRUST TAX RULES ARE CHANGED: The 1996 law attempts to shut down some perceived “loopholes” that permit certain persons to use foreign trusts to avoid (or defer) U.S. taxes. One of these “loopholes” applies where a foreign person creates a foreign trust and then becomes a citizen of the U.S. Another is where a foreign person creates a foreign trust for a U.S. beneficiary. A third is where a domestic trust changes into a foreign trust - as when the U.S. grantor dies. A perceived abuse of foreign trusts is that some U.S. grantors are not reporting all of their income from these trusts to the IRS. Most of these new rules are affective for distributions to beneficiaries after August 20, 1996. (Further details about these new rules will be published in the OFFSHORE eJournal and at my web site for the Asset Protection Strategies newsletter. [http://www.rpifs.com/ap101.htm] )

The following changes that were introduced by the 1996 tax laws may present opportunities to help your clients (or yourself) to find new ways to reduce your taxes in 1997 and future years.

Small Business Tax Issues

INCREASED MEDICAL INSURANCE DEDUCTION FOR SELF EMPLOYED: For 1996, a self employed person could deduct 30% of their medical insurance expenses as a deduction for adjusted gross income (above the AGI line). This limit will be increased to 80% by the year 2006, with a deduction of 40% allowed for 1997. [HIPAA Sec. 311; IRC Sec. 162(I)(1)]

SEVERE NEW RULES ON HEALTH CARE EXCLUSIONS: The 1996 law mandates certain coverages for health care insurance relative to pre-existing conditions and coverage limitations (called “discrimination” in the new law) based on an individual’s health status. Penalties are imposed on the employer to force the insurance companies to comply with the new rules on policy provisions. Certain small employers with less than 50 employees and with less than two covered employees at the beginning of the plan year are exempted - for now. Certain church plans and government plans are also exempted. You can expect much higher premiums for group health insurance after the effective date of June 30, 1997. [HIPAA Sec. 401 & 402; IRC Sec. 4980D, 4980I, 9801 - 9806]

HIGHER BUSINESS EQUIPMENT TAX WRITEOFFS AFTER 1996: The IRC Sec. 179 deduction for tangible business equipment purchases will be increased from $17,500 (for 1996) to $18,000 in 1997. The maximum deduction will be increased to $25,000 by the year 2003. [SBJPA Sec. 111(a); IRC 179(b)(1)]

MORE LIBERAL RULES FOR S CORPORATIONS: S corporations may now become a significant alternative to limited liability companies or limited partnerships where the owners want to have a pass through entity. The number of eligible shareholders of an S corporation have been increased from 35 shareholders to 75, for tax years starting in 1997. Trusts that own S corporation stock will be treated as separate trusts with respect to such stock - which will avoid the termination of the S corporation. (However, income accumulated in the trust will be subject to the highest rate of tax.) S corporations will now be permitted to own stock in other corporations, subject to some restrictions. Some exempt organizations are now permitted to be shareholders after 1997, certain banks may be shareholders after 1996 and S corporations will be permitted to own stock in C corporations or other S corporations. [SBJPA Sec. 1301-1316; IRC Sec. 1361-1362, and others]

NO MORE INTEREST EXCLUSION ON ESOP LOANS: One of the major enticements for financial institutions to loan money to employee stock ownership plans was a tax exemption for 50% of the interest on the loan. That exemption has been repealed as of August 20, 1996. Most likely, this will result in a lot fewer ESOP deals in the future. Although this technically was effective for 1996, the impact on your clients won’t be noticed until 1997 or future years. [SBJPA Sec. 1602; IRC Sec. 133, 291, 812, 852, 4978, 6047 and 7872]

NEW TAX ENTITY CREATED FOR SECURITIZATION OF NON-MORTGAGE DEBT: The 1996 SBJPA created a complex new entity called a Financial Asset Securitization Investment Trust (FACIT) to facilitate the financing of revolving, non mortgage debt such as credit card receivables, auto loans and certain home equity loans. The new entity will be a flow through entity for tax purposes and the tax provisions will be effective as of September 1, 1997. Chances are this will not represent a new investment opportunity for your personal clients because a FACIT must be entirely owned by a taxable C corporation. However, it will offer corporations a way to ensure that they can deduct the cost of financing these revolving debt obligations and may be useful to some of your corporate clients. [SBJPA Sec.1621; IRC Sec. 860H-L]

Qualified Savings Plans

INCREASED SPOUSAL IRA: Starting in 1997 tax years, non working spouses will be able to make deductible IRA contributions of up to $2,000 per year rather than the prior limit of $250 per year. The maximum contribution for both spouses is also limited to the combined earnings of both spouses. The maximum contribution is also limited when the working spouse is covered by a qualified plan at work and earns over $40,000 per year. [SBJPA Sec. 1427; IRC Sec. 219 and 408(d)(5)]

WAIVER OF EARLY IRA WITHDRAWAL PENALTY FOR MEDICAL EXPENSES: For taxpayers who are under the age of 59.5, distributions from an IRA after 1996 can be made without the 10% pre-mature distribution penalty tax if the distribution is used for medical expenses. However, the penalty exemption is limited to the amount of medical expenses in excess of the annual exclusion for 7.5% of adjusted gross income. In addition, the 10% penalty is waived if distributions from an IRA are used to pay for medical insurance premiums when the taxpayer is separated from employment and receives unemployment compensation for at least 12 consecutive weeks. Certain self employed individuals may also be eligible if the taxpayer would have otherwise been eligible for unemployment compensation. [HIPAA Sec. 361; IRC Sec. 72(t)]

ANOTHER NEW SIMPLIFIED SMALL BUSINESS RETIREMENT PLAN: The Congress just won’t admit that you can’t get small employers to pay for the retirement savings of their employees if you don’t give the employer a substantial financial incentive. Every few years, they come up with another simplified plan based on the questionable premise that it’s the complexity that is keeping employers from giving their employees a lot of expensive retirement benefits. Starting in plan years after 1996, we have a new and improved SIMPLE retirement plan for small businesses that employ less than 100 employees. Meanwhile, they repealed the salary reduction simplified employee plans (SARSEP) that they introduced a few years ago. To help pay for these changes, they will eliminate a major tax break for rank and file employees after 1999 - the pension distribution five year averaging tax. (On smaller distributions, up to half of the distribution is tax free.) They did eliminate some of the complex nondiscrimination rules for highly compensated employees and repealed the limitation on contributions for combinations of plans. Anyone who works in the small business market will need to spend some CPE time getting familiar with these rules early this year. (There’s no citation here because these new rules cover a wide range of the tax code.)

Income Exemptions & Exclusions

ACCELERATED DEATH BENEFITS ARE TAX FREE NOW: Beginning in tax years after 1996, amounts received from the sale or assignment of any portion of a death benefit for a life insurance contract will be tax free to the owner of the contract if the owner is chronically or terminally ill. The exclusion is limited to $175 per day, adjusted for inflation. [HIPAA Sec. 331, IRC Sec. 101(g)]

Itemized Deductions & Tax Credits

LONG TERM CARE EXPENSE AND INSURANCE IS DEDUCTIBLE STARTING IN 1997. One of the major deterrents to the purchase of long term care insurance (apart from the cost) has been the fact that the insurance premium wasn’t deductible. Apparently the Congress decided they needed to give up something to encourage private solutions to the problem and to reduce future demands on Medicaid. The rules and restrictions are quite detailed, but if you are in this market (or are thinking about it), this is the time to get up to speed. In addition to the deductibility of LTC insurance, the new law treats expenses paid for long term care services as deductible medical expenses. [HIPAA Sec. 321 & 322; IRC Sec. 106, 125, 162, 213, and 4980B]

NEW MEDICAL SAVINGS ACCOUNTS AVAILABLE ON LIMITED SCALE: It may already be too late for your clients to be among the first to take advantage of the new medical savings accounts (MSA) but it may still be worth looking into for next year. This pilot program will be limited to the first 750,000 participants each year from 1997 through 2000. If your clients can’t get in for 1997, it might be a good idea to find out how to apply for later years. Generally, MSAs are like IRAs but they are intended to permit certain taxpayers to accumulate tax deductible funds for medical expenses. The rules are quite extensive and complex, so any further details should be obtained by reading a copy of the Health Insurance Portability and Accountability Act, Section 301.

ADOPTION TAX CREDIT: Starting in 1997, taxpayers can get a tax credit (non refundable) for qualified adoption expenses of up to $5,000 per child. For children with special needs, the maximum credit per child is $6,000. Special rules apply to the adoption of foreign children. Any excess credit can be carried forward up to five years. Where employers have a qualified adoption assistance program, the employee will not be taxed on the value of the benefits. These benefits are phased out for taxpayers with an adjusted gross income between $75,000 and $115,000. [SBJPA Sec. 1807; IRC Sec. 23, 25 & 1016]

Excise Tax Issues

SUSPENSION OF 15% EXCESS DISTRIBUTIONS TAX FOR THREE YEARS: The 15% excise tax on excess pension distributions in excess of an indexed annual exemption of the allocated grandfathered exemption (if available) has been suspended through the end of 1999. The tax applies to distributions from a qualified plan in excess of $155,000 per year or to lump sum distributions in excess of $775,000 a year for 1996. These amounts are indexed for inflation and will change each year. This provision is effective for tax years after 1996.

Vernon K. Jacobs

Jan. 30, 1997

(C) 1997, Vernon K. Jacobs, All rights reserved.