| MMM 358 | October 29, 1997 |
Introduction:
The 1997 Tax Relief Act has been hailed as a great benefit to all taxpayers by politicians on both sides of the aisle. The act does contain many benefits for taxpayers in general, and several specific to farmers. However, note below that many of the changes phase in over a long period, and that many taxpayers will not meet the strict requirements for some benefits. The following summary of the new law was prepared by Dr. Mike Hardin, Tax Management Specialist at Oklahoma State University. While Dr. Hardin's analysis provides an excellent summary of potential tax savings for South Carolina farmers, we urge readers to consult with their tax advisors/preparers to help determine if an individual situation meets all requirements for the following categories of potential benefits:
Child Tax Credit
The Act provides taxpayers a maximum child tax credit of $500 ($400 for 1998)
for each qualifying child. A qualifying child is an individual that can be
claimed as an exemption, who is under the age of 17 (determined at the close
of the calendar year in which the taxpayer's taxable year begins), and who is
a child, a stepchild or eligible foster child of the taxpayer. For higher
income taxpayers, there is a phase-out of the child credit. The credit is
reduced by $50 for each $1,000 that the taxpayers modified Adjusted Gross
Income (AGI) exceeds $110,000 for married taxpayers filing jointly, $75,000
for single taxpayers, or $55,000 for married taxpayers filing separately. The
Act provides a complex formula for determining the limitations on the amount
of the credit and whether it is refundable. This formula depends on whether
the taxpayer has three or more children and interacts with the earned income
credit (EIC). The child tax credit applies to taxable years beginning after
December 31, 1997.
Education Incentives
The Act provides taxpayers with a HOPE Scholarship credit plus a Lifetime Learning credit. The HOPE credit equals 100% on the first $1,000 of qualified tuition and fees, plus 50% of the next $1,000 of such expenses paid. The HOPE credit is not available for the purchase of books. The HOPE credit is only available for a student pursuing a course of study on at least a half-time basis. The HOPE credit is disallowed if the student has been convicted of a felony drug offense.
The Lifetime Learning credit is a nonrefundable credit
equal to 20% of qualified tuition expenses not exceeding $5,000. For taxable
years beginning on or after January 1, 2003, the dollar amount increases to
$10,000. The credits have AGI phase-out amounts and are indexed for inflation.
For a taxable year, a taxpayer may elect with respect to an eligible student
the HOPE credit, the 20% Lifetime Learning credit, or the exclusion from gross
income for certain distributions from an education IRA. Qualified tuition and
fees for purposes of the Lifetime Learning credit include tuition and fees
incurred with respect to undergraduate or graduate-level (and professional
degree) courses. The Lifetime Learning credit is also allowed with respect to
any course of instruction at an eligible educational institution (whether
enrolled in by the student on a full-time, half time, or less than half-time
basis) to acquire or improve job skills of the student. The HOPE credit is
effective for expenses paid after December 31, 1997 (in taxable years ending
after such date), for education furnished in academic periods beginning after
such date. The Lifetime Learning credit is applicable to expenses paid after
June 30, 1998 (in taxable years ending after such date), for education
furnished in academic periods beginning after such date.
The Act provides an above-the-line deduction for interest paid on student
loans. In 1998, the maximum amount is $1,000; 1999 $1,500; 2000 $2,000; 2001
or thereafter $2,500. The deduction phases out at income levels beginning at
$40,000 for individuals and $60,000 for joint returns (indexed for inflation
beginning after 2002). The deduction is allowed only with respect to interest
paid on any qualified education loan during the first 60 months in which
interest payments are required. No deduction is permitted for taxpayers who
may be claimed as dependents on another taxpayer's return. The deduction of
student loan interest applies only to qualified education loans incurred on,
before, or after the date of enactment, but only with respect to any loan
interest payment due and paid after December 31, 1997, and the portion of the
60-month period after December 31, 1997.
Beginning in 1998, the 10% early withdrawal tax penalty on IRA distributions
would not apply to distributions from IRAs. The taxpayer must use the amounts
to pay qualified higher education expenses (including those related to
graduate-level courses) of the taxpayer, the taxpayer's spouse, or any child,
or grandchild of the taxpayer or the taxpayer's spouse. The provision would
be effective for distributions after December 31, 1997, with respect to
expenses paid after such date for education furnished in academic periods
beginning after such date.
Education Individual Retirement Accounts
The act allows taxpayers to establish education IRAs, meaning trusts or
custodial accounts treated exclusively for the purpose of paying qualified
higher education expenses of a named beneficiary. Annual contributions to
education IRAs may not exceed $500 per beneficiary, and may not be made after
the beneficiary reaches age 18. The contribution limit is phased out
for certain high-income contributors. No contribution may be made by any
person to an education IRA during any year in which any contributions are made
by anyone to a qualified State tuition program on behalf of the same
beneficiary. Until a distribution is made from an education IRA, earnings on
contributions to the account are not subject to tax. In addition, the
bill provides that distributions from an education IRA are excludable from
gross income to the extent that the distribution does not exceed qualified
higher education expenses incurred by the beneficiary during the year the
distribution is made, regardless of whether the student is enrolled
in classes on a full-time, half-time, or less than half-time basis. However,
certain room and board expenses are qualified higher education expenses only
if the student incurring such expenses is enrolled at an eligible educational
institution on at least a half-time basis. The earnings portion of an
education IRA distribution not used to pay qualified higher education
expenses is includible in the gross income of the distributee and generally is
subject to an additional 10-percent tax penalty. However, prior to the
beneficiary reaching age 30, the bill allows tax-free (and penalty-free)
rollovers of account balances from an education IRA benefitting one family
member to an education IRA benefitting another family member. The
provisions governing education IRAs apply to taxable years beginning after
December 31, 1997.
Savings and Investment Incentives
Individual Retirement Arrangements
The Act increases the adjusted gross income (AGI) phase-out limits for determining eligibility to make deductible contributions to an IRA over a period of years. For single taxpayers the range is as follows:
For taxpayers filing joint returns, the range is as follows:
Under prior law a spouse not covered by a retirement plan could not make a
deductible IRA contribution if the other spouse was covered by a qualified
retirement plan. The Act provides that a non-covered spouse can make a
deductible IRA deduction. However, the maximum deductible IRA contribution for
an individual who is not an active participant, but whose spouse is, is
phased out for taxpayers with AGI between $150,000 and $160,000.
The Act establishes a new type of nondeductible IRA called the "Roth IRA". If
the Roth IRA is invested for more than 5 years and withdrawn after age 59 .5,
the earnings are not taxable. The maximum contribution that can be made to a
Roth IRA is phased out for individuals with AGI between $95,000 and $110,000
and for joint filers with AGI between $150,000 and $160,000. The Roth IRA is
not subject to the current minimum distribution requirements at age 70 .5
and contributions can be made after that age. Only taxpayers with AGI of less
than $100,000 are eligible to roll over or convert a current IRA into a Roth
IRA. In 1998, all or part of a current IRA can be rolled into a Roth IRA with
the income tax spread over a four-year period. The bill retains present-law
nondeductible IRAs where the earnings are tax-deferred until withdrawn.
Thus, an individual can make contributions to either a deductible IRA, the
current non-deductible IRA, or a Roth IRA. In no case can contributions to all
an individual's IRAs for a taxable year exceed $2,000. In most situations,
the Roth IRA will yield better financial returns than either a current
deductible or non-deductible IRA. Also, the 10% early withdrawal penalty for
distributions from an IRA before age 59 1/2 does not apply to distributions
from any IRA for first-time homebuyer expenses. The provision applies to
payments and distributions in taxable years beginning after December 31, 1997.
In addition, effective for taxable years beginning after Dec. 31, 1997, the
IRAs assets may be invested in certain platinum coins and in certain gold,
silver, platinum, or palladium bullion.
Capital gain
The Act reduces the maximum capital gains rate for individuals from 28% to 20%
(10% for taxpayers in the 15% bracket), effective May 7, 1997. Real estate
depreciation recapture generally will be taxed at a maximum rate of 25
percent. The present maximum 28% rate will be retained for collectibles and,
effective July 29, 1997, for assets held between 1 year and 18 months.
Beginning in `01, the 20% rate drops to 18% (10% drops to 8%) for assets
purchased on or after January 1st, '01 and then held for 5 years. An existing
asset can qualify by paying the tax or marking to market value. Caution: Does
it make sense to recognize gain and pay tax on an appreciated asset in '01 to
hold the asset an additional 5 years to get a 2% reduction in capital
gain rate???
Sales of personal residence
No tax is owed on the gain from the sale of a principal residence up to
$250,000 (single return), $500,000 (joint return) effective May 7, 1997.
Taxpayers must have owned and lived in the home for 2 of the last 5 years.
This provision replaces the over age 55 exclusion of $125,000 of gain
and the IRC §1034 rollover of gain into a replacement residence. The new
provision has no age requirements and can be used as often as every 2 years.
However, any depreciation taken on a portion of the personal residence used
for a home office or other business purpose, after May 7, 1997 will result in
taxable income if the personal residence is later sold at a gain.
Alternative minimum tax
The Act repeals IRC § 56(a)(6) which was the basis for the IRS position that
installment sales income for deferred payment contracts were subject to the
alternative minimum tax effective for contracts after 1987. Thus, qualified
farmers are eligible to use the installment sales method of accounting for
both regular tax and alternative minimum tax purposes.
Generally, farmers sell crops in the fall with a portion of the payment to be
received the following year. High prices, traditional marketing practices,
and a shortage of storage have provided an incentive for farmers to enter into
contracts that lock in these high prices, transfer title, which avoids storage
costs, and receive payment in the following tax year. If the contract
meets the deferred payment contract requirements, the income is reported for
regular tax purposes in the next year when the money is received. A valid
deferred payment contract can not be assigned or used as collateral for a
loan. Also, the contract must not allow any legal right to the money until
the next year. Farmers should ignore IRS Notice 97-13, which allowed taxpayers
until the due date for 1997 farm tax returns to change their method of
accounting and pay (AMT)on deferred payment contracts. The United States tax
court has recently decided a case in favor of William and Vivian Loomis,
farmers that the IRS said should pay (AMT) on their deferred payment
contracts. Farmers may be able to claim a refund if they voluntarily paid
(AMT) on deferred payment contracts. Many farmers were audited by IRS and
paid the tax. Other farmers may have paid tax as a result of an IRS appeals
settlement or court case decided before the new law was passed.
Two distinct procedures are available for farmers to claim a refund. First,
tax returns filed within the last 3 years can be amended by filing Form 1040X.
This form requires an explanation of the reason for the change. Simply state
that the Tax Relief of 1997 repealed (AMT) for installment sales retroactive
to 1987. Second, for taxes paid within the last 2 years, the IRS form 843 can
be used to file a claim for refund. The dollar amount of the claim is not
required to hold the statute open for refund. The form 843 may be marked
"Protective Claim for Refund of (AMT)". IRS will calculate the amount of the
refund. Caution: There is no provision to extend the 3-year statute for
filing an amended return, or the 2-year window to request a refund from the
date tax was paid. If a farmer paid (AMT) on a deferred payment contract, act
now to secure a refund.
Alternative Minimum Tax repealed for Small Corporations
Corporations both farm and non-farm with gross receipts of less the $5 million
will be exempt from the Alternative minimum tax beginning in 1998. To qualify,
a corporation must have average gross receipts of $5 million or less for the
three years prior to its 1998 tax year. To continue to qualify after 1998, or
to qualify for the first time as a small business, the company's three-year
average gross receipts can not exceed $7.5 million. If a business fails to
qualify in a later tax year, it will apply the (AMT) rules to income,
deductions, and transactions from the failure year and all future years.
Alternative Minimum Tax Depreciation Adjustment
The 1997 Tax Relief Act allows the same recovery period for both regular tax
and (AMT) purposes. Previously (AMT) required a longer alternative MACRS
recovery period. This change conforms the recovery period to one period for
both for assets placed in service after 1998. However, if a non-farm taxpayer
selected a 200% macrs depreciation method, it would create an (AMT) adjustment
because 150% macrs method for (AMT) would result in less depreciation. The
new law conforms regular tax and (AMT) recovery periods but does not
conform depreciation methods. Thus an (AMT) depreciation adjustment would be
possible for a non-farm taxpayer. Because the 1988 Tax Act limits farmers to
150% macrs for all property used in the trade or business of farming, a
farmer's depreciation method would be the same for both regular and (AMT)
purposes. Thus, the (AMT) depreciation adjustment for farmers is
eliminated but only for assets purchased after 1998. Don't throw away the
(AMT) software yet.
Estate Tax
The present-law Federal estate tax exemption of $600,000 is increased to
$625,000 for decedents dying and gifts made in `98; $650,000 in `99; $675,000
in 2000 and `01; $700,000 in `02 and `03; $850,000 in `04; $950,000 in `05;
and $1 million in `06 and thereafter. These amounts are not indexed for
inflation. After `98, the $10,000 annual exclusion for gifts, the $750,000
ceiling on special use valuation, the $1,000,000 generation-skipping transfer
tax exemption, and the $1,000,000 ceiling on the value of a closely-held
business eligible for the special low interest rate are indexed annually for
inflation.
Estate tax exclusion for qualified family-owned businesses
For estate tax purposes beginning in `98, an executor may elect to exclude the
value of certain qualified "family-owned business interests" if such interests
comprise more than 50 percent of a decedent's estate and certain other
requirements are met. The decedent or a member of the decedent's family must
have participated in the business for 5 of 8 years before death. Also, a
qualified heir must participate in the business for 5 of 8 years during the 10
years after death. Also, during the 10-year period after death the estate tax
benefits will be recaptured if assets are sold to other than a qualified heir.
To meet the before and after participation requirements decedents or heirs
must be involved in the physical production and/or management
of agricultural production to a level that makes the earnings from that
production subject to self-employment tax. Farmers who "rent out" farm assets
to draw social security benefits in 4 of the 8 years before their death, may
not qualify, unless they or a qualified family member meets the 5 of
8 year participation requirements. The exclusion for family-owned business
interests may be taken only to the extent that the exclusion for family-owned
business interests, plus the amount effectively exempted by the federal estate
tax deduction, does not exceed $1.3 million.
Reduction in estate tax for certain land subject to permanent
conservation easement
An executor may elect to exclude from the taxable estate 40 percent of the
value of any land subject to a qualified conservation easement. It must meet
the following requirements: (1) the land is located within 25 miles of a
metropolitan area or a national park or wilderness area, or within 10 miles of
an Urban National Forest; (2) the land has been owned by the decedent or a
member of the decedent's family at all times during the three-year period
ending on the date of the decedent's death; and (3) a qualified conservation
contribution of a qualified real property interest was granted by the decedent
or a member of his or her family. The maximum exclusion for land subject to a
qualified conservation easement is limited to $100,000 in 1998, $200,000 in
1999, $300,000 in 2000, $400,000 in 2001, and $500,000 in 2002 and thereafter.
The exclusion for land subject to a qualified conservation easement may be
taken in addition to the maximum exclusion for qualified family-owned business
interests (i.e., there is no coordination between the two provisions).
Debt-financed property is eligible for this provision to the extent of the net
equity in the property.
Installment payments of estate tax attributable to closely held
businesses
For estate tax installment payments a 2% interest rate applies to tax on
$1,000,000 in taxable value of the closely held business assets above any
federal exemption. The remainder of such taxes is subject to interest at a
rate equal to 45 percent of the rate applicable to underpayments of
tax (this rate is now approximately 8.5%), and all interest paid on the
installment basis are made nondeductible. Taxpayers currently deferring taxes
can make a one-time election to receive similar treatment.
Estate tax recapture from cash leases of specially-valued property
If land in a farmer's estate is worth more for non-farm uses, the land can be
valued at farm use if a qualified heir operates the land for 10 years after
death. The Act clarifies that the cash lease of special use valued real
property by a lineal descendant of the decedent to a member of the lineal
descendant's family, who continues to operate the farm or closely held
business, does meet the qualified farm use test. Under prior law such cash
leases triggered recapture or immediate payment of estate tax at the higher
non-farm use value.
Livestock sales effect Earned Income Credit
The 1996 Tax Reform Act of 1996 added two new classes of "disqualified
income". Farmers that receive more than $2200 of capital gain net income and
net passive activity income are not eligible for earned income credit.
Interest, dividends, net rents and royalties are also disqualified income.
IRS interpreted capital gain net income to include gains realized on the sale
of draft, breeding, dairy and sporting livestock. Thus, a farmer who sold
cull cows of more than $2200 was not allowed EIC. Provisions in both the
House and Senate versions of the 1997 legislation were designed to fix the
problem. Those changes were not included in the final bill.
For 1997 breeding cow sales could knock out the EIC. Possible Solution: Sales
of breeding livestock are reported on Form 4797 based on the farmer's intended
breeding use. If, after the decision was made to cull breeding cows, these
same cows were sent to the feedlot or fattened on pasture, they may be held
for sale in the ordinary course of the farmer's trade or business.
Caution: additional self-employment tax must be weighed against savings from
the earned income credit.
Treatment of livestock sold on account of weather-related conditions
Under prior law, farmers could use either of two provisions to defer gain
recognized on the sale of livestock sold on account of drought. IRC §451(e)
allows farmers to postpone reporting of gain from the sale of livestock for
one year. The other provision allows farmers to postpone gain from dairy,
draft, or breeding livestock if like animals are replaced within two years,
IRC §1033(e). Gain is postponed only for sales in excess of normal sales, and
is subject to other requirements. See Farmer's Tax Guide, Pub 225. The 1997
act expands these present-law exceptions to livestock sold on account of flood
or other weather-related conditions. The provisions are effective for sales
and exchanges after 1996.
Income averaging
Income averaging for farmers is allowed on a temporary basis for three years
only starting in 1998, 1999, and 2000. Farmers can elect to remove all or part
of current (1998) farm income from total taxable income and spread it over the
3 pres. Tax would be based on the marginal rate effective in the last 3 years.
The provision applies only to income tax and would not change self- employment
tax.
Net operating losses and business credits
The act modifies net operating loss ("NOL") carryback and carryforward rules.
The NOL carryback period is reduced to two years (from three years) and
increases the NOL carryforward period to 20 years (from 15 years). The 3-year
carryback is retained for NOLs attributable to casualty losses of individuals
and NOLs of farmers and small businesses attributable to losses
incurred in Presidential declared disaster areas. The provision is effective
for NOLs arising in taxable years beginning after the date of enactment. The
act also reduces the carryback period for the general business credit to one
year (from three years) and extends the carryforward period to 20 years (from
15 years). The provision is effective for credits arising in taxable years
beginning after December 31, `97.
Self-employed health insurance deduction
The act increases the deduction for health insurance of self-employed
individuals. The deduction is 40 percent in `97, 45 percent in `98 and `99, 50
percent in `00 and `01, 60 percent in `02, 80 percent in `03 through `05, 90
percent in `06, and 100 percent in `07 and thereafter. The business
percentage is taken as an adjustment to Gross income with the remainder
allowed as a medical expense on schedule A, itemized deductions.
Home office deduction: clarification of definition of principal
place
of business:
The act expands the definition of "principal place of business" to include a
home office that is used by a taxpayer to conduct administrative or management
activities of the business, provided that there is no other fixed location
where the taxpayer conducts substantial administrative or management
activities of the business. As under present law, deductions will be allowed
for a home office only if the office is exclusively used on a regular basis as
a place of business and, in the case of an employee, only if such exclusive
use is for the convenience of the employer. The provision applies to taxable
years beginning after December 31, 1998. This new provision may allow a farmer
who lives in a town near the farm to deduct home office expenses. The
business portion of the home must be used regularly and exclusively for record
keeping, management, marketing, and other administrative activities.
The 1997 Tax Relief Act provides significant tax savings for many farmers. While complex requirements and phase-in rules must be met, this law offers the most generous tax planning opportunities of any recent tax legislation. We encourage farm clients to get their records "up-to-date" before year-end to take advantages of these planning opportunities. Tax benefits like the 1.3 million estate tax exclusion will require long-term tax and business organization planning, but the potential tax savings may be well worth the effort.
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