1996 tax legislation offers planning opportunities.

• Author: Bukofsky, Ward M.

Although no major (e.g., budget reconciliation) tax bill was enacted in 1996, many provisions affecting individuals were included in the seven pieces of tax legislation that were passed. Although not headlinegrabbing, these tax law changes present a host of new information with which practitioners should be familiar to properly advise clients in 1997 and beyond. This article summarizes these provisions and highlights the available planning opportunities.(1)

Spousal IRAs

Effective for tax years beginning after 1996, SBJPA Section 1427(a) amends Sec. 219(c) to allow a one-earner couple to contribute to an individual retirement account (IRA) and deduct up to $4,000 a year ($2,000 per spouse), as long as the spouses, combined compensation at least equals their total contributions. The additional $1,750 ($2,000 - $250) of available deduction for the nonworking spouse can save up to $693 of Federal taxes for a couple in the 39.6% tax bracket. Although not a dramatic development, clients should be alerted to this opportunity; over time, the value of the deduction and additional tax-deferred retirement build-up can be significant.

Adoption Credit

SBJPA Section 1807(a) enacted Sec. 23 to provide a nonrefundable $5,000 adoption expense credit per child for qualified adoption expenses (QAEs) paid or incurred by the taxpayer. The credit increases to $6,000 for "special needs" adoptions (e.g., ethnic background, age, membership in a minority or sibling group, or physical, emotional or mental handicaps) of children who are US. citizens or residents. Any unused credit can be carried forward for up to five years. For credit purposes, QAEs are taken into account in the year after the year first paid or incurred and in the year the adoption becomes final.

Example 1: Y pays $2,000 in QAEs in 1997, $1,000 in 1998 and $3,000 in 1999 (when the adoption becomes final) to adopt a U.S. nonspecial-needs child. Y can take a credit of $2,000 in 1998 and $3,000 in 1999.

QAEs are defined by Sec. 23(d)(1)(A) to include reasonable and necessary adoption fees, court costs, attorneys, fees, travel expenses, certain expenses for a birth mother's prenatal care and other expenses directly related to the legal adoption of an eligible child. Home construction and renovation costs are also eligible if a state agency requires them as a condition of adoption.

No credit is allowed for (1) an adoption of a child of the taxpayer's spouse, (2) a surrogate parenting arrangement, (3) adoption expenses paid or reimbursed by the individual's employer (whether or not reimbursed under an adoption assistance program) or (4) expenses for which a grant is received under any Federal, state or local program.

In addition, under SBJPA Section 1807(b), amending Sec. 137, an employee may exclude from income up to $5,000 per child for specified adoption expenses paid by the employer. The exclusion increases to $6,000 for domestic special-needs adoptions.

There are phase-outs of the credit md exclusion at specified income limits; each phases out ratably for taxpayers with modified adjusted gross incomes (MAGIs) (as defined in Secs. 23(b)(2)(B) and 137(b)(3)) above $75,000, with full phase-out at $115,000 of MAGI. The credit or amount excludible is reduced (but not below zero) by an amount that bears the same ratio to the credit or excludible amount (determined without the phase-out but with regard to the dollar limits) as the excess (if any) of the taxpayer's MAGI over $75,000 bears to $40,000.

Example 2: X, who is single, adopts a U.S. nonspecial-needs child in 1997, incurring $5,000 in QAEs; the adoption becomes final that year. X's 1997 MAGI is $110,000; X's adoption credit for 1997 is limited to $625, determined as follows:

Allowable Credit = QAE - (QAE MAGI - $75,000/$40,000)

= $5,000 - ($5,000 ($110,000 - $75,000)/40,000)

= $5,000 - ($5,000 ($35,000/$40,000)

= $5,000 - ($5,000 (0.875))

= $5,000 - $4,375

= $625

The taxpayer is required to provide (if known) the child's name, age and taxpayer identification number (TIN); the IRS may require other information instead, such as identification of the agent assisting with the adoption. Taxpayers should maintain records to support any adoption credit or exclusion claimed. Notice 97-9(2) provides additional information on both the credit and the exclusion.

These provisions are effective for tax years beginning after 1996; an expense paid (by a cash-basis taxpayer) or incurred (by an accrual-basis taxpayer) in a tax year beginning before 1997 is not a QAE eligible for credit or exclusion. The credit will be available for QAEs paid or incurred after 2001 only if the adoptee is a special-needs child, the exclusion win not be available at all for amounts paid or expenses incurred after that year.

Medical Expense Provisions

MSAs

HIPAA Section 301 created medical savings accounts (MSAs) in Sec. 220, tax-favored savings (i.e., IRA-type) accounts established to fund employee health benefits and medical care expenses in conjunction with high-deductible health insurance policies. The rules are somewhat complicated and the applicability limited, but the benefits could be worthwhile for certain small-business employees and self-employed (SE) individuals.

An MSA is available only to small employers (those who employed an average of 50 employees or less in either of the two preceding years), and SE individuals with a high-deductible health plan. Employees are eligible for MSA coverage only through employer-sponsored high-deductible health plans; no other health insurance may be provided by the employer. A high-deductible health plan is defined by Sec. 220(c)(2) as one with a $1,500-$2,250 deductible for individual coverage ($3,000-$4,500) deductible for family coverage).

Contributions and distributions: Generally, the maximum annual deductible contribution that an individual may make to an MSA is 65% of the annual deductible (for individual coverage) or 75% of the annual deductible (for family coverage); the actual calculation under Sec. 220(b) is done on a monthly basis. The deduction is above the line, but cannot exceed the employee's compensation from the employer maintaining the MSA, or, for SE taxpayers, the individuals earned income from the business maintaining the MSA.

Normally under Sec. 106(a), contributions by small employers to MSAS are not includible in an employee's income. According to Sec. 220(d)(4)(B), for a given year, employees may make tax-deductible contributions to an MSA until April 15 of the following year, if certain requirements are met. Distributions used for medical expenses of an account holder (as defined in Sec. 220(d)(3)) are tax-free under Sec. 220(f)(1); otherwise, they are includible in income and subject to an additional 15% penalty under Sec. 220(f)(2) and (4). However, the penalty is waived under Sec. 220(f)(4)(B) and (C) if the distribution is taken after age 65 or if the taxpayer dies or becomes disabled.

Treatment of account at death: The fair market value (FMV) of the MSA balance at death is includible in the decedent's gross estate under Sec. 220(f)(8)(A). If the account holder's surviving spouse is the MSA's named beneficiary, the MSA becomes the surviving spouse's and the marital deduction is available; the surviving spouse is thus not required to include the MSA balance in income as a result of the death. The surviving spouse can exclude from income amounts withdrawn from the MSA for expenses incurred by the decedent prior to death (if they otherwise are qualified medical expenses).

If, on death, the MSA...