Identifying Planning Opportunities In The New Tax Act
On May 28, President Bush signed the Jobs and Growth Tax Relief Reconciliation Act of 2003. It was the third time in the last three years that Washington has enacted a major tax cut bill.
The Act may be the third largest tax cut in U.S. history. Although the Joint Committee on Taxation indicated the Act will result in a revenue reduction of approximately $330 billion, others estimate that the true cost could be as high as $850 billion, effectively dwarfing the 2001 Tax Act which provided about $726 billion in tax relief.
The Act was passed without Congress enacting any revenue increases to balance the budget. The Act also did not address any estate and gift tax issues (e.g., making the elimination of the estate tax permanent) or provide for any broad changes in the Alternative Minimum Tax.
The Act is relatively simple in its terms, except for the fact that (1) it effectively lays on top of the crazy-quilt changes of the 2001 Tax Act and (2) it adopts its own crazy-quilt of effective starting dates and sunset dates.
This article will discuss the general terms of the tax bill but will not cover all of its changes or nuances.
Income Tax Rate Reduction. Retroactive to Jan. 1, 2003, are significant across-the-board reductions in income tax rates for individuals, estates and trusts. The Act basically accelerates the phased-in rate changes adopted in the 2001 Tax Act. The original tax rates for 2003 were 10%, 15%, 27%, 30%, 35% and 38.6%. The new 2003 rates are 10%, 15%, 25%, 28%, 33% and 35%.
In addition, for 2003 and 2004, the 10% income tax bracket is expanded, thus reducing the tax for most taxpayers and the 15% tax bracket is expanded for married couples.
Insight: As a result of the retroactive nature of the bill, taxpayers will pay significantly less tax in 2003 than they expected. Taxpayers should review their withholding and quarterly payments to adjust for the new changes.
Insight: The Act did not reduce the income tax rate for C corporations. With the federal corporate income tax rate capping out at 39% (i.e., taxable income from $100,000 to $335,000), the benefit of using pass-through entities like S corporations, LLCs and partnerships is somewhat increased (i.e., the top individual rate is 4% lower than the top corporate tax rate).
Planning: Taxpayers should explore planning techniques designed to spray income to family members in lower income tax brackets. For example, assume a client in the 35% tax bracket places $500,000 in an irrevocable lifetime unified credit trust and the trust earns 6% on the funds. The client has been providing $24,000 annually in support to his mother and three children who attend college. Assume the children and mother are in a 10% bracket. To create $24,000 to the family, the client had to earn $36,923 and pay $12,923 in taxes. When he uses the trust, the family members receive $30,000 and pay no more than $3,000 in taxes, netting around $27,000 for the family.
Similar benefits could occur if the client hired family members or had them own part of the family business. However, make sure that taxpayers under age 14 do not have more then $1,500 in unearned income that would be taxed at the parents tax rate (the “Kiddie Tax”). Moreover, if the family member has earned income (i.e., a salary), Social Security and unemployment taxes will offset some of these benefits.
Planning: The Acts reduction in income tax brackets applies to “tax years beginning after Dec. 31, 2002.” Estates which have not yet elected their tax years should consider using a Dec. 31, 2002, tax year, so that estate income earned after Dec. 31, 2002, will be taxed at the lower rates. For example, assume a client died in December 2002. By electing a Dec. 31, 2002 year-end, 11 months of income would be taxed at the new lower rates. If the estate used Nov. 30, 2003, as its year-end, the 2003 trust taxable income from January through November would be taxed at the old, higher rates.
Planning: Taxpayers should consider decreasing the amount withheld from their paychecks and use the funds to invest in an IRA or SEP. By doing this, they can effectively double-up the tax relief (i.e., using the additional cash flow from the tax rate reduction this year to create a deduction that they would not have been able to fund).
Marriage Penalty Relief. Retroactive to Jan. 1, 2003, the Act accelerates some of the marriage penalty relief of the 2001 Tax Act. The Act provide two benefits to married couples:
For 2003 and 2004, the Act doubles the standard deduction available for married couples to twice the standard deduction of a single person. In 2005, the standard deduction for married taxpayers will fall to 174% of a single taxpayers standard deduction but then gradually rise to double the single taxpayer standard deduction by 2009 (as provided for in the 2001 Tax Act).
For 2003 and 2004, the 15% bracket will be expanded for married couples. After 2004, the phased-in provisions of the 2001 Tax Act will apply.
Insight: The doubling of the standard deduction will only benefit those married taxpayers who do not itemize their deductions. The expansion of the 15% bracket will not relieve all of the pain of the married penalty for married couples with dual incomes. Thus, the Act does not really eliminate the marriage penalty.
Insight: The marriage penalty relief is intended to benefit dual income married couples. However, it will also reduce taxes on couples where only one spouse has income. Moreover, the rate changes apply to both earned and unearned income.
Planning: Taxpayers who have itemized deductions that are close to the new doubled standard deduction should consider deferring or accelerating itemized deductions between 2003 and 2004. For example, if a clients itemized deductions are close to the new standard deduction, accelerating charitable deductions, state income taxes and other itemized deductions into 2003 could provide large itemized deductions for 2003.
In 2004, the taxpayers itemized deductions could be below the doubled standard deduction, allowing a greater deduction if the taxpayer uses the standard deduction instead of itemizing.
Childcare Credit. Retroactive to Jan. 1, 2003, the child tax credit is immediately boosted from $600 to $1,000. However, the increase will only occur for 2003 and 2004. In 2005, the childcare credit will fall to $700 but be phased-back to $1,000 by 2010. Based upon 2002 tax filings, the federal government may begin issuing tax-refunds of up to $400 to taxpayers who are entitled to the child tax credit.
Insight: The phase-out of the child tax credit for married taxpayers having more than $110,000 of modified adjusted gross income remains in place. However, because the phase-out is reduced by $50 for each $1,000 of income, and with a higher credit level, more high-income taxpayers will benefit from the credit.
Alternative Minimum Tax. The number of taxpayers paying an Alternative Minimum Tax (“AMT”) is expected to explode in the next four years. Although Congress has acknowledged the need to totally revamp AMT, it has continued to defer the issue. The Act does nothing to reform AMT but does provide for higher exemption levels.
Insight: Sometime in the next two to three years, Congress will have to address AMT reform. Without question, the reform will reduce the revenue earned from AMT, resulting in either higher budget deficits or the need to find replacement sources of revenue.
Capital Gain Tax Reduction. Under previous law the maximum federal capital gains tax rate was 20% and has now been reduced to 15%. For those taxpayers who would have been taxed at a 10% capital gains rate, the rate has been reduced to 5%.