Making sense of the new tax legislation.

EXECUTIVE SUMMARY

* PRESIDENT BUSH SIGNED THE ECONOMIC GROWTH AND Tax Relief Reconciliation Act of 2001 into law June 7. The $1.35 trillion tax relief package affects almost every taxpayer in a variety of ways. CPAs may, need to reconsider some of the tax planning assumptions that have guided them over the last few years.

* THE CENTERPIECE OF THE NEW LAW IS A CONSOLIDATION and reduction of the marginal tax rates for individuals. Most taxpayers will come out ahead as a result of the rate cuts, which include a new 10% tax bracket and advance refund checks--$300 for single taxpayers, $600 for married filing jointly and $500 for head of household--for most Americans.

* LOWER TAX RATES MAY MAKE CLIENTS LESS INCLINED to jump through hoops to get the 20% rate on long-term capital gains. The lower rates also will make tax-deferred saving for retirement less of a priority, but they should make Roth IRAs more attractive.

* THE 2001 ACT GRADUALLY INCREASES THE ESTATE TAX exemption to $3.5 million and then repeals the estate tax for just one year--2010. The 10-year phase-in and the possibility the estate tax will return in 2011 will make careful planning essential. The estate tax repeal also means the step-up in basis at death is eliminated, subject to some modified-carryover-basis rules and exemptions.

* CONGRESS INCREASED THE CONTRIBUTION LIMITS for traditional and Roth IRAs to $5,000 by 2008. Taxpayers age 50 and older will be permitted to make catch-up contributions to IRAs, 401(k) plans and other salary-reduction arrangements. Contributions to 401(k) plans also will be higher, increasing to $15,000 by 2006.

At first, the Economic Growth and Tax Relief Reconciliation Act of 2001, the legislation Congress passed on May 26 and the President signed into law on June 7, appeared deceptively simple. The national press focused on the bill's hallmark across-the-board tax cut and advance refund, and taxpayers initially assumed most of the tax benefits would "just happen" on a fairly predictable schedule.

In fact, the 10-year, $1.35 trillion tax relief package affects nearly all taxpayers in more ways than one. And experts are quickly recognizing its complexity. While the 2001 act introduces many new opportunities, it comes with pitfalls and challenges neither taxpayers nor tax practitioners can afford to overlook. This broad tax package offers plenty of planning alternatives, which will challenge CPAs to reconsider the tax-planning assumptions that have guided them in the last few years. The bottom line is that practitioners should get ready to crunch the numbers--time-based, phase-in projections and recommendations will drive tax planning now more than ever--even without the complication of the additional tax legislation that is sure to follow.

INCOME TAX RATE CHANGES

The centerpiece of the law is a $958 billion consolidation and reduction of the marginal tax rates for individuals, marking the first time since 1986 that ordinary income tax rates will drop.

Most taxpayers come out ahead under these rate cuts, which start with a new 10% tax bracket carved out of the lower portion of the existing 15% bracket. For 2001 this will result in most taxpayers receiving advance refund checks. Congress also cut all other individual income tax rates, except the 15% bracket, for 2001 effectively by 0.5% across the board. Those cuts, however, will not result in advance refunds. The retroactive rate cuts for 2001--from the across-the-board benefit of the new 10% rate to the reduced 27.5%, 30.5%, 35.5% and 39.1% effective tax rates for 2001--amount to "small change" for some taxpayers compared to the benefits they will gain from rate cuts to come over the next five years.

Through 2007, the new 10% bracket will apply to all income up to $12,000 on joint returns, $10,000 on head of household returns and $6,000 on the returns of single filers. After 2007, these amounts will be adjusted annually for inflation--as will the amounts for the other rate brackets. (The exhibit on page 27 shows the phase-in of some tax rate changes for 2001 to 2006 and beyond.)

So, who wins? A number of factors will decide who will win, lose or draw. Whether they earn $1 million or $12,000 in 2001, taxpayers will get a $300 tax benefit in the form of an advance refund check ($600 for married filing jointly, $500 for head of household). This refund comes from the introduction of the 10% tax rate and is intended to jump-start the economy. Starting in July 2001, however, some clients will get more than others.

* Taxpayers who remain in the 15% bracket will get no further benefit.

* Taxpayers in the top 39.6% bracket, however, eventually will receive a 4.6% tax cut on all their marginal income (no matter how high it rises because of inflation) when the rate reductions are fully phased in after 2005. In addition to this and the $600 bonus, married taxpayers who are in the top bracket will see more savings from the reduced income tax brackets: approximately $960 savings for the drop to the 25% bracket from the 28% bracket, $860 for the drop to the 28% bracket from the 31% bracket and $1,960 for the drop to the 33% bracket from the 36% bracket.

Digging deeper. Figuring out winners and losers by running the numbers based on the new tax rate schedules is the easy part. The far more complicated task CPAs face is assessing the relative importance lower rates will have in driving future tax strategies. Here is a short list of some of the areas accountants should review:

* Capital gains transactions. Even before the ink was dry on the new law, some in Congress were trying to bring net gains from the sale of long-term capital assets into the tax-cut juggernaut. As it now stands, beginning in 2006 when the rate cut fully takes effect, the difference between the 20% rate on long-term capital gains for the average investor (those who previously had fallen into the 28%, 31%, 36% or 39.6% tax brackets) and ordinary income tax rates will only be 5%, 8%, 13% and 15%, respectively--hardly enough for some taxpayers to jump through the planning "hoops" necessary to qualify for long-term gain treatment.

* Family-income-shifting techniques. Using the lower tax brackets of children or grandchildren is one mainstay of family income shifting. As long as the child is not subject to the "kiddie tax" (for those under age 14 with unearned income), shifting up to $6,000 in income to another family member can save 25% in taxes even when the new rates are fully phased in (the difference between the 10% and 35% brackets for child and parent, respectively).

* Deferred compensation. CPAs will find the potential planning opportunities in the aftermath of a fully phased-in rate cut are based on postponing recognition of income until a lower-rate year--either during the phase-in or after 2006. However, lower rates on ordinary income will take some of the value away from converting wages to incentive stock options and other equity-based compensation.

* Retirement planning. Reduced tax rates will leave taxpayers with more money to put in IRAs or 401(k) plans. Despite the opportunity to contribute more to these accounts under the new law, however, taxpayers may find lower rates make saving for retirement on a tax-deferred basis less of a priority. One exception: Lower tax rates should make Roth IRAs more attractive, especially if you believe the rates only can go up in the future when clients will be withdrawing IRA assets.

Itemized deductions, personal exemptions and the AMT. Beginning with the 2006 tax year, the provisions of the current law that restrict the value of itemized deductions and personal exemptions will be reduced by one-third; they will be reduced by two-thirds in 2008. Beginning with 2010, the restrictions no longer will exist. The new law also softens--at least temporarily--the bite of the alternative minimum tax (AMT), which tends to affect higher-income taxpayers more than others. In calculating potential AMT liability, taxpayers can take advantage of generous AMT exemption amounts. Beginning with 2001, the bill increases the exemptions by $4,000 for joint filers and $2,000 for everyone else. But the relief ends for tax years beginning after December 31, 2004, unless a future Congress decides to extend it.

Ironically, even during the 2001 to 2004 period, the reduced income tax brackets the new law mandates will serve to lower many taxpayers' "regular" tax liability below their AMT liability. This will cause the legislation's AMT relief merely to halt the increase in taxpayers subject to the AMT until after 2004, rather than significantly lowering the number subject to it. Starting in 2005, the number of taxpayers subject to AMT is likely to resume its rapid increase.

MARRIAGE, EDUCATION AND CHILDREN

In addition to the basic income tax rate cuts, the 2001 act includes changes in joint-filer benefits and tax cuts for education savings and child care. As a result, the complexities of determining a client's tax obligations will continue to increase.

Marriage penalty relief. When the marriage penalty relief finally arrives, it will provide joint filers with a standard deduction twice that for single filers, phased in over a four-year period starting in 2005 and ending in 2008. Relief also will come in the form of an expanded 15% bracket equal to twice that of single taxpayers over the 2006 to 2008 period.

Although the expanded 15% tax rate will benefit all couples, those who usually itemize instead of taking the standard deductions (statistically, this group includes most taxpayers above the new 25% tax bracket) should not expect marriage penalty relief to bring a substantial reduction in their tax bill.

2001 Act Income Tax Rates: Phase-in

The scheduled reduction in some tax brackets in
effect prior to passage of the act follows:

                  28% rate    31% rate    36% rate    39.6% rate
Calendar year

2001                27.5%       30.5%       35.5%        39.1%
2002 to 2003        27%         30%         35%          38.6%
2004 to 2005        26%         29%         34%          37.6%
2006 and later      25%         28%         33%          35%

Education incentives. The new legislation greatly expands the role education IRAs can play in future family savings strategies as a result of a dramatic increase in the contribution limits, starting in 2002, to $2,000. Also starting in 2002, contributions will be allowable not only from individuals but also from corporations, tax-exempt organizations and other entities. Taxpayers now can make contributions until April 15 of the following year, rather than the current December 31 cutoff.

Congress also has broadened the universe of those who may contribute to an education IRA. The contribution phase-out range for joint filers jumps to double that of single filers and is $190,000 to $220,000. Education IRAs now are available to pay for elementary and secondary school tuition--public and private--as well as the costs of higher education.

Some taxpayers also stand to benefit from other education provisions in the bill, including an above-the-line college tuition deduction and an enhanced student-loan deduction. CPAs and their clients facing college education expenses will need to plan carefully to get maximum benefits from these incentives due to varying eligibility requirements, income phase-outs and other qualifications.

Child tax credit. The new law doubles the current child tax credit to $1,000, phased in over 10 years, starting in tax years beginning after December 31, 2000. In addition, the law allows taxpayers to claim the credit against the AMT permanently and repeals the AMT offset of refundable credits. Retroactive application increases the credit, currently $500, to $600 for 2001.

DEATH AND TAXES

Longer-term aspects of the legislation's impact on clients, particularly in areas such as estate and retirement planning, become even more complicated. Under the new legislation, estate tax "repeal" has become estate tax "complexity and uncertainty." Some in Congress claim they have repealed the estate tax. More precisely, however, the new law gradually increases the estate tax exemption (more slowly in the earlier years) from $1 million to $3.5 million through 2009 and then repeals the estate tax for just one year--2010. Due to budgetary restrictions, the new law allows the current estate tax rules, rates and exemptions to come back in force in 2011.

CPAs and attorneys not only will have to do some complex planning because of the law changes over the next 10 years but also will need to address the 2001 act's immediate impact on estate plans, especially marital and family trusts, as a result of the increase in the exemption amount from $675,000 this year to $1 million next year, as well as the repeal of the qualified family-owned-business deduction starting in 2004.

Without a crystal ball, it will be virtually impossible for estate planners to predict what tax rate and provisions will apply in the year a client dies. In the meantime, some wealthy clients may require an annual estate plan to take full advantage of the changes applicable to that year. At the very least, CPAs should encourage all clients to review their current estate plan before yearend and at least annually thereafter over the 10-year phase-in period.

Modified carryover basis. To complicate matters further, in 2010 when estate taxes are fully repealed for one year, a modified-carryover-basis rule immediately goes into effect. At that time, death becomes an income tax problem. The basis of assets received from a decedent will carry over from the decedent, rather than be stepped up to fair market value at the date of death (or alternate valuation date) as is now the law. With proper planning, two exceptions will help many estates:

* $1.3 million of basis can be added to certain assets.

* $3 million of basis can be added to assets transferred to a surviving spouse.

Not all property is eligible for an increase in basis. Property a decedent acquired by gift from a nonspouse less than three years before death is excluded (to prevent "gifts" of low-basis assets in anticipation of stepped-up basis). Similarly, property that constitutes a right to receive income in respect of a decedent is excluded. Stock in foreign investment and personal holding companies also is ineligible for a basis increase. Finally, in situations where there is no surviving spouse, reliance on only the $1.3 million exemption--especially after inflation does its work for 10 years--will not adequately protect a large number of estates from carryover-basis problems.

Hypothetically, real estate or other assets that remain in a family for generations will require decades of accurate basis records. Without accurate records, clients will find the IRS winning basis cases in court on the burden-of-proof issue, thereby keeping basis low and taxing such assets at an artificially high rate. Since it is unclear now if these basis rules will ever go into effect, CPAs and their clients should not spend too much time worrying about or planning for them until it becomes clearer what actually will happen with estate tax repeal over the long term.

Partial gift-tax remains. To prevent the significant use of gifts to transfer property with a lower tax basis from higher-to-lower-rate taxpayers, the 2001 act retains a modified gift tax. Starting in 2010, gifts in excess of a lifetime $1 million exemption will be subject to a gift tax equal to the top individual income tax rate at that time.

State estate-tax relief. Creating even more problems on the state level, the state death-tax credit allowed against the federal estate tax will be reduced by 25% in 2002, 50% in 2003, 75% in 2004 and completely repealed thereafter--replaced by only a deduction for death taxes. Many states depend on the state death-tax credit as a significant source of revenue.

RETIREMENT SAVINGS AND PENSION REFORM

Retirement savings incentives and pension plan reform make up a significant part of the new bill. Reform in total weighs in at a cost of approximately $50 billion, and retirement savings incentives, including expansion of IRAs and 401(k) plans, are projected to cost $40 billion. The increased contribution limits and tax-favored savings options will likely leave many taxpayers bewildered by the choices and requiring assistance to make intelligent decisions.

Among the more popular changes the new legislation makes to qualified plan and contribution limits are these:

* IRA contributions. For both traditional and Roth IRAs the limit on contributions will rise from the current $2,000 annual cap to $5,000 ($3,000 for 2002 to 2004, $4,000 for 2005 to 2007 and $5,000 for 2008 and thereafter) with annual adjustments for inflation after 2008.

* Catch-up contributions. Taxpayers age 50 and older will be permitted to make "catch-up" contributions to IRAs, 401(k) plans and other salary-reduction arrangements. They can contribute an additional $500 each year from 2002 to 2005 and $1,000 more in 2006 and all years thereafter. These catch-up payments either can be deductible or made to a Roth IRA if the taxpayer meets the baseline AGI limits for regular contributions for the year.

* Defined contribution plan limits. Starting in 2002, the limit on annual additions to a defined contribution plan will rise to $40,000.

* Defined benefit plan limits. The annual limit on benefits under a defined benefit plan will rise to $160,000 from $140,000.

* 401(k) contribution limits. The limit on salary-reduction contributions to IRC section 401(k)-type plans (including 403(b) annuities and salary-reduction SEPs) will rise from $10,500 to $15,000 by 2006. Special catch-up contributions also apply.

* Contribution tax credit. Lower-income workers will be entitled to a tax credit, instead of just a tax deduction, for contributions to retirement savings.

* Other qualified plan breaks. The limit on maximum annual elective deferrals to a SIMPLE plan will increase to $10,000 by 2005. The limit on compensation taken into account under a qualified plan rises to $200,000 (to be increased for inflation in $5,000 increments).

NOT SO EASY

While the new tax legislation significantly overhauls the existing system, it is by no means tax simplification. As a result, tax planning will be anything but easy for CPAs in the coming years. But while clients may focus on the refund checks they already have begun receiving, CPAs would be better off spending time gaining a thorough understanding of the new legislation's deductions, credits, estate tax and pension reform aspects--and their timing. This will enable practitioners to help clients make the best plan for their future financial circumstances and minimize their tax obligations.

GEORGE G. JONES, JD, LLM, is a senior tax analyst with CCH Inc. in Riverwoods, Illinois. His e-mail address is [e-mail]. MARK A. LUSCOMBE, CPA, JD, LLM, is principal tax analyst for CCH in Riverwoods. His e-mail address is [e-mail].