Wandering Tax Pro Remembers The Tax Reform Act of 1986

Originally Published on forbes.com on October 20th,2011

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A collection of reflections on the silver anniversary of the Internal Revenue Code of 1986 would not be complete without the thoughts of Robert Flach – The Wandering Tax Pro.

President Ronald Reagan’s “TRA 86” was the largest revision of the Tax Code since 1954, and has been referred to as “the most sweeping revision in the history of tax law”. There were so many drastic changes to the Code that it became known in the industry as the “Accountants Full Employment Act of 1986”.

• It reduced the number of tax brackets from 14 to 2 and decreased the maximum tax rate from 50% to 28%.
• It repealed the dividend exclusion, the itemized deduction for sales tax paid, and the preferential treatment of long-term capital gains, phased out the itemized deduction for personal (credit card, auto loan, etc.) interest, and limited the deduction for business meals and entertainment to 80%.
• It made all state unemployment benefits fully taxable beginning in 1987.  Unemployment compensation had been made partially taxable in 1979.  (As an aside, when unemployment benefits first became taxable in 1979 I remember saying to my mentor that Social Security benefits would be next – and in 1984 Social Security and Railroad Retirement benefits became partially taxable).
• It almost doubled the personal exemption and indexed it for inflation beginning in 1990.  And it replaced the “zero bracket amount” that was previously built into the tax rate schedules and tax tables with a Standard Deduction, indexed for inflation beginning in 1989.  The additional personal exemption for age 65 and blind was replaced with an increased Standard Deduction.
• It created the “Kiddie Tax”.
• It did away with two of the major “tricks” that tax preparers could use to “pull a rabbit out of a hat” and cut literally thousands of dollars from a client’s tax bill (and assure client loyalty for life) – Income Averaging and Ten-Year Averaging.  While a form of Ten-Year Averaging available to older taxpayers did remain, it was nowhere near the humongous tax break that had once been.
• It repealed the ability of all taxpayers to make and deduct contributions to an individual retirement account (IRA), restricting the deduction to single workers with income up to $25,000, married couples with income up to $40,000, and all workers who were not covered by an employer-provided pension plan.
• It introduced complicated “passive activity” rules to close many of the loopholes that allowed tax shelters to thrive. As such, the Act should have also done away with the dreaded Alternative Minimum Tax (AMT), whose original purpose was to keep high-income taxpayers from taking excessive advantage of tax shelters to altogether avoid paying federal income taxes.  Instead the Act helped to create the monster that the dreaded AMT has become today, denying many upper-Middle Class taxpayers the tax savings provided to others by TRA 86.
• It started the ball rolling on limitations based on a taxpayer’s Adjusted Gross Income (AGI), limiting the allowable rental loss deduction for taxpayers with an AGI in excess of $100,000 and phasing-out the amount of IRA contributions that could be deducted based on an AGI threshold (see above), thus making the AGI the most important number on the 1040.  The Act also gave us the 2% of AGI limitation on most miscellaneous itemized deductions and increased the limit on medical deductions from 5% of AGI to 7½%.  
• It went wild with its use of acronyms.  I remember attending a class where the speaker told us about ACRS, MACRS and FACRS (which described the entire process – “Foolhardy Acts of Congress under the Ruse ofSimplification”).  If you had a PAL (passive income loss) you now needed to find a PIG (positive income generator).
• And for the first time taxpayers were required to list the Social Security number of dependent children age 5 and over.  I seem to recall reading somewhere that there were some 5000+ less dependents reported on 1987 tax returns.

A post in the Tax Foundation’s TAX POLICY BLOG from 2006 pointed out that in the then 20 years since the enactment of the Tax Reform Act of 1986, “much of what passed in 1986 to limit special tax loopholes has already crept back into the system courtesy of politicians quick to give in to whatever lobby fills their pockets”.  Even more “damage” has been done to the Tax Code in the following five years.

The time has come for another total overhaul of the federal income tax system.  We should totally shred the current Tax Code and start from scratch – beginning with “everything is taxable and nothing is deductible” and adding back only a handful of the most necessary “exceptions”.

The best year to have accomplished this was this year – 2011.  However nothing has been, or will be, done this year.  And 2012 is an election year, so nothing will be done in 2012.  But something must be done in 2013, as the extended “Bush tax cuts” will expire again on December 31, 2012.

However, as I am known for saying, the members of Congress are idiots, and Barack Obama has dropped the ball on the issue.  We need another committed politician with brass ones like Reagan to take the lead on tax reform.

Robert D Flach is a “previously unenrolled” tax professional from Jersey City NJ who has been preparing 1040s for individuals in all walks of life since 1972.  He writes the popular tax blogs THE WANDERING TAX PRO and THE NJ TAX PRACTICE BLOG.