|CATHERINE L. CARLOZZI is a corporate communications consultant and freelance writer based in New Jersey. She formerly served as associate national director of publications at Laventhol & Horwath.|
"Complex" is the adjective most widely used to describe the Taxpayer Relief Act of 1997 signed into law by President Clinton on August 5, 1997—at least in polite company. Pundits, tax professionals and the press all agree that simplification was not part of the congressional agenda this time around. The new law makes more than 800 changes and will add an as-yet uncalculated number of pages to the Internal Revenue Code, already monumental at close to 3,600 pages.
Nearly all taxpayers—individuals, small businesses and corporations—are likely to be affected by the act in some way. However, overlapping provisions, a multiplicity of rates and a labyrinthine structure of floors and ceilings, phase-ins and phase-outs, effective dates and sunsets, exceptions, exclusions and givebacks will make it difficult to determine exactly how, when and to what extent. After giving the accounting profession nearly two months to wade through the new tax act—itself a weighty document of some 800 pages—the Journal spoke with five CPAs in both public practice and business and industry to learn their opinions of the law, the challenges it presents for them, the implications for their taxpaying constituencies and the strategies and priorities they are developing to meet new planning and compliance needs.
A PUBLIC RELATIONS CHALLENGE
For Katherine M. Rowe, a member of the American Institute of CPAs women and family issues executive committee, dealing with what she calls "the public relations aspects" of the act will be a challenge for CPAs. Her practice, Rowe & Rowe, PC, in Albuquerque, New Mexico, centers on tax, retirement and estate planning for middle- to high-income individuals.
"Explaining to clients that what theyve read about isnt going to happen right away—and that they dont even qualify for 75% of the laws benefits because of phase-outs and exclusions—will be difficult," says Rowe. For example, she cites the provision that broadens the definition of a home office, making it easier for the growing number of home-based workers to deduct related costs. "I dont look forward to explaining to self-employed clients, who already feel they have been unfairly excluded from this deduction in the past, that they will continue to have to live with the unfairness until 1999."
The client education process. The laws complexity has created another set of challenges for CPAs. "The education process that comes with any major tax law change is particularly onerous this time," Rowe observes. "So much is hidden, and recognizing the interplay of new provisions with existing law is crucial. It was tough to get a sufficient working knowledge to apply the new provisions to third-quarter estimated tax filings. The lag time between passage of the act and the availability of updated resource books and software made it even tougher."
The impact of this challenge was brought home to Rowe when she found 10% of New Mexicos practicing CPAs in attendance at a course on the new act in September. "Thats significant for such a sparsely populated state," she comments.
Benefits for older taxpayers. With a client roster tipped toward individuals of retirement age, Rowe sees the increase in the unified credit for estate and gift taxes and the provisions relating to capital gains and the sale of a principal residence as having the most impact on her practice. She believes the latter provision will be a boon, particularly to people who plan to use home-sale proceeds to enter retirement homes—something that didnt qualify for deferral in the past. Another "godsend" for her clients is the repeal of the 15% excise tax on excess distributions and accumulations from qualified retirement plans.
Rowe expects to do more yearend tax planning, although so far the number of calls her firm is fielding is only slightly ahead of normal. "People were still in summertime mode when the law passed, so the changes didnt seem immediate. But theyll start tearing the doors down in December."
The Taxpayer Relief Act of 1997
BETTER ON PAPER THAN IN PRACTICE
Ronald J. Linders firm, Delagnes, Mitchell & Linder, has an extensive practice serving high-net-worth individuals and related entities, including trusts, partnerships and closely held businesses. The San Francisco-based CPA firm began contacting its biggest clients immediately after the laws enactment to discuss relevant issues and then worked its way down through its client list.
"We discovered that, in general, the bigger the client, the smaller the issues because of the phase-outs and exclusions," says Linder. "Theres a lot that looks wonderful in print but isnt worth much when you focus on the dollars and cents." He points to the new education "IRA"—a $500 nondeductible annual contribution per beneficiary which accumulates tax free until withdrawn—as the extreme example. "If you have to pay for advice on whether to take advantage of this, you wont realize much net profit. Every brokerage firm in America is probably wondering whether to get involved with these small accounts, given the paperwork and reporting requirements." Congress clearly wasnt relating to "real-world economics" when it created them.
Benefits for upscale taxpayers. Linder expects the provisions affecting treatment of capital gains to have by far the most impact on his clients, along with the home-sale provisions, which will be particularly important in California. He notes that the $500,000 capital gains exclusion for home sales may hurt some long-time residents of the states urban markets, where home prices are highly inflated. Someone who invested $100,000 in a house 20 years ago might have a gain greater than $500,000 and will have to pay some tax, even if he or she reinvests all of the sale proceeds.
On the estate planning side, Linder singles out the exclusion of the first $1.3 million of value for a qualified family-owned business interest and the change in the unified credit as being of the most significance to his firms clients, although he is quick to qualify the latter. "The heirs of a wealthier client might realize an additional $153,000 if the client lives until the $1 million credit is fully phased in, 10 years from now. In the current bull market, a wealthy individuals net worth can fluctuate much more than that on a single day. You have to put it into perspective."
Another question Linder expects to be important is whether to roll existing individual retirement accounts and pension plans into the newly created Roth IRAs, on which earnings accumulate tax-free if certain requirements are met. "The preliminary indication is that theres some advantage, but it remains to be seen whether the savings are worth the cost of professional advice," he says. "Were advising our clients to wait until next summer and let someone else do the pioneering work."
Bubbles in the system. In Linders opinion, one of the new laws chief challenges is the "bubbles" created by the phase-outs. "When youre going through a bubble, your marginal tax rate is not what it appears to be." Linder says this is nothing new, but the large number of phase-outs increases the number of cases where it occurs. And then there are the interactions among provisions of new and existing law. If, for example, you opt for an education IRA and itemize your deductions, Linder says your marginal rate goes up 8% starting at about $150,000. The Hope tuition credit—$1,500 per student for qualified tuition and fees during the year paid on a students behalf—stands alone. "It phases out at $100,000 of adjusted gross income, increasing your effective marginal tax bracket by about 7.5%." As a result, Linders firm has warned staff not to advise taxpayers what bracket they fall into.
The impact of a significant transaction is no longer obvious either. Linder relates the case of a client with a huge capital gain who wanted to know whether to make a $50,000 charitable contribution this year or next. "At first glance, my reaction was 1997," he says. But running the numbers showed that holding off a year would make a $6,000 difference in the clients favor, partly as a result of phase-outs and the alternative minimum tax (AMT). "Its totally counterintuitive."
FOR SMALL BUSINESSES: MORE PAPERWORK
For the business clients of Postlethwaite & Netterville, APAC, in Baton Rouge, Louisiana, the new tax law means more planning and bookkeeping, according to associate Carolyn Turnbull. The firm plans to offer those clients—mostly nonpublic entities with up to $40 million in gross annual revenue—a seminar on the law before yearend.
"The problem with this tax act is the way Congress went about it," says Turnbull, citing the numerous effective dates and cumbersome calculations. "Because so many of the business provisions are transaction-specific and not something you encounter on a daily basis, the challenge will be to keep an eye on effective dates and specific provisions to avoid falling into a trap."
Relief for CPAs and clients. On the plus side, Turnbull mentions the AMT relief provision for small corporations. She says calculating depreciation for AMT can be one of the most time-consuming aspects of preparing a tax return. "Although the repeal isnt effective until 1998, we may be able to save some calculations on the 1997 returns of clients who will be affected by it." If the clients ever have enough revenue to be subject to AMT in the future, theyll start at zero and prior adjustments no longer will be important.
Turnbull notes that in two years, when the law conforms the recovery periods used for AMT purposes with those used for regular tax purposes, the decision whether to elect the 150% declining-balance method for new assets will be important because it will mean having to deal with only one depreciation schedule.
The extension of the work opportunity tax credit is among the other likely benefits for Turnbulls clients. Under prior law, employers received a credit of 35% of the first $6,000 of first-year wages paid to members of targeted groups if those employees worked more than 180 days or 400 hours per year. The new law extends the credit through June 30, 1998, and increases it to 40%, among other changes.
"Quite a few of our clients hire in the target groups in question," says Turnbull. "We stress that they should continue to certify those employees when the provision ends, because its been extended several times." She anticipates extending that advice to the new welfare-to-work credit.
NOL change negative. For Turnbull, one of the negative surprises in the act was the cutback of the net operating loss (NOL) carryback. President Clintons 1998 budget proposals cut the carryback from three years to one. The House and Senate proposed a 2-year carryback, which ultimately was adopted by the joint conference committee, with a 20-year carryforward. "The reduced carryback will make it more difficult for some businesses to realize any benefits, while the 20-year carryforward will be meaningless to most. A company that couldnt use up its carryforward in the original 15 years may be out of business within 20. This is strictly a revenue-raising provision."
"Tax season will start in October this year, and itll have some problems. But well just have to hang tough," observes Stanley Person, a partner of Person & Co. "There are some complex and important changes that will affect us as a small business, as well as our clients, although many are not always obvious." Roughly 90% of Persons client base is made up of closely held businesses with under $5 million in gross annual revenue and individuals filing schedule C.
The New York City-based firm sent its clients a general alert about the proposed changes a month before the law was enacted. Two weeks later, a second mailing highlighted provisions likely to affect small business clients. A third, individualized letter to the latter group focused on specific provisions of the enacted legislation.
Small business defined. Person acknowledges that the AMT repeal will have important bottom-line consequences for small businesses but focuses on a subtler benefit. "The government has finally defined what constitutes a small business," he says with some satisfaction. "Years ago, the yardstick was $50 million in sales, which seemed crazy. The new definition—$5 million in average annual gross receipts over three years, increasing to $7.5 million—makes more sense and generally is consistent with the trigger point for changing from a cash-basis method of accounting to the accrual basis."
Unlike Carolyn Turnbull, Person expects the NOL provisions to benefit his clients. He also points to the extension of employer-provided educational assistance as a way to help small businesses develop a management base for future growth. That provision will encourage employees to upgrade their skills by enabling them to continue excluding from taxable income up to $5,250 in employer reimbursement for specific undergraduate educational expenses.
Finding a more even footing. Many small businesses enjoy the best of both worlds: They benefit from provisions aimed at individual as well as business taxpayers. Person cites the Roth IRA—which allows nondeductible contributions to accumulate tax-free—as an example. It will be of particular benefit to owners and employees in businesses that lack pension plans. "With things like the new IRAs, the home-office provision and last years increased deduction for medical expenses and insurance, the government has put self-employed individuals who earn $150,000 or less on a more even footing with corporations," he says. "The issue of whether to incorporate has become less relevant. You dont want to put someone at that income level into a corporate structure just to save 2% on taxes, especially when you know your fee will eat up the savings."
Person has been counseling his small business clients to review their estate plans and make whatever changes are necessary to take advantage of the $1.3 million estate tax exclusion for family-owned businesses. He applies the same general advice to home-office arrangements.
The biggest tax return preparation challenge Person sees in the coming tax season relates to the capital gains changes. "With this years different holding periods, determining the applicable tax rates will be complicated." Gathering information from clients also has become more difficult. Its not an issue of getting piles of information stored in shoe boxes, Person says, but one of multiple transactions resulting from a very active stock market. "Ive spent more time talking with clients investment advisers this year than ever before. Most of our small business clients are very sophisticated about putting funds away for future business needs and are attracted to the equity markets as a way to realize the best rates of return. Their tax profiles and business needs, however, sometimes get in the way of investment decisions."
FOR CORPORATIONS: ONLY MINOR GAINS
For Benson Chapman, vice-president—taxation at Alleghany Corp., one of the tax acts biggest surprises was the number of provisions added by the joint conference committee. "The Clinton administration was obviously an equal third party in the process, and whoever was negotiating on the part of the Treasury and the Internal Revenue Service had a lot of input," Chapman observes. "You had to check the final law very carefully." He says that like many corporations, Alleghany welcomed the provision that would have reduced the corporate capital gains rate, but it was dropped from the final bill. Over the short term, the company expects to realize only mild benefits from the act.
Feeling the effects of international provisions. For Alleghany, a $2 billion publicly held multinational company—headquartered in New York City—that does business in the insurance and mining industries in 15 countries, the acts international provisions will have an impact on both ongoing operations and proposed transactions. Changes in the foreign tax credit, for example, will raise questions of whether the company should restructure some operations and also will affect the repatriation of funds from the companys 25 wholly owned foreign subsidiaries.
"The ability to continue to defer income in a foreign subsidiary before its repatriated in the form of dividends will have the most impact on us," says Chapman. "We also need to become comfortable with the provisions on acquisitions and dispositions."
Lag time creates burden. The fact that it may be several years before the IRS publishes some of the regulations that will affect the company has stepped up Chapmans quest for interpretive input. "I can read the bare tax code as well as the next person," he says. "But what does it really mean? I find it extremely helpful to hear presentations by speakers from the IRS, Treasury and the large accounting firms and to talk with my peers to find out how various provisions are affecting their corporate tax planning." This act also has put a premium on reading. "Im always searching for articles that convey tax practitioners interpretations of what the provisions mean."
A WORK IN PROGRESS
The U.S. tax code has been described as a house that undergoes continual remodeling and expansion by changing teams of builders but without the benefit of a master architectural plan. This latest remodeling effort is itself a work in progress. The ink was scarcely dry on the presidents signature before congressional and administration staffers were back at work, drafting technical corrections to fix glitches, define intent and clarify provisions that perplex tax experts. Given the likely length of that process and the long phase-in period for some provisions, it will take more than one tax season for tax advisers, preparers and payers to decide whether the intended "relief" of the Taxpayer Relief Act outweighs the headaches.