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The New Tax Act "Job Creation and Worker Assistance Act of 2002" Fixes 2002 SEP Contribution Error

It's Official . . . The New SEP Limit for 2002 is Now 25%

New IRS Publications are Now Incorrect

Effective for 2002, EGTRRA 2001 (Economic Growth and Tax Relief Reconciliation Act of 2001) increased the SEP (Simplified Employee Pension) contribution that can be made by self-employed people or for employees of companies who offer SEPs from 15% to 25%. In 2001, the maximum SEP contribution was $25,500 which is based on 15% of a maximum compensation of $170,000 ($170,000 x 15% = $25,500).

The intent of the new law was to raise the maximum deductible SEP contribution limit for 2002 and later years to 25% of compensation from 15% of compensation, but the tax writers goofed. They forgot to change one of the IRS Code Sections, leaving the SEP deduction for 2002 capped at 15% instead of the 25% intended. That has been fixed by a technical correction buried deep in the new Job Creation Tax Act.

Now it's official. The 2002 SEP limit is 25% of up to $200,000 in compensation (limited to a $40,000 annual SEP contribution.)

The only problem is that the affected IRS Publications are already in print with the 15% limit. IRS had to show the 15% because that was the law without the correction. These Publications show the maximum 2002 SEP contribution as $30,000 (15% x $200,000 = $30,000) instead of the $40,000 maximum that was intended. These IRS Publications, specifically Publications 560 and 590 need to be amended.

More Technical Corrections Plug Tax Loopholes

As you may recall, The Taxpayer Relief Act of 1997 created lower capital gain tax rates that first became effective for 2001 tax returns being filed right now. The lower rates are only available for taxpayers who hold property more than 5 years. If you are in the 15% tax bracket, your capital gain rate is 10%. Under this new provision, the 10% rate drops to 8%, if the asset is held for more than 5 years. This rate can apply to property acquired before 2001. The regular 20% capital gain rate is reduced to 18%, if the property is held for more than 5 years. But to get the 18% rate, the property must be acquired in 2001 or later. Property acquired before 2001 does not qualify for the 18% rate. But it could under a special provision in the tax law that would allow you to treat the asset as if it were sold on January 1, 2001 at its fair market value on that date. The gain from this "deemed sale" would be reported on the 2001 tax return and tax would be owed at the 20% rate. The property would also be deemed to be repurchased on the same day, increasing the basis. The property would then qualify as being acquired in 2001, even though it really wasn't. If you then hold that property for more than 5 years, when it is sold, it will qualify for the 18% rate. That's a lot to go through for a 2% break 5 years out.

Stories were circulating that although this deemed sale and repurchase strategy may not be worth it, it could work well with your home. If you sell your home that you lived in and owned for at least 2 years during the 5 years before the home is sold, $500,000 (married joint) of gain can be excluded form tax ($250,000 if single).

The strategy that has been circulating is to use the home under the deemed sale provision and thereby receive a double exclusion. Married couples for example could exclude $1,000, 000 of gain from tax.

Some tax advisors, including myself, have looked at this strategy and have commented "this seems too good to be true."

On October 30, 2001 IRS issued Revenue Ruling 2001-57 which stated that you could elect the deemed sale for your principal residence, but if you do, you will not be allowed to exclude the gain. The $500,000 / $250,000 home sale exclusion will not apply to the deemed sale. You will not be able to double-up on the home sale exclusion. This would result in a large tax being owed on the sale. You'll get the step-up in basis, but you will have paid dearly for it.

However . . .
Some advisors still were not convinced, so the tax writers included the IRS position in a technical correction tacked on to the new Job Creation Act that amends the 1997 tax law. Now it's law. The deemed sale option DOES NOT APPLY to home sales.

In addition, the Job Creation Act also states that the deemed sale option does not apply to sales of passive activities. These would be rental properties and limited partnerships that have built up suspended losses. Congress was worried that if the deemed sale option applied to these passive activities, it could free up the suspended passive losses creating big unintended tax deductions for taxpayers.

The moral is . . .
if you think you've figured out a tax loophole, keep it to yourself. Congress and the IRS are listening . . . and reacting.

-by Ed Slott, CPA
Rockville Centre, New York
Copyright 2002, Ed Slott, CPA

Ed Slott, CPA
Publisher, Ed Slott's IRA Advisor
100 Merrick Road - Suite 200 East
Rockville Centre, New York 11570
(516) 536-8282

email: Ed Slott
website: www.irahelp.com