The Contract With America: the new majority in Congress sets out to prove fewer taxes are the cornerstone of economic prosperity.

The Republican Party has emerged from exile and is geared up to take on the task of improving the economy. Their strategy is grounded in the party's traditional stance that less government and fewer taxes are the cornerstone of economic prosperity. Accordingly, Republicans feel the "Contract With America" is truly a mandate from the people and that they have both the momentum and, more important, the votes to make the transformation from rhetoric to law.

The contract contains myriad proposals that are pleasing to the ear, including a capital gains tax rate reduction, indexing the basis of capital and selected other assets, a "neutral cost recovery system" for depreciating business assets, a higher expensing limit for small business equipment, liberalization of the home office deduction rules, family tax credits, "marriage penalty" relief, "American Dream" savings (ADS) accounts, changes to the Social Security earnings limit and the amount of benefits subject to tax as well as tax breaks for long-term care insurance and employee benefits. Passage of all of these cuts depends on offsetting spending cuts, especially if the proposed balanced budget amendment becomes law. (For details of the American Institute of CPAs testimony on the contract before the House Ways and Means Committee, see "AICPA Testifies on Tax Provisions of Contract With America," page 23.)

CAPITAL GAINS

The proposed capital gains cut--the contract's focal point--generally goes back to pre-1987 law. A 50% deduction for individual or corporate taxpayers' "net capital gains" (the excess of net long-term capital gains over net short-term capital losses) would be available for sales of capital assets on or after January 1, 1995. Installment payments on sales executed before 1995 but received on or after January 1 1995, also would be eligible. This deduction would effectively cut the capital gains tax rate to half that imposed on ordinary income. And the deduction amount would not constitute a preference item for purposes of calculating the alternative minimum tax.

So-called pass-through entities, including partnerships, S corporations, mutual funds and real estate investment trusts, would determine the eligible gain at the entity level; the deduction effectively would flow through to shareholders.

Taxpayers will benefit even further because the capital gains deduction is part of the adjusted gross income (AGI) calculation. Thus, taxpayers will be less susceptible to the phaseout of itemized deductions and personal exemptions because they will take effect when AGI exceeds specified levels.

Conversely, for purposes of the 50% deduction, eligible net capital gains must be reduced by the amount a taxpayer elects to treat as "investment income." In 1993, net long-term capital gains were removed from the investment interest definition unless the taxpayer elected not to subject them to the 28% maximum tax. For this purpose, net capital gains are investment income only if a taxpayer forgoes the 50% deduction.

This provision also would repeal recently enacted Internal Revenue Code section 1202, which allows noncorporate shareholders to exclude 50% of the gain on the sale of "qualified small business stock" held more than five years. The contract's 50% deduction provides more favorable treatment for investments than the rules being repealed.

Currently, taxpayers can deduct net capital losses against up to $3,000 of ordinary income. Before 1987, it took $2 of net long-term loss to offset $1 of ordinary income. The contract returns to this system: Capital losses are allowed as deductions to the extent of capital gains, dollar for dollar, plus the lesser of $3,000 or the sum of net short-term losses plus half of net long-term losses.

For example, under the contract a taxpayer with net long-term losses of $4,000 can offset only $2,000 of ordinary income. In contrast, if the same taxpayer has net short-term losses of $4,000, he or she can offset $3,000 of ordinary income with the unused loss carried forward to succeeding years. This amendment will apply to taxable years ending after December 31, 1994. The timing is significant because even if it is enacted late in 1995, it would still apply to sales during 1995.

Loss on the sale of a principal residence. The contract would allow a loss on the sale of a principal residence to be treated as a deductible capital loss, rather than as a nondeductible personal loss. Currently, deductible losses are not allowed on home sales, but any gains are taxed. The provision would apply to sales or exchanges after December 31, 1994.

Indexing. This provision is extremely complicated. The contract would increase--or index--for inflation the adjusted basis of certain capital and other assets for purposes of determining the gain or loss on sale. Basis would not be indexed under this provision, however, in determining depreciation, depletion or amortization deductions. The rules will apply to individual and corporate taxpayers for indexed assets held for at least one year before disposal. In these cases the adjusted basis, calculated under familiar tax principles, is replaced by "indexed basis."

An indexed asset is either stock in a corporation or tangible property that is a capital asset or depreciable or real property used in a trade or business and held in excess of one year. A capital asset is any asset other than the specific exclusions found in IRC section 1221, most notably inventory and other property held primarily for sale to customers in the ordinary course of a trade or business.

Property described in IRC section 1231(b), so-called section 1231 assets, are not capital assets but are, nevertheless, treated as indexed assets. This category embraces depreciable or real property held for more than a year and used in a trade or business.

The provision lists a host of items denied indexed asset status, some of which may appear surprising. Items specifically listed are: creditors' interests (bonds and the like), lessors' interests in "net lease" property, options (an unexpected inclusion), stocks fixed and preferred as to dividends and not participating in corporate growth to any significant extent (plain vanilla preferred), stock in a foreign corporation (except those listed on a domestic securities exchange), property using the contract's neutral cost recovery and S corporation stock.

Calculating indexed basis is complex. The adjusted basis-computed in the normal manner--must be multiplied by the "applicable inflation ratio." For the ratio to be activated, it must exceed one, that is, be a positive number. The applicable inflation ratio, in turn, is determined using a gross domestic product (GDP) deflator, as follows:

GDP deflator for the calendar quarter the indexed asset is sold = Applicable inflation ratio

GDP deflator for the calendar quarter the asset was acquired

The latter calendar quarter can be no earlier than the one ending December 31, 1994. Periods the asset is not an indexed asset are not taken into account. Thus, if an investor buys a convertible bond (not an indexed asset) and later converts it to stock (an eligible asset) the conversion date is considered the acquisition date.

If a taxpayer invests in a pass-through entity, such as a partnership, S corporation, mutual fund or real estate investment trust (REIT), indexing is done at the entity level and passed through to taxpayers. However, in the case of stock in a mutual fund or REIT, there is another level of complexity. The stock can be an indexed asset but only equal to the ratio of the value of the mutual fund's or REIT's indexed assets to the total value of its assets. So, if a REIT has only 80% of its assets invested in indexed assets, only 80% of the REIT stock is an indexed asset.

Mercifully, the contract provides a rule of convenience: If a mutual fund's or REIT's ratio is 90% or more, the entire stock is indexed and, conversely, if the ratio is 10% or less (highly improbable for a mutual fund) none of the stock is indexed. This rule could create a dichotomy between mortgage REITs and property REITs. The former primarily hold creditor interests--not indexed assets--so few of their holdings would be eligible for indexing. Conversely, property REITs principally own section 1231 assets, and the 90% rule would mean all of such stock would be eligible for indexing. Accordingly, a two-tier market could develop.

To the extent indexing creates or increases an ordinary loss on the sale of property, its application would be barred and the incremental ordinary loss treated as a long-term capital loss. This situation might arise if, for example, section 1231 assets were sold at a loss. The new rules would clearly increase that loss because of a higher basis. Therefore, to the extent of this increment, that element of the loss is recharacterized as a capital loss. These provisions would affect dispositions after December 31, 1994.

DEPRECIATION REFORM

The contract's neutral cost recovery proposal, while less tedious than indexing, is even more complicated. Depreciation deductions would be increased to approach the economic equivalent of expensing the asset's purchase price at the time it is acquired. Currently, taxpayers cannot fully recover (on an economic basis) the cost of investments in depreciable business property. The proposal's goal is to increase depreciation deductions to account for inflation and the time value of money.

The provision applies to tangible property placed in service after 1994; the enhanced deduction initially is available in the year following the year the property is placed in service. The calculation base equals the amount allowable under the modified accelerated cost recovery system (MACRS). Currently, the amount allowable is calculated using 200% declining balance depreciation for property with a recovery period of 10 years or less. The proposal calls for a 150% declining balance method.

Although the contract initially results in deceleration of "normal" depreciation, it ultimately permits a dramatic increase in two ways:

1. The allowable deduction is multiplied by the "applicable neutral recovery ratio," determined as follows:

GDP deflator for the calendar quarter in the year the calculation is being done corresponding to the calendar quarter the property was placed in service = Applicable neutral

GDP deflator for the calendar recovery ratio quarter which the property was placed in service

2. This intermediate amount is multiplied by 1.035 to the nth power. N represents the number of full years from the beginning of the calendar quarter the property was placed in service to the day before the beginning of the corresponding calendar quarter in the year for which the calculation is being performed. However, the final element (the time value of money) does not apply to MACRS property with a recovery period in excess of 10 years.

These enhanced depreciation deductions will make companies more valuable as acquisition targets because buyers can recoup more of their initial outlay from tax benefits stemming from acceleration of depreciation on the stepped-up asset bases.

The AMT depreciation rules are changed in the same way. For property placed in service after 1994, there should be little exposure (except from the use of longer "class lives" versus "recovery periods" to the AMT resulting from depreciation. Moreover, for purposes of the adjusted current earnings (ACE) adjustment component of AMT, a different approach has been submitted. For any year beginning after 1994, regardless of when property is placed in service, the depreciation deduction is the same as that allowed in computing AMT income. Thus, as a practical matter, there will no longer be an ACE adjustment beginning in 1995.

A similar rule was partially introduced in the 1993 tax act but applied only to property placed in service after 1993. Neutralization of the AMT normally triggered by depreciation will permit companies in capital intensive industries, notably airlines, to enjoy a significant tax reduction.

Finally, the neutral cost recovery ratio would not be taken into account in determining

* The adjusted basis of depreciable property.

* Corporate earnings and profits.

* Gain "recaptured" as ordinary income upon disposal.

MISCELLANEOUS PROPOSALS

The contract includes some additional tax proposals.

Family tax credit. The contract proposes a $500 refundable tax credit for each "qualifying child" under age 18. The full credit would be available only to families with AGI under $200,000. The credit would be phased out for income in excess of this amount; no credit could be claimed by families with AGI over $250,000. This provision would be effective for taxable years beginning after 1995. After 1996, both the credit and phaseout threshold would be indexed for inflation.

Marriage penalty tax relief. The Republicans' support for "family values" has inspired a proposal to make tax relief available to married couples in each of the five years after enactment. Two-earner married couples filing jointly could claim a credit up to the amount of the marriage penalty--the amount by which the couple's joint tax liability exceeds the sum of the individual liabilities they would incur if they filed as single taxpayers--a situation that arises even when one spouse generates as much as 70% of a couple's gross income. The credit is capped so the overall benefit to all filers does not exceed $2 billion.

ADS accounts. These accounts supplement IRAs and would be governed by certain rules.

* A nondeductible contribution of up to $4,000 for a married couple filing jointly ($2,000 for individual filers) would be allowed annually. This threshold would be indexed for inflation beginning after 1996.

* A rollover from a regular deductible IRA could be placed in an ADS account in 1997. However, the amount would be includable in income. To soften the blow, this amount would be included ratably over four years beginning with the year the transfer occurs. The 10% IRA early withdrawal tax would not be assessed.

* "Qualified distributions," including distributions of contributions and earnings from the account, would not be subject to tax or early withdrawal penalties. A qualified distribution is one made after five years beginning with the first year the taxpayer makes a contribution to an ADS account and is precipitated by:

1. Retirement. Distributions occurring after the holder has attained age 59 1/2 or becomes disabled.

2. Death. Distributions made to a beneficiary (or the individual's estate) on or after the individual's death.

3. Special circumstances. The distribution is a "qualified special purpose distribution" made to fund:

a. The purchase of a principal residence of a "first-time home buyer," an individual who has not owned a principal residence at any time during the three preceding years.

b. Postsecondary education expenses for account holders, their spouses, children or grandchildren.

c. Medical expenses or long-term care insurance premiums incurred by the taxpayer, his or her spouse or dependents.

In contrast to IRAs, ADS contributions would continue after the holder reaches age 70 1/2 and the minimum distribution rules would not apply. The accounts would become available in tax years beginning after 1995.

Expensing for small businesses. The contract would increase the amount of property a small business (one purchasing $200,000 or less of eligible property) can expense" under IRC section 179. Currently, it may immediately deduct the first $17,500 of property it acquires, with the remainder subject to the regular depreciation rules. Under the contract, section 179 would be amended to allow an additional $7,500 of property acquisitions to be expensed. This provision would be effective in years beginning after December 31, 1995.

Estate and gift tax unified credit. This credit, available for taxable transfers by gift and at death, would be increased from its current level of $192,800 to $248,300. The larger credit effectively exempts $750,000 in taxable transfers from estate and gift taxes. It would be phased in over three years beginning in 1996. After 1998, the credit would be indexed annually for inflation.

Home office deduction. Broadening the circumstances under which this deduction can be taken has become more of a priority as the number of individuals starting businesses has increased with the number of layoffs. Currently, a deduction can be taken only if the majority of client contact takes place in the home office, meaning a teacher's principal place of business would be the classroom, even though activities performed at home (such as class preparation) may be more time consuming.

The contract proposes a home office constitute a principal place of business if it is where a taxpayer's "essential administrative or management activities" are conducted on a regular basis, but only if the taxpayer has no other location to perform these functions. This provision would overturn the IRS's views regarding the notion of a principal place of business as upheld by the U.S. Supreme Court in the Soliman case. These changes would be available in years beginning after 1995.

Senior citizens. The contract would gradually repeal the provisions of the 1993 tax act that subjected as much as 85% of Social Security benefits to taxation. The percentage would be reduced in five percentage point decrements through 1999 so that in the year 2000 no more than 50% of benefits could be included in gross income.

TAX REFORM ACT OF 1995?

The contract undoubtedly is the most ambitious tax initiative since the Tax Reform Act of 1986. Its chances of passage, given the makeup of Congress, are obviously quite high. The principal changes pertain to attempts to increase capital availability through capital gain and depreciation reform. Whether the contract ultimately becomes the Tax Reform Act of 1995 will depend on whether enhanced economic activity can create sufficient revenues to plug budgetary shortfalls.

RELATED ARTICLE: EXECUTIVE SUMMARY

* THE REPUBLICAN PARTY'S Contract With American includes a wide variety of tax proposals ranging from a capital gains tax cut and enhanced depreciation deductions to more liberal home office deductions and tax breaks for long-term care insurance.

* IN ADDITION TO REDUCING THE capital gains taxrate, the contract would index the cost basis of certain capital assets to account for inflation.

* THE CONTRACT'S NEUTRAL COST recovery proposal would increase depreciation deductions to approach the economic equivalent of expensing an asset's purchase price at the time it is acquired.

* A FAMILY TAX CREDIT OF $500 for each qualifying child would be available to families with adjusted gross incomes under #200,000. Two-earner married couples filing jointly could claim a credit up to the amount of the so-called marriage penalty--the amount their joint tax liability exceeds their liability if they filed as single taxpayers. American dream savings accounts would allow taxpayers to save for purpose such as retirement, home purchase and education on a tax-favored basis.

* OTHER PROVISIONS WOULD increase the estate and gift tax unified credit to $248,300--equivalent to passing $750,00 tax free--allow home office deductions when it is the place a taxpayer regularly conducts essential administrative or management activities and repeal a 1993 provision that taxes up to 85% of Social Security benefits, so that by the year 2000 no more than 50% are taxed.

ROBERT WILLENS, CPA, is a managing director of Lehman Brothers in New York City. An adjunct professor at the Columbia University School of Business, he is a member of the American Institute of CPAs and serves on the Journal of Accountancy board of consultants. ANDREA J. PHILLIPS is an assistant tax and accounting analyst with Lehman Brothers in New York City.