By Jeffrey B. Sansweet, Esq.
On August 5, 1997, the President signed into law the Taxpayer Relief Act of 1997. The Act contains over 800 amendments to the Internal Revenue Code and nearly 300 new Code provisions. The changes affect individuals, corporations, partnerships, pensions and estates. There are many different effective dates, including January 1, 1997, May 6, 1997, August 5, 1997, January 1, 1998 and January 1, 1999. Congress is already close to approving a 1997 Technical Corrections Bill. Needless to say, tax planning has become more complex. Fortunately, however, the Act does provide for significant tax relief, even for high income earners. This article will summarize the provisions of the Act which are most likely to affect physicians and their practices.
Capital Gains Cut
Perhaps the most publicized and significant change was the reduction in the maximum income tax rate on long-term capital gains from 28 percent to 20 percent. The 20 percent maximum rate applies to sales of capital assets on or after July 29, 1997 that were held for more than 18 months. Assets sold after May 6, 1997 but before July 29, 1997 and held for more than 12 months will also qualify for the 20 percent rate. In addition to the obvious impact of a reduction in taxes for sales of publicly held stock, physicians may also benefit upon a sale of their practices to the extent of the allocation of the purchase price to intangible assets (i.e., goodwill). The portion allocated to goodwill will be taxed at the lower capital gain rates except if the entity selling the practice assets is a regular C Corporation, in which case the rate is still 35 percent. In addition, physicians may be more likely to structure a larger part of their practice buy-ins as stock sales, as opposed to salary adjustments, since the difference in capital gain rates and the highest ordinary income rate is now almost 20 percent.
Sale of Personal Residence
Another significant change is the treatment of gain from the sale of a personal residence. Under prior law, there was a once-in-a-lifetime exclusion from taxation of up to $125,000 of gain from the sale of a principal residence, provided the seller was at least 55 and used the property as a principal residence for at least three of the five years preceding the sale. Prior law also defers the taxation of gain if a new residence with a cost at least equal to the sale price of the old residence is purchased and used as a principal residence within two years of the sale. The tax basis of the new residence is reduced by the gain on the old residence. The Act replaces the prior law one-time exclusion and rollover provisions. Under the Act, a married taxpayer filing jointly is generally able to exclude up to $500,000 ($250,000 for single taxpayers) of gain on the sale of a principal residence. To be eligible, the residence is required to have been owned and occupied as the taxpayer’s principal residence for a least two of the five years prior to the sale. The new provision is effective for sales after May 6, 1997.
Individual Retirement Accounts
The Act provides for a new type of IRA—the Roth IRA—first effective for taxable years beginning after December 31, 1997. Individuals may make nondeductible contributions of up to $2000 per year to a Roth IRA. The ability to make contributions is phased out for adjusted gross income levels between $95,000 and $110,000 for a single taxpayer, and between $150,000 and $160,000 for married taxpayers filing a joint return. The allowable contribution is also reduced by the amount of contributions made to regular non-Roth IRAs. Distributions received after age 59 1/2 that occur more than five years after the first contribution is made will be tax-free, which means the earnings of the Roth IRA would not be taxed.
Another new type of IRA—an Education IRA—is available under the Act effective for taxable years beginning after December 31, 1997. Annual nondeductible contributions are limited to $500 per named beneficiary and may not be made after the beneficiary reaches age 18. The distributions from this type of IRA are excludable from gross income to the extent that the distributions are used for higher education expenses. The contributions are limited by a ratio based on modified adjusted gross income, with the phase-out occurring at $95,000 and $110,000 for singles and at $150,000 and $160,000 for married couples filing jointly.
The Act also contains an easing of the restriction on deductible contributions to an IRA for nonworking spouses. Under prior law, if an individual or the individual’s spouse is an active participant in an employer-sponsored retirement plan, the individual’s $2000 IRA deduction limitation is phased out for adjusted gross income levels between $25,000 and $35,000 for singles and between $40,000 and $50,000 for married taxpayers filing jointly. The Act allows an individual who is not an active participant in an employer-sponsored retirement plan to deduct a contribution of $2000 to an IRA even if the individual’s spouse is an active participant. This deduction is first effective for taxable years beginning after December 31, 1997 and is phased out for levels of adjusted gross income between $150,000 and $160,000.
In addition, after December 31, 1997, withdrawals from regular IRAs for higher education expenses of the taxpayer, his or her spouse, child or grandchildren, will be permitted without a pre-age-59 1/2 ten percent penalty. Finally, up to $10,000 can be withdrawn from an IRA after 1997 for the purchase of a principal residence of a first-time home buyer without incurring the ten percent penalty.
Health Insurance Premiums
The Small Business Job Protection Act of 1996 phased in an increase in the deduction of health insurance premiums for self-employed individuals, partners and at least two percent owners of S Corporation stock. The Act accelerates the phase in as follows: 40 percent—1997; 45 percent—1998 and 1999; 50 percent—2000 and 2001; 60 percent—2002; 80 percent—2003, 2004, 2005; 90 percent—2006; 100 percent—after 2006.
Regular C Corporations may deduct 100 percent of such premiums for its shareholders.
The Act liberalizes the home-office deduction requirements effective for taxable years beginning after December 31, 1998. Under current law, a deduction is allowed for a portion of a home only if such portion is used exclusively and regularly:
• As the “principal place of business” for a trade or business.
• As a place of business used to meet with patients, clients or customers in the normal course of the trade or business.
• In connection with the trade or business and constitutes a separate structure not attached to the dwelling unit.
Under the Act, a home office qualifies as the “principal place of business” if the office is used to conduct administrative or management activities for a trade or business, and there is no other fixed location of the trade or business where the taxpayer conducts substantial administrative or management activities of the trade or business.
Thus, for example, a hospital-based anesthesiologist with a home office and no other office where he or she conducts substantial administrative or management activities may be able to deduct home office expenses beginning in 1999.
The 1996 Act may not contain as many pension changes, but there is one very important change. The 1996 Act suspended the 15 percent excise tax on distributions from retirement plans that exceed certain thresholds (generally $160,000 in one year or $800,000 for a lump sum) for 1997, 1998 and 1999. The Act repeals the 15 percent excise tax for distributions received after December 31, 1996.
Retirement plans will need to be amended in order to comply with the Act, the 1996 Act, and previous legislation. However, the amendments will not be required prior to the end of the plan year beginning after December 31, 1998.
The Act contains many estate tax provisions. The most significant is the increase of the $600,000 exemption as follows: 1998—$625,000; 1999—$650,000; 2000 and 2001—$675,000; 2002 and 2003—$700,000; 2004—$850,000; 2005—$950,000; after 2005—$1,000,000.
In addition, the $10,000 annual gift tax exclusion will be indexed for inflation annually starting in 1999, rounded to the next lowest multiple of $1000.
Beginning January 1, 1997, employers and corporations that deposited more than $50,000 of payroll and estimated income tax in 1995 were required to remit all tax payments electronically via the Electronic Federal Tax Payment System (EFTPS). The 1996 Act deferred the January 1, 1997 date to July 1, 1997. The Act provides that no penalties shall be imposed solely by reason of not using EFTPS prior to January 1, 1998 if the taxpayer was first required to use EFTPS on or after July 1, 1997.
Certain small business corporations, effective for taxable years beginning after December 31, 1997, will not be subject to the alternative minimum tax (AMT). The possible exposure to corporate AMT has been one reason for physicians not to have buy-sell life insurance policies on their lives owned by the practice P.C. and with the proceeds payable to the P.C. Instead, many physicians have used a more complicated cross-purchase arrangement with individual policies.
Prior to 1998, an additional tax may be imposed on an individual’s underpayment of estimated tax if the tax liability is at least $500. The Act increases the $500 amount to $1000 after 1997.
Note that I have not discussed the much-publicized Hope Credit, Lifetime Learning Credit, child tax credit or deduction for student loan interest due to the low adjusted gross income phaseout ranges.
In summary, there are many changes in the Act that will benefit physicians and their practices. It would be wise for physicians to check with their accountants and financial planners to see what actions can be taken to take advantage of the new laws.
Jeffrey B. Sansweet, Esq., is a principal of the Wayne, Pennsylvania health care law firm of Kalogredis, Tsoules and Sweeney, Ltd.