PL 99-514: Key Provisions of the Tax Reform Act

Public Law 99-514, known as the Tax Reform Act of 1986, was a comprehensive overhaul of the United States Internal Revenue Code. The legislation was a bipartisan effort aimed at restructuring the nation’s tax system with three core objectives. The first goal was revenue neutrality, meaning it was designed to redistribute the tax burden without changing the total revenue collected. The second objective was to enhance fairness by broadening the tax base, which involved eliminating or curtailing numerous deductions and loopholes. The third goal was simplification of the tax code to reduce compliance burdens and make the system more transparent.

Major Tax Changes for Individuals

The Tax Reform Act of 1986 altered how individual income was taxed by reducing the number of tax brackets. The existing system of fifteen brackets with a top rate of 50% was replaced by a simpler structure with just two rates: 15% and 28%. A 5% surcharge on certain income levels created a temporary 33% marginal rate for some, phasing out the benefit of the 15% bracket for higher-income taxpayers. The current system, established by later legislation, now uses seven federal income tax brackets.

The act also provided relief to lower-income individuals by increasing the standard deduction and personal exemption amounts, which removed millions of low-income households from the tax rolls. To offset this, the act broadened the tax base by eliminating or curtailing itemized deductions. The deduction for interest paid on consumer debt, like credit card balances and car loans, was phased out. The law also repealed the two-earner deduction for working married couples.

While the 1986 Act repealed the deduction for state and local sales taxes, this deduction was later reinstated as an option against state and local income taxes. Currently, the total deduction for all state and local taxes is capped at $10,000 per household annually through 2025.

The tax treatment of investment income also changed with the repeal of the 60% long-term capital gains exclusion. This meant long-term capital gains were taxed at the same rates as ordinary income for the first time in decades. This approach has since been reversed, and current law again provides for lower tax rates on long-term capital gains.

Finally, the act expanded the individual Alternative Minimum Tax (AMT), a parallel system ensuring that those who benefit from tax preferences still pay a minimum amount of tax. The 1986 law strengthened the AMT by increasing the number of preference items and raising its tax rate. Subsequent legislation has modified the AMT, and far fewer taxpayers are subject to it today.

Significant Corporate and Business Tax Reforms

The Tax Reform Act of 1986 reshaped business taxation, starting with a reduction in the top corporate tax rate from 46% to 34%. This rate structure is no longer in effect; the Tax Cuts and Jobs Act of 2017 replaced the graduated system with a flat 21% rate.

A foundational change was the repeal of the General Utilities doctrine. This principle had allowed corporations to distribute appreciated assets to shareholders during a liquidation without the corporation itself recognizing a taxable gain. The repeal required a corporation to recognize gain as if it had sold its assets at fair market value upon liquidation. This created a second layer of tax, as the corporation would pay tax on the appreciated assets, and shareholders would then pay a second tax on the distribution they received. This change fundamentally altered the tax consequences of selling or liquidating a business and was intended to curb tax-motivated corporate takeovers.

The system for calculating depreciation deductions was also overhauled with the replacement of the Accelerated Cost Recovery System (ACRS) by the Modified Accelerated Cost Recovery System (MACRS). ACRS had provided for very rapid depreciation of assets. MACRS generally slowed down these deductions by creating new asset classes and extending the recovery periods for many types of property. For example, the recovery period for residential rental property was extended to 27.5 years, while the period for commercial real estate was set at 31.5 years, a term that was later extended to the current 39 years.

Another change for businesses was the repeal of the regular Investment Tax Credit (ITC). The ITC had been an incentive for business investment, allowing companies to claim a direct credit against their tax liability for purchasing new machinery and equipment. By repealing the ITC, the Act increased the after-tax cost of acquiring new assets for many businesses.

Introduction of Passive Activity Loss Rules

A component of the Tax Reform Act of 1986 was the introduction of the Passive Activity Loss (PAL) rules under Section 469 of the Internal Revenue Code. These rules were a response to tax shelters that generated large, artificial losses for investors to offset other income. The legislation established three distinct categories of income and loss: active, portfolio, and passive.

The key to the new system was the definition of a “passive activity,” defined as any trade or business in which the taxpayer does not “materially participate.” Material participation requires involvement that is regular, continuous, and substantial. By definition, any rental activity was automatically classified as passive, regardless of the owner’s level of involvement. Interests in limited partnerships were also treated as inherently passive.

The core function of the PAL rules was to create a barrier between different types of income. The rules stipulated that losses generated from passive activities could only be used to offset income from other passive activities. Taxpayers were no longer permitted to use passive losses to reduce their taxable income from active sources, such as wages, or from portfolio sources, which includes interest and dividends. Any passive losses that could not be used in a given year were suspended and carried forward to future years.

These provisions had a profound impact on the tax shelter industry, which had become a focus of tax planning. Many shelters, particularly those involving real estate limited partnerships, were structured to generate significant non-cash deductions. The PAL rules dismantled this strategy by preventing investors from using these “paper losses” to shelter their high salaries from taxation.

Structural and Administrative Revisions

The Tax Reform Act of 1986 also implemented broader structural and administrative revisions. One of the most significant acts was the redesignation of the entire body of federal tax law from the “Internal Revenue Code of 1954” to the “Internal Revenue Code of 1986.” This change was intended to signal a clean break from the past and emphasize that the 1986 Act represented a complete overhaul of the tax structure.

The Act also included provisions designed to bolster compliance by increasing the penalties for failing to meet tax obligations. For instance, it consolidated and increased the penalties for failure to file required information returns and for failing to supply copies of those returns to the taxpayer. The penalty for substantial understatement of tax liability was also strengthened. This focus on stricter enforcement was a component of the Act’s effort to enhance fairness by ensuring that all taxpayers paid the amount of tax they legally owed.