Income taxes: what's new and different in 1991.

About 25 years ago, people were singing of the dawning of a new age--the "Age of Aquarius," from the Broadway musical Hair. Peace, tranquility and "people power" were on everyone's lips. As the United States enters the final decade of the century, not only may we be experiencing a rebirth of "Aquarius," as rapidly chaning world events have shown, but we also are seeing the dawning of yet another new age--a decade of higher taxes.

The year 1991 may be remembered for many things, but in the world of taxes it will be seen as the beginning of a period that will affect taxpayers' pocketbooks for many years to come. This article is intended as a reminder of what is new and different in 1991 as well as pointing out some continuing areas that deserve special scrutiny. With the "maturity" of tax laws such as the Tax Reform Act of 1986, nontraditional taxes and tougher guidelines, attempts are being made to broaden the tax base. Combine this with state and local governments' financial needs and many taxpayers may soon return to a top marginal tax rate approaching or exceeding 40% (combined federal, state and local).

STATE AND LOCAL TAX PRESSURES

The pressure on state and local governments to raise money has never been greater. Connecticut recently adopted its first-ever state income tax after a long battle. Other states, including New York and New Jersey, missed their fiscal year budget deadlines by a wide margin as they wrangled over ways to raise revenue. And local governments aren't without their problems. Bridgeport, Connecticut, declared bankruptcy. New York City raised income tax rates to make up for a huge budget shortfall that led to thousands of municipal employee layoffs. This means practitioners can't consider just federal income tax rates anymore in doing client tax planning.

Consider the case of New York City residents. Exhibit 1, page 75, shows the federal tax and the total tax (federal, state and local) for a New York City taxpayer under four different scenarios, for the years 1986 and 1991. The substantial increase in the marginal rate from 1986 to 1991, despite a drop in federal tax rates, dramatically illustrates the role state and local taxes play in overall planning.

WHAT'S NEW AND DIFFERENT FOR 1991

Many things have changed for 1991 as a result of the phase in of past legislation as well as changes enacted last year. For a summary of last-minute tax reminders, see the sidebar on page 76.

Tax rates. The Omnibus Budget Reconciliations Act of 1990 (OBRA) modified 1991 personal rates. The new rates, adjusted for indexing, are shown in exhibit 2, page 78.

How else will tax rates change? The old 33% "bubble" was dropped and a new 31% bracket added. As before, brackets will be indexed annually for inflation. Because of the exemption phaseout and loss of some itemized deductions for those with adjusted gross incomes (AGIs) above $100,000 (explained below), the top marginal rate for some taxpayers could be as high as 34%.

Alternative minimum tax (AMT). THe AMT rate was increased from 21% to 24%. For details, see page 78.

Capital gains tax. The top rate for capital gains has been set at 28%. There are some special rules with which practitioners should become familiar. Schedule D of form 1040 (August 1991 proof) has been changed to provide an area for calculating the capital gains tax.

PHASEOUTS

The "phaseout" era (1987 to 1990) created by the 1986 act has finally come to an end. Among the affected items not deductible in 1991 are

* Personal or consumer interest, such as that on auto loans, tuition loans, credit card or store accounts, personal loans, etc.

* Investment interest paid in excess of net investment income. The current deduction is limited to net investment income; however, unused investment interest can be carried over to subsequent years. Investment interest expenses related to passive activity losses (PALs) remain subject to such rules.

* Net PALs other than losses up to $25,000 from active participation in real estate. Real estate losses are phased out for those taxpayers with AGIs between $100,000 and $150,000.

OTHER INDIVIDUAL CHANGES

A number of other tax changes also will affect individuals.

Standard deduction. The new standard deductions for 1991 have been increased to

    Single                        $3,400
    Joint                         $5,700
    Head of household             $5,000
    Married, filing separately    $2,850

Personal exemption and new phaseout. The personal exemption has been increased for 1991 to $2,150. In calculating taxable income, exemptions will be phased out beginning at the following levels:

    Single                        $100,000
    Joint                         $150,000
    Head of household             $125,000
    Married, filing separately    $ 75,000

Exemptions are reduced by 2% for every $2,500 (or fraction) of income above the threshold levels. The reduction for married taxpayers filing separately is based on every $1,250 (or fraction) above $75,000. The levels are subject to indexing for inflation. The phaseout is to end in 1995.

Reduction in itemized deductions. Beginning in 1991 and continuing until 1995, taxpayers will have itemized deductions reduced by 3% of AGI in excess of $100,000. Medical expenses, investment interest and casualty losses will not be affected. Under this change, the most itemized deductions can be reduced by is 80%. The $100,000 floor will be indexed for inflation after 1991.

$01(k) maximum salary reduction. The maximum amount an individual can contribute tax free to an employer-sponsored 401(k) plan was increased for 1991 to $8,475.

Cosmetic surgery. Beginning in 1991, such expenses will no longer be allowed as a medical deduction.

Social Security and Medicare taxes. Beginning in 1991, FICA withholding taxes will be based on

    First $53,400          7.65%
    $53,401 to $125,000    1.45%

As always, employers will match the above amounts. Schedule SE of form 1040 has been redesigned to reflect the separate ceilings for Social Security and Medicare.

Social Security numbers for one-year-olds. The 1991 returns will have to have Social Security numbers of all dependents over one year of age.

Noncash contribution deduction window. Prior law changes made contributions of appreciated property an AMT add back. OBRA established a window for 1991 by which such gifts are not part of the AMT calculation. Tax planners should note this opportunity in particular, especially since those most likely to avail themselves of it will be in higher tax brackets. In addition, yearend contributions also could be a big plus for charities that have seen their budgets slashed in the recent recession.

EXTENSION OF EXPIRING DEDUCTIONS,

CREDITS AND BENEFITS

OBRA extended the following through December 31, 1991:

* Medical premium deduction for self-employed and certain S corporation shareholders.

* Most tax credits due to expire on December 31, 1990, including those for research expenditures, targeted jobs, business energy and low-income housing.

* Employer-provided education assistance and tax-free group legal services.

Gulf War regulations. Many special regulations were adopted to cover those serving in the Persian Gulf War. These rules cover extensions in filing, taxable income, suspension of time periods, etc., and still are applicable for those serving or released from service in 1991.

Luxury tax. Beginning in 1991, there is a 10% luxury tax on the purchase of

    Boats over           $100,000
    Cars over            $ 30,000
    Jewelry over         $ 5,000
    Furs over            $ 10,000
    Airplanes over       $250,000

AREAS OF CONTINUING CONCERN

No yearend review of taxes or tax planning would be complete without revisiting some areas of ongoing concern to both taxpayers and those who advise them.

Interest deduction on residences. Now that personal or consumer interest is no longer deductible, practitioners and their clients need to redouble their efforts to avoid incurring such interest. Sometimes, bad planning or poor timing may cause problems. To make matters worse, the present economic situation and falling mortgage interest rates may tempt clients to consider refinancing their homes or repaying their mortgages. Many planners advise converting personal debt into home equity debt and borrowing the equity out of a residence while interest rates are still low.

While the basic principle may be sound, it's important to be sure not to run into the limitations on acquisition and equity debt. The most common problem is refinancing an existing acquisition debt that has been paid down.

For example, a client purchased a home in 1988 for $300,000 with a $200,000 first mortgage. The client also has an outstanding home equity loan of $100,000. In 1991, the client wants to refinance the first mortgage (current balance $180,000) back to the original $200,000 and use the proceeds for personal purposes. The result: The client will not be able to deduct a portion of the interest paid on the refinanced first mortgage ($20,000; $200,000-$180,000) since the refinancing exceeded the original acquisition debt balance and the outstanding equity loan of $100,000 still exists.

Practitioners also should be aware of the rules for borrowing funds from retirement plans to purchase a personal residence. Such borrowing could be very helpful, especially for clients in tight money or credit situations.

Vacation or second homes. Vacation or second homes afford taxpayers the opportunity to make year-by-year elections on how to best report mortgage interest and other expenses. The decision generally depends on the nature of taxpayer-owner use.

* Personal use only. Real estate taxes and mortgage interest (subject to limitations) are deductible on schedule A of form 1040.

* Rental use only. The rental income is reportable and all expenses deductible on schedule E of form 1040 and subject to PAL rules.

* Mixed use.

a. Rented for fewer than 15 days: The rental income is not reportable. Real estate taxes and mortgage interest (subject to limitations) are deductible on schedule A.

b. Rented for more than 14 days and personal use is more than the greater of 14 days or 10% of the days rented: Considered to be a rental activity subject to PAL rules; real estate taxes are deductible, as is mortgage interest (subject to limitations).

c. Rented for more than 14 days and personal use is less than the above requirement (14 days or 10% of days rented): The rental activity is subject to PAL rules; real estate taxes and mortgage interest attributable to rental use are deductible; any remaining mortgage interest is considered nondeductible personal interest.

HOME OFFICE DEDUCTIONS

In a 1990 case (Soliman v. Commissioner), there was a major breakthrough on home office deductions. In Soliman, the Tax Court rejected the focal point test and adopted instead a facts and circumstances test. Three district courts also have rejected the focal point test.

The major difference between the two tests is the focal point test requires the home office to be where goods and services are provided to customers, while the facts and circumstances test means the taxpayer needs to show (1) the home office is essential to his or her trade or business, (2) there is no other available office and (3) substantial time is spent there. (For more on home office deductions, see J of A, July91, page 41.)

Soliman could have an important impact on 1991 tax planning as more taxpayers take deductions for maintaining a home office. Also, the 1991 schedule C of form 1040 (August 1991 proof) has eliminated the question about deducting expenses of maintaining a home office and added a separate, specific line for the deduction amount, which must be carried from a completed form 8829. Form 8829, new for 1991, will be used to compute the amount of deductible expenses for business use of a home.

"KIDDIE" TAX

The dialogue on whether to pay the "kiddie" tax by filing a separate return for a child's income or adding the income in question to the parents' return continues. In some cases, such as when a certain earnings level is reached ($5,000 in interest and dividends) or when estimated tax payments are made, the filing has to be on the separate return. With rising state and local tax rates, it probably would be best to file the kiddie tax as a separate return. The best strategy, of course, is to keep children's investments in tax-free or tax-deferred vehicles, including U.S. government education bonds. On a related issue, preparers also should advise when a child should or should not be a dependent on his or her parents' tax return.

ALTERNATIVE MINIMUM TAX

The bad news is the higher AMT rate of 24% may make more people subject to the tax but the good news is the AMT credit and a special opportunity for contributions of appreciated property in 1991 only. Such gifts will not be added back for AMT preference purposes. The AMT credit will offset future regular taxes to balance deferral items (such as depreciation timing differences) included in the AMT.

In all other regards, everything possible should be done to avoid the preference items the AMT comprises. Alternatively, steps should be taken to help clients make the most of an AMT situation. For example, if a taxpayer is subjected to the AMT, perhaps income should be accelerated so it can be taxed at 24% rather than having the income be taxed at 31% in the future. Also, if certain deductions will not reduce the AMT (such as state and local taxes), consider delaying estimated payments until the next tax year when these items may be fully deductible. Also, practitioners should remember the AMT exemption phases out as income increases.

PASSIVE ACTIVITY LOSSES

AND LIMITED PARTNERSHIPS

PALs and limited partnerships remain a concern, not only because PALS are now totally nondeductible (except as an offset to passive income) but also because the present economic situation, including bank failures, has caused much consternation among limited partnership investors.

For example, taxpayers who are investors in real estate limited partnerships that have defaulted on their mortgages, resulting in foreclosure, should be concerned about the possibility of having to recognize a gain (recapture) and other unexpected tax problems. It is vital practitioners get a handle on their clients' limited partnership investments to plan for such eventualities properly. The same also would be true for all limited partnerships that may be throwing off "phantom income" (income without cash flow). Relief may be sought with a new PAL investment, but extreme care must be exercised.

Many real estate limited partnerships that are in trouble also are trying to do loan "workouts" with funding sources. The danger here is a possible element of debt forgiveness, which could create income for taxpayers. Tax return preparers also should be fully aware of the recapture rules and get as much data from limited partnerships as possible.

SPECIAL SITUATIONS FOR 1991

Every tax year brings some surprise as new government rulings are released, court decisions are made and economic conditions change. All can play havoc with taxes; 1991 is no exception. As of this writing, the following have occurred:

* In letter ruling 9113009, the Internal Revenue Service has said a guarantee of a child's business loan is a taxable gift. The IRS also said that if the parent later has to make good on the guarantee, another gift could arise.

* In a late 1990 case (Huntsman v. Commissioner) the Eighth Circuit Court of Appeals allowed a taxpayer to deduct points on refinancing a mortgage. However, in an action on the decision (cc 1991-02--released February 11, 1991) the IRS said it would not appeal the decision but would limit it to the Eighth Circuit (Arkansas, Iowa, Minnesota, Missouri, South and North Dakota).

* In a 1991 First Circuit Court of Appeals case (Andrews v. Commissioner), the taxpayer was allowed to deduct expenses for travel where he had businesses in two different places. The IRS was not successful in applying the "two tax home concept." The court instead applied a "duplicate expense approach." The First District covers Maine, Massachusetts, New Hampshire, Puerto Rico and Rhode Island.

ON THE HORIZON

In terms of overall awareness and for current and future planning, practitioners should be aware of certain areas that appear to have the government's attention. Current tax law provisions that are candidates for repeal include

* Five- and 10-year averaging on lumpsum distributions from qualified employee benefit plans.

* The $125,000 exclusion on the sale of personal residences for taxpayers age 55 and older.

More intensive scrutiny is being placed on the explosive independent contractor vs. employee issue (see J of A, May91, page 34). The government has been very aggressive in assessing penalties in such situations.

On the brighter side, there is an attempt to expand the use of individual retirement accounts, once again making them available to more taxpayers. Also, fewer restrictions would be placed on use of the money, for example, to first-time homebuyers.

MORE TAX DOLLARS

Another year, more changes and more tax dollars. Government strategy appears to include broadening the tax base along with tighter compliance through the use of penalties. Taxpayers, as usual, need to keep one step ahead by getting good advice and being aware of the changes in the wind.

Practitioners must measure up to the task and assist clients by being alert and keeping an eye to the future. Good tax planning and preparation must include the effect of events over the long term and not a short-term, narrow view, which could result in impulsive actions.