On August 5th, 1997, President Clinton signed the Tax Relief Act of 1997. The majority of the changes apply for years beginning after December 31st, 1997. Exceptions to this include the Capital Gains Tax relief and the new exclusion for sellers of their principal residence.
HIGHLIGHTS OF NEW TAX ACT
TAX CREDIT FOR EACH QUALIFYING DEPENDENT CHILD UNDER AGE 18.
Beginning in 1998 parents get a tax credit equal to $400.00, $500.00 after 1998, for each qualifying dependent child under age 18. A phase out of the tax credit applies for joint taxpayers whose adjusted gross income exceeds $110,000.00.
IRAs DO NOT GO AWAY
Beginning in 1998 deductible IRA contributions will be easier. A spouse who is not a retirement plan participant, will be able to make a deductible IRA contribution, even if the other spouse is a plan participant. This new break phases out for those with adjusted gross income over $150,000.00.
ROTH IRA
This new IRA will not give you a deduction when you put the funds in, but will result in tax free distributions for payouts made after five years of maintaining the account after attaining age 59-1/2, death, disability or for certain first-time home buyer expenses. For joint filers, the phase out of this benefit is at $150,000.00.
Other IRA changes include non-deductible contributions up to $500.00 per beneficiary to an educational IRA. Distributions from the educational IRA to pay college expenses, will be tax and penalty free, if certain conditions are met.
INTEREST DEDUCTION BREAK
Part of qualified educational loan interest due and paid after 1997, may also be deductible. The maximum deductible amount is $1,000.00 for 1998, increases at $500.00 per year through 2001. Income restrictions are a bit more strict. Phase out occurs at $60,000.00 for joint filers.
CAPITAL GAINS BREAK
The top marginal tax rate on long-term capital gains has been reduced from 28% to 20%. This is for taxpayers in the maximum tax bracket. For those taxpayers who are not as fortunate, for example, a taxpayer in a 15% tax bracket, long-term capital gains would be taxed at only a 10% tax rate. There are new holding periods to comply with though, so be careful before your start selling your assets to receive the new law’s benefit.
For example, after July 8th, 1997, the new rates only apply if you held an asset for more than eighteen months on its sale date. This is a drastic change from the old law which provided for capital gain rates after twelve months.
CAVEAT
Long-term capital gains from the sales of collectibles continue to be taxed at a maximum rate of 28%, as well as additional exceptions to the rule.
HOMEOWNER TAX BREAK
Until the new tax law passed, homeowners were allowed a once-in-a-lifetime exclusion of $125,000.00, if they were age 55 or over. The new tax law allows up to a $250,000.00 of home sale profit to be tax free if the sale takes place after May 6th, 1997. For married parties filing joint, the exclusion is doubled to $500,000.00. This should be a major incentive for people to sell expensive homes and to be able to move down to a less expensive residence.
PROBLEMS FOR PAYMENTS TO LAWYERS
On all post-1997 payments to attorneys made in the course of a trade or business must now be reported to the IRS. The only exclusion would be payments already reported on a Form 1099 Misc. and a Form W-2. Obviously, the IRS is sending a message to attorneys who receive cash and may not have reported it. This provision is especially important to business taxpayers as they would generally be the entities on a regular and consistent basis paying legal fees.
Other unusual changes include the net operating loss carryback being decreased from two to three years, but increasing the carryforward from fifteen to twenty years. This change is relative to losses arising in tax years beginning after August 5th, 1997.
INDEPENDENT CONTRACTORS COVERED BY PENSION PLAN
Vizcaino et al vs. Microsoft, (9th Cir 1997.) During the late 1980s Microsoft employed a staff of regular employees who received a wide variety employee benefits, as well as using “freelancers”. The freelancers were considered to be independent contractors and a supplement to the regular staff. The freelancers were fully integrated into Microsoft’s work force, often working on teams with regular employees, sharing the same supervisors, performing the same functions, and working the same hours.
Microsoft required the freelancers to work on its premises, gave them admittance keys, office equipment and supplies. Unlike regular employees, however, they were not allowed to assign their work to others, nor were they paid overtime wages. Microsoft further did not issue the freelancer’s checks through the payroll department. The freelancers were required to submit invoices to the accounts payable department. They were also required to sign agreements acknowledging they were self-employed independent contractors who were responsible for their own taxes.
The IRS performed an employee-independent contractor audit at Microsoft. Utilizing the common-law factors to differentiate between employees and contractors, the IRS concluded that the freelancers were employees for income tax withholding and employment tax purpose. Microsoft thereupon issued the workers W-2s and paid its share of employment taxes for the year at issue. It then either offered the freelancers regular employment, or gave them the opportunity to work for a temporary agency that supplied workers to Microsoft.
A group of the freelancers then sought various Microsoft employee benefits, including participation in its 401-K Plan and its employee stock purchase plan, ESOP. Microsoft alleged their prior independent contractors’ agreement waived their right to benefits, and even if they had not, they would not deemed to be regular full-time employees and would otherwise not qualify.
The 9th Circuit Court of Appeals initially in a three judge panel had ruled that the independent contractors were common-law employees. Microsoft’s intent about their employment status was immaterial and assigned the case back to the plan administrator to the 401-K Plan. This particular issue on ESOP benefits then went back up to the 9th Circuit Court of Appeals, relative to whether the “employees” also qualified for the ESOP. The court held that the freelancers did indeed qualify as employees and, therefore, would also qualify for the plan.
This ruling is extremely important to all employers that have independent contractors, shared employees or other types of structures to eliminate employment taxes. The setup and structure of Employee vs. Independent Contractor, particularly with respect to fringe benefits is an extremely important issue and should be reviewed by your tax attorney immediately. In light of the court’s decision in Microsoft, it is clear that this issue will be hotly contested. Please feel to contact our firm to review your company’s status. Our firm is in the process of writing an extensive analysis of the new tax law. Please feel free to contact us for a complimentary copy after its publication.
Richard M. Colombik, JD, CPA, is an award-winning attorney and CPA with a doctorate in jurisprudence with distinction and was formerly on the tax staff of one of the world’s wealthiest families.
Mr. Colombik has also been a tax manager at a Big Four accounting firm, the State Bar’s liaison to the Internal Revenue Service (IRS), vice president of the American Association of Attorney-CPAs, and vice chairman of the American Bar Association’s Tax Section of the General Practice Council, as well as the past chair of the Illinois State Bar Association’s Federal Tax Committee. Mr. Colombik has also served on the liaison committee to the Washington, DC, National Office of the IRS. Mr. Colombik is also a member of the Asset Protection Committee, American Bar Association, and a member of its captive insurance subcommittee.
Mr. Colombik has appeared on numerous television shows, hosted a weekly radio show on tax and business planning, and authored more than 100 articles on income taxation, asset protection planning, IRS defense, and estate planning. He has also instructed more than 100 seminars to professional groups, business groups, bar associations, CPA societies, and insurance groups. This is in addition to authoring a published work on business entity structures offered by the Illinois Institute of Continuing Legal Education, as well as writing a chapter for The Estate Planning Short Course and Asset Protection Planning.