Thursday, October 27, 2011

Happy Belated Birthday

The 1986 Tax Reform Act was enacted on Oct. 22, 1986.

The goal was to simplify the tax code and to reduce individual tax rates.  The current tax rates are lower than the pre-1986 top marginal rate of 50%.  However, the Act had originally lowered the top marginal rate to 28%, but it has crept up over the years to the current 35%  (or 39.6% if the Bush Tax Cuts expire).

Unfortunately, the tax code did not remain simplified.  Over the past 25 years, an incredible amount of complexity has been written into the code.  Some provisions satisfy legitimate goals such as accurately taxing global profits.  Other provisions suffer from the problems of the past - penalties or rewards for specific taxpayers and needless complication.  The code is overdue for another comprehensive reform.

The Tax Reform Act saw the birth of IRC 469 - the passive activity loss rule.  This limited loss deductions on passive activities to the amount of gain from those activities.  Meaning if you made $10,000.00 in a business you start that qualifies as a passive activity, you can only deduct expenses against the $10,000.00 earned.

Passive Activities are activities in which the taxpayer does not materially participate, as determined under the code.  Losses will accumulate until the business is sold and only then can the taxpayer realize the loss against his income.

This reform was meant to prevent tax shelters.  An example would be a ranching business owned by a CEO of a company.  The CEO works full time for the company and only works on the ranch on weekends he can leave the office.  Unsurprisingly, the ranch never makes a profit.  Before IRC 469, the losses on the ranch would be deductible against his gross income.

By limiting questionable deductions, like passive activity losses, as well as limiting some corporate tax deductions, the reform act was able to be revenue neutral while lowering the tax burden on most Americans.