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OVERVIEW OF THE IRS RESTRUCTURING & REFORM ACT

On July 22nd 1998, President Clinton signed into law the IRS Restructuring and Reform Act of 1998. In addition to its primary focus on IRS restructuring and enhancements to the Taxpayer Bill of Rights the IRS Law contained certain conditions which are commonly called "Technical Corrections". This will review some of the highlights of the key provisions of the new law.

• Reduction in 18-month capital gains holding.

The Tax Reform Act of 1997 reduced the maximum long term capital gains tax rate to 20% for assets held more than 18 months. Under the new law for tax years ending after December 31st, 1997, the holding period to be eligible for the maximum 20% rate is reduced one year.

Family owned business exclusion technical changes

The Tax Reform Act of 1997 provided new estate tax exclusion for family owned business interests. Subject to a number of qualification requirements, the exclusion equaled $1.3 million minus the exemption equivalent of the unified credit in the year of the decedent’s death. Thus, for decedent dying in 1998 when the applicable exemption amount is $625,000, the family owned business exclusion equals $675,000. By 2006, when the exemption equivalent will be $1 million, the family owned business exclusion would equal $300,000. The new law makes the following changes to the family owned business exclusion rules:

The family owned business interest exclusion has been converted into a family owned business deduction. One reason for this change is that the old exclusion approach created an issue whether the excluded portion of the business interest was eligible for the step up and basis normally accorded only to assets included in the estate.

The new law takes a different approach to coordinating the combined limit on the deduction and exemption equivalent to $1.3 million. Under the new law, the maximum deduction available for a qualified family owned business interest is $675,000, regardless of the year of the decedent’s death. However, if the maximum deduction is taken, the estate is limited to an exemption equivalent of $625,000, also regardless of the year of the decedent’s death.

Under the new law the estate would get a maximum deduction of $675,000. However, the estate’s unified credit would be the exemption equivalent of $625,000 even though, for estates not taking the FOBI deduction, the estate’s unified credit would be the exemption equivalent of $1 million.

On the other hand, if the family owned business interest is worth less than $675,000, then the $625,000 exemption equivalent amount is increased by the difference between the $675,000 and the amount of the family owned business interest.

• Trusts can be a qualified heir or family owned business interest deduction purposes.

The new law, in the committee report, clarifies that property passing to a trust may be treated as passing to a qualified heir for purposes of the family owned business interest deduction if all beneficiaries of the trust are qualified heirs.

ROTH IRA changes.

The new law makes a number of technical changes to the ROTH IRA rules.

One of the well-publicized loopholes under the Tax Reform Act of 1997 related to converting a regular IRA to a ROTH IRA in 1998. Under the loophole, someone could do the conversion, elect to pay any income tax on the converted amount over four years, without penalty, and then immediately withdraw the balance from the ROTH IRA. Since the ROTH IRA at that point would not have any income, and thus the distributions would not be taxable, the result was effectively to permit taxpayers to withdraw all of the money from a regular IRA for any purpose with no ten percent penalty and with the taxes deferred over four years. The new law changes and closes that loophole retroactively to January 1st 1998.

• Four-year income spread now made elective.

Under the Tax Reform Act of 1997 the four-year income spread on the taxable portion of a regular IRA converted to a ROTH IRA in 1998 was mandatory. The taxpayer could not elect to include the full amount of the conversion in the 1998 tax year.

The new law gives taxpayers the right to elect to recognize all of the income in the year of conversion. While most taxpayers are likely to want to take advantage of the opportunity to spread the taxable income over four years, those taxpayers, such as someone who expects to be in a higher bracket in later years, who want can now elect out of the four year rule.

• Taxpayer Bill of Right changes

After Congressional Hearings dealing with "abuses" by the IRS in dealing with taxpayers on audits and in Court proceedings, the new law contains a number of measures designed to better protect taxpayers involved in disputes with the IRS. Here are a few of the changes.

• Burden of Proof Changes

Under prior law, taxpayers generally have the burden of proof when contesting a tax that had been determined by the IRS. In other words, the taxpayer generally had to provide, by a preponderance of the evidence, that the IRS’s determination was in error.

Under the new law, except for certain large partnerships corporations and trusts, if the taxpayer introduces credible evidence with respect to an issue and meets certain other conditions (such as substantiation, maintenance of records, and cooperation with reasonable requests from the IRS), then the IRS will have the burden of proof with respect to that issue in any Court proceeding.

The new law also shifts the burden of proof to the IRS in any Court proceeding-involving reconstruction of income based on statistical information involving other taxpayers. This is commonly known as the cash "T"method.

Finally, the IRS will now have the "burden of production" in any Court proceeding on the issue of penalties. This means that the IRS must first introduce evidence to justify that it is appropriate to impose the penalty. If it meets that burden of production, then the burden of proof will be determined based on the normal rules including the rules discussed above.

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