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Tax reform panel calls for major changes to income tax system

By Kellee Fitzsimmons, CPA

On Nov. 1, 2005 President Bush's Advisory Panel on Federal Tax Reform (the panel) unveiled its recommendations to overhaul the current federal income tax system. The panel recommends abolishing the individual alternative minimum tax (AMT), converting several current deductions into credits, consolidating tax benefits and overhauling retirement savings.

The panel's recommendations are grouped into two plans — the "Simplified Income Tax Plan" and the "Growth and Investment Tax Plan." Both plans preserve the basic tax system based on income realized through wages and investments.

This article outlines some of the major changes proposed by the panel.

Reforms targeting individuals

• AMT REPEAL: The panel recommends eliminating the alternative minimum tax (AMT). If the AMT remains unchanged, it is likely to affect more than 50 million taxpayers by 2015. The panel estimates that 13 percent of taxpayers with income levels between $100,000 and $200,000 will pay AMT in 2005.
• LOWER TAX RATES: The panel recommends consolidating and lowering the individual marginal tax rates. It recommends four tax brackets under the Simplified Income Tax Plan (15, 25, 30 and 33 percent) and three brackets under the Growth and Investment Plan (15, 25 and 30 percent). In an effort to reduce the "marriage penalty," rate brackets for married couples would be twice the amounts for single taxpayers.
• DIVIDENDS AND CAPITAL GAINS: Under the Simplified Income Tax Plan, 100 percent of dividends paid would be excluded from U.S. income. In addition, the plan would exclude 75 percent of the capital gains from an investor's sale of stock of domestic corporations as long as the holding period is over one year. Under this plan, capital gains rates would range from 3.75 to 8.25 percent. Interest income under the Simplified Income Tax Plan would remain taxed at normal rates.
• NEW 'FAMILY CREDIT:' The panel recommendations would consolidate the personal exemption, the standard deduction and the child tax credit into a new "family credit." The age cutoff for the credit will be 18, or 20 for a full-time student. The credit would be computed starting with a base amount for a family's household type and adding amounts for each child and other dependents of the household. Under the current tax system there are phaseouts of the personal exemption and the child tax credit. The new family credit would be allowed in full for taxpayers at any income level.
• HOME OWNERSHIP: The panel recommendations replace the home mortgage interest deduction with a new "home credit." This credit would be equal to 15 percent of mortgage interest paid by a taxpayer on a loan secured by the taxpayer's principal residence and used to acquire, construct or substantially improve that residence subject to certain limitations. Under this plan, itemized deductions for mortgage interest on second homes and home equity loans would be completely eliminated.
• CHARITABLE GIVING: Currently, charitable contribution deductions are available only to those taxpayers who itemize deductions. The panel recommends expanding the deductions for charitable giving to all taxpayers, not just those who itemize. Contributions would be deductible to the extent that they exceed 1 percent of income.
• EDUCATION BENEFITS: The panel proposes a new "family credit" which would entitle all families with full-time students under age 20 to a credit of $1,500. The panel recommends eliminating the HOPE and Lifetime Learning Credits, the above-the-line deduction for education expenses and the deduction paid for interest on student loans.
• STATE AND LOCAL TAXES: Currently, state and local income taxes paid are deductible by taxpayers as itemized deductions. The panel proposes abolishing the deduction for state and local taxes.

Reforms for retirees / other savers

The panel proposes eliminating current savings plans in favor of three options:

• "Save-at-work" plans,
• "Save-for-retirement" plans, and
• "Save-for-family" plans.

These plans replace all other savings plans, including 401(k) plans, IRAs and qualified tuition plans.

Reforms targeting businesses

The panel also proposes business reforms under the Simplified Income Tax Plan and the Growth and Investment Tax Plan. The plans are similar in that they both remove impediments to saving and business investments, but they each use a different approach. The Simplified Income Tax Plan more resembles the current tax system. Treatment under the Growth and Investment Tax Plan is modeled after a consumption tax model.

Going forward

Tax reform will likely not take effect before the 2007 tax year. This makes 2006 a critical year for taxpayers to stay on top of proposals and consult with their tax advisors to structure transactions accordingly.

Kellee Fitzsimmons is a CPA with Stout, Causey & Horning.