Tax Reform Act of 1986

Federal legislation that modified many significant aspects of the U.S. tax system.

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Landmark federal legislation enacted that made comprehensive changes in the system of U.S. Taxation. Among the law's major provisions:

Provisions Affecting Individuals

1. Lowered maximum marginal tax rates from 50% to 28% beginning in 1988 and reduced the number of basic Tax Brackets from 15 to 2-28% and 15%. Also instituted a 5% rate surcharge for high-income taxpayers.

2. Eliminated the preferential tax treatment of Capital Gains. Starting in 1988, all gains realized on asset sales were taxed at ordinary income rates, no matter how long the asset was held.

3. Increased the personal exemption to $1,900 in 1987, $1,950 in 1988, and $2,000 in 1989. Phased out exemption for high-income taxpayers.

4. Increased the Standard Deduction, and indexed it to inflation starting in 1989.

5. Repealed the deduction for two-earner married couples.

6. Repealed income averaging for all taxpayers.

7. Repealed the $100 ($200 for couples) dividend exclusion.

8. Restricted the deductibility of IRA contributions.

9. Mandated the phaseout of consumer interest deductibility by 1991.

10. Allowed investment interest expense to be offset against investment income, dollar-for-dollar, without limitation.

11. Limited unreimbursed medical expenses that could be deducted to amounts in excess of 7.5% of adjusted gross income.

12. Limited the tax deductibility of interest on a first or second home mortgage to the purchase price of the house plus the cost of improvements and amounts used for medical or educational purposes.

13. Repealed the deductibility of state and local sales taxes.

14. Limited miscellaneous deductions to expenses exceeding 2% of adjusted gross income.

15. Limited the deductibility of itemized charitable contributions.

16. Strengthened the Alternative Minimum Tax, and raised the rate to 21%.

17. Tightened home office deductions.

18. Lowered the deductibility of business entertainment and meal expenses from 100% to 80%.

19. Eliminated the benefits of Clifford Trusts and other income-shifting devices by taxing unearned income over $1,000 on gifts to children under 14 years old at the grantor's tax rate.

20. Repealed the tax credit for political contributions.

21. Limited the use of losses from Passive activity to offsetting income from passive activity.

22. Lowered the top rehabilitation tax credit from 25% to 20%.

23. Made all unemployment compensation benefits taxable.

24. Repealed the deduction for attending investment seminars.

25. Eased the rules for exercise of Incentive Stock Options.

26. Imposed new limitations on Salary Reduction Plans and Simplified Employee Pension (SEP) Plans.

Provisions Affecting Business

27. Lowered the top corporate tax rate to 34% from 46%, and lowered the number of corporate tax brackets from five to three.

28. Applied the Alternative Minimum Tax (AMT) to corporations, and set a 20% rate.

29. Repealed the investment tax credit for property placed in service after 1985.

30. Altered the method of calculating Depreciation.

31. Limited the deductibility of charges to Bad Debt reserves to financial institutions with less than $500 million in assets.

32. Extended the research and development tax credit, but lowered the rate from 25% to 20%.

33. Eliminated the deductibility of interest that banks pay to finance tax-exempt securities holdings.

34. Eliminated the deductibility of Greenmail payments by companies warding off hostile takeover attempts.

35. Restricted Completed Contract Method accounting for tax purposes.

36. Limited the ability of a company acquiring more than 50% of another firm to use Net Operating Losses to offset taxes.

37. Reduced the corporate Dividend Exclusion from 85% to 80%.

38. Limited cash and installment method accounting for tax purposes.

39. Restricted tax-exemption on Municipal Bonds to Public Purpose Bonds and specified Private Purpose Bonds. Imposed caps on the dollar amount of permitted private purpose bonds. Limited Prerefunding. Made interest on certain private purpose bonds subject to the AMT.

40. Amended the rules for qualifying as a Real Estate Investment Trust and the taxation of REITs.

41. Set up tax rules for real estate mortgage investment conduits (REMICs).

42. Changed many rules relating to taxation of foreign operations of U.S. Multinational companies.

43. Liberalized the requirements for employee Vesting rules in a company's qualified pension plan, and changed other rules affecting employee benefit plans.

44. Enhanced benefit of Subchapter S corporation status.

The Tax Reform Act of 1986 (100 Stat. 2085, 26 U.S.C.A. §§ 47, 1042) made major changes in how income was taxed. The act either altered or eliminated many deductions, changed the tax rates, and eliminated several special calculations that had been permitted on the basis of marriage or fluctuating income. Though the act was the most massive overhaul of the tax system in decades, some of its key provisions were changed in the Revenue Reconciliation Act of 1993 (107 Stat. 416).

The 1986 act reduced the number of income tax rates to two rates of 15 percent and 28 percent for most taxpayers, although a third rate of 33 percent was imposed on income within a certain upper-middle income bracket. Congress and the administration of President Ronald Reagan believed a policy of low rates on a broad tax base would stimulate the economy and end an era of complex tax laws and regulations that mainly benefited those who knew how to manipulate the system.

The 1986 act also sought to eliminate special incentives that made tax shelters attractive and the tax law more complicated. Income derived from real estate became distinguishable on the basis of whether it was "active" or "passive." Passive income is income derived from a situation in which the taxpayer does not have an active management role, but it does not include capital gains on stocks, interest income on bonds, or interest on money market accounts. Before 1986 wealthy individuals could use passive income losses from a real estate tax shelter to offset active income. The 1986 act limited the deduction of passive losses to the amount of passive income but allowed taxpayers to carry forward any excess passive losses to the next year.

The act also eliminated the deductibility of nonmortgage consumer interest payments such as interest on credit card balances, automobile loans, and life insurance loans. It also established the floor for miscellaneous expenses at two percent of adjusted gross income for taxpayers who itemized deductions.

Individual Retirement Accounts (IRAs) once allowed a taxpayer to invest before-tax dollars and enjoy tax-free compounding of interest. The 1986 statute ended full deductibility of IRAs for single employees covered by qualified retirement plans and earning more than $35,000 annually. For married employees the cutoff for full deductibility was set at $50,000. In addition, the law imposed a penalty on withdrawals of IRA contributions before the age of fifty-nine and a half years.

Another retirement plan, the Keogh plan, permitted under section 401(k), once allowed a taxpayer to invest up to $30,000 a year without paying taxes on this income. The ceiling dropped to $7,000 in 1987.

The act also eliminated a provision that had enabled two-income married couples to reduce their taxes. A couple can no longer take a deduction based on the lower salary of the two; the deduction had allowed them to pay the same tax on the lower salary as a single person would pay on that amount. The act also abolished "income averaging." Formerly, individuals whose incomes varied considerably from year to year could average their income over several years, a calculation that resulted in lower taxes owed in the years of highest income.

The ballooning federal budget deficits of the late 1980s and early 1990s led Congress to make changes in the 1986 act. The 1993 Revenue Reconciliation Act revamped the rate structure, imposing rates of 15, 28, 31, 36, and 39.6 percent. The act also limited itemized deductions for upper-income taxpayers and removed the limit on earned income subject to Medicare tax. The 1993 act also established tax incentives for selected groups and reduced the amount that can be deducted for moving expenses and meals and entertainment.

See: taxation.

The Tax Reform Act of 1986 (P.L. 99-514, 100 Stat. 2085) implemented a tax code that at once swept away and reenacted its predecessor, the Internal Revenue Code of 1954. As a result, the tax code is now formally known as the Internal Revenue Code of 1986. Although the 1986 act reenacted the great bulk of the 1954 code, the fact that Congress renamed the Internal Revenue Code indicates the importance of the changes put in place by the 1986 act.

The new law did not affect the bedrock concepts of federal taxation. Before and after the Tax Reform Act of 1986, the income tax law relied on the concept of taxing only the income taxpayers realized during the taxable year (usually in the form of cash). The new law did not initiate radical variations of taxation, such as a sales or value-added tax base. Nor did the 1986 act have any meaningful impact on other components of the existing Internal Revenue Code, including:

• Excise taxes, such as taxes on gasoline, cigarettes, and alcohol
• Estate taxes, meaning taxes imposed on the taxable value of the estate of a dead person
• Social Security taxes

The heart of the 1986 changes in the federal income tax act consist of the following six features:

1. The act equalized the rate of taxation on long-term capital gains paid by individual taxpayers with the top rate of federal income taxation imposed on individuals. This was a dramatic change, because up to that point, capital gains enjoyed lower rates of taxation than did ordinary income from labor and investments, such as wages and dividends. Prior to 1986, these lower rates of taxation on capital gains led wealthy taxpayers to spend time and energy structuring their finances to maximize the portion of their incomes earned in the form of long-term capital gains. Consequently, the 1986 tax reform seemed to close a tax loophole . Later amendments to the Internal Revenue Code of 1986, however, reinstated the divergence in tax rates between capital gains and ordinary income this reform-minded element was eliminated, and the loophole continues to exist.
2. The act decreased the use of tax shelters, devices taxpayers used to generate deductions and tax credits Congress accomplished this goal by enacting Section 469 of the Internal Revenue Code, known to tax experts as the "passive loss rules." The heart of the passive loss rules is that losses from passive tax shelters and losses from operating rental real estate can only be used as a deduction, or credit, against profits from other passive tax shelters and real estate. For example, a doctor could not deduct losses from real estate holdings against the income she earned in her medical practice. This largely put an end to taxpayers' use of tax shelters, which had, up until 1986, dramatically reduced federal revenues. Section 469 has a number of exceptions and limits, the most important of which are the following: (a) the rules do not apply to widely held corporations; and (b) passive losses are available in full only when a taxpayer disposes of the entire investment in a taxable sale or exchange. The new rules reportedly resulted in significant declines in the values of real estate.
3. The act dropped the top rate of federal income taxation of individuals from 50 percent to 28 percent. After Congress reduced the tax rate to 28 percent, however, it increased the rate to almost 40 percent, but is on its way to reducing it again. The 28 percent rate applied equally to capital gains, discussed above, and all forms of other income. In addition, Congress reduced the top rate of taxation on corporations from 46 percent to 34 percent.
4. The act eliminated deductions for interest expenses associated with buying personal consumption goods. (The sole exception is interest payments on home loans.) The prior law allowing interest expense deductions for borrowing money to buy consumer goods has always been questionable because it encouraged personal consumption. The repeal of the deduction eliminated this incentive. This part of the 1986 act has withstood the test of time and remains an important feature of American tax law.
5. The act repealed the universal individual retirement account (IRA) deduction in favor of restricting the deduction to people who did not have pension coverage through other avenues, such as their employer. Before repeal, everyone, no matter how wealthy or how much they benefited from other pension arrangements, could take a deduction for contributions made to an IRA. Now, only certain taxpayers are permitted to do so. The universal IRA deduction was appropriately considered an unjustifiable source of revenue losses. The 1986 act is applauded for this change.
6. The act eliminated federal income tax liability for those below the poverty line. This restored the laws as they existed in the late 1970s, when poor people were excluded from the obligation to pay taxes. This particular reform was made necessary by the effects of inflation: inflation increases people's nominal income and therefore their income taxes, even though in real economic terms they live in poverty.

History of the 1986 Act

The first inkling of the 1986 act appeared in 1984 in President Ronald Reagan's State of the Union address. Reagan announced that he was asking the secretary of the treasury to develop and present a comprehensive plan to simplify the tax code by the year 1984. Reagan was reacting to Republican concerns that Senator Walter Mondale, Democrat of Minnesota, might propose radical simplifications of the Internal Revenue Code and thus gain political popularity—popularity Reagan and his Republican Party hoped to enjoy. Reagan proposed that the new law be simple, fair, and broad-based. Specifically, it had to contain these features:

• It had to be revenue-neutral, that is, neither adding to nor subtracting from federal revenues. Instead, the focus was on broadening the tax base and reducing rates.
• It had to be distributionally neutral, that is, not favor one economic group over another.
• It had to close major tax loopholes, such as the tax shelters described above. Reagan hoped that by closing loopholes, more taxes would be paid into the government, which would, in turn, allow an overall reduction in the tax rates (like the reduction in tax rates from 50 percent to 28 percent described above).

These proposals sat well with the powerful head of the House Ways and Means Committee, Representative Dan Rostenkowski of Illinois. Rostenkowski, a traditional populist Democrat, wanted to reduce the burden of taxation on working people and was capable of imposing his will on his committee. Without his cooperation, the proposals would have been doomed. On the opposite side of the aisle, Senator Robert Packwood, Republican of Oregon, played a less significant but nevertheless important role in working for passage of the act.

The act itself was capable of passage only because it had features that were attractive to both conservative and liberal politicians. To fiscal conservatives, dropping tax rates represented an opportunity to impose supply-side economics (a theory of economics that assumes lower taxes will generate more government revenue in the long run). Liberal tax theorists were attracted to broadening the tax base by closing loopholes, arguably taken advantage of by wealthy taxpayers and paid for by the poor through higher tax rates. Both conservatives and liberals believed the act promised higher levels of compliance by the taxpaying public.

Since passage of the Tax Reform Act of 1986, Congress has tinkered with the tax code almost every year, generally adding to the code's complexity and length.

Bibliography

Birnbaum, Jeffrey, and Alan Murray. Showdown at Gucci Gulch: Lawmakers, Lobbyists and the Unlikely Triumph of Tax Reform. New York: Vintage Books, 1987.

Graetz, Michael. "Paint-by-Numbers Lawmaking." 95 Columbia Law Review 609 (1995).

Steuerle, C. Eugene. The Tax Decade. Washington, DC: Urban Institute Press, distributed by National Book Network, Lanham, MD, 1992.

President Ronald Reagan signs the Tax Reform Act of 1986 on the South Lawn.

The U.S. Congress passed the Tax Reform Act (TRA) of 1986, (Pub.L. 99-514, 100 Stat. 2085, enacted October 22, 1986) to simplify the income tax code, broaden the tax base and eliminate many tax shelters and other preferences. Referred to as the second of the two "Reagan tax cuts" (the Kemp-Roth Tax Cut of 1981 being the first), the bill was also officially sponsored by Democrats, Richard Gephardt of Missouri in the House of Representatives and Bill Bradley of New Jersey in the Senate.

The tax reform was designed to be revenue neutral, but because individual taxes were decreased while corporate taxes were increased, Congressional Budget Office estimates (which ignore corporate taxes) suggested every tax payer saw a decrease in their tax bill. As of 2009, the Tax Reform Act of 1986 was the most recent major simplification of the tax code, drastically reducing the number of deductions and the number of tax brackets.

Contents 1 Income tax rates 2 Tax incentives 3 Changes to the Alternative Minimum Tax 4 Passive losses and tax shelters 5 Name change for the Internal Revenue Code 6 Notes 7 External links

Income tax rates

The top tax rate was lowered from 50% to 28% while the bottom rate was raised from 11% to 15% since many lower level tax brackets were consolidated, and the upper income level of the bottom rate was increased from $5,720/year to $29,750/year. This package ultimately consolidated tax brackets from fifteen levels of income to four levels of income. ^[1] This would be the only time in the history of the U.S. income tax (which dates back to the passage of the Revenue Act of 1862) that the top rate was reduced and the bottom rate increased concomitantly. In addition, capital gains faced the same tax rate as ordinary income. Moreover, interest on consumer loans such as credit card debt were no longer deductible. An existing provision in the tax code, called Income Averaging, which reduced taxes for those only recently making a much higher salary than before, was eliminated (although later partially reinstated, for farmers in 1997 and for fishermen in 2004). The Act, however, increased the personal exemption and standard deduction.

The rate structure also maintained a novel "bubble rate." The rates were not 15%/28%, as widely reported. Rather, the rates were 15%/28%/33%/28%. The "bubble rate" of 33% simply elevated the 15% rate to 28% for higher-income taxpayers. As a result, for taxpayers after a certain income level, TRA86 provided a flat tax of 28%. This was jettisoned in the Omnibus Budget Reconciliation Act of 1990, otherwise known as the "Bush tax increase", which violated his Taxpayer Protection Pledge.

Tax incentives

The Act also increased incentives favoring investment in owner-occupied housing relative to rental housing by increasing the Home Mortgage Interest Deduction. The imputed income an owner receives from an investment in owner-occupied housing has always escaped taxation, much like the imputed (estimated) income someone receives from doing his own cooking instead of hiring a chef, but the Act changed the treatment of imputed rent, local property taxes, and mortgage interest payments to favor homeownership, while phasing out many investment incentives for rental housing. To the extent that low-income people may be more likely to live in rental housing than in owner-occupied housing, this provision of the Act could have had the tendency to decrease the new supply of housing accessible to low-income people. The Low-Income Housing Tax Credit was added to the Act to provide some balance and encourage investment in multifamily housing for the poor.

The Individual Retirement Account (IRA) deduction was severely restricted. The IRA had been created as part of the Employee Retirement Income Security Act of 1974, where employees not covered by a pension plan could contribute the lesser of $1500 or 15% of earned income. The Economic Recovery Tax Act of 1981 (ERTA) removed the pension plan clause and raised the contribution limit to $2000 or 100% of earned income. The 1986 Tax Reform Act retained the $2000 contribution limit, but restricted the deductibility for households that have pension plan coverage and have moderate to high incomes. Non-deductible contributions were allowed.

Depreciation deductions were also curtailed. Prior to ERTA81, depreciation was based on "useful life" calculations provided by the Treasury Department. ERTA81 set up the "accelerated cost recovery system," or ACRS. This set up a series of useful lives based on 3 years for technical equipment, 5 years for non-technical office equipment, 10 years for industrial equipment, and 15 years for real property. TRA86 lengthened these lives, and lengthened them further for taxpayers covered by the alternative minimum tax (AMT). These latter, longer lives approximate "economic depreciation," a concept economists have used to determine the actual life of an asset relative to its economic value.

Defined contribution pension contributions were curtailed. The law prior to TRA86 was that DC pension limits were the lesser of 25% of compensation or $30,000. This could be accomplished by any combination of elective deferrals and profit sharing contributions. TRA86 introduced an elective deferral limit of $7000, indexed to inflation. Since the profit sharing percentage must be uniform for all employees, this had the intended result of making more equitable contributions to 401(k)'s and other types of DC pension plans.

Changes to the Alternative Minimum Tax

The original AMT targeted tax shelters used by a few wealthy households. However, the Tax Reform Act of 1986 greatly expanded the AMT to aim at a different set of deductions that most Americans receive. Things like the personal exemption, state and local taxes, the standard deduction, private activity bond interest, certain expenses like union dues and even some medical costs for the seriously ill could now trigger the AMT. In 2007, the New York Times reported, "A law for untaxed rich investors was refocused on families who own their homes in high tax states."^[2]

Passive losses and tax shelters

By enacting 26 U.S.C. § 469 (relating to limitations on deductions for passive activity losses and limitations on passive activity credits) to remove many tax shelters, especially for real estate investments, the Act significantly decreased the value of many such investments which had been held more for their tax-advantaged status than for their inherent profitability. This may have contributed to the end of the real estate boom of the early to mid '80s as well as to the Savings and Loan (S&L) crisis.

Prior to 1986, much real estate investment was done by passive investors. It was common for syndicates of investors to pool their resources in order to invest in property, commercial or residential. They would then hire management companies to run the operation. TRA 86 reduced the value of these investments by limiting the extent to which losses associated with them could be deducted from the investor's gross income. This, in turn, encouraged the holders of loss-generating properties to try and unload them, which contributed further to the problem of sinking real estate values. This turmoil and repositioning in real estate markets was caused not by changes in market conditions.

Mortgages and similar real property loans constituted a significant portion of S&Ls' asset portfolios. Significant declines in the market value of real properties resulted in the erosion of the value of these institutions' major assets.

Some economists consider the net long-term effect of eliminating tax shelters and other distortions to be positive for the economy, by redirecting money to the most inherently profitable investments.

To help less-affluent landlords, TRA86 gave a $25,000 net rental loss deduction provided that the home was not personally used for the greater of 14 days or 10% of rental days, and AGI is less than $100,000 (pro-rated phase-out through $150,000).

Name change for the Internal Revenue Code

Section 2(a) of the Act also officially changed the name of the Internal Revenue Code from the Internal Revenue Code of 1954 to the Internal Revenue Code of 1986. Although the Act made numerous amendments to the Code, it was not a substantial re-codification or reorganization of the overall structure of the Code.

Notes

1. ^ "Federal Individual Income Tax Rates History". TaxFoundation.org. 1913-2009. http://www.taxfoundation.org/files/federalindividualratehistory-200901021.pdf. Retrieved on 2009-03-06. 
2. ^ "Alternative Minimum Tax". New York Times. 2007. http://topics.nytimes.com/top/reference/timestopics/subjects/a/alternative_minimum_tax/index.html. Retrieved on 2008-05-16. 

External links

• http://cwx.prenhall.com/bookbind/pubbooks/dye4/medialib/docs/tax1986.htm
• http://www.ctj.org/html/taxvotes.htm
• Showdown at Gucci Gulch is a book about the bill's passage

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