Copyright 1996 by A/N Group, Inc. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is distributed with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional should be sought. The information is not necessarily a complete summary of all materials on the subject.--ISSN 1089-1536
Note. There are other tax changes affecting individuals in other sections. For example, pension changes are covered in the Pension Simplification section, home office deductions in the Business and Investment section, etc.
Under prior law, damages received on account of personal injury or sickness are generally excluded from gross income. The exclusion does not apply to punitive damages received in connection with a cost not involving physical injury or sickness. However, courts have differed as to whether the exclusion applies to punitive damages in connection with a case involving a physical injury. In addition, some courts have taken a broad view that the exclusion applies to awards for personal injury that do relate to a physical injury or sickness. For example, employment discrimination and injury to reputation. In a number of cases the damages have consisted of back pay.
The Act provides that the exclusion from gross income does not apply to any punitive damages received on account of personal injury or sickness, whether or not related to a physical injury or sickness.
Prior law will continue to apply to punitive damages received in a wrongful death action if the applicable state law (in effect on September 13, 1995) provides that only punitive damages can be awarded in a wrongful death action.
The new law provides that the exclusion from gross income only applies to damages received on account of personal physical injury or physical sickness. Emotional distress is not considered a physical injury or physical sickness. An exception is provided to the extent of any amounts paid for associated medical care. On the other hand, because all damages received on account of physical injury are excludable, the exclusion will apply to any damages received based on a claim of emotional distress.
Example--Fred Flood is involved in a car accident. He sustains a broken leg and other physical injuries. He sues the driver of the other car and is awarded $30,000 for his physical injuries, $50,000 for emotional distress associated with recurring nightmares, and $500,000 in punitive damages.
Fred can exclude the $30,000 for physical injuries and $50,000 for emotional distress (since it's associated with the physical injuries) from his income. The $500,000 in punitive damages is fully taxable.
Example--Fred is involved in a car accident. He sustains no physical injuries but has recurring nightmares. He spent $1,800 on psychiatric help. A jury awards him $50,000 in damages. He can exclude $1,800 from his income; the remaining $48,200 is taxable.
This provision is effective for amounts received after August 20, 1996.
Computation of credit. For purposes of the disqualified income test for the credit, the Act adds capital gain net income and net passive income (if greater than zero), that is not self-employment income, to interest (taxable and tax exempt), dividends, and net rental and royalty income. In addition, the threshold for disqualified income is reduced from $2,350 to $2,200 and the threshold is indexed for inflation after 1996. This provision is generally effective for tax years after December 31, 1996.
Comment--The effect here is to increase the types of income that make up disqualified income. That could mean that some taxpayers that had qualified for the credit no longer will.
Earned income amount and phaseout. The earned income amount is $6,330 for an eligible individual with 1 qualifying child, $8,890 for 2 or more qualifying children and $4,220 for an individual with no qualifying children. The phaseout amounts are $11,610 for an individual with children and $5,280 for an individual with no children. The phaseout percentages are based on modified adjusted gross income, or, if greater, earned income.
Modified adjusted gross income. The Act modifies the definition of AGI (adjusted gross income) used for phasing out the earned income credit by disregarding certain losses. The losses are:
Taxpayer identification numbers. The Act makes a technical change with respect to the earned income tax credit. Now, individuals claiming the credit must include a valid social security number for themselves, spouses, and any children on the return. Failure to do so, or failure to pay the self-employment tax on a return claiming the earned income credit, can result in an automatic denial. Then, in order to claim the credit you will have to file a request for abatement within 60 days of the date the notice was sent.
Note. A similar provision applies with respect to the personal dependency exemption.
This provision (taxpayer id numbers) applies to 1996 tax returns.
This provision is from the Personal Responsibility and Work Opportunity Reconciliation Act, more commonly referred to as the Welfare Reform Act.
In general. Under the new law taxpayers can claim a credit of up to $5,000 for qualified adoption expenses for each eligible child. The credit is nonrefundable and applies to tax years beginning after 1996. Only expenses incurred after 1996 are eligible. The credit cannot be taken until the adoption is finalized. The $5,000 limitation is per child. Thus, you could claim more than one credit in a year if you adopt more than one child.
The credit is increased to $6,000 for a child with special needs (see definition below). The regular credit is not available for expenses paid or incurred after December 31, 2001.
The credit is phased out ratably for taxpayers with modified adjusted gross income (AGI) above $75,000, and is fully phased out at $115,000.
Eligible child. An eligible child is one who has not attained the age of 18 at the time of adoption, or is physically or mentally incapable of caring for himself.
A special needs child is one who the state has determined (1) cannot or should not be returned to the home of the birth parents, and (2) has a specific factor or condition because of which the child cannot be placed with adoptive parents without adoption assistance. Examples of factors or conditions are the child's ethnic background, age, membership in a minority or sibling group, medical conditions, or physical, mental, or emotional handicaps.
Qualified adoption expenses. The term is broad enough for most directly related expenses to qualify. For example, reasonable adoption fees, court costs, legal expenses, etc. Any expenses required by the state as a condition of the adoption might also qualify. For example, alterations to your home to accommodate the child.
No credit is allowed for expenses incurred in violation of state or federal law, in carrying out any surrogate parenting arrangement, or in connection with the adoption of a child of the taxpayer's spouse.
Double benefits. The Act denies the credit to the extent the taxpayer may use otherwise qualified adoption expenses as the basis of another credit or deduction. In addition, if the adoption credit is allowed for an expense chargeable to capital account, you must reduce your basis in the house to the extent of the adoption credit. For example, you pay $1,000 to construct a wheelchair ramp to your house and take a $1,000 credit for the expense, you can't increase your basis in your home by $1,000. However, you can claim credit for other expenses first. Using the example above, if you incurred $6,000 in legal fees, court costs, etc. in addition to the $1,000, you could claim the credit on the $5,000 in legal fees and the $1,000 would increase your basis.
Carryforward. Any credit that cannot be used because of the limitation in tax liability can be carried forward up to 5 years.
Example--In 1997 you incur $3,000 in qualified expenses attempting to adopt a child with special needs. The adoption is not finalized until 1998 when you incur another $4,000 in expenses. Subject to the AGI phaseout rules, you can take a credit of $6,000 on your 1998 return.
Example--Assume the facts are the same as in the example above but in 1998 your tax liability is only $4,000. The $6,000 credit eliminates your tax liability for 1998 and you can carry forward the remaining $2,000 to reduce your 1999 tax liability.
Caution--Amounts paid in 1996 can't be carried forward. They can never count toward the credit. If you're planning an adoption, try to defer as much of the cost as possible till 1997.
The Act provides a maximum exclusion of $5,000 from the gross income of an employee for qualified adoption expenses paid by an employer. Like the adoption tax credit, the $5,000 is a per child, not an annual limit. Also, the total exclusion allowed to two or more taxpayers with respect to the adoption of the child may not exceed $5,000. In order for the exclusion to apply, the expenses have to be paid under an adoption assistance program in connection with an adoption of an eligible child (see Adoption Credit, above for a definition of eligible child).
An adoption assistance program is an nondiscriminatory plan of an employer under which the employer provides employees with adoption assistance. No more than 5% of the benefits under the program for any year can benefit a class of individuals consisting of more than 5% owners of the employer or their spouses or dependents. Adoption assistance is a qualified benefit under a cafeteria plan. Like the adoption credit, the exclusion is phased out ratably for taxpayers with modified AGI above $75,000 and is fully phased out at $115,000 of modified AGI.
Adoption expenses paid or reimbursed under an adoption assistance program may not be taken into account in determining the adoption credit. A taxpayer may, however, satisfy the requirements of the adoption credit and exclusion with different expenses paid or incurred by the taxpayer and employer.
The definition of a qualifying individual, qualifying expenses, etc. are the same as for the Adoption Credit, above.
Example--Madison Inc. has an adoption assistance program. Fred Flood adopts a child that qualifies under the program and the IRS rules. His modified AGI is below the phaseout range. The costs of adoption total $14,000. Madison reimburses Fred for $6,000. Fred can exclude from income $5,000 of the $6,000 amount reimbursed by Madison. In addition, since Fred incurred $8,000 in expenses in excess of the amount reimbursed, he can take a $5,000 credit.
This provision is effective for tax years beginning after December 31, 1996.
Under prior law a taxpayer with a nonworking spouse could generally make a maximum deductible contribution of $250 on his or her behalf. Thus, a couple where only one spouse worked could contribute up to $2,250, subject to the gross income limitations.
The new law increases the maximum spousal contribution to $2,000. Thus, under the new law a couple where one of the partners does not work can still contribute $4,000.
Caution--All the normal IRA rules apply. Thus, if the either spouse is covered by a pension plan during the year, the deduction for IRA contributions is phased out beginning when the couple's AGI is $40,000 (married, filing joint). When AGI reaches $50,000 no deductible contribution is allowed. Another point. The total contributions can't exceed the combined compensation of both spouses.
Example--Sue Flood earns $32,000 per year. She is covered by a pension plan at work. Her husband is unemployed for all of 1997. The couple's adjusted gross income is $35,000. Sue could make a $2,000 deductible IRA contribution for herself and a $2,000 spousal IRA for her husband.
Example--Assume the facts are the same as in the example above, except the couple's AGI is $45,000. Because Sue is covered by a pension plan, her deductible contribution to an IRA is limited by her AGI to $1,000. A $1,000 deductible contribution can be made to her spouse's plan.
A taxpayer with a child under age 14 may elect to include the child's income on his or her own return rather than file a separate return for the child. The idea was to make it easier for taxpayers to comply with the law. However, under prior law, certain dollar thresholds were not adjusted for inflation, resulting in the election being disadvantageous.
Under the new law the $75 additional tax liability, $500 threshold, $1,000 alternative minimum tax exemption and $5,000 earned income maximum for the election will all be adjusted for inflation, effective for tax years beginning after December 31, 1995.
The Revenue Reconciliation Act of 1990 contained several provisions relating to the 'estate tax freeze.' The estate tax freeze is a method for transferring a stock or a partnership interest to your heirs by splitting the interest into two pieces, a 'junior equity' interest and, in the case of a corporation, a preferred stock interest. The preferred interest has a fixed value and must receive dividends. The junior interest consists of the common stock of the corporation. This junior interest enjoys all the appreciation in the value of the company.
Example--Madison Inc. is valued at $1,000,000. Madison issues preferred stock worth $800,000. Fred and Susan Flood own all the outstanding common stock of Madison. They gift the shares to their 12 children and grandchildren, retaining the preferred stock. Since the common stock is worth only $200,000 they escape gift taxes on the distribution. In addition, the value of their remaining interest is fixed at $800,000. Assume that Madison does well and 6 years later when Fred and Susan die in freak bicycle accident at 82 the company is worth $20,000,000. The value of their interest in Madison is still $800,000. The value of their children's and grandchildren's interest is $19,200,000. Only the $800,000 is included in their estate.
The new law makes a number of technical changes to the rules for estate tax freezes. We're mentioning them so that you're aware of them. Since they are effective for transfers after October 8, 1990, if you're done an estate tax freeze you may want to check with your tax advisor.
Valuation. The act provides that an applicable retained interest conferring a distribution right to qualified payments with respect to which there is no liquidation, put, call, or conversion right is valued without regard to Code Sec. 2701. The Act also provides that the retention of such right gives rise to potential inclusion in the transfer tax base.
Junior equity interest. The Act modifies the definition of junior equity interest to allow the IRS to draft regulations to treat a partnership interest with rights that are junior with respect to either income or capital as a junior equity interest.
Comment--The new definition will allow more partnerships to qualify for the estate tax freeze. If you do business as a partnership, this change should be of particular interest.
Election. The Act modifies the rules for election into or out of qualified payment treatment. A dividend payable on a periodic basis and at a fixed rate under a cumulative preferred stock held by the transferor is treated as a qualified payment unless the transferor elects otherwise. If held by an applicable family member, such stock is not treated as a qualified payment unless the holder so elects. In addition, a transferor or applicable family member holding any other distribution right may treat such right as a qualified payment to be paid in the amounts and at the times specified in the election. The time for making the applicable family member election cannot expire before the due date (including extensions) for filing the transferor's gift tax return for the first calendar year ending after August 20, 1996.
Inclusion in transfer base. The Act gives the IRS authority to issue regulations to make subsequent transfer tax adjustments to reflect the inclusion of unpaid amounts with respect to a qualified payment. Among other things, it would permit elimination of double taxation that might result from a transfer to a spouse, who under the law, is both an applicable family member and a member of the transferor's family.
The new law treats a transfer to a spouse falling under the annual exclusion the same as a transfer qualifying for the marital exclusion. Thus, no inclusion would occur upon the transfer of an applicable retained interest to a spouse, but subsequent transfers by the spouse would be subject to the inclusion. The Act also clarifies that the inclusion continues to apply if an applicable family member transfers a right to qualified payments to the transferor.
The new law extends the special rule contained in Code Sec. 170(e)(5) that allows a deduction equal to the fair market value of appreciated stock contributed to private foundations made during the period July 1, 1996 through May 31, 1997. The rule doesn't apply to contributions made between January 1, 1995 and June 30, 1996.
Tax Tip-- A private foundation can provide some significant tax planning opportunities, but the cost of setting one up and administrating it generally restricts its use to taxpayers who can afford to contribute significant sums to the entity. If you have large stock holdings that you may be contributing in the future, check with your tax advisor to determine if the extension of these special rules could prove beneficial.