The U.S. Congress passed the
Tax Reform Act of 1986
Tax Reform Act of 1986 (TRA) (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. Referred to as the second of the two "Reagan tax cuts"
Economic Recovery Tax Act 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
Tax Reform Act of 1986
Tax Reform Act of 1986 was given impetus by a detailed
tax-simplification proposal from President Reagan's Treasury
Department, and was designed to be tax-revenue neutral because Reagan
stated that he would veto any bill that was not. Revenue neutrality
was achieved by offsetting tax cuts for individuals by eliminating
$60 billion annually in tax loopholes and shifting $24 billion of
the tax burden from individuals to corporations by eliminating the
investment tax credit, slowing depreciation of assets, and enacting a
stiff alternative minimum tax on corporations.
Income tax rates
2 Tax incentives
3 Fraudulent dependents
4 Changes to the AMT
5 Passive losses and tax shelters
6 Tax treatment of technical service firms employing certain
7 Name of the Internal Revenue Code
9 External links
Income tax rates
The top tax rate for individuals for tax year 1987 was lowered from
50% to 38.5%. Many lower level tax brackets were consolidated, and
the upper income level of the bottom rate (married filing jointly) 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. The standard deduction, personal exemption, and earned
income credit were also expanded, resulting in the removal of six
million poor Americans from the income tax roll and a reduction of
income tax liability across all income levels. The higher
standard deduction substantially simplified the preparation of tax
returns for many individuals.
For tax year 1987, the Act provided a graduated rate structure of
11%/15%/28%/35%/38.5%. Beginning with tax year 1988, the Act provided
a nominal rate structure of 15%/28%/33%. However, beginning with 1988,
taxpayers having taxable income higher than a certain level were taxed
at an effective rate of about 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.
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.
Moreover, interest on consumer loans such as credit card debt was 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
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
Economic Recovery Tax Act of 1981 (ERTA) removed the
pension plan clause and raised the contribution limit to the lesser of
$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 ERTA,
depreciation was based on "useful life" calculations provided by the
Treasury Department. ERTA 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 (DC) 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.
The Act required people claiming children as dependents on their tax
returns to obtain and list a
Social Security number for every claimed
child, to verify the child's existence. Before this act, parents
claiming tax deductions were on the honor system not to lie about the
number of children they supported. The requirement was phased in, and
initially Social Security numbers were required only for children over
the age of 5. During the first year, this anti-fraud change resulted
in seven million fewer dependents being claimed, nearly all of which
are believed to have involved either children that never existed, or
tax deductions improperly claimed by non-custodial parents.
Changes to the AMT
Alternative Minimum Tax targeted tax shelters used by a
few wealthy households. However, the
Tax Reform Act of 1986
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."
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 in large part for their
tax-advantaged status, as opposed to the non-tax aspects of their
profitability. The enactment of section 469 may have contributed to
the end of the real estate boom of the early-to-mid 1980s, as well as
to the savings and loan crisis.
Prior to 1986, much real estate investment was done by passive
investors. It was common for syndicates of investors to pool their
resources to invest in commercial or residential property. Investors
would then hire management companies to run the operation of the
property. 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 value reduction, in turn, encouraged
the holders of loss-generating properties to try to sell them, which
contributed further to the problem of sinking real estate values.
Mortgages and similar real property loans constituted a significant
portion of the asset portfolios of savings and loan associations.
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 productive 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 adjusted gross income
was less than $100,000 (pro-rated phase-out through $150,000).
Tax treatment of technical service firms employing certain
Internal Revenue Code does not contain any definition or rules
dealing with the issue of when a worker should be characterized for
tax purposes as an employee, rather than as an independent contractor.
The tax treatment depends on the application of (20) factors provided
by common law, which varies by state.
Introduced by Senator Daniel Patrick Moynihan, Section 1706 added a
subsection (d) to Section 530 of the Revenue Act of 1978, which
removed "safe harbor" exception for independent contractor
classification (which at the time avoided payroll taxes) for workers
such as engineers, designers, drafters, computer professionals, and
"similarly skilled" workers.
If the IRS determines that a third-party intermediary firm's worker
previously treated as self-employed should have been classified as an
employee, the IRS assesses substantial back taxes, penalties and
interest on that third-party intermediary company, though not directly
against the worker or the end client. It does not apply to
individuals directly contracted to clients.
The change in the tax code was expected to offset tax revenue losses
of other legislation Moynihan proposed that changed the law on foreign
taxes of Americans working abroad. At least one firm simply
adapted its business model to the new regulations. A 1991 Treasury
Department study found that tax compliance for technology
professionals was among the highest of all self-employed workers and
that Section 1706 would raise no additional tax revenue and could
possibly result in losses as self-employed workers did not receive as
many tax-free benefits as employees.
In one report in 2010, Moynihan's initiative was labeled "a favor to
IBM." A suicide note by software professional Joseph Stack, who
flew his airplane into a building housing IRS offices in February
2010, blamed his problems on many factors, including the Section 1706
change in the tax law while even mentioning Senator Moynihan by name,
though no intermediary firm is mentioned, and failure to file a return
Name of 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 1954 Code, it was not a re-enactment or a
substantial re-codification or reorganization of the overall structure
of the 1954 Code. Thus, the tax laws since 1954 (including those after
1986) have taken the form of amendments to the 1954 Code, although it
is now called the 1986 Code.
^ Birnbaum, Jeffrey H.; Murray, Alan S. (1988). Showdown at Gucci
Gulch : Lawmakers, Lobbyists, and the Unlikely Triumph of Tax
Reform (1st ed.). New York: Vintage Books. p. 288.
^ a b Longley, Kyle; Mayer, Jeremy D.; Schaller, Michael; Sloan, John
W. (2007). Deconstructing Reagan: Conservative Mythology and America's
Fortieth President. Armonk, N.Y.: M.E. Sharpe. p. 49.
^ Tax Rate Schedules, page 47, Instructions for 1987 Form 1040,
Internal Revenue Service, U.S. Dep't of the Treasury.
^ "Federal Individual Income Tax Rates History" (PDF).
TaxFoundation.org. 1913–2009. Retrieved 2009-03-06.
^ Brownlee, Elliot; Graham, Hugh Davis (2003). The Reagan Presidency:
Pragmatic Conservatism & Its Legacies. Lawrence, Kansas:
University of Kansas Press. pp. 172–173.
^ Steuerle, C. Eugene (1992). The Tax Decade: How Taxes Came to
Dominate the Public Agenda. Washington D.C.: The Urban Institute
Press. p. 122. ISBN 0-87766-523-0.
^ Tax Rate Schedules, page 51, Instructions for 1988 Form 1040,
Internal Revenue Service, U.S. Dep't of the Treasury.
^ Graney, Paul J. (2004). Retirement Savings Plans. Nova Publishers.
p. 45. ISBN 159033907X.
^ Jeffrey B. Liebman (December 2000). "Who Are the Ineligible EITC
Recipients?". National Tax Journal. 53: 1165–1186.
^ Hulse, Carl; Lee, Suevon (2007). "Alternative Minimum Tax". The New
York Times. Retrieved 2008-05-16.
^ "Internal Revenue Manual - 4.23.5 Technical Guidelines for
Employment Tax Issues". irs.gov. Retrieved 2014-06-13.
^ "IRS Rev. Rul. 87-41". web.archive.org. Archived from the original
on 2001-07-31. Retrieved 2014-06-13.
^ "New Tax Law threatens high-tech consultants" by Karla Jennings, The
New York Times, February 22, 1987. Retrieved 2010-06-17.
^ Andrew Davis, Synergistech Communications. Laws affecting Brokered
Independent Contractors' tax status. 2007-03.
URL:http://www.synergistech.com/ic-taxlaw.shtml. 2010-08-22. (Archived
by WebCite at https://www.webcitation.org/5sBKtV48u)
^ "Taxation of technical services personnel : section 1706 of the
Tax Reform Act of 1986 : a report to the Congress". archive.org.
^ "Tax Law Was Cited in Software Engineer’s Suicide Note" by David
Kay Johnston, The New York Times, February 18, 2010. Retrieved
^ "WebCite query result". webcitation.org. Archived from the original
on February 18, 2010. Retrieved 2014-06-13. CS1 maint: Unfit url
Campaign 2000 Information Page,
Citizens for Tax Justice "scorecard."
Showdown at Gucci Gulch: Lawmakers, Lobbyists and the Unlikely Triumph
of Tax Reform (1987), by
Jeffrey Birnbaum and Alan Murray, is a book
about the bill's passage.
Full text of the Act
Apps, P. F. (2010, June). Why the Henry Review Fails on Family Tax
Reform. In Australia’s Future Tax System: A Post-Henry
Tax Acts of the United States
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