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Tax Wizard
Spring 1998

Featured Sites

 

A Quarterly Feature highlighting Sites of Interest

This month we feature a press release from the AICPA

For Immediate Release
April 9, 1998

CONTACT: Lynn Drake

(202) 434-9214
LDrake@aicpa.org

Carol Ferguson
(202) 434-9243
CFerguson@aicpa.org

As April 15 again approaches, many taxpayers are already anticipating the headaches that come with filing their tax returns. The American Institute of Certified Public Accountants prescribes 10 tax simplification cures that could go a long way towards relieving the BIG HEADACHES experienced by many taxpayers.

Headache #1 - Earned Income Tax Credit.  Childhood dreams turn into adult nightmares for low-income parents trying to figure out the earned income tax credit. The credit has been changed 13 times since 1976 and now requires taxpayers to wind their way through a maze of eligibility tests and worksheets. This credit is one of the most error prone, complex provisions of the individual income tax.
Headache #2 - Individual Alternative Minimum Tax.  The alternative minimum tax is the iceberg on the horizon sneaking up on unsuspecting middle-income taxpayers as fast as the Titanic went down. The number of taxpayers subject to the AMT is escalating at a phenomenal rate. Many of these taxpayers were not intended as targets of this tax.
Headache #3 - Individual Capital Gains Tax.  Taxpayers now need relief from capital gains tax relief. The Taxpayer Relief Act of 1997 added complexity to both capital gains tax rates and holding periods. Don't start your spring cleaning yet. You'll need records to show when you bought and sold investments, not to mention a great deal of patience (and a few aspirins) in filling out the 1997 Schedule D.
Headache #4 - Marriage Penalty.  There are a lot of things that make marriage a plus or minus. The tax law should not be one of them. The Internal Revenue Code has over 60 provisions where tax liability depends on whether a taxpayer is married or single.
Headache #5 - Phase-Outs Based on Income Level.  The multitude of phase-outs based on income level makes calculating whether you qualify for a tax benefit as predictable as an El Niño winter. The numerous (and differing) dollar ranges of income are based not only on what you made, but also on a variety of ways to measure what you made.
Headache #6 - Health Insurance Premium Deduction.  A self-employed taxpayer could become ill just trying to figure out his or her health insurance premium deduction. The calculation is scheduled to change every year until 2007. Headache #7 - Kiddie Tax.  This is not child's play. The so-called "kiddie tax" taxes the unearned income of children under the age of 14 at the parents' tax bracket. It has grown up into a very complicated calculation.
Headache #8 - Individual Estimated Tax Safe Harbor.  Nothing feels safe about a "safe harbor" if it's here today and somewhere else tomorrow. Under the current law, some taxpayers will calculate estimated taxes on a percentage that is set to rise, remain steady, jump, and then drop over the next six years.
Headache #9 - Employee vs. Independent Contractor.  The "battle" is not between employees and independent contractors — rather, it's a three-way fight: Congress vs. the Internal Revenue Service vs. small businesses. The rules relating to the classification of a worker as an employee or independent contractor are as clear as cement.
Headache #10 - Half Year Requirements.  Only the tax law celebrates a person's half-birthday. Where else will you find concerns about whether someone is 59 1/2 or 70 1/2? Eliminating half-year requirements is a gift from Uncle Sam all taxpayers would appreciate.
The AICPA is the national professional organization of CPAs with more than 331,000 members in public practice, business and industry, government and education.


Attached is a technical analysis of each of these taxpayer headaches and the AICPA's solution or "relief" for all ten.


Relief #1 — Simplification of Earned Income Tax Credit
Present law
The refundable EITC was enacted in 1975 with the policy goals of providing relief to low-income families from the regressive effect of social security taxes, and improving work incentives among this group. According to the IRS, EITC rules affect almost 15 million individual taxpayers.
Over the last few years, the most common individual tax return error discovered by the IRS during return processing has been the EITC, including the failure of eligible taxpayers to claim the EITC, and the use of the wrong income figures when computing the EITC. The frequent changes made over the past twenty years contribute greatly to the credit's high error and noncompliance rates.
In fact, the credit has been changed 13 times (1976, 1977, 1978, 1979, 1984, 1986, 1988, 1990, 1993, 1994, 1995, 1996 and 1997). The credit now is a nightmare of eligibility tests, requiring a maze of worksheets. Computation of the credit currently requires the taxpayer to consider 9 eligibility requirements:

the number of qualifying children — taking into account relationship;
residency test;
age test;
the taxpayer's earned income — taxable and non-taxable;
the taxpayer's AGI;
the taxpayer's modified AGI;
threshold amounts;
phase out rates; and,
varying credit rates.
As part of the health insurance deduction act that Congress passed in 1995, a new factor was added to determining eligibility — the amount of interest (taxable and tax-exempt), dividends, and net rental and royalty income (if greater than zero) received by a taxpayer, even if total income is low enough to otherwise warrant eligibility for the EITC. A threshold of this type of disqualified income was set at $2,350 in 1995, but was then altered as part of the Personal Responsibility and Work Opportunity Reconciliation Act of 1996 to be $2,200. In addition, in 1996, capital gain net income and net passive income (if greater than zero) that is not self-employment income were added to this disqualified income test.
In 1996, the credit computation became even more complicated, with the introduction of a modified AGI definition for phasing out the credit, wherein certain types of nontaxable income need to be considered and certain losses are disregarded. Specifically, nontaxable items to be included are: tax-exempt interest, and nontaxable distributions from pensions, annuities, and individual retirement arrangements (but only if rolled over into similar vehicles during the applicable rollover period). The losses that are to be disregarded are:
net capital losses (if greater than zero);
net losses from trusts and estates;
net losses from nonbusiness rents and royalties; and
50 (changed to 75% in 1997 — see below) percent of net losses from businesses, computed separately with respect to sole proprietorships (other than in farming), sole proprietorships in farming, and other businesses — but amounts attributable to business that consist of performance of services by an individual as an employee are not taken into account.
In addition to the prior requirement that a taxpayer identification number (TIN) be supplied for all qualifying children, starting in 1996, individuals are also required to be authorized to be employed in the U.S. in order to claim the credit, and failure to provide a correct TIN is now treated as a mathematical or clerical error. In 1997, as part of the Taxpayer Relief Act of 1997 (TRA '97), additional restrictions are placed on the availability of the EITC. For example, taxpayers who improperly claimed the credit in earlier years are denied the credit for a period of years. If the improper claim was due to fraud, the disallowance period is ten years after the most recent tax year for which the final determination is made. If it was due to reckless or intentional disregard of the rules, the disallowance period is two tax years after the most recent tax year for which the final determination was made. Taxpayers who are denied the EITC for any tax year as a result of tax deficiency procedures must demonstrate eligibility for the credit and provide additional information to the IRS in order to claim the credit in any later tax year.
In addition, the 1997 law provides that the amount of net losses from carrying on trades or businesses that is disregarded in determining modified AGI is increased from 50% to 75%. The 1997 legislation also includes the following items in determining modified AGI for the credit:
 

tax-exempt interest received or accrued during the tax year; and
non-taxable distributions from pensions, annuities, or individual retirement plans (if not rolled over into similar vehicles during the rollover period).

Additionally, the 1997 law provides that workfare payments are not earned income for EITC purposes.
To claim the credit, the taxpayer may need to complete:
a checklist (containing 8 complicated questions);
a worksheet (which has 9 steps);
another worksheet (if there is self-employment income);
a schedule with 6 lines and 2 columns (if qualifying children are claimed); and
usually, the normal Form 1040 (rather than Form 1040EZ).
For guidance, the taxpayer may refer to 7 pages of instructions (and 39 pages of IRS Publication 596). The credit is determined by multiplying the relevant credit rate by the taxpayer's earned income up to an earned income threshold. The credit is reduced by a phaseout rate multiplied by the amount of earned income (or AGI, if less) in excess of the phaseout threshold.
While Congress and the IRS may expect that the AICPA and its members can comprehend the many pages of instructions and worksheets, it is unreasonable to expect those individuals entitled to the credit (who will almost certainly NOT be expert in tax matters) to deal with this complexity. Even our members, who tend to calculate the credit for taxpayers as part of their volunteer work, find this area to be extremely challenging. In fact, we have found that the EITC process can be a lot more demanding than completing the Schedule A — Itemized Deductions, which many of our members complete on a regular basis for their clients.
Our analysis suggests that most of the EITC complexity arises from the definitional distinctions in this area. While each departure from definitions used elsewhere in the Code can be understood in a context of accomplishing a specific legislative purpose, the sum of all the definitions variances causes this Code section to be unmanageable by taxpayers and even the IRS. We recognize that many of the additions and restrictions to the credit over the years were for laudable purposes. However, the rules are so complex that the group of taxpayers to be benefited find them incomprehensible and are not effectively able to claim the credit to which they are entitled.
Suggested changes
We recommend that Congress adopt the following changes to the EITC:
 

A. Simplify definitions and the calculation.

B. Define "earned income" as taxable wages (Form 1040, line 7) and self-employment income (Form 1040, line 12).

C. Modify the "qualifying child" rules.

 

1. Replace the "qualifying child" definition with the existing "dependent child" definition.

2. Increase the incremental amount of credit provided for two children versus one child.

3. Use the dependency exemption rather than the EITC to provide benefits for children.

D. Combine and expand the denial provision.

 

1. Deny the credit for taxpayers with: foreign earned income, alternative minimum tax liability, and AGI that exceeds earned income by $2,200 or more.

Contribution to simplification

Instructions and computations would be greatly simplified. The error rate should be dramatically reduced.


Relief #2 — Simplification of the Individual Alternative Minimum Tax

Present law

Our tax laws give special treatment to certain types of income and allow special deductions for certain types of expenses. These laws enable some taxpayers with substantial economic income to significantly reduce their regular tax. The purpose of the AMT is to ensure that these taxpayers pay a minimum amount of tax on their economic income.

The AMT is one of the most complex provisions in the tax system. Each of the adjustments of Internal Revenue Code (IRC) section 56, and preferences of IRC section 57, requires computation of the income or expense item under the separate AMT system. The supplementary schedules used to compute the necessary adjustments and preferences must be maintained for many years to allow the computation of future AMT as items "turn around."

Generally, the fact that AMT cannot always be calculated directly from information on the tax return makes the computation extremely difficult for taxpayers preparing their own returns. This complexity also calls into question the ability of the Internal Revenue Service (IRS) to audit compliance with the AMT. The inclusion of adjustments and preferences from "pass through" entities also contributes to the complexity of the AMT system.

Several items enacted in TRA '97 will have a dramatic effect on a number of individuals who will find themselves shifting from the regular tax system to the alternative minimum tax (AMT) system. For many, this will come as a real surprise, and in all likelihood, will cause substantial concern to the IRS, which will have to focus significant efforts to this area in the future to enforce compliance, educate taxpayers, and handle taxpayer questions.

In fact, John Scholz, Deputy Assistant Secretary in the Treasury Tax Policy Analysis Office, has stated that the number of taxpayers subject to the AMT, which is currently less than one percent, is expected to escalate at a rate of 30 percent a year for at least ten years. He noted that the trend will mean eight percent, or 11 million taxpayers, will be subject to AMT by 2007.

Most sophisticated taxpayers understand that there is an alternative tax system, and that they sometimes wind up in its clutches; the unsophisticated taxpayer may never have heard of the AMT, certainly does not understand it, and has no expectation that he or she is ever going to have to worry about it. Unfortunately, that is changing — and fairly rapidly — since a number of the more popular items, such as the education and child credits that were recently enacted, only offset regular tax and do not offset AMT. Due to these changes, we believe it is most important that Congress obtain information (from Treasury, the Joint Committee on Taxation staff, or OMB) not only as to the revenue impact of the interaction of all these recent tax changes with the AMT, but also of the likely number of families or individuals that will be paying AMT as a result of 1997's tax legislation.

Specifically, taxpayers' situations were exacerbated by the following.

 

1. The child tax credit is not available against the AMT. Thus, middle-income taxpayers will see their regular tax go down by $500 or more (depending upon the number of dependent children), but their AMT potential liability will not be reduced at all.

2. Under the Hope tuition tax credit, middle-income families receive up to a $1,500 credit, per eligible student, for regular tax purposes, though none of the credit is available against AMT. The same is true with respect to the Lifetime Learning Credit, with a maximum $1,000 credit before 2003, and $2,000 credit thereafter. These credits alone will generate a substantial number of new AMT filers. Combine a child in the first or second year of college with others at home below 17 years of age, and the result is a potentially significant new group of taxpayers who would under no circumstances be considered rich, but who will now be paying the alternative minimum tax.

It is becoming more widely known that the failure to index the AMT brackets and exemption, while regular tax brackets and exemptions are indexed, will come close to quadrupling the number of individual taxpayers subject to AMT in the next ten years. We urge Congress to index the AMT brackets and exemption amounts.

While we have not undertaken detailed studies ourselves, anecdotal examples exist that indicate the possibility that taxpayers with adjusted gross incomes in the $60,000-$70,000 range can be subject to AMT. Aside from the fairness issues involved — this is not the group that the AMT has ever been targeted to hit — we see some potentially serious problems of compliance and administration as well. Many of these taxpayers have no idea that they may be subject to the AMT (if, indeed, they have any familiarity with the fact that there is an AMT). Thus, we anticipate large numbers of taxpayers not filling out a Form 6251 or paying the AMT, thus requiring extra enforcement efforts on the part of the Internal Revenue Service to make these individuals (most of whom will be filing in absolute good faith) aware of their added tax obligations.

Suggested changes

We wish we had "the" answer to the problem, but recognize there is no simple solution given the likely revenue loss to the government. As a start, however, Congress might consider:

 

1. Indexing the AMT brackets and exemption amounts.

2. Eliminating itemized deductions and personal exemptions as adjustments to regular taxable income in arriving at alternative minimum taxable income (AMTI) (e.g., all — or possibly a percentage of — itemized deductions would be deductible for AMTI purposes).

3. Eliminating many of the AMT preferences by reducing for all taxpayers the regular tax benefits of AMT preferences (e.g., require longer lives for regular tax depreciation).

4. Allowing certain regular tax credits against AMT (e.g., low-income tax credit, tuition tax credits).

5. Providing an exemption from AMT for low and middle-income taxpayers with regular tax AGI of less than $100,000.

6. Considering AMT impact in all future tax legislation.

Due to the increasing complexity and compliance problems, and a perceived lack of fairness towards the intended target, Congress might want to consider the additional alternative of eliminating the individual AMT altogether.

Contribution to Simplification

The goal of fairness that is the basis for AMT has created hardship and complexity for many taxpayers who have not used preferences to lower their taxes but have mathematically been caught up in AMT's attempt to bring fairness. Many of these individuals are not aware of these rules and complete their return themselves, causing confusion and errors. The 1997 law and the inflation of tax brackets are causing more lower income taxpayers to be inadvertently included in AMT. Recommendation 1 of indexing the AMT brackets and exemption would solve this problem.

Under recommendation 2, those individuals who are affected only by itemized deductions and personal exemption adjustments would no longer have to compute the AMT amount. We note that itemized deductions are already penalized by the 3 percent AGI adjustment, 2 percent AGI miscellaneous itemized deduction adjustment, and the 50 percent disallowance for meals and entertainment. Similarly, the phase out of exemptions already affects high income taxpayers. It is also worth noting that because state income taxes vary, taxpayers in high income tax states may incur AMT solely based on the state in which they live, while other taxpayers with the same adjusted gross income (AGI), but who live in states with lower or no state income taxes, would not have any AMT.

In addition, under recommendation 3, many of the AMT preferences could be eliminated by reducing for all taxpayers the regular tax benefits of present law AMT preferences (e.g., require longer lives for regular tax depreciation). This would add substantial simplification to the Code, record keeping and tax returns.

Under recommendation 4, those who are allowed certain regular tax credits, such as the low income or tuition tax credits, would be allowed to decrease their AMT liability by the credits. This would increase simplicity and create fairness. Compliance would be improved.

Under recommendation 5, fewer taxpayers will be subject to AMT and the associated problems. By increasing the AMT exemption to exclude low and middle income taxpayers, the AMT will again be targeted at the high-income taxpayer to whom it was originally intended to apply.

By eliminating AMT altogether, all the individual AMT problems would be solved.

Relief #3 — Simplification of the Individual Alternative Capital Gains Tax

Present Law

The taxation of capital gains is extremely complex, involving definitions and special rules of what are capital assets, holding periods required, and the alternative rates of tax depending upon the holding period. TRA '97 added complexity in the area of rates and holding periods. Net gains from the disposition of capital assets are taxed at the following maximum rates:

Holding Period Maximum rate
28% or + bracket 15% bracket
One year or less 28%, 36%, or 39.6% 15%
More than one year but not more than 18 months 28% 15%
More than 18 months 20% 10%
More than five years (if acquired after 2000) 18% 8%
More than five years (regardless of when acquired) n/a 8%
More than five years (if acquired before 2000 and taxpayer elects to recognize gain on assets held as of January 1, 2001 18% n/a
More than 18 months - real property depreciation recapture 25% 15%
More than one year - Collectibles 28% 15%


Suggested Change

There should be one holding period and one alternative capital gains tax rate, such as more than twelve months and 20 percent, either or both of which could be modified depending upon revenue considerations.

Another suggestion is that the changes to holding periods be implemented through changes to section 1222, which already defines holding periods.

Contribution to Simplicity

With the different holding periods and rates for capital gains, Schedule D of Form 1040, together with instructions, has become unduly complex. Having one holding period and one capital gains tax rate will simplify tax law and tax reporting and will improve compliance. Taxpayers have needed capital gains tax relief, but without the needless complexity. Changing the definition of long-term via section 1222 rather than changing the taxing/holding scheme via section 1(h) would be simpler. The section 1222 definition is still relevant for various provisions, such as section 170(e).

Relief #4 — Eliminate the Marriage Penalty

Present Law

Under the current tax system, a "marriage penalty" and "marriage bonus" exist. The "marriage penalty/bonus" results when two married individuals have a greater (penalty) or smaller (bonus) tax liability as compared to two similarly situated single individuals (i.e., individuals with the same total incomes). The marriage penalty is a likely, unintended result from prior legislative efforts to be equitable. As each Congress introduces changes to the Code, complexity and unintended tax effects often result.

There are also at least 63 provisions in the Internal Revenue Code where tax liability depends on whether a taxpayer is married or single. Most of these differences were created to be fair; to target benefits to specific taxpayers, or to prevent abuses. Some examples are the tax rates, standard deduction, and earned income tax credit, as well as social security benefits taxation, capital loss limits, IRAs, dependent care credit, child credit, and education tax incentives.

The two major factors that have created the marriage penalty problems are:

 

1. The "stacking of income" problem, resulting from the different and progressive tax rate/bracket schedules applicable to different filing statuses, and

2. Different income thresholds and phase-outs of deductions and credits for single versus married taxpayers.

The progressive tax rate/bracket schedules impose a higher marginal tax on combined spousal earnings, as compared to two single persons. Additionally, the tax brackets for married filing joint are not twice as wide as those for single taxpayers, and the tax brackets for married filing separately do not equate to the tax brackets for single taxpayers. We refer to this phenomenon as the "stacking of income" problem and there are a variety of ways to address it.

The second factor contributing to the marriage penalty is the large number of provisions that phase-out based on income levels that may or may not differ based on marital/filing status. TRA '97 significantly increased the provisions with different phase-outs for different filing status (i.e., based on joint, single, or married filing separately).

There are also related joint liability issues. For example, when a married couple files a joint federal income tax return, each spouse becomes individually responsible for paying the entire amount of tax associated with that return. Because of this joint and several liability standard, one spouse can be held liable for tax deficiencies assessed after a joint return was filed that were solely attributable to actions of the other spouse. The current "innocent spouse" relief provisions are not effective, are too restrictive to help very many aggrieved taxpayers, and are in need of reform. In addition, due to the high divorce rate in this country, the current divorce taxation rules affect a large percentage of taxpayers inequitably, many of whom do not have or cannot afford sophisticated tax advice.

A number of bills have been introduced in Congress addressing the marriage penalty and joint liability problems, including:

  • HR 2593 (Herger, R-CA), providing a two-earner deduction up to $3,000;
  • HR 2456 (Weller, R-IL) / HR 2462 (Kasich, R-OH) / HR 3059(Jackson-Lee, D-TX) / S 1314 (Hutchinson, R-TX), allowing combined returns with single rates;
  • S 1285 (Faircloth, R-NC), allowing combined returns with single rates and allocating half the taxable income to each spouse;
  • HR 1584 (Johnson, R-TX), providing a $145 marriage penalty credit;
  • HR 2718 (Knollenberg, R-MI), eliminating the marriage penalty in the standard deduction;
  • HR 2467 (Stupak, D-MI), allowing divorce decree allocation; and
  • HR 2292 (Portman, R-OH) / S 1096 (Kerrey, D-NE), requesting a study of separate returns.

Recommended Change

The AICPA has been studying this area for many years and recommends that the marriage penalty be eliminated or reduced because it is inequitable. There are a number of possible approaches to address the marriage penalty problem.

 

1. Provide on one return, a separate calculation of each spouse's taxable income and use one tax rate schedule that would apply to all individuals. The income and deductions of each spouse could be allocated in a variety of ways, e.g., by property ownership, by AGI, by percentage of earned income, 50/50, or in the parties' discretion. In our opinion, conceptually, this one-return, separate calculation proposal could produce the most equitable system. However, any allocation of income and deductions adds complexity in return filing and tax administration. The total increase in complexity will depend on the allocation methods used. Many states that have an income tax, such as Virginia, use this approach. (This is similar to HR 2456 and related bills.)

2. Provide a deduction to reduce the marriage penalty, such as the two-earner deduction. This would be the simplest solution to implement, and would eliminate some, but not necessarily all, of the marriage penalty and could add to marriage bonuses. It would have to apply for regular tax and alternative minimum tax (AMT) and not be subject to an AGI phase-out to be fully effective. (This is similar to HR 2593.)

3. Provide a tax credit to address the marriage penalty. This would eliminate some, but not necessarily all, of the penalty. It would have to apply to both regular tax and AMT to be fully effective. Several considerations would have to be taken into account, such as the complexity in the calculation, the treatment of carryovers and carrybacks, and the priority ordering of the many tax credits that could apply. (This is similar to HR 1584.)

4. Adjust/broaden the current rate/bracket schedules applicable to married individuals. The joint schedule could be modified to eliminate the marriage penalty (by increasing the joint brackets to twice the single brackets) or to reduce the penalty. Another approach would be to conform the married filing separate and single rate/bracket schedules (such as in Arizona). This approach would be better than the current system and could be viewed as elective complexity for those couples that chose to file separately.

5. Adopt standard phase-outs for three income levels — low, middle, and high income taxpayers (rather than the 20 current levels), and adopt one standard phase-out method. This would eliminate marriage penalties, since the joint amounts would be twice the single ranges, and the phase-out ranges applicable to married filing separate taxpayers would be the same as those for single taxpayers.

In addition, there are related tax problems that arise because of marriage and joint liability, and we urge the Committee to give these matters consideration. For example, the innocent spouse rules need modification, as do the treatment of carryover tax attributes and NOL computations in divorce situations. Further, we suggest Congress provide for allocated liability instead of joint and several liability on joint tax returns, and further consider separate returns as an option. We also note that various Internal Revenue Code regulations (i.e., under sections 108, 121, 154, 163, 1041, and 6013) regarding spouses and divorce situations need to be amended.

This recommendation discusses a number of possible approaches to address the marriage penalty problem. However, each of these provisions needs to be thoroughly analyzed in order to provide the economic, tax, and social benefits that Congress determines is appropriate. Further, to eliminate marriage penalties and improve simplification, standard phase-outs (with joint ranges being twice the single and married filing separate ranges) for three income levels — low, middle, and high income taxpayers (rather than the 20 current levels) — and one standard phase-out method should be adopted.

Contribution to Simplification

By eliminating or reducing the marriage penalty and marriage bonus the tax system would become "marriage neutral." The tax system would be made more rational and equitable.


Relief #5 — Elimination or Standardization of Phase-Outs Based on Income Level

Present Law

Numerous sections in the tax law provide for the phase-out of benefits from certain deductions or credits over various ranges of income based on various measures of the taxpayer's income. There is currently no consistency among these phase-outs in either the measure of income, the range of income over which the phase-outs apply, or the method of applying the phase-outs. Furthermore, the ranges for a particular phase-out often differ depending on filing status, but even these differences are not consistent. For example, the traditional IRA deduction phases out over a different range of income for single filers than it does for married-joint filers; whereas the $25,000 allowance for passive losses from rental activities for active participants phases out over the same range of income for both single and married-joint filers. Consequently, these phase-outs cause inordinate complexity, particularly for taxpayers attempting to prepare their tax returns by hand; and the instructions for applying the phase-outs are of relatively little help. See the attached Exhibit for a listing of most current phase-outs, including their respective income measurements, phase-out ranges (for 1998) and phase-out methods.

Note that currently many the phase-out ranges for married-filing-separate (MFS) taxpayers are 50 percent of the range for married-filing-joint (MFJ), while many of the phase-out ranges for single and head of household (HOH) taxpayers are 75 percent of married-joint. That causes a marriage penalty when the spouses incomes are more equal.

Recommended Change

True simplicity could easily be accomplished by eliminating phase-outs altogether. However, if that is considered either unfair (simplicity is often at odds with equity) or bad tax policy, significant simplification can be achieved by creating consistency in the measure of income, the range of phase-out (including as between filing statuses) and the method of phase-out.

Instead of the at least 20 different phase-out ranges (shown in attached Exhibit A), there should only be three — at levels representing low, middle, and high income taxpayers.

If there are revenue concerns, the ranges and percentages could be adjusted, as long as the phase-outs for each income level group (i.e., low, middle, high income) stayed consistent across all relevant provisions. In addition, marriage penalty impact should be considered in adjusting phase-out ranges for revenue needs.

We have proposed that to eliminate the marriage penalty and simplify the Code, all phase-out ranges for married-filing-separate (MFS) taxpayers would be the same as those for single and head of household (HOH) taxpayers, which would be 50 percent of the range for married-filing-joint (MFJ) range.

The benefits that are specifically targeted to low-income taxpayers, such as the earned income credit, elderly credit, and dependent care credit, would phase-out under the low-income taxpayer phase-out range. The benefits that are targeted not to exceed middle income levels, such as the traditional IRA deduction and education loan interest expense deduction, would phase-out under the middle-income taxpayer phase-out range. Likewise, those benefits that are targeted not to exceed high income levels, such as the new child credit, new education credits and IRA, and the new Roth IRA, as well as the existing law AMT exemption, itemized deductions, personal exemptions, adoption credit and exclusion, series EE bond exclusion, and section 469 $25,000 rental exclusion and credit, would phase-out under the high-income taxpayer phase-out range. See the chart below.

Additionally, instead of the differing methods of phase-outs (shown in attached Exhibit B), the phase-out methodology for all phase-outs would be the same, such that the benefit phases out evenly over the phase-out range. Every phase-out should be based on adjusted gross income (AGI).

Proposed Income Level Range for Beginning to End
of Phase-Out for Each Filing Status

Category of Taxpayer Married Filing Joint Single & HOH & MFS
LOW-INCOME $ 15,000 - $ 37,500 $ 7,500 - $ 18,750
MIDDLE INCOME $ 60,000 - $ 75,000 $ 30,000 - $ 37,500
HIGH INCOME $ 225,000 - $ 450,000 $ 112,500 - $ 225,000


Contribution to Simplification

The current law phase-outs complicate tax returns immensely and impose marriage penalties. The instructions are difficult to understand and the computations often cannot be done by the average taxpayer by hand. The differences among the various phase-out income levels are tremendous. Either we should eliminate phase-outs and accomplish the same goal with a lot less complexity by adjusting rates, or at least make the phase-outs applicable at consistent income levels (only 3) and apply them to consistent ranges and use a consistent methodology. This would ease the compliance burden on many individuals. If there were only three ranges to know and only one methodology, it would be a lot simpler and easier to recognize when and how a phase-out applies. Many portions of numerous Internal Revenue Code sections could be eliminated. By making the MFJ phaseout ranges double the ranges applicable to single individuals and making the MFS ranges the same as single individuals, the marriage penalty relevant to phase-out ranges would be eliminated.

EXHIBIT A - Selected AGI Phase-out Amounts

IRC Section Provision Ft
nt.
Current -
Joint
Current -
Single & HOH
Current -
Married/Sep.
Proposed -
Joint
Proposed -Single
& HOH & MFS
PHASE-OUT LEVELS FOR LOW-INCOME TAXPAYERS
21 30 Percent Dependent Care Credit (3) $10,000-$20,000 $10,000-$20,000 No credit $15,000-$37,500 $7,500-$18,750
22 Elderly Credit (4) $10,000-$25,000 $7,500-$17,500 $5,000-$12,500 $15,000-$37,500 $7,500-$18,750
32 EITC
(No Child)
(2,3, 4) $5,570-
10,030
$10,030 No credit $15,000-$37,500 $7,500-$18,750
32 EITC
(1 Child)
(2,3, 4) $12,260-$26,473 $12,260-$26,473 No credit $15,000-$37,500 $7,500-$18,750
32 EITC
(2 or More Children)
(2,3, 4) $12,260-$30,095 $12,260-$30,095 No credit $15,000-$37,500 $7,500-$18,750
PHASE-OUT LEVELS FOR MIDDLE-INCOME TAXPAYERS
219 IRA Deduction w/ retiremt. plan (1,7,9) $50,000-$60,000 $30,000-$40,000 No deduction $60,000-$75,000 $30,000-$37,500
221 Education Loan
Interest Exp.
(1,2,6) $60,000-$75,000 $40,000-$55,000 No deduction $60,000-$75,000 $30,000-$37,500
PHASE-OUT LEVELS FOR HIGH-INCOME TAXPAYERS
24 Child Credit (1,5,6) $110,000- $75,000- $55,000- $225,000-$450,000 $112,500-$225,000
25A Hope Credit & Lifetime Learning Cr. (1,2,6) $80,000-$100,000 $40,000-$50,000 No credit $225,000-$450,000 $112,500-$225,000
23 & 137 Adoption Credit/

Exclusion

(1,7) $75,000-$115,000 $75,000-$115,000 No benefit $225,000-$450,000 $112,500-$225,000
55(d) AMT Exemption (1,8) $150,000-$330,000 $112,500-$247,500 $75,000-$165,000 $225,000-$450,000 $112,500-$225,000
68 Itemized Deduction level (2) $124,500- $124,500- $62,250- $225,000-$450,000 $112,500-$225,000
135 EE Bond int. Exclusion (1,2,7) $78,350-$108,350- $52,250-$67,250 No exclusion $225,000-$450,000 $112,500-$225,000
151 Personal Exemption (2) $186,800-$309,300 $124,500-$247,000 HOH$155,650 -$278,150 $93,400-

$154,650

$225,000-$450,000 $112,500-$225,000
219(g) (7) IRA w/spouse w/retrmt.plan (1,6,7) $150,000-$160,000 $10,000-$20,000 No deduction $225,000-$450,000 $112,500-$225,000
408A Roth IRA Deduction (1,6) $150,000-$160,000 $95,000-$110,000 No deduction $225,000-$450,000 $112,500-$225,000
408A IRA to Roth IRA Rollover (1,6,7) $100,000 $100,000 No rollover $225,000-$450,000 $112,500-$225,000
469(I) $25,000 Rent

Passive Loss

(1,7) $100,000-$150,000 $100,000-$150,000 $50,000-$75,000 $225,000-$450,000 $112,500-$225,000
469(I) Passive Rehab. Credit (1,7) $200,000-$250,000 $200,000-$250,000 $100,000-$125,000 $225,000-$450,000 $112,500-$225,000
530 Education IRA Deductn (1,6) $150,000-$160,000 $95,000-$110,000 No deduction $225,000-$450,000 $112,500-$225,000
 

Footnotes: (1) Modifications to AGI apply; (2) Inflation indexed; (3) Earned income limitations; (4) Low income only; (5) Phase-out range depends on number of children; (6) Newly enacted in 1997; (7) Also see section 221(b)(2); (8) Phase-out applies to alternative minimum taxable income rather than AGI; (9) Increases for future years are specifically provided in the statute.

EXHIBIT B - Current Method of Phase-Out

Code Section(s)
Tax Provision

Current Methodology for Phase-outs' Application
21 Dependent Care
Credit
Credit percent reduced from 30 percent to 20 percent in AGI range noted by 1 percent credit for each $2,000 in income
22 Elderly Credit Credit amount reduced by half of excess over AGI range
23 & 137 Adoption Credit
&Exclusion
Benefit reduced by excess of modified AGI over lowest amount noted divided by 40,000
24 Child Credit Credit reduced by $50 for each $1,000 in modified AGI over lowest amount noted divided by 40,000
25A Education Credits
(Hope/Lifetime Lrng)
Credits reduced by excess of modified AGI over lowest amount divided by 10,000 (single) and 20,000 (joint)
32 Earned Income Credit Credit determined by earned income and AGI levels
55 AMT Exemption Exemption reduced by 1/4 of AGI in excess of lowest amount noted
68 Itemized Deductions Itemized deductions reduced by 3 percent of excess AGI over amount noted
135 Series EE Bonds Excess of modified AGI over lowest amount divided by 15,000 (single), 30,000 (joint) reduces excludable amount
151 Personal Exemption AGI in excess of lowest amount, divided by 2,500, rounded to nearest whole number, multiplied by 2, equals the percentage reduction in the exemption amounts
219 Traditional IRA w/
Retirement Plan
Individual retirement account (IRA) limitation ($2,000/$4,000) reduced by excess of AGI over lowest amount noted divided by $10,000
219(g)(7) IRA w/Spouse w/
Retirement Plan
Deduction for not active spouse reduced by excess of modified AGI over lowest amount noted divided by 10,000
221 Education Loan Interest
Expense Deduction
Deduction reduced by excess of modified AGI over lowest amount noted divided by 15,000
408A Roth IRA Contribution reduced by excess of modified AGI over lowest amount noted divided by 15,000 (single) and 10,000 (joint)
408A IRA Rollover-Roth IRA Rollover not permitted if AGI exceeds 100,000 or if MFS
469(i) Passive Loss Rental
$25,000 Rule
Benefit reduced by 50 percent of AGI over lowest amount noted
530 Education IRA
Deduction
Contribution reduced by excess of modified AGI over lowest amount noted divided by 15,000 (single) and 10,000 (joint)


Relief #6 — Simplify Health Insurance Premium Deduction

Present Law

Currently, self-employed individuals are only allowed to deduct from gross income the following portion of their health insurance premiums:

1997 40%
1998 - 1999 45%
2000 - 2001 50%
2002 60%
2003 - 2005 80%
2006 90%
2007 - and later 100%

This deduction is limited to the net profit from self-employment minus the deduction for one-half of self employment tax, Keogh, or SEP contribution. So, if the earned income is a loss for the current year then no deduction is allowed.

Also, the deduction is not allowed for any month that the self-employed individual or the spouse is eligible to participate in a subsidized health plan maintained by an employer.

Recommended Change

The health insurance premium deduction for self-employed individuals should be brought to 100%, or at least the deduction should be allowed if the business sustains a loss for the year.

Contribution to Simplification

Currently, "C" corporations are allowed to deduct 100% of health insurance premiums paid for their employees including their employee-owners. Equal treatment should be afforded to the self-employed. This proposal carries some tax cost, but it will serve the goal of providing health benefits to as many families as possible by creating a tax incentive for the self-employed to protect their families as well as the families of their employees.


Relief #7 — Simplification of Kiddie Tax

Present law

The 1986 Tax Reform Act introduced the so-called "Kiddie Tax" which taxes the unearned income of children under the age of 14 at the parents' bracket. While at first this seems to be straight forward approach, it has evolved into a very complicated calculation. When first proposed in 1986, there was not a preferential tax rate for capital gains. The introduction of the maximum 28% capital gain rate has further complicated the situation. Under certain limited circumstances, parents can elect to include their children's income on their return. However, the election in not available for parents of a child with any earned income, unearned income in excess of $5,000, capital gains, withholding or estimated tax payments.

Instructions for utilization of Form 8615, "A Tax for Children Under Age 14 Having Investment Income of More Than $1,200," cannot be contained on the reverse of the form. Instead, the IRS has issued Publication 929, a 22-page booklet which provides the "hidden worksheets" that allow the taxpayer, or the return preparer, to calculate the child's taxable income, as well as the tax. In situations in which there are multiple siblings falling underneath this provision, the complexity expands. Similarly, if a child is subject to the AMT, additional calculations are required. In the overwhelming majority of situations, the additional tax revenue generated by the "Kiddie Tax" appears to be insignificant when compared to the complexity of the calculations. Also, the Kiddie Tax provision only considers the regular tax of section 1 and not the alternative minimum tax (AMT) of section 55. Therefore, the way the current rules are written, if a parent must pay AMT, the children's income is still taxed at the parent's regular marginal tax rate, while the parent is taxed at the AMT rate without taking into account the child's income or the child's regular tax liability. This results in taxpayers paying more tax than if the parent and children's income are both included in the parent's AMT calculation.

Suggested Change

The linkage of a child's taxable income to parents' and other siblings' taxable income should be repealed. Income (other than capital gains) subject to Kiddie Tax should be taxed at a separate rate schedule (e.g., fiduciary income tax rates). The child's capital gains would be taxed at the capital gains rates. The election to include a child's income on the parent's return should be expanded to allow all income, regardless of its nature or amount, to be included. The election could apply whether or not the child has withholding or estimated payments. There could be a checkoff , similar to the current nominee interest checkoff, or column added to the Form 1040 Schedules B and D so as to indicate whether the item applies to another social security number, in order to avoid any matching problems.

Contribution to Simplicity

Removing the linkage to parental and sibling returns would allow children's returns to stand on their own. Issues regarding missing information on one return, matrimonial issues, and unintended AMT problems would be eliminated. The perceived loop-hole of shifting income to minors would remain closed since fiduciary income moves to higher tax brackets at lower income levels than individuals.

Allowing across-the-board inclusion of a child's income on a parent's return could eliminate many children's returns and their associated compliance burdens for taxpayers and the government.


Relief #8 — Simplification of the Individual Estimated Tax Safe Harbor

Present Law

Individuals with adjusted gross incomes of $150,000 or less may base their current year estimated taxes on 100 percent of their prior year tax. As changed by TRA '97, individuals with adjusted gross incomes in excess of $150,000 may base their current year estimated taxes on a percentage of their taxes for the prior year as follows:

Current Estimated Tax Year Percentage of Prior Tax Year
1998 100
1999 105
2000 105
2001 105
2002 112
2003 - and thereafter 110


Suggested Change

The percentage of prior year tax should be 100 percent for all years.

Contribution to Simplicity

In general, the estimated tax rules are complex. Prior to TRA '97, the provisions for basing individual estimated taxes on their prior year taxes were straight forward and simple. To change to different percentages for different years results in poor tax policy, and adds needless complexity. By basing all estimates on the same percentage, such as 100 percent of the prior year tax, the complex calculations that are made quarterly by taxpayers are reduced and simplicity is added to the Code.


Relief #9 — Simplification of Employee vs. Independent Contractor

Present Law

The rules relating to classification of a worker as an employee or independent contractor are unclear. This results in needless confusion and potentially large tax assessments for businesses who are attempting to comply with the law.

Recommended Change

A bill (S. 460) simplifying the classification of workers was introduced in the Senate on March 18, 1997 by Senator Christopher Bond (R-MO). This bill establishes a safe harbor for employers classifying workers as independent contractors when either of the following two criteria are met:

  • A worker demonstrates economic and workplace independence meeting a set of stipulated criteria, and a written agreement exists between the parties; or
  • A worker conducts business through a corporation or limited liability company, the worker does not receive benefits from the service recipient, and a written agreement exists between the parties.

A companion bill was introduced in the House of Representatives by Rep. James Talent (R-MO).

Contribution to Simplification

This is obviously a hotly-debated issue within Congress, the Internal Revenue Service and small business organizations. Until we are provided with a clear-cut definition by Congress, this area will continue to provide many uncertainties for small business owners, as well as a continuation of the many "battles" between taxpayers and the Internal Revenue Service.

Even the Treasury Department has testified that the 20-factor test, historically used by the Internal Revenue Service to classify workers, is confusing and "does not yield clear, consistent, or even satisfactory answers, and reasonable persons may differ as to the correct classification."

This issue has been chosen as the top priority by many small business organizations, including the 1995 White House Conference on Small Business, the U.S. Chamber of Commerce, etc. The economic ramifications of reclassification of a worker from an independent contractor to an employee are significant.


Relief #10 — Simplification of Half Year Requirements

Present Law

The Internal Revenue Code uses 1/2 year age requirements to allow individual taxpayers to begin to withdraw from their pension plans without penalty. (Example, distribution must be made after the taxpayer reaches age 59 1/2 to avoid penalty).

Recommended Change

Change the Internal Revenue Code by eliminating the various Code sections that use 1/2 year requirements: A) Age 70 1/2 for mandatory IRA distributions and B) Age 59 1/2 for penalty free retirement plan withdrawals. Instead, use whole years: Age 70 and Age 59.

Contribution to Simplification

Many taxpayers, employers and banks are confused when calculating this part of the requirement. It would be easier to remember, calculate and administer, and be more user-friendly if the ages were changed. AICPA

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