1997 tax legislative initiatives and the AICPA.

1997 was a fascinating year in the context of tax policy and legislation. The Taxpayer Relief Act of 1997 (TRA '97) has (properly) been criticized as a law that increased the complexity of our tax system; however, it also brought significant tax relief to certain targeted groups of taxpayers. The IRS Restructuring Bill, passed by the House of Representatives as of presstime and having an excellent chance of passage in the Senate (most likely with some alterations), will cause significant changes in the way the Service interacts with taxpayers and tax professionals.

The AICPA was involved with both these bills (and will continue to be involved with the Restructuring Bill until its final passage), submitting written and oral testimony to both houses of Congress and supporting particular provisions of both bills with visits to Capitol Hill members and staff. This effort was hardly restricted to the Tax Division: The AICPA Key Persons Group (i.e., members that have particular personal or professional relationships with members of Congress) was extremely helpful; also, for the first time, the Institute's Spring Council Meeting was held in Washington, D.C., specifically so that Council members could also visit Capitol Hill and interact with their elected representatives on issues of importance (both tax and nontax) to the AICPA.

As might be anticipated, the results of these activities have been mixed; on the whole, the AICPA is pleased that many of its recommendations have been accepted. This column will focus on selected provisions of the TRA '97 which were of more than general interest to our members, regardless of whether they had the greatest political significance. (Assuming early passage in 1998 of the IRS restructuring legislation, it may be worthwhile to revisit that law in a future column.)

* After many years, corporate employees and self-employeds now have parity in the full deductibility of health insurance. While the Small Business Job Protection Act of 1996 had increased deductible limits for self-employeds' health insurance (from 30% to 80%), the TRA '97 finally phases in full deductibility of such costs. While equity should call for immediate full deductibility, revenue requirements led to a phase-in period of 10 years, with full deductibility in 2007.

* Also after an effort of several years, the home office deduction has been significantly liberalized, by legislatively revising the Supreme Court's Soliman decision. Effective in 1999, a home office deduction will be allowed when that office is used to conduct the administrative or management aspects of a business and there is no other fixed location from which the taxpayer conducts such activities. (Note: for employees, the "convenience of the employer" requirement must still be met.)

* The AICPA has been a strong supporter of an increase in the de facto estate tax exemption, which is now scheduled to rise gradually until it hits $1 million in 2006. In fact, we have noted that this provision does not give taxpayers any major new relief. The $600,000 exemption equivalent has been in existence since 1987, and has never been indexed; indexing for inflation would have put the exemption equivalent above $800,000 today. Under the TRA '97, that level is not reached until 2004, and the $1 million equivalent will not be indexed after 2006. Thus, the provision may be described only as "rough equity," though we are obviously pleased that it has been adopted.

* The original proposals to tighten the availability of tax-free spinoffs under Sec. 355 (the so-called anti-"Morris Trust" provisions) were, in the AICPA's view, much too broad, and the Institute urged that the final legislation include a number of restrictions on the proposals, so that these new rules would be used only for antiabuse purposes and not to foreclose valid business tax planning. The TRA '97 adopted these views, in part.

* Given the extreme compression of the income tax rates applicable to trusts and estates (39.6% in 1997 for only $7,500 of taxable income), the Institute has urged for several years that the throwback rules be repealed, on the grounds they have limited practical effect but are highly complicated. The TRA '97 adopts this recommendation for domestic trusts.

* As practitioners, AICPA members have long wondered why it is necessary for taxpayers to incur the cost and effort of filing gift tax returns if the only reportable gifts are to charitable organizations. The TRA '97 has largely adopted our recommendation that such returns no longer be required.

* One of the most frustrating and disappointing legislative failures during my years with the AICPA, has been our inability to have Congress enact an alternative approach to dealing with CPAs' workload compression, by allowing pass-through entities to adopt any fiscal year. This failure has been due to an inability to solve the revenue loss problems that seem to be inherent in any such proposal. We have, however, been able to cure a technical defect in the present Sec. 444 structure (which allows the adoption of a fiscal year ending in September, October or November). A Sec. 444 election requires payment of a deposit that approximates the owners' taxes on the income deferred by adopting a noncalendar year-end; however, the law also includes a 10% penalty for late payment of that deposit, even if the payment was only one day overdue and if there was a "reasonable cause" for the lateness. The IRS had absolutely refused to waive this penalty, even when there was reasonable cause and the deposit was only two or three days late. The TRA '97 provides a "reasonable cause" exception for that penalty.

Equally important as provisions we supported in the TRA '97 are a few which we opposed and which did not find their way into the final law. For example:

* The AICPA strongly opposed the proposal to index the basis of capital assets--even though we are on record as supporting indexation in the tax law as a matter of policy (see, e.g., the earlier comments on the estate tax exemption). However, we found the indexation proposal for capital assets to be incredibly complex, and were also concerned about the possibility of economic arbitrage inherent in the proposal (the proposal would have indexed the basis of assets, but would not have indexed either debt or interest on debt used to acquire those assets). The indexing provision was dropped from the final legislation.

* An early proposal for inclusion would have required the use of average cost (rather than specific identification or FIFO) in computing gains on the sales of securities, when there was more than one lot sold. We viewed a mandated-average-cost approach as having no basis in tax policy, but only in raising money for the government. It was not included in the TRA '97.

* An issue that has arisen twice in the past four years--again, as a money-raising plan--has been to repeal, for tax purposes, lower of cost or market inventory valuation, a concept that has been in the tax law since about 1917 and which has been part of generally accepted accounting principles since there were any. Fortunately, this proposal again failed. (Like many bad ideas, however, it will probably resurface as a revenue-raising suggestion in some future tax bill.)

* Also back for a second round was a proposal to repeal Sec. 1374 for so-called "large" corporations (i.e., those with a fair market value exceeding $5 million). Such a provision would result in instant taxation of built-in gains on the conversion of a C corporation to S status. Congress felt that including such a provision would raise significant revenue on C-to-S conversions. Our view was that the provision's enactment would simply result in C corporations deciding not to convert--an artificial barrier that should not be created. The proposal failed.

The TRA '97 took some major steps backward with respect to simplification of our tax system. (To review a CPA's (or a tax software developer's) nightmare, see D.C. Currents, The Tax Adviser, November 1997, on the multiplicity of income phase-out rules now in the Internal Revenue Code, many of which were added by the TRA '97.) Obviously, simplification will continue to be an important initiative of the AICPA as we look to future tax legislation (as will IRS restructuring). There are also, however, substantive areas of "unfinished business" on which the Institute expects to be vocal in the upcoming year:

* The individual alternative minimum tax (AMT) has been slowly heading for a crisis, and the TRA '97 will dramatically speed up its approach. Failure to index AMT brackets and exemptions before 1997 has led to projections that, by 2006, the number of individual AMT taxpayers would rise from today's 600,000 to 2.6 million. With the TRA '97 providing new dependent child and education credits--to be taken only against regular tax, not AMT--a top economist at Treasury has estimated that over 11 million taxpayers (8% of all projected individual taxpayers) may owe AMT by 2007. If 11 million families actually have to pay AMT, the number of taxpayers who will have to prepare Form 6251, Alternative Minimum Tax--Individuals, to find out whether they will be in an AMT position, will be staggering. We have seen scenarios in which two-earner couples, with AGI of $60,000-$65,000 and a few children eligible for dependent child or education credits, will actually be AMT taxpayers. We have pointed out to Congress that many of these families have never heard of an AMT and certainly would not believe that it should apply to them (as middle-class Americans); the IRS is going to have an impossible time educating them as to their new responsibilities and enforcing a law under which many otherwise compliant taxpayers will not even try to prepare the form that would indicate they owe more tax.

* We have been working with congressional staff and members for the past several years, to try and get a legislative safe harbor built into the tax determination of independent contractors. While one approach to such a safe harbor (not favored by the AICPA, because we believe there is a better one) was in an early version of the 1997 legislation, it did not survive. We intend to continue making an independent contractor safe harbor a legislative priority of the AICPA.

Editor's note. This department is written by the AICPA Tax Division's professional staff. It is designed to heighten awareness of the Division's work and keep readers apprised of Tax Division activities involving tax policy, technical issues and other practice support matters.

Mr. Padwe's views, as expressed in this column, do not necessarily reflect the views oF the AICPA. Official positions are determined through certain specific committee procedures, due process and deliberation.