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%.
Unlike the income tax rate reductions, the new rates apply only to transactions and payments received after May 6, 2003, through Dec. 31, 2007. The 15% maximum rate will continue through 2008. In 2008, the 5% capital gain rate for low-income taxpayers drops to a zero percentage but only for 2008. On Jan. 1, 2009, all the pre-2003 capital gain rates are reinstated.
The long-term capital gain benefit will not benefit all assets. For example, sales of collectible items remain subject to a 28% maximum capital gain rate. Un-recaptured Code Section 1250 gain is still subject to a 25% maximum rate. Deduction of capital losses against ordinary income continues to be limited to $3,000 per year for individual taxpayers.
Insight: With the 2008 changes five years away, there is a significant chance that other changes will be enacted before 2008. Therefore, taxpayers will be well advised not to assume that the 2008 zero tax rate and/or 15% tax rate will be retained.
Insight: With the new rules effective May 6, 2003, complicated calculations may be necessary to properly compute the new Long Term Capital Gain for 2003. Transition rules are provided for in the Act and the IRS will probably issue additional clarifications. The IRS has indicated that the new law will create eight more lines to Schedule D of the 1040.
Insight: Because the new rules apply a maximum rate on long-term capital gains, as opposed to excluding the gain from taxable income, the states that use the federal return as the basis of their taxation of capital gains will not lose any revenue–unless they decide to provide a similar state tax benefit. Given the current state budget deficits, this is not likely.
Planning: The reduction in capital gain rates will reduce the tax-drive benefit of making charitable contributions to charities (including through Charitable Remainder Trusts) using appreciated capital gain assets.
Planning: The split between the top ordinary income rate and the top capital gain rate has increased from 18.6% to 20%. This change will add the additional benefit of trying to structure transactions to generate capital gains rather than ordinary income. In addition, compensation methods which provide for long-term capital gain benefits (e.g., Incentive Stock Options) will become more favorable.
Planning: As clients approach 2008, they will need to address how to take advantage of the changes. For example, the client may transfer an appreciated asset to a child in the lowest income tax bracket and have the child sell the asset in 2008–creating no tax on the sale.
Planning: As clients approach 2009, (and the reinstatement of the 20% top capital gain bracket) the 5% tax savings may encourage clients to sell appreciated assets before 2009. This potentially huge sell-off could impact the stock market.
Under the previous law a special tax rate was provided for capital gain property held for more than five years. Effectively, those rules are gutted until the new capital gain rules are revoked on Jan. 1, 2009.
Divident Income Tax Rate. Retroactive to Jan. 1, 2003, the Act provides for a maximum 15% tax rate for dividends paid by domestic and certain qualified foreign corporations. Lower income individuals will pay tax at a new rate of 5%. The new rates terminate on Jan. 1, 2009. The 5% dividend rate for low-income taxpayers is reduced to zero percent in 2008 and the current law is reinstated on Jan. 1, 2009.
One central issue is the definition of what constitutes a dividend under the new rules. The Act provides for a number of exclusions that will undoubtedly be refined in future regulations and rulings by the Internal Revenue Service. For example, dividends received from an REIT generally are not considered a dividend, unless they were previously taxed to the REIT.
Insight: The market will react with creating new investment vehicles whose distributions are treated as dividends and which provide some market stability using options and other financial instruments.
Insight: Because the new rules apply a maximum rate on dividend income, as opposed to excluding dividends from taxable income, the states which use the federal return as the basis of their taxation of dividends, will not lose any revenue–unless they decide to provide a similar state tax benefit. Given the current state budget deficits, this is not likely.
Insight: At least until 2009, the interest rate on bonds and similar investments will probably go up to compete with the after-tax return on investments which pay dividends.
Planning: With the rate reduction at 15%, owners of C corporations should evaluate the potential tax benefit of paying significant dividends out of the corporation, particularly before 2009. For example, assume a corporation has accumulated $100,000 in cash and the owner is retiring. Instead of paying the funds out as taxable salary (i.e., subject to Social Security taxes and a top income tax rate of 35%), the owner should consider paying the $100,000 out as a dividend, taxed at 15%.
Planning: This change reduces the tax cost of the sale of a corporate business by selling its assets (i.e., as opposed to a stock sale). One of the principal problems with the sale of assets by a C corporation has been the double taxation of the proceeds. First, the corporation pays taxes (without the benefit of any capital gain break) and when proceeds are distributed, the shareholder pays taxes again, sometimes at the highest income tax bracket. Under the Act, the business should consider having the payment treated as dividend to take advantage of the new rates.
Accumulated Earnings and Personal Holding Company Taxes. Both the accumulated earnings tax and the personal holding tax will be reduced to 15% effective Jan. 1, 2003.
Insight: Both of these taxes will be less of a threat to taxpayers who are accumulating income in their C corporations–at least until 2009.
Planning: Taxpayers with potential accumulated earnings tax or the personal holding tax concerns should consider paying dividends before 2009, when the 35% rate will be restored.
Small Business Expenses. Under previous law taxpayers were allowed to currently deduct (pursuant to Code Section 179) up to $25,000 in qualified new property purchases. The new law increases this amount to $100,000 and raises the threshold level for taxpayers to use the benefit from $200,000 to $400,000. Taxpayers should be aware that the deductions are permitted only to the extent that the business has taxable income equal to or in excess of the amount of the deduction (i.e., the deduction cannot create a net operating loss in the business).
In addition, bonus depreciation jumps to 50% of property acquired after May 5, 2003, and before Jan. 1, 2005.
Insight: Because of these new deductions, states that use the federal tax return as the basis of their own income taxes stand to lose significant dollars over the next few years. CCH estimates the loss at $600 million to $700 million from 2003 through 2005. Some states may adjust their tax statutes to eliminate or reduce this new benefit–creating additional complexity in the preparation of state income tax returns.
Insight: Previous law did not permit section 179 deductions for off-the-shelf computer programs. The Act now permits such deductions.
Planning: Although there were discussions of eliminating the deduction for large SUV vehicles from the section 179 expensing rules, the Act does not contain any such restrictions. Therefore, if a client purchases an SUV of over 6,000 pounds for the business, the entire cost currently may be deductible.
Planning: Businesses are allowed to pick and choose which assets will be subject to the new rules. In general, choosing assets that would have the longest depreciable life should create the greatest tax benefit.
While the new changes will provide some additional complexity to the Internal Revenue Code (primarily as a result of effective dates and phase-out dates), it is a relatively simple bill that will provide significant tax savings for many taxpayers. The single biggest beneficiaries of the new law are (1) investors who will see decreased taxes on both capital gain transactions and dividends and (2) businesses which may be making significant new purchases in the near term.
John J. Scroggin, J.D., LL.M., is an estate planning attorney in Roswell, Ga., and author of “The Family Incentive Trust,” published by The National Underwriter Company. He can be reached via e-mail at email@example.com.
Reproduced from National Underwriter Edition, June 23, 2003. Copyright 2003 by The National Underwriter Company in the serial publication. All rights reserved. Copyright in this article as an independent work may be held by the author.