A New Wave of Tax Changes Nears

Partisan bickering shelved hopes for a major tax bill in 1996, but Congress passed significant tax changes anyway by folding them into three recent pieces of legislation--all of which President Clinton has promised to sign into law.

Taken together, there are more than 650 tax changes included in the minimum-wage act, the health insurance portability bill and the welfare reform law--although most are minor--according to CCH Inc., a Riverwoods, Ill., publisher of tax information.

How might these changes affect you? Here’s a rundown of some of the more significant consumer-oriented changes.

* Spousal individual retirement accounts: Under current law, couples with a stay-at-home spouse can contribute a maximum of $2,250 to a tax-deductible IRA--generally broken down as $2,000 for the worker and $250 for the nonworking spouse. The new legislation would allow these couples to contribute up to $4,000 annually--$2,000 per person.

However, the ability to deduct IRAs is still limited for those who are eligible to participate in another qualified pension.

* Damage awards: In the past, if you won compensatory damages in a court case involving a personal injury, the damages were exempt from federal income taxes, says Philip J. Holthouse, partner at Holthouse Carlin & Van Trigt in Los Angeles. However, the minimum-wage law stipulates that compensatory damages are only tax-free when there is a physical injury. Emotional and other personal injuries will not qualify for the preferential tax treatment, he says. In addition, punitive damages will always be taxable--regardless of whether or not they result from a physical injury--thanks to the new law.

These rules go into effect on the date of enactment, but settlements involving continuing payments will continue to be tax-free if they were entered into by Sept. 13, 1995.

* Long-term care premiums: Individuals who buy long-term care insurance will be able to deduct premium costs as a medical expense, thanks to the health-reform law. In addition, the new law permits tax-free treatment of policy benefits that do not exceed $175 a day. The $175-a-day figure will be indexed for inflation after 1997, according to CCH.

* Accelerated death benefits: A long-standing question about the taxability of accelerated death benefits--also known as viatical settlements--has been answered by the health-care bill.

Starting next year, terminally ill people who sell their life insurance contracts will not have to pay federal income taxes on the income they receive from that sale. Chronically ill individuals with more than 24 months to live can sometimes convert to a long-term-care insurance contract and be subject to those limitations cited above.

* Adoption assistance: In the past, if you adopted a special-needs child--a child who was unlikely to be adopted because of physical, emotional or mental handicaps or other problems--you could have received up to $1,000 in nontaxable government assistance to reimburse you for some adoption expenditures.

The minimum-wage law provides an additional tax break to all adoptive parents--regardless of the child’s special needs. The tax break--a nonrefundable tax credit--would amount to the family’s qualified adoption expenses up to $5,000 per child. In addition, those who adopt special-needs children would get an additional $1,000 credit for a total of $6,000.

What are qualified adoption expenses? Attorney’s fees, court costs and other expenses that are directly related to a legal adoption. Even construction and renovation costs would be eligible for the credit if a state agency required you to add onto your house to adopt a child, according to a summary of the legislation prepared by the Bureau of National Affairs in Washington, D.C.

Any portion of the credit that wasn’t used up in the year the expenses incurred could be carried forward and used in subsequent tax years.

However, no credits are allowed for illegal adoptions; surrogate parent arrangements; or in connection with adopting the child of the taxpayer’s spouse. The credit is phased out for those with modified adjusted gross income above $75,000 and is completely eliminated for those with more than $115,000 in modified AGI.

* Expatriates: The health-insurance bill raises revenue by penalizing people who give up their U.S. citizenship and move to foreign lands.

Under current law, expatriates can be subject to U.S. taxes if the Internal Revenue Service can prove that you left the country to avoid taxes, Holthouse says.

However, the new law eliminates that burden of proof. In the future, the government will assume that anyone with annual income exceeding $100,000 or assets in excess of $500,000 who leaves the U.S. and renounces their citizenship has moved to avoid taxes. That gives the government the ability to tax these expatriates on their U.S. source income for up to 10 years, Holthouse says.

There are a few minor exceptions for people who currently have dual citizenship or were born in foreign countries, he adds. But most high-income individuals who leave the United States will simply be branded as tax cheats and penalized under the new law.

* Earned income tax credit rules tightened: The welfare law makes a series of technical modifications to the earned income tax credit, which are aimed at making sure that people with substantial assets and nontaxable income are excluded from the program, says Nancy Anderson, manager of special tax projects at H&R; Block in Kansas City, Mo.

Specifically, it says that capital losses--those incurred when you lose money on an investment--cannot be used to decrease your taxable income for purposes of claiming the earned-income credit. Additionally, some nontaxable income--including interest earned on municipal bonds--will have to be included in the calculation, which could knock out a few EIC recipients.

Separately, the government will also tighten rules regarding reporting taxpayer identification and Social Security numbers. Those who don’t have valid numbers will be barred from claiming a host of tax breaks, including the EIC, the dependent-care credit and personal-exemption deductions.