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.
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
# # # #
And don’t forget to add this to your bookmark
or favorites menu to help you in visiting us monthly.
To See other issues of Tax Wizard see
our archives
The
materials on this Web site are for informational purposes only and
are not intended and should not be construed as accounting advice.
This information is not intended to create, and receipt of it does
not constitute, a CPA-Client relationship. You should not act upon
this information without seeking counsel from a Certified Public Accountant
