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The individual provisions of the Omnibus Budget Reconciliation Act of 1993.

On Aug. 10, 1993, President Clinton signed the Omnibus Budget Reconciliation Act of 1993 (the "1993 Act"). Although a few of President Clinton's original high-priority proposals--such as the investment tax credit and the broad-based Btu energy tax--ended up on the cutting-room floor, the broad outlines of his original plan remained intact: estimated deficit reduction of close to $500 billion over five years; some tax incentives and investment spending; cuts in defense and Medicare spending; an energy tax; and most of the additional tax burden falling on higher-income individuals.

This article will highlight the tax provisions of the 1993 Act that generally affect individual taxpayers, and provide planning ideas. Many of the provisions are complex and far-reaching, and may require immediate action.

Individual Tax Rates

Beginning in 1993, a new 36% tax rate applies to taxable income of more than $140,000 for a married couple filing a joint return ($115,000 for an unmarried individual). The existing 15%, 28% and 31% tax brackets continue to apply as under prior law.

A fifth tax bracket of 39.6%, referred to as a "surtax," applies to taxpayers with taxable income of more than $250,000, whatever their filing status. (Note: Married individuals filing separately will pay the surtax beginning at $125,000 of taxable income.)

As under prior law, capital gains are taxed at a maximum 28% rate (i.e., the surtax does not apply to capital gains).

The thresholds for the new 36% and 39.6% tax brackets will not be indexed for inflation until Jan. 1, 1995. Thus, for the 1994 tax year, the thresholds for imposition of the 28% and 31% tax rates will be adjusted for inflation from their 1993 levels, but the higher-rate thresholds will not be adjusted. All of the rate bracket thresholds will be indexed for inflation after 1994.

The current-law phaseout of personal exemptions and disallowance of a portion of itemized deductions are both made permanent.

* Observation

Taxpayers subject to the surtax (except married individuals filing separate returns) will face a marginal tax rate of at least 39.6%. A taxpayer will effectively face an additional 0.74% marginal rate for each personal exemption, to the extent exemptions are still being phased out above the surtax level of taxable income, and an additional 1.2% marginal rate if the scaleback of itemized deductions still applies when taxable income is above the surtax level. For example, a taxpayer with four exemptions would face a marginal income tax rate of up to 43.76%.

Also effective for 1993, the individual alternative minimum tax (AMT) rate is increased. The AMT rate is currently 24% on all alternative minimum taxable income (AMTI) in excess of an exemption of up to $40,000 on a joint return ($30,000 for a single individual). The rate is increased to 26%, with a second 28% bracket starting at $175,000 of AMTI in excess of the exemption. The maximum exemption is raised to $45,000 on a joint return ($33,750 for an unmarried person). There is no surtax on AMT liability.

* Observation

The increase in the top individual tax rates also increases the so-called marriage penalty/bonus (the difference in total tax liability of a couple filing as single taxpayers versus filing married on a joint return).

Example 1: B is a single father with two children; C is a single mother of one. Each earns $100,000, has $20,000 of itemized deductions and files as a head of household.

Under present law, their combined separate tax liabilities if both were to file as single taxpayers would be $33,814; if they marry and file a joint return, their liability would increase to $40,430, resulting in a marriage penalty of $6,616. Under the new law, their combined separate tax liabilities remain the same, but their married filing jointly liability would rise to $41,156, increasing their marriage penalty by $726 to $7,342.

Individuals who realize a marriage bonus under present law will in many cases increase that bonus under the new law.

Revised tax withholding tables are not planned for the remainder of 1993, and the 1993 Act waives 1993 estimated tax penalties resulting from the tax rate changes. Thus, individuals may compute their Sept. 15, 1993 and Jan. 18, 1994 estimated tax payments as if old-law rates were in effect but will need to make a catch-up payment by Apr. 15, 1994, the due date for 1993 individual tax returns.

However, because of the potential burden from imposing the higher tax rates retroactively, individuals can elect to pay the portion of their increased 1993 income tax liability arising from the new 36% and 39.6% rates in three installments, due Apr. 15, 1994, 1995 and 1996. The deferral election does not apply to increased liability due to the new AMT rates. Interest and penalties will not be charged on the deferred tax payments, but all unpaid tax will become due if an installment payment is missed. The election must be made on the 1993 tax return.

* Observation

Some states' income tax rates may also be retroactively increased as a result of the Jan. 1, 1993 effective date for Federal individual rate increases.

* Strategies

1. Taxpayers expecting to be subject to the new 36% and 39.6% marginal tax rates should consider investing more savings in municipal bonds. Municipal bonds generally are not subject to Federal income tax, and certain municipal bonds are not subject to state income tax.

2. The amount of income deposited in tax-deferred retirement programs should be maximized. If the employer sponsors a Sec. 401 (k) plan, consider making the maximum contribution permitted (for 1993, the maximum amount is $8,994).

3. If funds can be invested for an extended period of time, consider investing in tax-deferred annuities and life insurance investment products. The cash values of tax-deferred annuities accumulate tax free until payment is received. The increase in the cash surrender value of life insurance is not subject to income tax unless the policy is sold or surrendered.

4. Because the maximum tax rate on capital gains remains 28%, seek out investments that generate capital gains. Exchanging ordinary income for capital gains can increase the after-tax rate of return by 19%.

Incentive stock options (ISOs) provide an excellent means for converting otherwise ordinary compensation income into capital gains. Taxpayers expecting to be given stock options in the future should consider requesting that the options be structured as ISOs.

5. Although taxpayers will not be subject to penalties resulting from an underpayment of 1993 estimated taxes attributable to an increase in rates, they should consider putting aside the extra taxes that will be due on Apr. 15, 1994 to avoid unpleasant surprises.

Although the election to pay in installments any additional 1993 tax liability resulting from the new rates allows taxpayers to postpone the payment of a portion of their tax, they should not accelerate additional unearned income into 1993 to take advantage of this deferral. The installments apply only to the portion of tax in excess of 31%. By accelerating income into 1993, taxpayers would actually accelerate the payment of most of the tax (i.e., 31% of the additional 1993 income). The opportunity cost of this acceleration will more than offset any benefit obtained from deferring that portion of the tax imposed at 36% or 39.6% over the next two years. However, see the discussion below under "Expanded FICA Taxes."

6. With the increase in the top individual tax rate, shareholders in profitable S corporations that retain most of their income on an annual basis should consider whether it is advantageous to retain their S status.

Estate and Trust Income Tax Rates

The income tax rates applicable to estates and trusts are greatly increased, compared to current law.
Rates Old law New brackets
15% $0-$3,750 $0-$1,500
28% $3,750-$11,250 $1,500-$3,500
31% Over $11,250 $3,500-$5,500
36% $5,500-$7,500
39.6% Over $7,500

As with the individual income tax rate changes, these new rates and brackets are effective for tax years beginning after 1992. The election to pay any increased 1993 income tax over three years is not available to trusts and estates.

Estimated Tax Payments

In tax years beginning after 1993, individuals with adjusted gross income (AGI) of more than $150,000 in the preceding tax year can, as a safe harbor, base their estimated tax payments on 110% of their preceding year's tax liability. Individuals with a preceding year AGI of $150,000 or less can use a safe harbor of 100%. The current "special" estimated tax rules that prevent some taxpayers with AGI of more than $75,000 from using a safe harbor based on their preceding year's tax are repealed. As under present law, individuals can instead make payments based on 90% of the current year's liability, using actual or annualized tax liability.

* Observation

First quarter 1994 estimated tax payments, the first to be computed under the new rules, are due Apr. 15, 1994, the same deadline for paying any additional 1993 tax liability attributable to the higher tax rates and other changes made by the 1993 Act. The first quarter 1994 estimated payment will need to take the new higher tax rates into account. If the 1994 first quarter payment is to be based on the preceding year's tax, an individual with 1993 AGI of more than $150,000 will need to pay in an amount equal to 27.5% of the full amount of tax liability shown on the 1993 return (even if the election is made to pay the 1993 tax attributable to the new higher rates in installments).

For estates and trusts, AGI is defined to include deductions for various administrative expenses, the personal exemption deduction, amounts required to be distributed currently, and any other amounts properly paid or credited for the tax year.

Estate and Gift Tax Rates

The 53% and 55% top estate and gift tax rates on taxable transfers over $2.5 million and $3 million, respectively, which expired at the end of 1992, are reinstated retroactively. The higher rates are effective for gifts made and individuals dying on or after Jan. 1, 1993. The graduated rates and unified credit phase out for taxable estates of between $10 million and $21.04 million. The 55% rate also applies for generation-skipping tax purposes.

Taxation of Social Security Benefits

Beginning in 1994, some taxpayers receiving social security benefits will be taxed on up to 85% of those benefits, while others will continue, as under current law, to be taxed on up to 50% of the benefits. The higher percentage applies to taxpayers whose gross income, plus 50% of their benefits, exceeds $44,000 on a joint return ($34,000 for an unmarried person). These taxpayers must include in gross income the lesser of --85% of the total benefits received, or --85% of the amount by which adjusted gross income plus one-half of the social security benefits exceeds the $44,000 or $34,000 threshold, plus the smaller of 1. the amount included under current law, or 2. $6,000 (joint return) or $4,500 (unmarried taxpayer).

Example 2: A married couple filing a joint return has $10,000 of social security benefits and $40,000 of other income. Under current law, $5,000 of those benefits would be included in gross income. In 1994, they would include in income $5,850: the lesser of $8,500 (85% of $10,000) or $5,850 (the sum of $850 [85% of ($40,000 + [50% of $10,000] -- $44,000)] plus the smaller of ([$5,000 or $6,000]).

* Observation

Taxing 85% of social security benefits is intended to approximate the portion of private qualified pension benefits taxed. According to the administration, about 13% of social security recipients will be subject to the 85% inclusion.

Limit Pension Compensation Cap to $150,000

Under current law, compensation in excess of $200,000 annually (indexed for inflation; the 1993 limit is $235,840) cannot be considered when calculating the level of retirement benefit that may be paid to an employee or the level of contribution that may be made to an employee's retirement plan. The limit is reduced to $150,000 for plan years beginning after 1993. Previously accrued benefits are not affected.

The $150,000 limit will be indexed for inflation in years after 1994 but only when the indexed limit reaches an increment of $10,000 in excess of $150,000. Transition rules are provided for certain participants in retirement plans of state and local governments and for certain collectively bargained plans.

* Observation

The $150,000 limit can affect those earning far less than $150,000 when salary is projected for funding defined benefit plans. This reduction will also make it more difficult to comply with certain qualified plan nondiscrimination rules and, consequently, may lead to a reduction in the amount highly compensated employees can contribute to Sec. 401(k) plans.

Expanded FICA Taxes

The cap on wages or self-employment income subject to the 1.45% (2.9% for self-employment income) Medicare Hospital Insurance (HI) portion of the social security (FICA) tax will not apply after Dec. 31, 1993. In 1993, the cap is $135,000. The elimination of the $135,000 cap also extends to the 1.45% employer portion of the tax on wages above that level, beginning in 1994. Thus, employees and employers will be subject in 1994 to the 1.45% tax on all wages; self-employed individuals will be subject to the 2.9% tax on all self-employment income (and will be allowed a deduction for half of these taxes in computing taxable income).

* Observations

* Deferred compensation generally is not subject to social security tax until the time any substantial risk of forfeiture on its receipt is lifted. Thus, repeal of the wage cap means that employers and employees may have a larger liability for social security tax on deferred compensation several years after the compensation was earned.

* The taxation of high-income workers through payroll taxes to fund Medicare and Medicaid benefits may be revisited when Congress reviews the administration's health care proposals.

* Strategy

Taxpayers should consider accelerating earned income into 1993 to avoid the higher HI tax.

Self-Employed Health Insurance Deduction

The deduction allowed to self-employed individuals for 25% of the amount paid during the tax year for health insurance for themselves and their families is extended through Dec. 31, 1993, retroactive to July 1, 1992. Whether an individual is disqualified for the deduction because of coverage under an employer's plan is determined on a month-by-month basis beginning in 1993.

* Observations

* Affected taxpayers may want to file amended 1992 returns to claim larger deductions.

* The self-employed health insurance deduction is also likely to be revisited during consideration of health care reform.

Tax Relief for Disaster Damage to a Home

Under the 1993 Act, insurance proceeds received for a principal residence or any of its contents destroyed in a presidentially declared disaster area on or after Sept. 1, 1991 will generally be tax free, under more lenient rules than usually apply to exclude gains from involuntary conversions. At the taxpayer's election, proceeds are taxable only to the extent that they are received for a qualifying principal residence (or any of its "scheduled" contents) and are not reinvested within four years to acquire similar property.

* Observations

* The effective date makes this relief available to residences damaged by Hurricane Bob in 1991, Hurricanes Andrew and Iniki and Typhoon Omar in 1992, the flooding in the Midwest, as well as other recent natural disasters.

* Taxpayers may need to file amended returns to claim the benefits.

Capital Gains Exclusion for Individuals

Individuals who invest in stock in "small" corporations after the date of enactment and hold such stock for at least five years will have an opportunity to exclude up to 50% of any gain when the stock is sold. Only investments by individuals (directly or through a partnership, S corporation, mutual fund or common trust fund) in original issues of stock qualify. The stockholder must pay cash or property (other than stock) or receive the stock as compensation for services (other than as an underwriter). A small company is one that (on a controlled-group basis) has gross assets of no more than $50 million, including the amount paid for the stock, from Jan. 1, 1993 through the date the stock is acquired. The company must engage in the active conduct of a trade or business for substantially all of the taxpayer's holding period for the exclusion to be allowed. The gain eligible for the exclusion for stock in any company may not exceed 10 times the taxpayer's original basis in the stock of such corporation (or, if greater, $10 million). Fifty percent of the excluded gain will be an AMT preference item.

Stock will not be qualified if the corporation purchases other shares of its stock from the taxpayer within two years before or two years after the taxpayer's purchase, or if the corporation redeemed or redeems more than 5% of its stock within one year before or one year after the taxpayer's purchase. Also, stock would not satisfy the five-year holding period if the taxpayer holds an offsetting short position with respect to the stock during that period.

Investments in S corporations, domestic international sales corporations (DISCS), former DISCS, Sec. 936 corporations, regulated investment companies (RICs), real estate investment trusts (REITs), real estate mortgage investment conduits (REMICs) and cooperatives will not qualify. Additionally, the exclusion is not available for investments in corporations engaged in personal or professional services, banking, insurance, financing, leasing, investing, farming, mineral extraction or hospitality activities, or those whose gross assets consist of more than 10% (in value) of investment real estate. The exclusion also will be denied for stock in corporations that have investments in nonsubsidiary corporations of more than 10% (in value) of their net assets. The assets of a corporation and its 50%-or-greater subsidiaries will be aggregated to determine if the corporation's stock qualifies.

Educational Assistance

The income exclusion for educational assistance provided under an employer plan, which expired July 1, 1992, is retroactively reinstated, but only for payments or expenses incurred after June 30, 1992 and before Jan. 1, 1995. The 1993 Act clarifies that other amounts provided by an employer for education or training are nontaxable to the employee only if they qualify as a working condition fringe benefit after Dec. 31, 1988.

* Observation

Amended returns and Forms W-2 may be required to ensure that assistance provided in 1992 is properly reported. The Conference Report to the 1993 Act states that Congress expects the IRS to use its existing authority to alleviate administrative problems and facilitate refunds arising from the lapse in the exclusion.

Provisions to Prevent Conversion of Ordinary Income to Capital Gain

The 1993 Act includes several provisions that are intended to forestall various investment strategies that might become more attractive with the increased differential between the top marginal tax rate on ordinary income and the maximum 28% rate on capital gains.

* Effective for tax years beginning after 1992, net capital gain generally will not be considered investment income for purposes of computing the investment interest limitation, except to the extent the taxpayer elects to forgo the 28% maximum rate on the gain.

* Strategies

1. Taxpayers in the upper-income tax brackets who have both net capital gain and excess investment interest expense generally will be better off forgoing the lower capital gain tax rate and deducting the additional investment interest expense.

2. In certain situations, advance planning may enable investment interest expense to be converted into fully deductible trade or business interest expense. This could avoid the need to have any capital gains taxed at ordinary rates. For example, if a partner or an S shareholder has excess investment interest expense, the loan giving rise to such interest could be restructured by having the partnership or S corporation borrow money that is then distributed to the partner or shareholder to pay off the original debt; the interest paid by the partnership or S corporation can then flow through to the partner or shareholder as deductible trade or business interest expense.

3. This new limitation on the deduction of investment interest expense should be considered in evaluating the after-tax cost of investment borrowing.

* Amounts received by a partner in liquidation of a partnership interest that are attributable to substantially appreciated inventory will be treated as ordinary income even if the fair market value (FMV) of the inventory received is less than 10% of the value of all partnership property other than money. This provision is effective for sales, exchanges and distributions after Apr. 30, 1993.

* The 1993 Act subjects all market discount bonds purchased after Apr. 30, 1993, even those issued before July 18, 1984, to the market discount rules. In general, these rules recharacterize a portion of the gain on disposition of market discount bonds as ordinary income and require the deferral of interest incurred to purchase or carry the bonds under certain circumstances.

* Market discount on tax-exempt obligations purchased after Apr. 30, 1993 is subject to the general rule that recharacterizes a portion of any gain as ordinary income on disposition. Any gain treated as ordinary, as under current law, is not treated as tax-exempt income.

* A purchaser of preferred stock after Apr. 30, 1993 that is stripped of dividend rights is required to recognize the stock's stated redemption price in excess of the purchase price as ordinary income (not as a dividend or interest) under rules similar to those that apply to bonds with original issue discount.

* Observation

The 1993 Act does not address the treatment of the holder of the dividend rights with respect to the availability of the dividends-received deduction. Further, the legislation implies that, contrary to the position taken by the IRS, tax ownership of dividend income can be divorced from tax ownership of the underlying stock.

* The 1993 Act recharacterizes as ordinary income a portion of what would otherwise be capital gain on the disposition of property in certain covered "conversion transactions" entered into after Apr. 30, 1993 that are structured to produce a return based on the time value of the net investment, including certain straddles, transactions marketed and sold as producing capital gains and other transactions specified by the IRS. This will not apply to most transactions of options dealers or commodities traders in the ordinary course of their business.

* Observation

These special rules are directed at sophisticated financial transactions. Many standard tax planning investment strategies will remain effective to convert ordinary income into capital gains.

AMT Treatment of Appreciated Charitable Contribution Property

The AMT preference item for the appreciated value of charitable contributions of tangible personal property is repealed, effective for contributions made after June 30, 1992. The AMT preference item for the appreciated value of charitable contributions of other property is repealed, effective for contributions made after Dec. 31, 1992. Thus, beginning in 1993, the full FMV of charitable contributions of any property, including stock, is fully deductible for AMT purposes. The relief does not apply to any deduction carryover from a contribution made before the effective date.

* Observation

Taxpayers may want to file amended 1992 returns.

The 1993 Act also clarifies that no adjustment related to the earnings and profits effects of any charitable contribution is to be made in computing adjusted current earnings for corporate AMT purposes.

Donee Acknowledgements

Beginning in 1994, charitable contribution deductions of $250 or more will be denied when the taxpayer has not received a contemporaneous written acknowledgement from the charity.

The acknowledgement from the charity must include a "good faith estimate" of the value of any goods or services received by the taxpayer from the charity in connection with the contribution. The donee is not required to value any property or services contributed that the taxpayer claims to have a value of $250 or more, but must still provide a receipt. The value of any intangible religious benefit received that is generally unavailable outside the donative context does not need to be valued, but the benefit must be acknowledged.

A written disclosure must also be provided to a taxpayer who makes a donation of more than $75, with a similar good faith estimate of value, if the charity gives the taxpayer goods or services of more than de minimis value in return for the donation. The statement must inform the donor that a deduction is allowed only for the value of the donation in excess of the value of the goods or services received from the organization. A $10 penalty will be imposed on a donee organization for each failure to disclose such information (capped at $5,000 per event or mailing).

Luxury Taxes

The 10% luxury excise tax on purchases of certain boats, aircraft, furs and jewelry is repealed, retroactively to Jan. 1, 1993. The luxury excise tax on automobiles is retained, but the $30,000 threshold will be indexed annually for inflation (rounded to the next lowest $2,000 increment) for automobiles sold on or after the date of enactment. Congress's intention was to index the 1993 limitation from $30,000 to $32,000. However, due to a statutory drafting error any inflation adjustment is delayed until Jan. 1, 1994. (This may be changed later by a technical correction.)

Exemptions from the tax are provided for automobile equipment required to make a vehicle suitable for use by a disabled person (effective Jan. 1, 1991) and for a dealer's use of an automobile purchased as a demonstrator vehicle (effective Jan. 1, 1993). The 1993 Act gives taxpayers who paid tax on equipment in a vehicle for a disabled person at least one year from the date of enactment to claim a refund even if the statute of limitations would otherwise expire.

Taxpayers who have previously paid luxury tax on purchases now not subject to the tax are entitled to a refund. The refund must be requested from the seller of the taxed item, who will then obtain a refund from the IRS. Retailers must satisfy certain documentation requirements for customer refunds to obtain their own refund from the IRS.

Partner Liquidation Payments

For partners withdrawing, retiring or dying on or after Jan. 5, 1993, liquidating payments from the partnership are treated as made in exchange for the partner's interest in partnership property, generally as capital gain. The provision will not apply if there was a written binding contract in effect on Jan. 4, 1993-specifying the amount and timing of any payments--to purchase the partner's interest on later retirement or withdrawal. General partners in service partnerships can continue to treat such payments as a distributive share or guaranteed payment--generally ordinary income to the withdrawing or retiring partner and deductible by the partnership--as under current law.

Interest on IRS Refunds

An interest-free period of up to 45 days will be imposed on a refund arising from any type of original tax return if the overpayment is refunded within 45 days after the later of the original due date of the return or the date the return was filed. A similar rule will apply to deny interest on amended returns and claims for refunds (but only for the period from the date the amended return or claim is filed) when the IRS pays the refund within 45 days. Also, the interest paid on tax adjustments initiated by the IRS will be eliminated for 45 days of the overpayment period. Extension of the 45-day rule to refunds of taxes other than income taxes will apply to returns with original due dates after 1993; extension of the 45-day rule to amended returns and claims for refund will apply to returns and claims filed after 1994 (regardless of the tax period involved); and denial of interest on IRS adjustments will apply to refunds paid after 1994.

Motor Fuels Tax Increase

A permanent 4.3 cents per gallon transportation fuels excise tax is imposed, in addition to existing Federal excise taxes on motor fuels (gasoline, diesel fuel and special motor fuels) used for highway transportation. Thus, beginning Oct. 1, 1993, Federal excise taxes on gasoline and diesel fuel for highway use will total 18.4 cents per gallon and 24.4 cents per gallon, respectively.
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Publication:The Tax Adviser
Date:Sep 1, 1993
Previous Article:Processing income tax returns.
Next Article:The corporate provisions of the Omnibus Budget Reconciliation Act of 1993.

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