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Bursting the bubble: tax planning in the '90s.

The Tax Reform Act of 1986 made a major change in the vertical equity of the tax system by replacing the progressive range of tax rates imposed on individuals with two rates, 15 and 28%. The act also contained a controversial provision which phased out the 1590 bracket and the benefit of the personal and dependency exemptions for certain high income" taxpayers. The phase-out was accomplished under Code Sections 1(g)(1)and(2) by imposing a 5% rate adjustment to the 28% bracket on a range of taxable incomes. Once the benefits of the taxpayer's 15% rate and exemptions were eliminated, the marginal rate imposed on the taxpayer fell to 28%. Although the effect of the rate adjustment was to levy a flat 28% rate on taxable income, the device came to be known as the "bubble" that caused the tax system to be regressive - higher income taxpayers were subject to marginal tax rates that were lower than those imposed on lower income taxpayers. The Revenue Reconcillation Act of 1990 has been touted as eliminating the bubble and making the tax rate schedule more equitable. The purpose of this article is to analyze whether or not the bill has accomplished this objective and to discuss tax saving moves that should be considered in 1991 to deal with the bubble's elimination.

The Bubble

For the 1990 tax year, single taxpayers are subject to a 5% surtax on taxable incomes over $47,050 but not over $97,620. This increase in the marginal rate from 28 to 33% eliminates the benefit of the taxpayer's 15% bracket. To phase out the benefit of the personal and dependency exemptions, the tax bracket on which the surtax is imposed is extended by an additional $11,480 for each exemption. As a result, the 33,70 bracket extends, at a minimum, to $109,100 of a single individual's taxable income.(1) Once a single taxpayer has taxable income over $109,100, all of his taxable income is, in effect, taxed at a flat 28% and his marginal tax rate falls to 28%.

Married couples who file jointly in 1990 are subject to the same 5% rate adjustment. The tax schedule applies the 33% rate to taxable income over $78,400 but not over $162,700 to phase out the benefit of the 15% marginal rate. The 33% bracket is actually extended to $185,730 to phase out the benefit of the couple's two personal exemptions. The bracket would be extended by an additional $11,480 for each dependency exemption that the couple claimed.(2)

Revenue Reconcitiation Act of 1990

The 1990 act eliminates the 5% rate adjustment and imposes in its place a 31% rate on all taxable income in excess of $49,300 for single taxpayers, $82,150 for married taxpayers filing jointly, $70,450 for taxpayers filing as head of household, and $41,075 for a married taxpayer filing a separate return. The 31% marginal rate is not intended to phase out the benefits of the 15% rate or exemptions and it is permanent. The rate does not fall back to 28%. As a result, it has been claimed that vertical equity has been restored.

The Revenue Reconciliation Act has a new provision, however, which phases out the deductions for personal and dependency exemptions instead of imposing a 5% rate adjustment. The result is the same - the benefit of the deduction is lost. In effect, the individual pays a rate that is higher than the stated 31% marginal rate. The personal and dependency exemptions are phased out under Code Section 151 (d)(3) by reducing the deductions by 29% for each $2,500 ($1250 for a married taxpayer filing separately) of adjusted gross income (or part of) in excess of a threshold. The thresholds are listed below:
 AGI Filing Status
 $100,000 Single
 150,000 Married Filing
 jointly
 125,000 Head of Household
 75,000 Married Filing
 Separately


Since the 1991 exemptions are $2,150 each, $43 ($86 for MFS) of each exemption deduction is lost for each $2,500 of adjusted gross income in excess of the thresholds. In 1991, the exemptions are lost completely once the taxpayer has the following AGI:
 AGI Filing Status
 $222,501 Single
 272,501 Married Filing
 jointly
 247,501 Head of Household
 136,251 Married Filing
 Separately


To illustrate, assume a single taxpayer has $110,000 of adjusted gross income. Since his AGI exceeds the $100,000 threshold by $10,000, his $2,150 personal exemption is reduced by 89c ($172) to only $1,978.

By phasing out the exemptions, Congress has created a bubble in the effective marginal rate imposed on taxpayers. Each $43 reduction in the exemption costs the taxpayer in the 31% marginal bracket an additional $13.33 in taxes. Therefore, the effective marginal rate imposed on the taxpayer is increased by .533% ($13.33/$2,500) for each exemption (or part of) lost. A single taxpayer subject to the phase out pays an effective marginal rate of 31.53%. A married couple subject to the phase out pays an effective marginal rate of 32.07%. If the couple has two dependent children, the effective marginal rate is 33.1%. The effective marginal rate does not fall back to 31% until the taxpayer's exemptions are reduced to $0. Although Congress eliminated the 5% bubble in stated marginal rates, it created a new bubble as illustrated in Tables 1 and 2.

The effect of the Revenue Reconciliation Act of 1990 is not that it eliminated the bubble but that it simply shifted its starting point. While the bubble in effect for the 1990 tax year affects single taxpayers with taxable incomes over $47,050, the 1991 bubble affects single taxpayers with taxable incomes over $94,450. Although the new provision applies to taxpayers with higher incomes, it is difficult to argue that it has restored equity to the tax system. Itemized Deductions

For 1990, taxpayers can elect to itemize deductions for certain medical costs, interest, taxes, charitable contributions, casualty and theft losses, moving expenses and miscellaneous expenses if their total exceeds the taxpayer's standard deduction. Beginning in 1991, the total of the itemized deductions other than Code Section 213 medical expenses, Code Section 165(a) casualty and theft losses, and Code Section 163(d) investment interest must be reduced by 3% of AGI in excess of $100,000 ($50,000 for MFS). Code Section 68(a)(2) stipulates that the otherwise allowable itemized deductions will never be reduced by more than 80%.

This provision will not result in an increase in the taxpayer's stated marginal tax rate but will again increase the effective marginal rate. For a taxpayer in the 31% marginal tax bracket, the loss of 3% of itemized deductions will, in effect, increase his marginal rate by .93%. Since the .93% point increase in the effective marginal rate will not be terminated until 80% of the taxpayer's itemized deductions are eliminated, it will be a permanent increase in the effective marginal rate for many taxpayers with adjusted gross incomes above $100,000. The combined effect of the phase out of the itemized deductions and exemptions is that the effective marginal rates in the bubble will be even higher than that shown in Tables 1 and 2.

To illustrate, assume that a single taxpayer with AGI of $140,000 has $20,000 of itemized deductions. The taxpayer's income is above the threshold for both the exemption and itemized deduction phase-out. His stated marginal rate of 31% will be increased, in effect, to 31.53% as a result of the loss of part of his personal exemption. He will also lose $1,200 of his itemized deductions (($140,000 - $100,000) x .03). In effect, the individual's highest marginal rate will be 32.46%.

Tax Saving Moves

Because the phase-outs of both the exemptions and deductions depend on adjusted gross income, taxpayers should attempt to maximize their deductions from gross income to minimize AGI. The Tax Reform Act of 1986 eliminated many of the deductions used in calculating AGI such as moving expenses, unreimbursed travel and transportation expenses and individual retirement account deductions for higher income taxpayers who are active participants pension or profit sharing plans. There are several steps that are still available to taxpayers to reduce adjusted gross income and avoid the thresholds for the phase-outs.

Since interest on municipal bonds is tax exempt under Code Section 103(a), taxpayers with incomes above the thresholds should consider switching from investments that yield taxable interest and dividends to tax-free municipal bonds. Rental real estate should also be considered as an investment alternative. Although rental property is considered a passive activity under Code Section 469(c)(2), up to $25,000 of rental real estate losses can be used as an offset against nonpassive income if - 1. The taxpayer owns at least a 10% interest in the property, and

2. He actively participates in the management decisions or arranges for others to provide services.

Under Code Section 469(i)(3)(A), the $25,000 loss limit is phased out by 50% of adjusted gross income in excess of $100,000. Use of a rental real estate loss by a taxpayer with adjusted gross income above $100,000 could reduce his income for the phase-outs. To illustrate, assume that a single taxpayer has adjusted gross income of $110,000 before considering any rental losses and a rental loss of $20,000. The $25,000 loss limit would be reduced by $5,000 (.5 x ($110,000 AGI $100,000)) to $20,000. The taxpayer could deduct the full $20,000 rental loss, reduce his adjusted gross income to $90,000 and avoid any reduction in his personal exemption and itemized deductions.

Taxpayers with a child 14 years of age or older should consider making a gift of income-producing property to the child. By shifting the property and thus the income to the child, the taxpayer's adjusted gross income will be reduced.

Taxpayers who qualify under Code Section 453(b)(1) to use the installment method of reporting income from sales of real or personal property should analyze the impact of installment reporting on their exemptions and itemized deductions. The effect on AGI should be considered in determining the amount and timing of the installments as well as whether an election out of the method should be made.

An individual who qualifies to contribute to a self-employment retirement account (Keogh plan) under Section 401(a) can deduct up to the lesser of 20% of earned income or $30,000. Since these contributions are deductions for AGI, a taxpayer might be able to minimize his exposure to the phase-outs by increasing the contributions to his Keogh account.

An employee can reduce his adjusted gross income by electing to defer compensation through a Code Section 401(k) qualified cash or deferred arrangement. Code Section 402(g) limits the elective deferrals to a maximum of approximately $8,000. Not only will the deferred income reduce adjusted gross income, but the earnings on the plan will grow tax-free and will not be included in AGI until the individual withdraws them. Employees of public schools and certain tax-exempt organizations can also defer compensation by electing to have up to $9,500 of compensation contributed to a Code Section 403(b) tax-sheltered annuity. The amount contributed to the annuity will be excluded from gross income.

Individuals who are eligible to use a Code Section 129 dependent care assistance program can elect to have up to $5,000 excluded from their gross income to pay for dependent care services. In the case of a married employee, the exclusion cannot exceed the earned income of the lower-earning spouse. If a taxpayer has been using the Code Section 21 dependent care credit and qualifies to use the exclusion, he should elect the exclusion to reduce his adjusted gross income.

Employees who are covered under Code Section 125 cafeteria plans which offer employees a choice between cash and qualified benefits (such as health and life insurance) should choose the qualified benefits. The benefits are excluded from gross income which makes them more valuable than the cash, and AGI is reduced.

It is now more important than ever that employees who incur expenses under an expense account or reimbursement plan meet the substantiation requirements for accountable plans. If the substantiation requirements of Code Section 62(c) are met, the reimbursements will not be included in gross income. If the requirements are not met, the employer must report the reimbursements as wages subject to withholding and employment taxes. The employee will then have to claim the expenses as a miscellaneous itemized deduction subject to the 2% of AGI floor. If an employee reaches the threshold for phase-out of the exemptions and itemized deductions and has not substantiated his expenses, he will be doubly penalized. The reimbursement will increase AGI and the higher AGI will cause a greater reduction in his miscellaneous itemized deductions, a greater phase-out of his itemized deductions, and a larger reduction in the personal and dependency exemptions.

Employees should monitor the withholdings for state income taxes carefully since under Code Section 111(a) a refund of taxes claimed as a deduction in an earlier year is includible in gross income. A refund of state income taxes will increase adjusted gross income and could lead to a phase-out of exemptions and itemized deductions.

Some taxpayers who have elected to itemize deductions in the past under Code Section 63(b) may find that as a result of the phase-out it is better to use the standard deduction. To illustrate, assume that a single individual with $200,000 AGI has $5,000 of itemized deductions. Since his adjusted gross income exceeds the phase-out threshold by $100,000, $3,000 of his itemized expenses (.03 x $100,000) will not be deductible. Since the 1991 standard deduction of $3,400 exceeds his $2,000 net itemized deductions, the taxpayer should use the standard deduction in calculating taxable income.

Conclusion

The Revenue Reconcillation Act of 1990 eliminated one bubble beginning in 1991 but replaced it with another. Although the act shifted the starting points of the bubble to higher taxable incomes, the bubble still exists. The effective marginal rates in the bubble may actually be higher than the 33% stated marginal rate imposed in 1990 depending on the number of exemptions claimed by the taxpayer and whether or not he itemizes deductions. Taxpayers need to carefully analyze their sources of income and expenses for 1991 to minimize AGI and the impact of the new phase-out rules.

Footnotes

1. If a single taxpayer can claim a dependency exemption for another individual through the use of a multiple support agreement, the bracket subject to the 33 percent rate would be extended by another $11,480.

2. The bubble also affects taxpayers who file as head of household (HH) and married filing separately (MFS). For HH, the 33 percent bracket applies to taxable income over $67,200 but not over $146,410 and for MFS it applies to taxable income over $39,200 but not over $135,050. These ranges included the phaseout for the personal exemption. The ranges would be extended by $11,480 for each additional exemption the taxpayer claimed. (TABULAR DATA OMITTED)
COPYRIGHT 1991 National Society of Public Accountants
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1991 Gale, Cengage Learning. All rights reserved.

Article Details
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Author:Dykxhoorn, Hans J.; Sinning, Kathleen E.
Publication:The National Public Accountant
Date:Jul 1, 1991
Words:2552
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