Tax Relief—Chapter 2003

EXECUTIVE SUMMARY

CONGRESS PASSED THE JOBS AND GROWTH TAX RELIEF Reconciliation Act of 2003 to boost consumer spending and increase business capital expenditures. The act accelerates previously passed rate reductions, lowers long-term capital gains tax rates, reduces the tax on qualified dividends and provides increased IRC section 179 and bonus depreciation deductions for businesses. LONG-TERM CAPITAL GAINS A TAXPAYER REALIZES after May 5, 2003, and before January 1, 2009, will be taxed at 15% for most taxpayers. Certain taxpayers will pay only 5%. A small business owner contemplating retirement thus may want to consider selling his or her business during this period to take advantage of the lower rates. THE ACT LOWERS THE TAX RATE ON QUALIFIED dividends to 15% for most taxpayers. A planning tip for closely held corporations suggests they reconsider their pay packages to include more dividends in lieu of salary or bonus. Investors might change their asset allocations to give greater weight to dividend-paying stocks. THE NEW LAW INCREASES THE MAXIMUM ALLOWABLE section 179 expensing deduction to $100,000 on qualified business property the taxpayer places in service in 2003, 2004 and 2005. For these years the act expands the definition of qualified property to include off-the-shelf computer software. JGTRRA BOOSTS THE BONUS DEPRECIATION DEDUCTION to 50% from 30% on property the taxpayer places in service after May 6, 2003, and before January 1, 2005. Taxpayers who plan to acquire or construct a new building may want to engage an expert to help them identify components that qualify for the bonus depreciation.

REBECCA CARR, CPA, is an instructor in accounting at Arkansas State University at Jonesboro. Her e-mail address is rcarr@astate.edu . TINA QUINN, CPA, PhD, is associate professor of accountancy at Arkansas State University. Her e-mail address is tquinn@astate.edu .

n an attempt to jump-start the economy by boosting consumer spending and increasing business capital expenditures, Congress passed, and President Bush signed into law, the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA). The act is intended to put more disposable income in the pockets of individual taxpayers. For small businesses the act provides incentives to buy technology, machinery and other equipment and to expand. This article describes JGTRRA’s major provisions and offers planning tips CPAs can use when working with their clients to help them take maximum advantage of the act in the remaining months of 2003 and in future years.

LOWER RATES AND BEYOND
JGTRRA makes several changes for individual taxpayers. Most clients will benefit from the acceleration of the lower rates Congress passed under the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA). But confusion may also reign as a result of the myriad different dates when those rates change and when they revert to pre-JGTRRA levels. In addition to changing the rates on ordinary income, the 2003 act lowers long-term capital gains rates, reduces the tax on qualifying dividends, increases the child tax credit and provides marriage penalty relief.

Planning tips. Here are some pointers CPAs can discuss with their clients to help them minimize capital gains taxes.

With a 20% spread between rates on ordinary income and capital gains, it becomes critical for clients to avoid short-term gains, which are taxed at the client’s marginal rate. CPAs should encourage clients to hold assets for more than one year whenever possible before selling them.

It may be advantageous for some taxpayers to transfer appreciated property to children (over age 13—to avoid the kiddie-tax pitfalls). Any gain on the sale of the transferred property would be taxed at the lower 5% rate. For sales in 2008, the entire gain could be tax-free. This would be an excellent way to provide funds for future college costs. When recommending transfers, CPAs should keep college financial aid limits in mind to ensure the transaction doesn’t harm the student’s aid eligibility.

For small business owners considering retirement, the changes in capital gains rates may signal it is time to scale back or sell their businesses to take advantage of the lower rates.

When helping clients structure installment sales, remember that capital gains rates revert to old levels in 2009. Clients can save substantial tax dollars by receiving all installment payments by the end of 2008.

With capital gains rates at historic lows, this is the perfect time for CPAs to recommend clients sell low-basis stock they may have acquired through gift, inheritance or the sale of a business.

Reduced rate on dividends. T he act cuts the tax rate on qualified dividends corporations pay to individuals to the level of the new capital gains rates, generally 15%. For taxpayers in the 10% or 15% tax brackets, dividends will be taxed at 5% through 2007 and drop to 0% in 2008. The new rates are retroactive to January 1, 2003, and will expire on December 31, 2008, when they revert to ordinary income tax rates.

Qualified dividends include those from domestic corporations and qualified foreign corporations. A qualified foreign corporation is one incorporated in a possession of the United States or eligible for the benefits of a U.S. tax treaty. The law treats nonqualified corporations as qualified if their stock is readily tradable on an established U.S. securities market.

JGTRRA explicitly excludes certain dividends from the definition of qualified dividend income. The exclusion applies to

Any dividend from a corporation that is tax-exempt under IRC section 501 or section 521 during the year of distribution or the prior year.

Any amount allowed as a deduction under IRC section 591 (deduction for dividends paid by mutual savings banks).

Any dividend described in IRC section 404(k).

Dividends that fail to meet the revised holding period of 60 days instead of 45 days under IRC section 246(c)(1).

The extent to which the taxpayer is obligated to make payments under section 246(c).

Taxpayers cannot consider qualified dividends “investment income” for purposes of computing the allowable investment interest deduction unless they elect to have the dividends taxed at ordinary income tax rates. Congress did not want to permit taxpayers to “double-dip” by taxing dividends at the lower rate while also reducing the taxpayer’s ordinary income by the investment interest deduction.

Planning tips. There are several ways CPAs can help taxpayers take maximum advantage of this provision.

Closely held corporations may want to reconsider their pay packages to include more dividends in lieu of salary or bonus. The lower rate on dividends will allow owners to withdraw more profits at lower tax rates. However, CPAs should keep in mind the “reasonable compensation” standard applies to pay that is unreasonably low as well as unreasonably high.

Some clients should consider changing their asset allocation strategy. Income stocks now may be more attractive than some growth stocks. Although the same tax rate applies to both dividends and long-term capital gains, the time value of money makes current dividend income more attractive than future gains. However, asset allocation should be driven primarily by the client’s investment goals and risk tolerance, not by tax planning alone.

While JGTRRA’s dividend changes may give clients an incentive to reallocate their investments, perhaps from growth to income stocks, the associated transaction costs of liquidating securities may outweigh the tax benefits of lower rates on dividends. However, CPAs may want to suggest clients allocate future investment capital based on the new rules.

Taxpayers who own convertible bonds might consider converting them into common stock if the shares pay a dividend.

For some taxpayers dividend-paying stocks now may be a more attractive investment than municipal bonds. CPAs will need to calculate the aftertax returns on both to see which makes better sense.

Although the 15% rate is attractive, certain taxpayers may want to elect to treat the dividends as ordinary income if they have enough investment interest to offset them.

Taxpayers with fixed-income portfolios may want to weight the portfolio more toward securities that pay qualified dividends rather than interest due to the lower tax rate.

Rate changes. JGTRRA reduces individual income tax rates retroactively to January 1, 2003. The act also broadens the 10% bracket to $7,000 for single taxpayers and $14,000 for married taxpayers filing joint returns and reduces the 27%, 30%, 35% and 38.6% brackets to 25%, 28%, 33% and 35%, respectively. This accelerates the rate reductions Congress passed under the 2001 act. Since JGTRRA did not change EGTRRA’s sunset provisions, after 2010 tax rates will return to pre-EGTRRA levels.

Planning tip. CPAs and their clients now may find pass-through entities, such as S corporations, more attractive. At most levels business income would be taxed at a lower rate. In addition S corporations avoid the double taxation that characterizes C corporations.

Child tax credit. The act increases the credit to $1,000 from $600. Qualified taxpayers already should have received checks for the additional amount. This advance payment will reduce the credit available when clients file their 2003 returns. In 2005, the credit will fall to the EGTRRA-scheduled amount of $700 and gradually rise until it reaches $1,000 again in 2010.

Planning tip. CPAs should warn clients that the $1,000 credit applies only in 2003 and 2004, reverting to the EGTRRA schedule in 2005.

Marriage penalty relief. The 2003 act accelerates the marriage penalty relief provisions in EGTRRA, changing the standard deduction for married taxpayers filing a joint return for 2003 and 2004 to twice that for single taxpayers. The deduction returns to the EGTTRA phase-in schedule in 2005 when it drops to 174% of the single taxpayer deduction. The act expands the 10% bracket to $14,000 and the 15% tax bracket to twice that of single taxpayers. This, too, is only temporary relief. The 10% bracket reverts to $12,000 for married taxpayers in 2005 and the 15% bracket falls to 180% of the single taxpayer amount.

Unfortunately JGTRRA does not give married couples complete parity with single taxpayers. The phaseouts on itemized deductions and Roth IRA limitations still are well below those available for two single taxpayers.

Planning tips. Here are some recommendations CPAs should discuss with their clients.

The increase in the standard deduction may make itemizing deductions less attractive. Wherever possible, taxpayers should try to defer large deductions (such as charitable contributions) until 2005 or later and take the increased standard deduction in 2003 and 2004.

Some taxpayers may want to change their estimated tax payments or withholding status as a result of the reduced marriage penalty to put more money in their pockets right away.

Alternative minimum tax. The act raises the exemption for single taxpayers to $40,250 and for married taxpayers to $58,000, but only for tax years beginning in 2003 and 2004. Serious AMT reform still is needed in the future.

Planning tip. Since any tax law provision that reduces the regular tax has the potential to subject a client to AMT, CPAs will have to plan carefully to make sure more clients don’t fall into the AMT trap. For some taxpayers it may make sense to structure transactions with potential AMT consequences in 2003 or 2004 to take advantage of the higher exemption.

BUSINESS CHANGES
JGTRRA includes several provisions for small businesses. Their intent is to encourage capital investment in technology, machinery and other equipment businesses need to expand. Many small business owners have been waiting for the economy to improve before expanding. Now they have an incentive to grow due to the tax savings, which can help pay for the expansion. Although this new law targets small businesses, nothing in the act precludes larger entities from taking advantage of the changes within the spending limits.

JGTRRA provides for increased IRC section 179 and bonus depreciation expense. Both are in addition to the regular depreciation expense (allowing for “triple-dipping”).

Section 179. This change allows taxpayers to expense part or all of the cost of qualifying property they place in service during the tax year. Qualified property is new or used depreciable tangible personal property a taxpayer purchases to use in the active conduct of a trade or business. This includes, for example, equipment or machinery such as the drill press or table saw a furniture maker might use.

The section 179 deduction is limited to the maximum amount allowed by law. There also are spending and net income limits. Pre-JGTRRA rules allowed taxpayers to expense a maximum of $25,000 under section 179 with a $200,000 spending limit. A taxpayer exceeding that restriction would lose the deduction dollar for dollar and, when spending reached $225,000, would lose the entire deduction. Any section 179 deduction could not exceed the taxpayer’s taxable income from any active trade or business computed without regard to the section 179 deduction. This means section 179 expenses could not create or increase a net operating loss. However, taxpayers could carry over any unused expense to future tax years where it again would be subject to the same restrictions. CPAs should remember that any section 179 carryover can result only from the net income limit. The law includes no carryover provision for deductions taxpayers lose due to the spending limit.

The new law increases the maximum allowable deduction to $100,000 and the spending limit to $400,000. Thus a taxpayer does not lose the entire deduction until spending reaches $500,000. These figures are indexed for inflation beginning in 2004. The act expands the definition of qualified property to include off-the-shelf computer software. Although such software is not considered qualified property, JGTRRA allows expensing under section 179 if the taxpayer places it in service in 2003, 2004 or 2005. The net income limitation remains the same. This provision is scheduled to expire after December 31, 2005.

Planning tips. If a business acquires several assets, CPAs should separate them based on their recovery period, whether they are new or used and their date of purchase. Here are some other suggestions.

Under section 179 taxpayers can cherry-pick which assets to expense. They should expense property with the longest useful life in order to recover the asset’s cost faster.

The bonus depreciation provision does not apply to used property, so taxpayers should expense any such property they bought during the year under section 179.

Property taxpayers acquired before May 6, 2003, does not qualify for the 50% bonus; CPAs should recommend clients expense such property under section 179.n The $100,000 limit is a maximum; taxpayers may expense a lesser amount.

Taxpayers shouldn’t exceed the spending restrictions. If necessary, they should lease property or postpone purchases. Remember, although section 179 allows a carryover due to low taxable income, any such carryover will still decrease the asset’s depreciable basis, thereby cutting allowable bonus depreciation.

Bonus depreciation. JGTRRA increases the bonus depreciation deduction to 50% from 30% for qualified property placed in service after May 5, 2003, and before January 1, 2005. Property does not qualify if there was a binding contract for acquisition before May 6, 2003. However, such property and other assets the taxpayer acquired before May 6, 2003, still qualify for the 30% bonus depreciation. The new law extends the 30% bonus depreciation to January 1, 2005.

The definition of qualified property has not changed. In general, it covers new tangible property with a “class” life of 20 years or less, and qualified leasehold improvements such as office partitions or carpet. Taxpayers may take the 50% bonus depreciation, elect the 30% bonus or elect out of any bonus. Unlike the section 179 provision, there are no spending or income limitations. Therefore, taxpayers can use the bonus depreciation to create or increase a net operating loss.

Planning tips. CPAs can make several recommendations to enable business taxpayers to take full advantage of the depreciation rules.

Since the bonus depreciation can create a loss, taxpayers must consider whether this is desirable. A taxpayer with sufficient taxable income in the prior two taxable years should carry back the loss to produce a refund. Bear in mind the new law did not extend a provision that allowed for a five-year carryback. CPAs should help clients consider the time value of the money as well as predicted future marginal tax rates before they elect to carry over a loss.

Taxpayers who plan to acquire or construct a new building may want to engage a cost classification expert to help them identify building components that qualify for the bonus depreciation.

Increased limit on passenger automobiles. The act also raised the bonus depreciation deduction for passenger automobiles to $7,650 from $4,600. This is in addition to the regular limit of $3,060, raising the overall limit for depreciation and section 179 expense for passenger automobiles to $10,710. If the taxpayer elects out of the bonus depreciation, the limit remains at $3,060.

OTHER PLANNING POINTERS
These new provisions provide a wealth of opportunities for businesses. Tax planning should involve both the section 179 and the bonus depreciation provisions. Any amount a taxpayer expenses under section 179 will decrease the depreciable basis for purposes of calculating the bonus depreciation. Section 179 is subject to limitations and applies to both new and used property, while the bonus depreciation provisions are not subject to restrictions but apply only to new property.

Although a taxpayer need not make the decision to elect section 179 expense or opt out of the bonus depreciation before filing its tax return, the effects of these provisions should figure into the investment decision. Any tax planning a CPA does must include both to maximize the benefits. There are several possible combinations of provisions to choose from. The maximum benefit results from using both the maximum section 179 and the 50% bonus depreciation while there is no benefit if the taxpayer takes only the regular MACRS depreciation. The exhibit on page 46 provides three scenarios in which taxpayers at different income levels can save various amounts by taking advantage of section 179 and bonus and regular MACRS depreciation.

Good and bad. A sole proprietor may reap an additional benefit by lowering his or her taxable income enough to reduce or eliminate any self-employment tax. However, since many states will not conform their section 179 and bonus depreciation rules to the new federal changes, taxpayers and their CPAs should proceed with caution. This is particularly true for multistate businesses.

MORE THAN TAXES
While JGTRRA makes it more important than ever for CPAs to help taxpayers evaluate the tax implications of investment decisions—personal and business—a purchase, be it stock or accounting software, should never be based on tax considerations alone. CPAs should encourage clients to come in for a consultation before committing to a major personal investment or business purchase. In the long run, by avoiding “bad” investments, clients will reap the rewards with maximum tax savings. And for CPAs, that’s what it’s all about.