Over 440 tax code changes-here is what church leaders need to know

Article summary. On June 7, 2001, President Bush signed a massive new tax law known as the Economic Growth and Tax Relief Reconciliation Act of 2001. While the Act’s most prominent feature is a $1.35 trillion tax-cut package, it also makes more than 440 other changes to the Internal Revenue Code. This feature article will review those changes of most relevance to ministers and church treasurers.

President Bush promised tax relief during the presidential campaign, and Congress delivered by enacting the Economic Growth and Tax Relief Reconciliation Act (EGTRA) in May of this year with strong bipartisan support (the votes were 240-154 in the House and 58-33 in the Senate). The Act’s most publicized feature is a $1.35 trillion package of tax cuts. However, the Act also contains more than 440 other tax law changes, some of which are of special relevance to ministers and church treasurers. We have carefully reviewed the entire text of this massive law, and are summarizing in this feature article those provisions that are of most relevance to ministers and church treasurers.

Individual Income Taxes

1. Reduction in income tax rates

Income taxes are computed by applying the applicable income tax rates to taxable income. The income tax rates are divided into several ranges of income, known as income brackets, and the tax rate increases as the individual’s income increases. Separate rate schedules apply based on filing status (single, heads of households, married individuals filing joint returns, married individuals filing separate returns, and estates and trusts). Tables 1 and 2 show the pre-EGTRA tax rates for single taxpayers and married taxpayers filing jointly.

Table 1: Pre-EGTRA 2001 Tax Rates for Single Persons

Table 2: Pre-EGTRA 2001 Tax Rates for Married Persons Filing Jointly

Note that prior to EGTRA there were five income tax rates, depending on a taxpayer’s income (15%, 28%, 31%, 36%, and 39.6%). These rates were modified by EGTRA as follows:

New 10% Rate

EGTRA creates a new 10% income tax bracket for a portion of taxable income that is currently taxed at 15%, effective for taxable years beginning after December 31, 2000. The 10% rate bracket applies to the first $6,000 of taxable income for single individuals, and $12,000 for married couples filing joint returns. This $6,000 increases to $7,000 and this $12,000 increases to $14,000 for 2008 and thereafter. The taxable income levels for the new low-rate bracket will be adjusted annually for inflation for taxable years beginning after December 31, 2008.

15% Bracket

The 15% income tax bracket is modified to begin at the end of the new low-rate regular income tax bracket. The 15% income tax bracket ends at the same level as under present law (Tables 1 and 2).

The 15% bracket is also adjusted in order to minimize the effect of the so-called “marriage penalty.” This is addressed later in this article.

Reduction of other brackets

The pre-EGTRA income tax rates of 28%, 31%, 36%, and 39.6% are phased down over six years to 25%, 28%, 33%, and 35%, effective after June 30, 2001, as described in Table 3. Since the tax rate changes do not take effect until July 1, 2001, rate reductions for 2001 will come in the form of a “blended” tax rate.

The taxable income levels for the new rates in all taxable years are the same as the taxable income levels that apply under the present-law rates.

Table 3: Income Tax Rate Reductions

Tables 4 and 5 show the tax rates and corresponding income levels for the year 2006, when the rate cuts are fully effective. Note that the income levels in these tables are projected amounts.

Table 4: Income Tax Rates for 2006 (Single Persons)

Table 5: Income Tax Rates for 2006
(Married Persons Filing Jointly)

Table 6 shows the federal income tax that would be paid by a married couple filing jointly under several different levels of taxable income, in 2001 (without the EGTRA tax reductions), in 2001 (with the EGTRA tax reductions for that year), and in 2006. Note the following: (1) The table only reflects federal income taxes. Social security and state and local taxes are not included. (2) The 2006 taxes use estimated amounts of taxable income that will be needed to trigger the corresponding tax rates. The actual taxes in 2006 may be slightly different.

Table 6: The Bottom Line-Tax Savings Under Different Scenarios

2. Rate reduction credit for 2001

One of the purposes behind the new 10% tax rate was to provide a stimulus to the economy. In order to achieve this stimulus more quickly, EGTRA allows a rate reduction credit in lieu of the new 10% tax rate for 2001, and this credit will be distributed in advance to eligible taxpayers in the form of a check from the Treasury Department. The IRS will automatically process these advance payments. Taxpayers will not have to complete applications, file any extra forms, or call the IRS to request their payments. In general, individuals who had a federal income tax liability for 2000 and who could not be claimed as a dependent on someone else’s tax return are eligible for a rate reduction credit this year. You had a liability if your tax was greater than the amount of your nonrefundable credits, such as the child tax credit, education credits or child care credit. Refundable credits, such as the earned income tax credit, are not a factor in determining eligibility or computing the credit or the advance payment. Those who did not have an income tax liability will not receive an advance payment. However, persons who did not have an income tax liability for 2000 but who have one for 2001 will be able to claim the tax credit on their 2001 return, provided they are otherwise eligible. Taxpayers whose advance payment is less than the credit amount figured on their 2001 tax return will be able to claim the rest of the credit when they file their 2001 return. Taxpayers whose advance payment is larger than the credit amount figured on the 2001 tax return will not have to pay back any difference.

The 2001 advance payment amount is 5% (the difference between the 15% and the 10% rates) of the amount of “taxable income” shown on a taxpayer’s 2000 tax return (less any credits), up to a maximum of $300 for a single taxpayer and $600 for a married couple filing a joint return. Taxable income is reported on line 51 of Form 1040, line 33 of Form 1040A, and line 10 of Form 1040EZ. Most taxpayers will get the full amount as an advance payment this year; some will have it split between this year and next; and some may get all of it as a credit on the 2001 tax return.

If a taxpayer’s advance payment is less than the maximum dollar amount for his or her filing status, that person may be able to claim a credit on the 2001 return, up to the difference between the allowable amount and the payment already received.

Eligible taxpayers should have received their check by October of 2001.

3. Elimination of the “marriage penalty”

When two persons are married, they often pay more taxes than if they had remained single. There are two reasons. First, their combined income may put them in a higher tax bracket; and second, the standard deduction for a married couple is less than the standard deductions for two single persons. These two consequences are generally referred to as the “marriage penalty.” EGTRA reduces this penalty in the following two ways:

#1-Income Tax Rates

Look at Tables 1 and 2 for a moment. Note that the tax rates prior to EGTRA (15%, 28%, 31%, 36%, 39.6%) correspond to ranges of taxable income, and these ranges are much higher for married couples filing jointly. This means that an unmarried couple paying the individual tax rates will pay less taxes than if they marry. The tax code “penalizes” them for marrying. Consider the following example.

EGTRA minimizes the effect of the marriage penalty by increasing the 15% income tax rate for a married couple filing a joint return to twice the size of the corresponding rate for a single person filing a single return. The increase is phased-in over four years, beginning in 2005. Therefore, this provision is fully effective (i.e., the size of the 15% income tax rate bracket for a married couple filing a joint return would be twice the size of the 15% tax rate bracket for single persons) for taxable years beginning after December 31, 2007. Table 7 summarizes the phase-in of this new rule.

Table 7: Increase in Size of 15% Rate for Married Couples Filing a Joint Return

#2-The Standard Deduction

The standard deduction for married persons filing jointly is increased, beginning in 2005, to minimize the marriage penalty. Table 8 summarizes this change.

Table 8: Increase in the Standard Deduction

4. Increase and expand the child tax credit

Prior to EGTRA an individual could claim a $500 tax credit for each qualifying child under the age of 17. In general, a qualifying child is an individual for whom the taxpayer can claim a dependency exemption and who is the taxpayer’s son or daughter (or descendent of either), stepson or stepdaughter, or eligible foster child. The child tax credit is phased-out for individuals with income over certain thresholds. Specifically, the credit is reduced by $50 for each $1,000 (or fraction thereof) of modified adjusted gross income over $75,000 for single individuals or $110,000 for married individuals filing joint returns. Modified adjusted gross income is the taxpayer’s total gross income plus certain amounts excluded from gross income (such as the foreign earned income exclusion). The length of the phase-out range depends on the number of qualifying children. The child tax credit is not adjusted annually for inflation.

EGTRA increases the child tax credit to $1,000, phased-in over ten years, beginning in 2001.

Table 9: Increase in the Child Tax Credit

5. Expansion of dependent care credit

A taxpayer who maintains a household that includes one or more qualifying individuals may claim a nonrefundable credit against income tax liability for up to 30% of a limited amount of employment-related expenses. Eligible employment-related expenses are limited to $2,400 if there is one qualifying individual or $4,800 if there are two or more qualifying individuals. Thus, the maximum credit is $720 if there is one qualifying individual and $1,440 if there are two or more qualifying individuals. The applicable dollar limit ($2,400/$4,800) of otherwise eligible employment-related expenses is reduced by any amount excluded from income under an employer-provided dependent care assistance program. For example, a taxpayer with one qualifying individual who has $2,400 of otherwise eligible employment-related expenses but who excludes $1,000 of dependent care assistance must reduce the dollar limit of eligible employment-related expenses for the dependent care tax credit by the amount of the exclusion to $1,400 ($2,400 – $1,000 = $1,400).

A qualifying individual is (1) a dependent of the taxpayer under the age of 13 for whom the taxpayer is eligible to claim a dependency exemption, (2) a dependent of the taxpayer who is physically or mentally incapable of caring for himself or herself, or (3) the spouse of the taxpayer; if the spouse is physically or mentally incapable of caring for himself or herself.

The 30 percent credit rate is reduced, but not below 20 percent, by 1 percentage point for each $2,000 (or fraction thereof) of adjusted gross income above $10,000. The credit is not available to married taxpayers unless they file a joint return.

Amounts paid or incurred by an employer for dependent care assistance provided to an employee generally are excluded from the employee’s gross income and wages if the assistance is furnished under a program meeting certain requirements. These requirements include that the program be described in writing, satisfy certain nondiscrimination rules, and provide for notification to all eligible employees. Dependent care assistance expenses eligible for the exclusion are defined the same as employment-related expenses with respect to a qualifying individual under the dependent care tax credit.

The dependent care exclusion is limited to $5,000 per year, except that a married taxpayer filing a separate return may exclude only $2,500. Dependent care expenses excluded from income are not eligible for the dependent care tax credit (sec. 21(c)).

EGTRA makes the following changes in these rules, beginning in 2003:

It increases the maximum amount of eligible employment-related expenses from $2,400 to $3,000, if there is one qualifying individual (from $4,800 to $6,000, if there are two or more qualifying individuals).

It increases the maximum credit from 30% to 35% (the maximum credit is $1,200, if there is one qualifying individual and $2,400, if there are two or more qualifying individuals).

It modifies the phase-down of the credit. The 35% credit rate is reduced, but not below 20 percent, by 1 percentage point for each $2,000 (or fraction thereof) of adjusted gross income above $15,000. Therefore, the credit percentage is reduced to 20 percent for taxpayers with adjusted gross income over $43,000.

6. Marriage penalty relief and simplification relating to the earned income credit

Eligible low-income workers are able to claim a refundable earned income credit. The amount of the credit an eligible taxpayer may claim depends upon the taxpayer’s income and whether the taxpayer has one, more than one, or no qualifying children. No earned income credit is allowed if the taxpayer has disqualified income in excess of $2,450 (for 2001) for the taxable year. [ ]In addition, no earned income credit is allowed if an eligible individual is the qualifying child of another taxpayer.

To claim the earned income credit, a taxpayer must either (1) have a qualifying child or (2) meet the requirements for childless adults. A qualifying child must meet a relationship test, an age test, and a residence test. First, the qualifying child must be the taxpayer’s child, stepchild, adopted child, grandchild, or foster child. Second, the child must be under the age 19 (or under age 24 if a full-time student) or permanently and totally disabled regardless of age. Third, the child must live with the taxpayer in the United States for more than half the year (a full year for foster children).

An individual satisfies the relationship test under the earned income credit if the individual is the taxpayer’s: (1) son or daughter or a descendant of either; (2) stepson or stepdaughter; or (3) eligible foster child. A married child of the taxpayer is not treated as meeting the relationship test unless the taxpayer is entitled to a dependency exemption with respect to the married child (e.g., the support test is satisfied) or would be entitled to the exemption if the taxpayer had not waived the exemption to the noncustodial parent. If a child otherwise qualifies with respect to more than one person, the child is treated as a qualifying child only of the person with the highest modified adjusted gross income.

To claim the earned income credit, the taxpayer must have earned income. Earned income consists of wages, salaries, other employee compensation, and net earnings from self employment. Employee compensation includes anything of value received by the taxpayer from the employer in return for services of the employee, including nontaxable earned income. Nontaxable forms of compensation treated as earned income include the following: (1) elective deferrals under a 403(b) annuity; (2) employer contributions for non-taxable fringe benefits, including contributions for accident and health insurance, dependent care, adoption assistance, educational assistance, and miscellaneous fringe benefits; (3) salary reduction contributions under a cafeteria plan; (4) meals and lodging provided for the convenience of the employer, and (5) housing allowance or rental value of a parsonage for ministers.

The maximum earned income credit is phased in as an individual’s earned income increases. The credit phases out for individuals with earned income (or if greater, modified adjusted gross income) over certain levels. In the case of a married individual who files a joint return, the earned income credit both for the phase-in and phase-out is calculated based on the couples’ combined income.

The credit is determined by multiplying the credit rate by the taxpayer’s earned income up to a specified earned income amount. The maximum amount of the credit is the product of the credit rate and the earned income amount. The maximum credit amount applies to taxpayers with (1) earnings at or above the earned income amount and (2) modified adjusted gross income (or earnings, if greater) at or below the phase-out threshold level.

For taxpayers with modified adjusted gross income (or earned income, if greater) in excess of the phase-out threshold, the credit amount is reduced by the phase-out rate multiplied by the amount of earned income (or modified adjusted gross income, if greater) in excess of the phase-out threshold. In other words, the credit amount is reduced, falling to $0 at the “breakeven” income level, the point where a specified percentage of “excess” income above the phase-out threshold offsets exactly the maximum amount of the credit. The earned income amount and the phase-out threshold are adjusted annually for inflation. Table 10 shows the earned income credit parameters for taxable year 2001.

Table 10: Earned Income Credit Limits (2001)

EGTRA makes the following changes in the earned income credit, beginning in 2002:

In the past, the earned income amount penalizes some individuals because they receive a smaller earned income credit if they are married than if they are not married. In order to minimize this penalty, EGTRA increases the phase-out amount for married taxpayers who file a joint return. For married taxpayers who file a joint return, EGTRA increases the beginning and ending of the earned income credit phase-out by $3,000. These beginning and ending points are to be adjusted annually for inflation after 2002.

EGTRA simplifies the definition of earned income by excluding nontaxable employee compensation from the definition of earned income for earned income credit purposes. As a result, earned income includes wages, salaries, tips, and other employee compensation, if includible in gross income for the taxable year, plus net earnings from self employment.

EGTRA simplifies the calculation of the earned income credit by replacing modified adjusted gross income with adjusted gross income.

EGTRA provides that the “relationship test” is met if the individual is the taxpayer’s son, daughter, stepson, stepdaughter, or a descendant of any such individuals. A brother, sister, stepbrother, stepsister, or a descendant of such individuals, also qualifies if the taxpayer cares for such individual as his or her own child. A foster child satisfies the relationship test as well. In order to be a qualifying child, in all cases the child must have the same principal place of abode as the taxpayer for over one-half of the taxable year.

EGTRA changes the so-called “tie-breaking rule.” If an individual would be a qualifying child with respect to more than one taxpayer, and more than one taxpayer claims the earned income credit with respect to that child, then the following tie-breaking rules apply. First, if one of the individuals claiming the child is the child’s parent (or parents who file a joint return), then the child is considered the qualifying child of the parent (or parents). Second, if both parents claim the child and the parents do not file a joint return together, then the child is considered a qualifying child first of the parent with whom the child resided for the longest period of time during the year, and second of the parent with the highest adjusted gross income. Third, if none of the taxpayers claiming the child as a qualifying child is the child’s parent, the child is considered a qualifying child with respect to the taxpayer with the highest adjusted gross income.

7. Phase-out of personal exemption reduction

In order to determine taxable income, an individual reduces adjusted gross income by any personal exemptions, deductions, and either the applicable standard deduction or itemized deductions. Personal exemptions generally are allowed for the taxpayer, his or her spouse, and any dependents. For 2001, the amount deductible for each personal exemption is $2,900. This amount is adjusted annually for inflation. Prior to EGTRA, the deduction for personal exemptions was phased-out for taxpayers with adjusted gross income over certain thresholds. For 2001, the thresholds are $132,950 for single individuals and $199,450 for married individuals filing a joint return (adjusted annually for inflation). The total amount of exemptions that may be claimed by a taxpayer is reduced by two percent for each $2,500 (or portion thereof) by which the taxpayer’s adjusted gross income exceeds the applicable threshold. For 2001, the point at which a taxpayer’s personal exemptions are completely phased-out is $255,450 for single individuals and $321,950 for married individuals filing a joint return.

EGTRA repeals the personal exemption phase-out over five years, beginning in 2006. The phase-out is reduced by one-third in taxable years beginning in 2006 and 2007, and is reduced by two-thirds in taxable years beginning in 2008 and 2009. The repeal is fully effective for taxable years beginning after December 31, 2009. In explaining the reason for repealing the phase-out, a congressional conference committee noted that “the personal exemption phase-out is an unnecessarily complex way to impose income taxes and the hidden way in which the phase-out raises marginal tax rates undermines respect for the tax laws.”

8. Increase the starting point for phase-out of itemized deductions

Taxpayers may choose to claim either the standard deduction or itemized deductions (subject to certain limitations) for certain expenses incurred during the year. Prior to EGTRA the total amount of allowable itemized deductions (with a few exceptions) was reduced by three percent of the amount of the taxpayer’s adjusted gross income in excess of $132,950 in 2001. However, itemized deductions could not be reduced by more than 80%. The starting point for the phase-out ($132,950 in 2001) was adjusted annually for inflation. EGTRA repeals this limitation on itemized deductions over a five year period beginning in 2006. The limit on itemized deductions is reduced by one-third in taxable years beginning in 2006 and 2007, and by two-thirds in taxable years beginning in 2008 and 2009. The overall limitation is repealed for taxable years beginning after December 31, 2009.

Education

9. Modifications to education IRAs

Current law allows taxpayers to create “education IRAs” for the purpose of paying the qualified higher education expenses of designated beneficiaries. Annual contributions to education IRAs may not exceed $500 per beneficiary (except in cases involving certain tax-free rollovers) and may not be made after the designated beneficiary reaches age 18. The $500 annual contribution limit for education IRAs is generally phased-out for single taxpayers with modified adjusted gross income between $95,000 and $110,000. The phase-out range for married taxpayers filing a joint return is $150,000 to $160,000 of modified adjusted gross income. Individuals with modified adjusted gross income above the phase-out range are not allowed to make contributions to an education IRA established on behalf of any individual. Earnings on contributions to an education IRA generally are subject to tax when withdrawn. However, distributions from an education IRA are excludable from the gross income of the beneficiary to the extent that the total distribution does not exceed the “qualified higher education expenses” incurred by the beneficiary during the year the distribution is made.

If the qualified higher education expenses of the beneficiary for the year are less than the total amount of the distribution (i.e., contributions and earnings combined) from an education IRA, then the qualified higher education expenses are deemed to be paid from a pro-rata share of both the principal and earnings components of the distribution. As a result, in such a case only a portion of the earnings are excludable (i.e., the portion of the earnings based on the ratio that the qualified higher education expenses bear to the total amount of the distribution) and the remaining portion of the earnings is includible in the beneficiary’s gross income. The earnings portion of a distribution from an education IRA that is includible in income is also subject to an additional 10-percent tax (unless a distribution is made on account of the death or disability of the designated beneficiary, or on account of a scholarship received by the designated beneficiary).

The term “qualified higher education expenses” includes tuition, fees, books, supplies, and equipment required for the enrollment or attendance of the designated beneficiary at an eligible education institution, regardless of whether the beneficiary is enrolled at an eligible educational institution on a full-time, half-time, or less than half-time basis. Qualified higher education expenses include expenses with respect to undergraduate or graduate-level courses. Moreover, qualified higher education expenses include, within limits, room and board expenses for any academic period during which the beneficiary is at least a half-time student.

EGTRA makes the following changes to educational IRAs, effective in 2002:

The annual limit on contributions to education IRAs is increased from $500 to $2,000. As a result, the total contributions that may be made by all contributors to one (or more) education IRAs established on behalf of any particular beneficiary is limited to $2,000 for each year.

The definition of “qualified education expenses” for which tax-free distributions form an education IRA may be made is expanded to include “qualified elementary and secondary school expenses,” meaning expenses for (1) tuition, fees, academic tutoring, special need services, books, supplies, computer equipment (including related software and services), and other equipment incurred in connection with the enrollment or attendance of the beneficiary at a public, private, or religious school providing elementary or secondary education (kindergarten through grade 12) as determined under state law, and (2) room and board, uniforms, transportation, and supplementary items or services (including extended day programs) required or provided by such a school in connection with such enrollment or attendance of the beneficiary.

The phase-out range for married taxpayers filing a joint return is increased so that it is twice the range for single taxpayers. As a result, the phase-out range for married taxpayers filing a joint return is $190,000 to $220,000 of modified adjusted gross income.

The rule prohibiting contributions to an education IRA after the beneficiary attains 18 does not apply in the case of a special needs beneficiary (as defined by IRS regulations).

Corporations and other entities (including tax-exempt organizations) are permitted to make contributions to education IRAs, regardless of the income of the corporation or entity during the year of the contribution.

Individual contributors to education IRAs are deemed to have made a contribution on the last day of the preceding taxable year if the contribution is made on account of such taxable year and is made not later than April 15 of the following year.

Taxpayers are permitted to claim a HOPE credit or Lifetime Learning credit for a taxable year and to exclude from gross income amounts distributed (both the contributions and the earnings portions) from an education IRA on behalf of the same student as long as the distribution is not used for the same educational expenses for which a credit was claimed.

10. Private prepaid tuition programs

Section 529 of the Code provides tax-exempt status to “qualified state tuition programs,” meaning certain programs established and maintained by a state (or agency or instrumentality thereof) under which persons may (1) purchase tuition credits or certificates on behalf of a designated beneficiary that entitle the beneficiary to a waiver or payment of qualified higher education expenses of the beneficiary, or (2) make contributions to an account that is established for the purpose of meeting qualified higher education expenses of the designated beneficiary of the account (a “savings account plan”). The term “qualified higher education expenses” generally has the same meaning as does the term for purposes of education IRAs (as described above) and, thus, includes expenses for tuition, fees, books, supplies, and equipment required for the enrollment or attendance at an eligible educational institution, as well as certain room and board expenses for any period during which the student is at least a half-time student.

No amount is included in the gross income of a contributor to, or a beneficiary of, a qualified State tuition program with respect to any distribution from, or earnings under, such program, except that (1) amounts distributed or educational benefits provided to a beneficiary are included in the beneficiary’s gross income (unless excludable under another section of the tax code) to the extent such amounts or the value of the educational benefits exceed contributions made on behalf of the beneficiary, and (2) amounts distributed to a contributor (e.g., when a parent receives a refund) are included in the contributor’s gross income to the extent such amounts exceed contributions made on behalf of the beneficiary.

A specified individual ordinarily must be designated as the beneficiary at the commencement of participation in a qualified State tuition program (i.e., when contributions are first made to purchase an interest in such a program).

EGTRA expands the definition of “qualified tuition program,” beginning in 2002, to include certain prepaid tuition programs established and maintained by one or more eligible educational institutions (which may be private institutions) that satisfy the requirements under code section 529. In the case of a qualified tuition program maintained by one or more private eligible educational institutions, persons are able to purchase tuition credits or certificates on behalf of a designated beneficiary but would not be able to make contributions to a “savings account plan” (as described in code section 529(b)(1)(A)(ii)). Except to the extent provided in regulations, a tuition program maintained by a private institution is not treated as qualified unless it has received a ruling or determination from the IRS that the program satisfies applicable requirements.

Distributions from qualified tuition programs established and maintained by an entity other than a State used to pay for qualified higher education expenses are excluded from the recipient’s taxable income beginning in 2004.

EGTRA allows a taxpayer to claim a HOPE credit or Lifetime Learning credit for a taxable year and to exclude from gross income amounts distributed (both the principal and the earnings portions) from a qualified tuition program on behalf of the same student as long as the distribution is not used for the same expenses for which a credit was claimed.

11. Exclusion for employer-provided educational assistance

Employer-paid educational expenses are excludable from the gross income and wages of an employee if provided under a “section 127” educational assistance plan. Section 127 provides an exclusion of $5,250 annually for employer-provided educational assistance. The exclusion does not apply to graduate courses beginning after June 30, 1996. The exclusion for employer-provided educational assistance for undergraduate courses expires with respect to courses beginning after December 31, 2001.

In order for the exclusion to apply, certain requirements must be satisfied. The educational assistance must be provided pursuant to a separate written plan of the employer and the educational assistance program must not discriminate in favor of highly compensated employees.

EGTRA extends the exclusion for employer-provided educational assistance to graduate education and makes the exclusion (as applied to both undergraduate and graduate education) permanent. This provision is effective with respect to courses beginning after December 31, 2001.

12. Deduction for qualified higher education expenses

Under current law, taxpayers may not deduct the education and training expenses of either themselves or their dependents. However, a deduction for education expenses is allowed if the education or training (1) maintains or improves a skill required in a trade or business currently engaged in by the taxpayer, or (2) meets the express requirements of the taxpayer’s employer, or requirements of applicable law or regulations, imposed as a condition of continued employment. Education expenses are not deductible if they relate to certain minimum educational requirements or to education or training that enables a taxpayer to begin working in a new trade or business. In the case of an employee, education expenses (if not reimbursed by the employer) may be claimed as an itemized deduction only if such expenses meet the above described criteria for deductibility under section 162 and only to the extent that the expenses, along with other miscellaneous deductions, exceed 2 percent of the taxpayer’s adjusted gross income.

EGTRA permits taxpayers an above-the-line deduction for qualified higher education expenses paid by the taxpayer during a taxable year. Qualified higher education expenses are defined in the same manner as for purposes of the HOPE credit.

In 2002 and 2003, taxpayers with adjusted gross income that does not exceed $65,000 ($130,000 in the case of married couples filing joint returns) are entitled to a maximum deduction of $3,000 per year. Taxpayers with adjusted gross income above these thresholds would not be entitled to a deduction. In 2004 and 2005, taxpayers with adjusted gross income that does not exceed $65,000 ($130,000 in the case of married taxpayers filing joint returns) are entitled to a maximum deduction of $4,000 and taxpayers with adjusted gross income that does not exceed $80,000 ($160,000 in the case of married taxpayers filing joint returns) are entitled to a maximum deduction of $2,000. This provision expires at the end of 2005.

Estates and Gift Taxes

13. Phase-out and repeal of estate and generation-skipping transfer taxes

Under current law, a gift tax is imposed on lifetime transfers and an estate tax is imposed on transfers at death. The gift tax and the estate tax are unified so that a single graduated rate schedule applies to cumulative taxable transfers made by a taxpayer during his or her lifetime and at death. The unified estate and gift tax rates begin at 18 percent on the first $10,000 in cumulative taxable transfers and reach 55 percent on cumulative taxable transfers over $3 million.

A generation-skipping transfer tax generally is imposed on transfers, either directly or through a trust or similar arrangement, to a “skip person” (i.e., a beneficiary in a generation more than one generation below that of the transferor). Transfers subject to the generation-skipping transfer tax include direct skips, taxable terminations, and taxable distributions. The generation-skipping transfer tax is imposed at a flat rate of 55 percent (i.e., the top estate and gift tax rate) on cumulative generation-skipping transfers in excess of $1 million (indexed for inflation occurring after 1997).

The congressional conference committee concluded that

As a result, EGTRA makes the following changes:

Beginning in 2011, the estate and generation-skipping transfers taxes are repealed.

After repeal, the “basis” of assets received from a decedent generally will equal the basis of the decedent (i.e., carryover basis) at death. However, a decedent’s estate is permitted to increase the basis of assets transferred by up to a total of $1.3 million. The basis of property transferred to a surviving spouse can be increased (i.e., stepped up) by an additional $3 million. As a result, the basis of property transferred to a surviving spouse can be increased (i.e., stepped up) by a total of $4.3 million. In no case can the basis of an asset be adjusted above its fair market value. For these purposes, the executor will determine which assets and to what extent each asset receives a basis increase. The $1.3 million and $3 million amounts are adjusted annually for inflation occurring after 2010.

From 2002 and through 2010, the estate and gift tax rates are reduced, the unified credit effective exemption amount are increased (from up to $1 million for lifetime transfers in 2004 to up to $4 million for deathtime transfers in 2010), and the generation-skipping transfer tax exemption amount is increased. The new rate structure is summarized in Table 11.

Table 11: Unified Credit Exemption; Highest Estate and Gift Tax Rates

Beginning in 2011, the top gift tax rate will be 40 percent, and, except as provided in the tax regulations, a transfer to a trust will be treated as a taxable gift, unless the trust is treated as wholly owned by the donor or the donor’s spouse under the grantor trust provisions of the tax code.

IRAs and Retirement Plans

14. Individual retirement arrangements (“IRAs”)

Under current law, an individual may make deductible contributions to an IRA up to the lesser of $2,000 or the individual’s compensation if neither the individual nor the individual’s spouse is an active participant in an employer-sponsored retirement plan. In the case of a married couple, deductible IRA contributions of up to $2,000 can be made for each spouse (including, for example, a homemaker who does not work outside the home), if the combined compensation of both spouses is at least equal to the contributed amount. If the individual (or the individual’s spouse) is an active participant in an employer-sponsored retirement plan, the $2,000 deduction limit is phased-out for taxpayers with adjusted gross income (“AGI”) over certain levels for the taxable year.

EGTRA increases the maximum annual dollar contribution limit for IRA contributions from $2,000 to $3,000 for 2002 through 2004, $4,000 for 2005 through 2007, and $5,000 for 2008. After 2008, the limit is adjusted annually for inflation in $500 increments. In addition, individuals who have attained age 50 may make additional “catch-up” IRA contributions. The otherwise maximum contribution limit (before application of the AGI phase-out limits) for an individual who has attained age 50 before the end of the taxable year is increased by $500 for 2002 through 2005, and $1,000 for 2006 and thereafter.

15. “Deemed” IRAs

EGTRA provides that, if an “eligible retirement plan” permits employees to make voluntary employee contributions to a separate account or annuity that (1) is established under the plan, and (2) meets the requirements applicable to either traditional IRAs or Roth IRAs, then the separate account or annuity is deemed a traditional IRA or a Roth IRA, as applicable, for all purposes of the tax code. For example, the reporting requirements applicable to IRAs apply. The deemed IRA is not subject to the rules pertaining to the eligible retirement plan. In addition, the deemed IRA is not taken into account in applying such rules to any other contributions under the plan. The deemed IRA is subject to the exclusive benefit and fiduciary rules of ERISA to the extent otherwise applicable to the plan, and are not subject to the ERISA reporting and disclosure, participation, vesting, funding, and enforcement requirements applicable to the eligible retirement plan. An eligible retirement plan includes a qualified plan under code section 401 or a tax-sheltered annuity (403(b) plan).

This provision is effective for plan years beginning in 2003.

16. Increase in benefit and contribution limits

Under current law, annual additions to a defined contribution plan with respect to each plan participant cannot exceed the lesser of (1) 25% of compensation, or (2) $35,000 (for 2001). Annual additions are the sum of employer contributions and employee contributions. The $35,000 limit is indexed for cost-of-living adjustments in $5,000 increments. Under a defined benefit plan, the maximum annual benefit payable at retirement is generally the lesser of (1) 100% of average compensation, or (2) $140,000 (for 2001). The dollar limit is adjusted for cost-of-living increases in $5,000 increments.

EGTRA increases the $35,000 limit on annual additions to a defined contribution plan to $40,000. This amount is indexed in $1,000 increments. It also increases the $140,000 annual benefit limit under a defined benefit plan to $160,000. The dollar limit is reduced for benefit commencement before age 62 and increased for benefit commencement after age 65.

These changes are effective in 2002.

17. Increase in compensation limitation

Under current law, the annual compensation of each participant that may be taken into account for purposes of determining contributions and benefits under a plan, applying the deduction rules, and for nondiscrimination testing purposes is limited to $170,000 (for 2001). The compensation limit is indexed for cost-of-living adjustments in $10,000 increments. EGTRA increases the limit on compensation that may be taken into account under a plan to $200,000. This amount is indexed in $5,000 increments.

This provision takes effect in 2002.

18. Increase in elective deferral limit

Under current law, under certain salary reduction arrangements, an employee may elect to have the employer make payments as contributions to a plan on behalf of the employee, or to the employee directly in cash. Contributions made at the election of the employee are called elective deferrals. The maximum annual amount of elective deferrals that an individual may make to a qualified cash or deferred arrangement (a “section 401(k) plan”), a tax-sheltered annuity (“section 403(b) annuity”) or a salary reduction simplified employee pension plan (“SEP”) is $10,500 (for 2001). The maximum annual amount of elective deferrals that an individual may make to a SIMPLE plan is $6,500 (for 2001). These limits are indexed for inflation in $500 increments.

EGTRA increases the dollar limit on annual elective deferrals under section 401(k) plans, section 403(b) annuities and salary reduction SEPs to $11,000 in 2002. In 2003 and thereafter, the limits are increased in $1,000 annual increments until the limits reach $15,000 in 2006, with indexing in $500 increments thereafter. The provision increases the maximum annual elective deferrals that may be made to a SIMPLE plan to $7,000 in 2002. In 2003 and thereafter, the SIMPLE plan deferral limit is increased in $1,000 annual increments until the limit reaches $10,000 in 2005. Beginning after 2005, the $10,000 dollar limit is indexed in $500 increments.

19. Treatment of self-employment income of members of certain religious faiths

In general, contributions to qualified plans and IRAs are based on compensation. For a self-employed individual, compensation generally means net earnings subject to self-employment taxes (“SECA taxes”). Members of certain religious faiths may elect to be exempt from SECA taxes on religious grounds. Because the net earnings of such individuals are not subject to SECA taxes, these individuals are considered to have no compensation on which to base contributions to a retirement plan. Under an exception to this rule, net earnings of such individuals are treated as compensation for purposes of making contributions to an IRA.

EGTRA amends the definition of compensation for purposes of all qualified plans and IRAs (including SIMPLE arrangements) to include an individual’s net earnings that would be subject to SECA taxes but for the fact that the individual is covered by a religious exemption. The provision is effective beginning in 2002.

20. Repeal of coordination requirements for “section 457 plans”

Compensation deferred under an eligible deferred compensation plan of a tax-exempt or state and local government employer (a “section 457 plan”) is not includible in gross income until paid or made available. In general, the maximum permitted annual deferral under such a plan is the lesser of (1) $8,500 (in 2001) or (2) 33 1/3% of compensation. The $8,500 limit is increased for inflation in $500 increments. In applying the $8,500 limit, contributions under a tax-sheltered annuity (“section 403(b) annuity”) are taken into account. Further, the amount deferred under a section 457 plan is taken into account in applying a special catch-up rule for section 403(b) annuities.

EGTRA repeals the rules coordinating the section 457 dollar limit with contributions under other types of plans, beginning in 2002.

21. “Roth contributions” to 403(b) plans

Individuals with adjusted gross income below certain levels generally may make nondeductible contributions to a Roth IRA and may convert a deductible or nondeductible IRA into a Roth IRA. Amounts held in a Roth IRA that are withdrawn as a qualified distribution are not includible in income and are not subject to the additional 10% tax on early withdrawals. A qualified distribution is a distribution that (1) is made after the 5-taxable year period beginning with the first taxable year for which the individual made a contribution to a Roth IRA, and (2) is made after attainment of age 59, is made on account of death or disability, or is a qualified special purpose distribution (i.e., for first-time home-buyer expenses of up to $10,000). A distribution from a Roth IRA that is not a qualified distribution is includible in income to the extent attributable to earnings, and is subject to the 10-percent tax on early withdrawals (unless an exception applies).

EGTRA allows a section 401(k) plan or a section 403(b) annuity to include a “Roth contribution program” that permits a participant to elect to have all or a portion of the participant’s elective deferrals under the plan treated as Roth contributions. Roth contributions are elective deferrals that the participant designates (at such time and in such manner as the IRS may prescribe) as not excludable from the participant’s gross income. The annual dollar limitation on a participant’s Roth contributions is the annual limitation on elective deferrals, reduced by the participant’s elective deferrals that the participant does not designate as Roth contributions. The plan is required to establish a separate account, and maintain separate recordkeeping, for a participant’s Roth contributions (and earnings).

A qualified distribution from a participant’s Roth contribution account is not includible in the participant’s gross income. A qualified distribution is a distribution that is made after the end of a specified nonexclusion period and that is (1) made on or after the date on which the participant attains age 59, (2) made to a beneficiary (or to the estate of the participant) on or after the death of the participant, or (3) attributable to the participant being disabled. The nonexclusion period is the 5-year-taxable period beginning with the earlier of (1) the first taxable year for which the participant made a Roth contribution to any Roth contribution account established for the participant under the plan, or (2) if the participant has made a rollover contribution to the Roth contribution account that is the source of the distribution from a Roth contribution account established for the participant under another plan, the first taxable year for which the participant made a Roth contribution to the previously established account. A participant is permitted to roll over a distribution from a Roth contribution account only to another Roth contribution account or a Roth IRA of the participant.

The Secretary of the Treasury is directed to require the plan administrator of each section 403(b) annuity that permits participants to make Roth contributions to make such returns and reports regarding Roth contributions to the Secretary, plan participants and beneficiaries, and other persons that the Secretary may designate.

This provision takes effect in 2006.

22. Nonrefundable credit to certain individuals for elective deferrals and IRA contributions

EGTRA provides a temporary nonrefundable tax credit for contributions made by eligible taxpayers to a qualified retirement plan. The maximum annual contribution eligible for the credit is $2,000. The credit rate depends on the adjusted gross income (“AGI”) of the taxpayer. Only joint returns with AGI of $50,000 or less, head of household returns of $37,500 or less, and single returns of $25,000 or less are eligible for the credit. The credit is in addition to any deduction or exclusion that would otherwise apply with respect to the contribution. The credit offsets minimum tax liability as well as regular tax liability. The credit is available to individuals who are 18 or over, other than individuals who are full-time students or claimed as a dependent on another taxpayer’s return.

The credit is available with respect to elective contributions to a section 401(k) plan, section 403(b) annuity, SIMPLE or SEP plans, and contributions to a traditional or Roth IRA. The rules governing such contributions continue to apply.

The amount of any contribution eligible for the credit is reduced by taxable distributions received by the taxpayer and his or her spouse from any savings arrangement described above or any other qualified retirement plan during the taxable year for which the credit is claimed, the two taxable years prior to the year the credit is claimed, and during the period after the end of the taxable year and prior to the due date for filing the taxpayer’s return for the year. In the case of a distribution from a Roth IRA, this rule applies to any such distributions, whether or not taxable.

The credit rates based on AGI are summarized in Table 12.

Table 12: Credit Rates Based on AGI

This provision is effective beginning in 2002. It expires at the end of 2007.

23. Additional salary reduction catch-up contributions

The limit on elective deferrals under a section 401(k) plan, section 403(b) annuity, SEP, or SIMPLE, or deferrals under a section 457 plan is increased for individuals who have attained age 50 by the end of the year. The catch-up contribution provision does not apply to after-tax employee contributions. Additional contributions may be made by an individual who has attained age 50 before the end of the plan year and with respect to whom no other elective deferrals may otherwise be made to the plan for the year because of the application of any limitation of the tax code (e.g., the annual limit on elective deferrals) or of the plan.

The additional amount of elective contributions that may be made by an eligible individual participating in such a plan is the lesser of (1) the applicable dollar amount, or (2) the participant’s compensation for the year reduced by any other elective deferrals of the participant for the year. The applicable dollar amount under a section 401(k) plan, section 403(b) annuity, SEP, or section 457 plan is $1,000 for 2002, $2,000 for 2003, $3,000 for 2004, $4,000 for 2005, and $5,000 for 2006 and thereafter. The applicable dollar amount under a SIMPLE is $500 for 2002, $1,000 for 2003, $1,500 for 2004, $2,000 for 2005, and $2,500 for 2006 and thereafter. The $5,000 and $2,500 amounts are adjusted for inflation in $500 increments in 2007 and thereafter.

Catch-up contributions are not subject to any other contribution limits and are not taken into account in applying other contribution limits. In addition, such contributions are not subject to applicable nondiscrimination rules.

An employer is permitted to make matching contributions with respect to catch-up contributions. Any such matching contributions are subject to the normally applicable rules.

This provision takes effect in 2002.

24. Revised limit on contributions to tax-sheltered annuities

In the case of a tax-sheltered annuity (a “section 403(b) annuity”), the annual contribution generally cannot exceed the lesser of the “exclusion allowance” or the section 415(c) defined contribution limit. The exclusion allowance for a year is equal to 20% of the employee’s includible compensation, multiplied by the employee’s years of service, minus excludable contributions for prior years under qualified plans, tax-sheltered annuities or section 457 plans of the employer. In addition to this general rule, employees of churches and some other charities may elect one of several “special rules” that increase the amount of allowable contributions. The election of a special rule is irrevocable, and an employee may not elect to have more than one special rule apply.

Under one special rule, in the year the employee separates from service, the employee may elect to contribute up to the exclusion allowance, without regard to the 25% of compensation limit under section 415. Under this rule, the exclusion allowance is determined by taking into account no more than 10 years of service.

Under a second special rule, the employee may contribute up to the lesser of: (1) the exclusion allowance; (2) 25% of the participant’s includible compensation; or (3) $15,000.

Under a third special rule, the employee may elect to contribute up to the section 415(c) limit, without regard to the exclusion allowance. If this option is elected, then contributions to other plans of the employer are also taken into account in applying the limit.

EGTRA repeals the exclusion allowance applicable to contributions to tax-sheltered annuities. As a result, such annuities are subject to the limits applicable to tax-qualified plans. A congressional conference committee explained this change as follows, “The present law rules that limit contributions to defined contribution plans by a percentage of compensation reduce the amount that lower and middle-income workers can save for retirement. The present-law limits may not allow such workers to accumulate adequate retirement benefits, particularly if a defined contribution plan is the only type of retirement plan maintained by the employer. Conforming the contribution limits for tax-sheltered annuities to the limits applicable to retirement plans will simplify the administration of the pension laws, and provide more equitable treatment for participants in similar types of plans.”

This change takes effect in 2002.

25. Increase in contribution percentage limit for defined contribution plans

In the case of a tax-qualified defined contribution retirement plan, section 415(c) of the tax code limits the annual additions that can be made to the plan on behalf of an employee to the lesser of $35,000 (for 2001) or 25% of the employee’s compensation. Annual additions include employer contributions, including contributions made at the election of the employee (through elective deferrals of salary), and after-tax employee contributions. For this purpose, compensation means taxable compensation of the employee, plus elective deferrals, and similar salary reduction contributions.

EGTRA increases the 25% of compensation limit on annual additions under a defined contribution plan to 100%. According to the congressional conference committee, the 25% limit was repealed because it has operated to reduce the amount that lower and middle-income workers can save for retirement. Further, conforming the contribution limits for tax-sheltered annuities to the limits applicable to retirement plans generally will simplify the administration of the pension laws, and provide more equitable treatment for participants in similar types of plans. This change takes effect in 2002.

26. Provisions relating to hardship withdrawals

Elective deferrals under a tax-sheltered annuity (403(b) plan) may not be distributed prior to the occurrence of one or more specified events. One such event is the financial hardship of the employee, which IRS regulations define as an immediate and heavy financial need for which a premature distribution is needed. The regulations provide a safe harbor under which a distribution may be deemed necessary to satisfy an immediate and heavy financial need. One requirement of this safe harbor is that the employee be prohibited from making elective contributions and employee contributions to the plan and all other plans maintained by the employer for at least 12 months after receipt of the hardship distribution.

EGTRA directs the IRS to revise the regulations to reduce from 12 months to 6 months the period during which an employee must be prohibited from making elective contributions and employee contributions in order for a distribution to be deemed necessary to satisfy an immediate and heavy financial need. The revised regulations are to be effective for years beginning in 2002.

27. Rollovers of retirement plan and IRA distributions

Under current law, “eligible rollover distributions” from a tax-sheltered annuity (“section 403(b)” plan) may be rolled over into an IRA or another section 403(b) annuity. Distributions from a section 403(b) annuity cannot be rolled over into a tax-qualified plan, and section 403(b) annuities are not required to accept rollovers. In addition, distributions from an IRA cannot be rolled over into a section 403(b) annuity. Plan administrators of 403(b) annuities are required to provide a written explanation of rollover rules to individuals who receive a distribution eligible for rollover. In general, the notice is to be provided within a reasonable period of time before making the distribution and is to include an explanation of (1) the provisions under which the individual may have the distribution directly rolled over to another eligible retirement plan, (2) the provision that requires withholding if the distribution is not directly rolled over, and (3) the provision under which the distribution may be rolled over within 60 days of receipt.

As is the case with the rollover rules, different rules regarding taxation of benefits apply to different types of tax-favored arrangements. In general, distributions from a qualified plan, section 403(b) annuity, or IRA are includible in income in the year received. In certain cases, distributions from qualified plans are eligible for capital gains treatment and averaging. These rules do not apply to distributions from another type of plan. Distributions from a qualified plan, IRA, and section 403(b) annuity generally are subject to an additional 10% early withdrawal tax if made before age 59 1/2. There are a number of exceptions to the early withdrawal tax. Some of the exceptions apply to all three types of plans, and others apply only to certain types of plans. For example, the 10% early withdrawal tax does not apply to IRA distributions for educational expenses, but does apply to similar distributions from qualified plans and section 403(b) annuities.

EGTRA provides that eligible rollover distributions from qualified retirement plans or section 403(b) annuities can be rolled over to any of such plans or arrangements. Similarly, distributions from an IRA generally are permitted to be rolled over into a qualified plan or section 403(b) annuity. Section 403(b) annuities are not be required to accept rollovers.

28. Employer-provided retirement advice

Current law does not specifically exclude from taxable income the value of employer-provided retirement planning services. EGTRA contains a new exclusion for qualified retirement planning services provided to an employee and his or her spouse by an employer maintaining a “qualified plan.” The term “qualified plan” is defined to include 403(b) annuities and several other types of retirement plans. This means that the value of retirement planning advice provided by a church that maintains a 403(b) plan does not constitute taxable income for payroll tax reporting purposes (it is not reported on Form W-2, Form 941, and there is no tax withholding on the value of such advice), and employees do not report the value of the advice as taxable income on their tax return.

This new exclusion does not apply with respect to highly compensated employees (generally, those earning annual compensation of at least $85,000) unless the services are available on substantially the same terms to each member of the group of employees who normally are provided education and information regarding the employer’s qualified plan.

The provision takes effect in 2002.

Miscellaneous changes

29. Backup withholding

Employers are required to engage in “backup withholding” at a rate of 31% for payments made to self-employed workers who do not disclose their social security number. The 31% is reported on the church’s 941 forms. Employers need the correct social security number to complete the worker’s Form 1099-MISC. EGTRA decreases the backup withholding rate from 31% to 30.5% for amounts paid to self-employed persons after August 6, 2001. For amounts paid after December 31, 2001, the backup withholding rate is equal to the fourth lowest income tax rate (for single persons). Table 13 shows the backup withholding rates for future years.

Table 13: Backup Withholding Rates

Advantages of a Charitable Remainder Trust

Church members with greatly appreciated property may be “better off” for tax purposes if they transfer their property to a charitable remainder trust. This is often a “win-win” situation, since both the church member and the church will benefit. Here’s how it works. A donor creates a charitable remainder trust and then transfers appreciated, income-generating property to the trust. The trust makes annual (or more frequent) distributions to the donor or one or more family members for a term of years (ordinarily not more than 20), with an irrevocable remainder interest to a designated charity. Many churches and other religious organizations are using these trusts to raise funds, since they provide the following benefits:

The donor receives a current charitable contribution deduction for the value of the “remainder” interest that will be distributed to the designated charity at the conclusion of the trust.

The donor, or anyone the donor designates, receives income payments for a specified number of years (up to 20).

The designated charity has the assurance that it will receive the trust property at some specified future date. This helps the charity with long-range planning.

The new carryover basis rule is avoided since the trust does not pay tax on any gain resulting from the sale of the property, so the property’s basis is irrelevant.

© Copyright 2001 by Church Law & Tax Report. All rights reserved. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is provided with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional person should be sought. Church Law & Tax Report, PO Box 1098, Matthews, NC 28106. Reference Code: m27 c0501