OVERVIEW

The IRS Restructuring and Reform Act of 1998 is a major attempt to rein in probably the most unpopular government agency, the IRS, through a ground-up reorganization - the most extensive in at least 40 years. But this legislation is far from being only about a new IRS organizational chart.

The two most important parts of the new Act, in fact, have nothing to do with IRS reform or reorganization at all. First, the Act changes the long-term Capital Gains holding period, and second, the Act's "technical corrections" significantly affect many of the initial tax planning assumptions associated with key provisions in last year's Taxpayer Relief Act of 1997.

The "Taxpayer Bill of Rights 3" - another major section in the Act - tackles IRS reform by giving taxpayers a broad array of new rights and protections which will create many planning opportunities (and pitfalls) for taxpayers and their advisors. The new law also carves out a separate "Electronic Filing" section which focuses on the increasingly critical role electronic filing plays in tax compliance.

To pay for all these new provisions - the Act adds a $13 billion lit of ":revenue raisers" that target both individuals and businesses.

CAPITAL GAINS LAW

The Act - in a measure that did not arise until the closing hours of Conference Committee negotiations - lowers the holding period for long-term capital gain entitled to the 20% capital gains tax rate that had been approved only last year (10% for those in the 15% income tax bracket.) Effective retroactively to January 1, 1998, the required holding period drops from 18 months to 12 months.

This change is also a solution to the embarrassingly complex computations required on Form 1040, Schedule D, as the result of a multi-tiered capital gain rate structure. Nevertheless, complications remain for some taxpayers, since the 25% rate group (in connection with unrecaptured section 1250 gain) started by TRA '97 continues intact (except it now encompasses property held more than 12 months.) Even the 28% rate group survives for collectibles and section 1202 gain.

ROTH IRA

New Rules for Roth Withdrawals
     The new Act now makes complex Roth IRA rules even more complicated for many taxpayers who go the Roth conversion route in 1998. TRA '97 originally intended that converted funds from existing IRAs be held in the Roth IRA for at least 5 years before withdrawal. But the statutory language did not stop taxpayers from receiving premature distributions from a Roth Conversion IRA while attaining the benefits of 4-year income averaging on 1998 converted amounts, and paying no early withdrawal tax. That has been changed, but not using the solution first proposed last fall.

The Act imposes a new toll charge on premature, unqualified withdrawals. If converted amounts are withdrawn within the 4-year spead period, then, to the extent attributable to amounts not yet paid for under the 4-year sperad rule, the amount withdrawn will be subject to an unfavoragle income-acceleration rule. But new ordering rules - to determine which amounts are withdrawn for tax purposes when a Roth IRA contains both conversion and contributory amounts (not recommended) or conversion amounts from different years - make computations even more complex in many situations.

EXAMPLE
  Jones has a nondeductible IRA containing $60,000 ($45,000 contributions and $15,000 earnings). Jones converst the IRA to a Roth IRA in 1998. As a result, the $15,000 is scheduled to be included in income at $3,750 per year in 1998, 1999, 2000 and 2001. Assume that at the beginning of 1999 the account value is $66,000, and Jones makes an $18,000 withdrawal for a new car.

Result:
   Under the deemed-first-out rule, $7,500 of the original $15,000 of deferred Roth conversion income has already been taxed (the $3750 installments for 1998 and 1999). Jone's withdrawal forces the $7,500 in income that would have been spread over years 2000 and 2001 to be accelerated into 1999.

Three New Roth Tax Breaks:

Roth IRA conversions now have additional options to consider:

(1) Those who convert to Roth IRAs may elect to recognize all income in the year of conversion rather than ratably over four years;

(2) Taxpayers have until the due date of their return, including extensions, to change their minds about any Roth IRA conversion that takes place at any time during the tax year (this rule particularly helps taxpayers who incorrectly project the size of their adjusted gross income (AGI) as less than the $100,000 cut-off for Roth conversion, and;

(3) A surviving spouse who is a beneficiary of a 1998 Roth conversion IRA can elect to continue to defer income over the remainder of the 4-year spread period.

Innocent Spouse Relief

Innocent spouse relief should generally be easier to obtain with the elimination of understatement thresholds and allowing relief for simply "erroneous," not only "gross erroneous," income items. In addition, spouses who are divorced, legally separated, or living apart for at least 12 months will be able to make a separate-liability election with respect to an understatement - as late as two years after the IRS has initiated collection activites. The Act will also requrie the IRS to establish procedures to notify taxpayers of their joint and several liability, as well as innocent spouse rights and election.

UNDER CONSTRUCTION

Overview

Capital Gains

Roth IRA
withdrawal rules
new tax breaks

Spouse Relief

IRS Changes

Taxpayer Rights