1996 tax legislation offers planning opportunities.

Although no major (e.g., budget reconciliation) tax bill was enacted in 1996, many provisions affecting individuals were included in the seven pieces of tax legislation that were passed. Although not headlinegrabbing, these tax law changes present a host of new information with which practitioners should be familiar to properly advise clients in 1997 and beyond. This article summarizes these provisions and highlights the available planning opportunities.(1)

Spousal IRAs

Effective for tax years beginning after 1996, SBJPA Section 1427(a) amends Sec. 219(c) to allow a one-earner couple to contribute to an individual retirement account (IRA) and deduct up to $4,000 a year ($2,000 per spouse), as long as the spouses, combined compensation at least equals their total contributions. The additional $1,750 ($2,000 - $250) of available deduction for the nonworking spouse can save up to $693 of Federal taxes for a couple in the 39.6% tax bracket. Although not a dramatic development, clients should be alerted to this opportunity; over time, the value of the deduction and additional tax-deferred retirement build-up can be significant.

Adoption Credit

SBJPA Section 1807(a) enacted Sec. 23 to provide a nonrefundable $5,000 adoption expense credit per child for qualified adoption expenses (QAEs) paid or incurred by the taxpayer. The credit increases to $6,000 for "special needs" adoptions (e.g., ethnic background, age, membership in a minority or sibling group, or physical, emotional or mental handicaps) of children who are US. citizens or residents. Any unused credit can be carried forward for up to five years. For credit purposes, QAEs are taken into account in the year after the year first paid or incurred and in the year the adoption becomes final.

Example 1: Y pays $2,000 in QAEs in 1997, $1,000 in 1998 and $3,000 in 1999 (when the adoption becomes final) to adopt a U.S. nonspecial-needs child. Y can take a credit of $2,000 in 1998 and $3,000 in 1999.

QAEs are defined by Sec. 23(d)(1)(A) to include reasonable and necessary adoption fees, court costs, attorneys, fees, travel expenses, certain expenses for a birth mother's prenatal care and other expenses directly related to the legal adoption of an eligible child. Home construction and renovation costs are also eligible if a state agency requires them as a condition of adoption.

No credit is allowed for (1) an adoption of a child of the taxpayer's spouse, (2) a surrogate parenting arrangement, (3) adoption expenses paid or reimbursed by the individual's employer (whether or not reimbursed under an adoption assistance program) or (4) expenses for which a grant is received under any Federal, state or local program.

In addition, under SBJPA Section 1807(b), amending Sec. 137, an employee may exclude from income up to $5,000 per child for specified adoption expenses paid by the employer. The exclusion increases to $6,000 for domestic special-needs adoptions.

There are phase-outs of the credit md exclusion at specified income limits; each phases out ratably for taxpayers with modified adjusted gross incomes (MAGIs) (as defined in Secs. 23(b)(2)(B) and 137(b)(3)) above $75,000, with full phase-out at $115,000 of MAGI. The credit or amount excludible is reduced (but not below zero) by an amount that bears the same ratio to the credit or excludible amount (determined without the phase-out but with regard to the dollar limits) as the excess (if any) of the taxpayer's MAGI over $75,000 bears to $40,000.

Example 2: X, who is single, adopts a U.S. nonspecial-needs child in 1997, incurring $5,000 in QAEs; the adoption becomes final that year. X's 1997 MAGI is $110,000; X's adoption credit for 1997 is limited to $625, determined as follows:

Allowable Credit = QAE - (QAE MAGI - $75,000/$40,000)

= $5,000 - ($5,000 ($110,000 - $75,000)/40,000)

= $5,000 - ($5,000 ($35,000/$40,000)

= $5,000 - ($5,000 (0.875))

= $5,000 - $4,375

= $625

The taxpayer is required to provide (if known) the child's name, age and taxpayer identification number (TIN); the IRS may require other information instead, such as identification of the agent assisting with the adoption. Taxpayers should maintain records to support any adoption credit or exclusion claimed. Notice 97-9(2) provides additional information on both the credit and the exclusion.

These provisions are effective for tax years beginning after 1996; an expense paid (by a cash-basis taxpayer) or incurred (by an accrual-basis taxpayer) in a tax year beginning before 1997 is not a QAE eligible for credit or exclusion. The credit will be available for QAEs paid or incurred after 2001 only if the adoptee is a special-needs child, the exclusion win not be available at all for amounts paid or expenses incurred after that year.

Medical Expense Provisions

MSAs

HIPAA Section 301 created medical savings accounts (MSAs) in Sec. 220, tax-favored savings (i.e., IRA-type) accounts established to fund employee health benefits and medical care expenses in conjunction with high-deductible health insurance policies. The rules are somewhat complicated and the applicability limited, but the benefits could be worthwhile for certain small-business employees and self-employed (SE) individuals.

An MSA is available only to small employers (those who employed an average of 50 employees or less in either of the two preceding years), and SE individuals with a high-deductible health plan. Employees are eligible for MSA coverage only through employer-sponsored high-deductible health plans; no other health insurance may be provided by the employer. A high-deductible health plan is defined by Sec. 220(c)(2) as one with a $1,500-$2,250 deductible for individual coverage ($3,000-$4,500) deductible for family coverage).

Contributions and distributions: Generally, the maximum annual deductible contribution that an individual may make to an MSA is 65% of the annual deductible (for individual coverage) or 75% of the annual deductible (for family coverage); the actual calculation under Sec. 220(b) is done on a monthly basis. The deduction is above the line, but cannot exceed the employee's compensation from the employer maintaining the MSA, or, for SE taxpayers, the individuals earned income from the business maintaining the MSA.

Normally under Sec. 106(a), contributions by small employers to MSAS are not includible in an employee's income. According to Sec. 220(d)(4)(B), for a given year, employees may make tax-deductible contributions to an MSA until April 15 of the following year, if certain requirements are met. Distributions used for medical expenses of an account holder (as defined in Sec. 220(d)(3)) are tax-free under Sec. 220(f)(1); otherwise, they are includible in income and subject to an additional 15% penalty under Sec. 220(f)(2) and (4). However, the penalty is waived under Sec. 220(f)(4)(B) and (C) if the distribution is taken after age 65 or if the taxpayer dies or becomes disabled.

Treatment of account at death: The fair market value (FMV) of the MSA balance at death is includible in the decedent's gross estate under Sec. 220(f)(8)(A). If the account holder's surviving spouse is the MSA's named beneficiary, the MSA becomes the surviving spouse's and the marital deduction is available; the surviving spouse is thus not required to include the MSA balance in income as a result of the death. The surviving spouse can exclude from income amounts withdrawn from the MSA for expenses incurred by the decedent prior to death (if they otherwise are qualified medical expenses).

If, on death, the MSA passes to a named beneficiary other than the surviving spouse, Sec. 220(f)(8)(B)(i) provides that the MSA ceases and the beneficiary is required to include its FMV in income for the tax year that includes the date of death. The amount includible is reduced by the qualified medical expenses incurred by the decedent before death and paid within one year after death. If there is no named beneficiary for the MSA, the account ceases as of the date of death and the FMV is includible in the decedent's final return, under Sec. 220(f)(8)(B)(i).

Participation: The MSA provisions are effective for tax years beginning after 1996, but after 2000, Sec. 220(i)(2) provides that no new MSAs may be created. Health insurers should be contacted before Sept. 1, 1997 to sign up for the program, as Sec. 220(i)(3)(C)(iv)(I) provides that as the first cutoff date for MSA eligibility for 1997.

Notice 96-53(3) provided guidance on MSAs, clarifying that eligible persons can participate without awaiting IRS permission or authorization. An MSA is established with a qualified trustee or custodian, in much the same way as an IRA. It is the eligible individual's responsibility, not the MSA trustee's, to determine whether distributions are used for medical expenses; thus, individuals must be able to substantiate their MSA information. Medical expenses eligible for tax-free distributions are defined under Sec. 213, but do not include expenses for insurance other than long-term care insurance, premiums for Consolidated Omnibus Budget Reconciliation Act of 1985-type health care continuation coverage, or premiums for health care coverage while an individual receives unemployment compensation.

Long-Term Care Insurance Exclusion

Under HIPAA Section 321, which added Sec. 7702B, the tax treatment of long-term care insurance is made comparable to that of accident and health plans. Long-term care insurance proceeds received on account of personal injuries or sickness are generally excludible, subject to a cap of $175 per day ($63,875 annually) on per diem contracts only. Additionally, employer contributions to a long-term care insurance plan are excludible from the employee's gross income; benefits paid by an indemnity-type long-term care insurance policy are also excludible.

If the aggregate payments under all qualified long-term care contracts exceed the dollar cap for the period, any excess payments received are excludible only to the extent the individual has incurred actual costs for qualified long-term care services. The dollar cap and annual limit are indexed for inflation for calendar years after 1997, using the medical care component of the consumer price index.

Generally, Sec. 7702B(c)(1) defines "qualified long-term care services" to include necessary diagnostic, preventive, therapeutic, curing, treating, mitigating and rehabilitative services, and maintenance or personal care services required by a chronically ill individual (defined in Sec. 7702B(c)(2)) and provided under a plan of care prescribed by a licensed health care practitioner. Under HIPAA Section 321(c), which amended Sec. 125(f), employer-provided coverage under a long-term care contract is not excludible by an employee if provided through a cafeteria plan, further, expenses for long-term care services cannot be reimbursed under a flexible spending account.

These provisions (as well as the medical deduction provision discussed below) are generally effective for contracts issued for years beginning) after 1996. HIPAA Section 321(f)(3) provides that a long-term care insurance contract can be exchanged tax-free after Aug. 21, 1996 and before 1998 for a qualified long-term care insurance contract (as defined in Sec. 7702B(b)), but any boot must be recognized.

Long-Term Care Expense Deduction

Under Sec. 213(d), as amended by HIPAA Section 322, certain long-term care insurance premiums and unreimbursed expenses paid for qualified long-term care services (e.g., nursing home services) are deductible medical expenses (subject to the 7.5%-of-AGI floor). Sec. 213(d)(11) provides that the deduction is not available to persons nursed by a spouse or other relative who is not a licensed health care professional. (The qualified long-term care services are the same as previously discussed for insurance exclusion purposes.) Sec. 213(d)(10)(A) caps the deduction as follows:

          Age           Annual deduction limit

40 and under                 $  200
Over 40, but under 50           375
Over 50, but under 60           750
Over 60, but under 70         2,000
Over 70                       2,500

As with the medical expense deduction in general, because of the 7.5% floor, greater tax savings win generally be achieved if long-term care expenses are aggregated into one year instead of being spread over two years.

Accelerated Death Benefits

Under HIPAA Sections 331(a) and 332(a), which amended Secs. 101(g) and 818(g), accelerated death benefits from life insurance policies are excludible from income if paid on account of a terminally or chronically ill individual; such individuals can cash in their life insurance policies before death without having to include in income the excess of the cash value of the policy over the premiums paid. The new rules also apply to the sale or assignment of a terminally or chronically ill person;s life insurance policy to a qualified viatical settlement company; typically, such companies buy the policies of those with life-threatening illnesses for a percentage of their face value.

A "terminally ill individual" is defined by Sec. 101(g)(4)(A) as one certified by a physician as having an illness or physical condition that reasonably can be expected to result in death within 24 months of the date of certification. (For this purpose, "physician" is defined in Social Security Act Section 1861(r)(1).(4)) The definition of "chronically ill individual" in Sec. 7702B(c)(2) is the same as is used when excluding long-term health care insurance proceeds, and generally is based on an individual's inability to perform routine day-to-day physical acts. For chronically ill individuals, the amount excludible is limited by Sec. 101(g)(3) to $175 per day ($63,875 per year), less reimbursements received for qualified long-term care services; in addition, the payment must be for costs incurred by the payee for qualified long-term care services provided for the insured.

A viatical settlement provider must meet certain requirements under Sec. 101(g)(2)(B), but is generally a person or entity regularly engaged in the trade or business of purchasing or taking assignments of life insurance contracts on the lives of terminally or chronically ill insureds.

The new provisions should make viatical settlements a more viable financial and estate planning tool, as there are no restrictions on the use of funds received therefrom. Thus, the receipt of funds from life insurance policies before death can help people face a variety of financial challenges, from payment of medical expenses to financing the cost of travel to visit family or friends; gifts from such funds will not be subject to the Sec. 2035 three-year lookback rule. However, practitioners and taxpayers should recognize that the receipt of viatical settlement proceeds could adversely affect a recipient's eligibility for certain means-based entitlement programs (e.g., Medicaid or other government benefits).

The exclusions are effective for amounts received after 1996. The issuance or modification of a qualified accelerated death benefit rider to an existing life insurance policy is not treated as a modification or material change to the policy (and is not intended to affect the issue date of any contract under Sec. 101(f)). This is a potentially important planning opportunity for taxpayers who would otherwise be financially devastated by illness.

Penalty-Free IRA Withdrawals

Under HIPAA Section 361, the 10% IRA early-withdrawal penalty under Sec. 72(t)(3)(A) is waived for withdrawals used for medical expenses to the extent the withdrawal exceeds 7.5% of AGI. This rule is now consistent with the existing rules for withdrawals for medical expenses from qualified plans. As under prior law, the amount withdrawn is subject to regular income tax (except to the extent any IRA contribution was nondeductible), but is somewhat offset if the taxpayer has sufficient medical expenses to be deductible.

The penalty is also waived under Sec. 72(t)(2)(D) for IRA withdrawals for medical expenses to the extent not exceeding medical insurance premiums paid during the tax year if the recipient (including an SE individual who would have received such funds if not self-employed) received at least 12 weeks of unemployment compensation in the current or preceding year.

These provisions are effective for tax years beginning after 1996. Taxpayers now have another option for funding medical expenses -- and another reason to contribute the maximum amount to an IRA, even if nondeductible.

SE Health Insurance Deduction

The Sec. 162(l)(2) above-the-line deduction for health insurance premiums for SE taxpayers is gradually raised under HIPAA Section 311(a) as follows:

        Year          Portion of premium deductible

1997                              40%
1998-2002                         45%
2003                              50%
2004                              60%
2005                              70%
2006 and thereafter               80%

The deduction is expanded under Sec. 162(l)(1)(C) to include long-term care insurance premiums paid after 1996. While this is a long-awaited benefit for SE taxpayers, they still do not enjoy the full tax-favored treatment that corporations receive for health insurance premiums, unreimbursed medical expenses and other fringe benefits.

Personal Injury Damages

Sec. 104(a)(2) and (c) have been narrowed under SBJPA Section 1605 to exclude from income only amounts received on account of a physical injury or illness after Aug. 20, 1996; punitive damages and compensatory awards relating to nonphysical injuries (e.g., race, sex or disability discrimination) are not excludible. Compensation for emotional distress is not excludible unless traceable to a physical injury or illness.

Compensatory damages received by family members in a wrongful death action are also excludible. Because of the requirement that emotional distress be connected to a physical injury or illness, good recordkeeping of expenses incurred and the reasons therefor may make the difference between taxability and excludibility of any later recovery.

Example 3: Z received in 1997 compensatory damages for loss of consortium due to the physical injury of his spouse, C. The damages are excludible from income.

Punitive damages are now includible, regardless of whether the action stems from physical injury or sickness, with a limited exception under Sec. 104(a)(2) for certain wrongful death actions (depending on applicable state law language as of Sept. 13, 1995).

Employment Discrimination

In Rev. Rul. 96-65,(5) the IRS explained the tax treatment of amounts received in satisfaction of a claim for denial of a promotion due to disparate treatment employment discrimination under Title VII of the Civil Rights Act of 1964. The IRS position takes into account the Supreme Court's decision in Schleier(6) and SBJPA Section 1605's amendment to Sec. 104(a)(2). (Rev. Rul. 93-88,(7) which the IRS issued following the Supreme Court's decision in Burke,(8) is now obsolete.)

Post-SBJPA Sec. 104(a)(2) provides that back pay received in satisfaction of a claim for denial of a promotion due to disparate treatment employment discrimination is not excludible from gross income because it is completely independent of (and thus, is not damages received on account of) personal physical injuries or physical sickness. Similarly, amounts received for emotional distress in satisfaction of such claims are not excludible from gross income under Sec. 104(a)(2), except to the extent they are damages paid for medical care attributable to emotional distress. Back pay includible in gross income is "wages" for FICA, FUTA and Federal income tax withholding purposes.

Under pre-SBJPA Sec. 104(a)(2), an amount received for a discrimination claim was not excludible because it was completely independent of (and thus, not damages received on account of) personal injuries or sickness. However, damages received for emotional distress in satisfaction of such claims were excludible because they were received on account of personal injuries or sickness.

Under SBJPA Section 1605(d)(1), Sec. 104(a)(2) is effective for amounts received after Aug. 20, 1996; SBJPA Section 1605(d)(2) excepts binding written agreements, court decrees or mediation awards in effect on Sept. 13, 1995.

Contributions of Appreciated Stock

to Private Foundations

SBJPA Section 1206(a) has reinstituted a window from July 1, 1996 to May 31, 1997, during which taxpayers may claim, under Sec. 170(e)(5), a charitable deduction for the FMV of appreciated securities contributed to private nonoperating foundations. (Contributions of appreciated securities to public charities or certain private operating foundations continue to be deductible at FMV.) A similar provision expired Dec. 31, 1994; any such contributions made during 1995 or the first six months of 1996 were limited to the donor's basis. Because of the odd expiration date of the window period (May 31, 1997) and the uncertainty as to whether it will be further extended, it is critical for practitioners to alert clients of this rather brief opportunity, perhaps when preparing their 1996 returns; care should be taken not to overlook clients whose 1996 returns may be filed on extension after May 31, 1997.

Contributions during the window period generate a charitable deduction (subject to the normal AGI limits on contributions of capital gain property) for the full FMV of the securities, without a need to recognize income for the excess of the stock's FMV over basis. The IRS has ruled that shares of open-end mutual funds meet the definition of qualified appreciated stock for contribution purposes, but publicly traded stock subject to "Rule 144" restrictions does not.(9)

Employer-Provided Educational Assistance Exclusion

Under SBJPA Section 1202(a), the Sec. 127 $5,250 exclusion for employer-provided educational assistance is retroactively extended for tax years beginning after 1994 to tax years beginning before June 1, 1997; it expires for courses beginning after May 31, 1997. However, the exclusion for graduate-level education applies only to courses beginning before July 1, 1996. Information Release 96-36(10) provided expedited procedures for refunding any tax (including income, FICA and FUTA tax) overpayments and withholdings caused by retroactive reinstatement of the exclusion. (Query whether it is fair that organizations that did not comply with the law for 1995 have no compliance burden now, but those that did comply will now incur additional compliance costs.)

Practitioners should be aware of the refund opportunities for employees and employers who previously paid or withheld taxes on employer-provided educational assistance. Retirement programs and IRAs can treat the 1995 income of an employee receiving a refund as having included the educational assistance eligible for exclusion under Sec. 127. Taxpayers who received educational assistance that was included in income for 1995 and made nondeductible IRA or other retirement plan contributions because they exceeded the income limits may now disregard such assistance and recompute their contribution deductions. For lower-income individuals, if the exclusion for 1995 decreases income to $26,673 or less, the employee may be eligible for the earned income tax credit (EITC) on the amended return.

Employers can adjust their Federal deposits and quickly claim a credit or refund from the IRS for both the employer and employee portions of FICA by filing Form 941, Employer's Quarterly Federal Tax Return, or Form 843, Claim for Refund and Request for Abatement. The use of Form 843 is preferred, because it allows interest to be claimed on the refund sought.

State Taxation of Nonresidents

The State Taxation of Pension Income Act of 1995 prohibits states from taxing the retirement income of former residents, effective for amounts received after 1995.

Approximately 40 states had laws authorizing a "source tax" that taxed the pension income of former residents who spent their working years in the state and then retired out of state. About a dozen of those states actively enforced such laws, arguing that the retirees' pensions were simply deferred wages that were earned in the state. Now, taxpayers are no longer subject to tax in their former states on retirement income.

In particular, states may not tax nonresidents on income from traditional tax-favored retirement plans (including qualified plans, IRAs, simplified employee pensions, annuity plans or contracts, eligible deferred compensation/Sec. 457 plans, and governmental plans). Such income is exempt from the former state's income tax, whether the income is received as a lump sum or as an annuity.

Additionally, states may not tax nonresidents on income from deferred nonqualified compensation plans if (1) the plan has at least a 10-year payout or a payout based on the participant's life expectancy or (2) distributions are paid in substantially equal annual installments after termination of employment under a qualifying excess plan (i.e., an excess or "mirror" plan maintained solely to provide retirement benefits in excess of the Code's limits on contributions or benefits). However, lump-sum distributions from nonqualified plans continue to be subject to source tax.

The law is ambiguous in several areas; thus, practitioners need to be particularly attentive to clients with nonqualified plans, such plans should be evaluated for eligibility under the new law and amended (if necessary). Many participants in nonqualified plans may prefer a payout faster than 10 years versus protection from their state of former residence. Plans that give employees the option of keeping the plan whole or dividing it into separate plans may trigger constructive receipt problems, as there is not supposed to be a choice of payout options.

Taxpayer Rights

The Taxpayer Bill of Rights 2 (TBR2) requires the IRS, on written request, to inform either spouse of attempts to collect a tax liability from the other spouse, the nature of the attempts and how much has been collected, effective for taxpayer requests for disclosures made after July 30, 1996. This is an important development for separated and divorced taxpayers, as they now have access to important collection information relating to a joint return. The TBR2 also repealed the "full payment" requirement as a prerequisite of married couples changing filing status from separate to joint, effective for tax years beginning after July 30, 1996.

In addition, the IRS is required to notify taxpayers 30 days before altering, modifying or terminating an installment agreement (except for jeopardy), and must give specific reasons for its actions. The Service has been granted authority to abate interest for any "unreasonable" error or delay caused by IRS employees performing managerial or ministerial acts (e.g., loss of records, personnel transfers, extended personnel training); this could help expedite many delayed audits.

For practitioners with last-minute tax returns, the IRS has the authority to expand the Sec. 750(a) "timely mailing as timely filing" rule to include certain private delivery services (PDSs), but a PDS must apply and be specifically designated by the IRS before it will qualify under Sec. 7502(a).(11) Thus, individuals will be able to use, e.g., Federal Express, United Postal Service and other overnight delivery services to send returns to the IRS and rely on the receipt as proof of timely filing. (As yet, however, no PDSs have been designated.)

The IRS has released proposed regulations(12) on various Code provisions affected by the TBR2, as well as on various areas affected by the PRWORA (discussed below under "Modified EITC").

Worker Classification Issues

Under SBJPA Section 1122, prior to my audit starting after 1996 that relates to employment status, the IRS is required to inform the employer in writing of the provisions of Revenue Act of 1978 Section 530; further, the "industry practice" safe harbor for independent contractor treatment is modified to apply when at least 25% of an industry has been so treated over a 10-year period.

The burden of proof shifts to the IRS to show that a worker is an employee after the employer makes a prima facie case that it was reasonable to treat the worker as an independent contractor. However, in seeking to shift the burden, the taxpayer had to have fully complied with "reasonable requests" from the IRS for information on the issue. The new law does not address the treatment of retirement plan benefit accruals for misclassified workers. The effective date generally is for periods after 1996; the burden of proof provision is effective for disputes arising after 1996.

Social Security Earnings Limit Increase

Practitioners will be able to deliver good news to their older clients who want to keep working. The Contract With America Advancement Act of 1996, Section 102(a), increased the Social Security earnings limit for those age 65-69 (up from $11,520) to $12,500 in 1996, $13,500 in 1997, $14,500 inn 1998, $15,500 in 1999, $17,000 in 2000, $25,000 in 2001, and $30,000 in 2002; thus, individuals can earn more money before their benefits will be reduced. As under prior law, $1 in benefits is lost for every $3 of earnings over the annual limit. The new increases do not affect persons under age 65; for these individuals, $1 of benefits continues to be lost for every $2 of excess earnings (determined annually).

Tax Relief for Soldiers in Bosnia

Under P.L. 104-117, enacted on Mar. 20, 1996, special tax benefits were extended to military personnel (and certain civilians) serving in Bosnia and Herzegovina, Croatia and Macedonia (as well as some of the support areas, including Italy and Hungary). The tax benefits include: extension of certain filing deadlines; exclusion of compensation (combat pay) earned by enlisted personnel and warrant officers (special rules apply to commissioned officers); exemption from Federal income tax and withholding for all income earned in any year in which an individual died as a result of service in the designated area, additional time to use the surviving spouse tax rates if a spouse died while in missing status; an extended period for joint return filing if a spouse is in missing status, partial estate tax relief for estates of individuals who die as a result of service in the designated area; and an exemption from telephone excise taxes for telephone calls originating in the area.

The IRS issued additional guidance in IR-96-21(13) and Notice 96-34,(14) providing that neither interest nor penalties would be charged during this period on any tax due for 1995 from these military personnel, and suspending return examinations and collection actions for pre-1995 years during this period without interest or penalties.

Modified EITC

The PRWORA made several changes to the EITC to improve tax compliance, under Sec. 32(c)(1)(F) and (l), as amended by PRWORA Section 451, EITC benefits are denied to individuals who do not have valid TINs (e.g., illegal aliens); under Sec. 6213(g)(2)(H), the IRS can expedite procedures for correcting claims for the EITC when a TIN is incorrect or missing, capital gain net income and net passive income that is not SE income are added to the definition of "disqualified income" under Sec. 32(i), as amended by PRWORA Section 909; the maximum amount of "disqualified income" (that causes the EITC to be unavailable) is reduced from $2,350 to $2,200 (adjusted for inflation after 1996); the phase-out of EITC benefits is now based on MAGI (rather than AGI) (defined by Sec. 32(c)(5), as amended by PRWORA Section 910(a), to disregard net capital losses, net losses from trusts and estates, net losses from nonbusiness rents and royalties and 50% of net losses from businesses), under Sec. 32(i)(2), tax-exempt interest and nontaxable distributions from annuities and IRAs are now included in the computation of AGI.

These provisions are generally effective for tax years beginning after 1995 and tax years beginning after 1996 for individuals who, as of June 26, 1996, had elected to receive the advanced EITC.

Current Outlook

The 105th Congress and a reelected President Clinton are certain to enact several more tax changes in the next few years. In 1997, the bipartisan-supported family/child tax credit is likely to finally be enacted. Expanded IRA provisions are also likely (with increased phase-out thresholds and penalty-free withdrawals for education, first-time home purchases, unemployment, etc.). Both parties favor targeted tax incentives (e.g., a deduction or credit for higher education expenses (possibly, a $5,000 annual deduction and credit). Capital gains relief may include the exclusion of up to $500,000 on residence sale gains. Expiring tax provisions will also be revisited, as several provisions (including employer-provided educational assistance) are scheduled to expire at the end of May 1997. There may be some modernization of the home office deduction (a proposal supported by the AICPA) and an increased SE health insurance deduction. Additionally, the Democrats are likely to consider expanding the child and dependent care credit.

Conclusion

Many tax changes affecting individuals were enacted in 1996 and will affect them for years to come. Most of the provisions are effective for 1997; thus, practitioners need to be aware of the changes and assist taxpayers in planning for and implementing them. Although sometimes subtle, there are many opportunities to save clients taxes while making their lives more enjoyable.

EXECUTIVE SUMMARY

* An adoption credit/exclusion is now available of up to $5,000 ($6,000 in the case of U.S. special-needs children), with phase-outs based on income.

* Viatical settlements to terminally ill individuals are now tax-free; the exclusion is limited for the chronically ill.

* If an employer makes a prima facie case that it was reasonable to treat a worker as an independent contractor, the burden of proof now shifts to the IRS to show the worker is an employee.

Editor's note: Mr. Bukofsky chairs the AICPA Tax Division Individual Taxation Committee. Ms. Sherr is the Committees Technical Manager. Ms. Sherr's views, as expressed in this article, do not necessarily reflect the views of the AICPA. Official positions are determined through certain specific committee procedures, due process and deliberation.

(1) The expatriation provisions of the Small Business Job Protection Act of 1996 (SBJPA) and the Health Insurance Portability and Accountability Act (HIPAA) are beyond the scope of this article; see Lifson and Guadiana, "Recent Legislation Imposes New Compliance and Tax Burdens on Individuals With Foreign Connections." 27 The Tax Adviser 676 (Nov. 1996).

(2) Notice 9709, IRB 1997-2, 35.

(3) Notice 96-53, IRB 1996-51, 5.

(4) 42 USC Section 1395x(r)(1).

(5) Rev. Rul. 96-65, IRB 1996-53, 5, obsoleting Rev. Ruls. 72-341, 1972-2 CB 32, 84-92, 1984-1 CB 204, and 93-88, 1993-2 CB 61, superseding Notice 95-45, 1995-2 CB 330, and modifying Rev. Proc. 96-3, IRB 1996-1, 82.

(6) Erich E. Schleier, 115 Sup. Ct. 2159 (1995)(75 AFTR2d 95-2675, 95-1 USTC [paragraph] 50,309).

(7) Rev. Rul. 93-88, note 5.

(8) Therese A. Burke, 504 US 229 (1992)(69 AFTR2d 92-1293, 92-1 USTC [paragraph] 50,254).

(9) IRS Letter Ruling 9511041 (12/21/94).

(10) IR-96-36 (8/26/96).

(11) See News Notes, "Designated Delivery Services," 27 The Tax Adviser 720 (Dec. 1996).

(12) REG-248770-96 (12/31/96).

(13) IR-96-21 (4/12-96).

(14) Notice 96-34, IRB 1996-24, 15.