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Clear Thinking on Tax Reform
How small-business owners and investors can benefit most
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Business New Haven
9/29/2003
By: Mitchell Young
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For many taxpayers, the key element of President Bush’s "Job and Growth Tax Relief Reconciliation Act of 2003" is its impact on budget deficits.
Featuring approximately $330 billion in tax cuts, the Jobs and Growth Act was less than one third the $1.35 trillion tax cut in the Economic Growth & Tax Relief Reconciliation Act of 2001 that was enacted soon after Bush took office. While that legislation, with its complicated estate provisions, helped to keep tax accountants and wealth planners employed, the direct benefits to the economy were deferred.
Indeed only 15 percent of the cuts took effect in the first three years of the act, and nearly 60 percent were deferred for six years.
With the concerns of deflation being discussed by the government’s chief inflation fighter, Federal Reserve Chairman Alan Greenspan, the Bush administration decided that the economy needed more immediate tax cuts to stimulate the economy immediately.
If what local tax planners and wealth managers have to say is any indication, the wide variety of tax cuts should be showing up on business and personal balance sheets, providing more spending just as we need it. Small-business people in particular appear to have a great deal to gain from this new tax bill.
Says Armand Rossi, managing partner of Konowitz & Kahn, a North Haven accounting practice, "It was a great act. The objective was stimulus and growth, and I certainly feel it is going to accomplish some stimulus and some growth. Some of the changes in the act really benefit just about every small-business owner."
Like much new tax legislation, the first businesses that are being stimulated are those that help sort the new rules out.
Andrew Pelletier, a director in Fleet Bank’s Wealth Strategies Group, agrees that the act provides a wealth of options for new financial strategies for business people and investors alike. He also agrees that companies like Fleet are among the many organizations that see new opportunity for their own businesses in these tax changes.
"People are discussing this act and some of the impetuses to create liquidity, which are likely to bring more business to our group," Pelletier says. "We’re positioning ourselves to provide these solutions. Taxes are a significant motivator to private business owners. A very good number I’ve spoken to as this act was being put into place were very aware of the changes and eager to hear strategies. Owners of ‘C’ corporations have a very good opportunity with this tax law change".
He adds: "The primary drivers are pretty obvious: the reductions in the long-term capital gains rate from 20 to 15 percent. These reductions may convince some people to sell something now that is highly appreciated. Another compelling advantage is the reduction in the dividend rate. Now dividends will be taxed similarly as long-term capital gains. They went from the [potentially] highest tax rate of 38.6 percent to 15 percent."
Growing small businesses are among the biggest potential winners. The current expense allowance for qualified tangible personal property is being quadrupled from $25,000 to $100,000 per year. Additionally, there is now a bonus depreciation for capital goods acquired between May 5, 2003 and January 2005 of 50 percent, up from 30 percent.
Pelletier as well as other financial planners, while cautioning that taking immediate action on the benefits of the new tax act are not necessary, say businesses might do well to make tax hay while the sun shines. Many of the provisions have potentially limited life spans.
Rossi emphasizes that "You need to keep in mind that some of the provisions could be short-lived, many have a sunset provision and do expire unless Congress votes to extend the provision. It is a narrow window of opportunity, and some of these benefits are substantial."
The reductions in capital-gains tax rates and the dividend treatment, for example, are set to expire at the end of 2008. A rebounding economy or growing deficits might encourage lawmakers to do an about-face.
According to researchers for Fleet Bank, the U.S. Department of the Treasury has estimated that 91 million taxpayers will receive an average tax cut of more than $1,125. Treasury also said that 34 million families with children should expect an average tax cut of more than $1,500, while three million low-income taxpayers will have their income-tax obligation eliminated entirely.
Some of the best publicized aspects to the tax cuts were decreases in income tax rates, typically about a two-percent reduction, and 3.5 percent in the highest bracket.
The much-discussed marriage "penalty" has finally been eliminated and it will present a major tax break to joint filers. Standard deduction for a single person in tax year 2003 is $4,750. Standard deduction for a couple married filing jointly is now $9,500. Under the old law it was only $7,950.
Families may see other significant deductions as well. The child tax credit was boosted to $1,000 per child from $600, although some higher-income filers will miss some of this increase.
Investors received their holiday presents early this year with provisions that dividends payments are taxed at only 15 percent instead of as ordinary income. For some investors this is a huge reduction. The capital gains tax likewise has been reduced to 15 percent — a 25-percent reduction in rates.
The variety of financial strategies needed to optimize the opportunities of this act appear to be as varied as taxpayers.
The differential between ordinary income tax rate and long-term capital gain rates has widened. That makes short-term trading and high-turnover strategies less tax efficient, for example.
New dividend taxation rates should trigger a portfolio review, says John Sholtis of Fleet’s Private Client Group, and for some investors may create major changes in asset allocations.
"Every family balance sheet has different tax characteristics, objectives and time horizons," notes Sholtis. "For that reason ‘asset class location’ decisions must be made to optimize cash flow and tax efficiency."
Rossi emphasizes the impact on small business. "This new act has opened a lot eyes because of the substantial accelerated depreciation."
The new deductions, $100,000 of expensing and the bonus depreciation of 50 percent, can be combined and added to existing accelerated depreciation. In the case of a $200,000 capital investment, more than $150,000 could be expensed in the first year depending on what type of depreciation schedule is chosen. This new expensing now covers software purchases also. This huge tax break is only small-business friendly, and phases out for larger investments.
Rossi cautions, however, that the economy is still the biggest driver of businesses expansion. "We have clients that are expanding their businesses, adding to their building and acquiring equipment," he says. "They are being cautious. I don’t think they are going as fast as they want because of the slower economy."
Small-business owners have an important new tool provided by the new dividend rules, notes Pelletier. Companies may see this as a good time to distribute any retained earnings in a company back to owners, instead of taking salary or bonuses that would be taxable as income. Fleet sees some good opportunity for more financing business here.
Pelletier says of customer’s logic, "I might go the bank and borrow some money at the corporate level, and pay a dividend to myself or use cash on hand and start to transfer money to myself where I can diversify by investments."
Because of the concerns that the tax deductions may not hold up in the future, many planners are suggesting that individuals look at asset appreciation and potential sales now. Capital gains rates are the lowest they’ve been since 1933.
One potential impact on business from the act and an improving economy may be to foster sales of more companies.
Explains Pelletier: "The past three years has been choppy and murky for sales of private businesses. Valuations have been all over, but mostly down. When a business owner looks to sell their company they’re really thinking about, ‘What is my net? Can I re-invest and live off that?’ With interest rates low it’s is getting more difficult to invest and live off that. What the tax act does is reduces the tax by 25 percent, so it leaves more money to re-invest."
Adds Sholtis: "It has been a pretty bad three years. You do have business owners that have missed the window on the other side of the big run-up, and they’ve been waiting for the opportunity. The combination of low interest rates, the economy showing signs of improvement and now this tax incentive, I’ve seen more companies strategizing about a sale now than I have in some time."
How important is immediate action to carve out an appropriate strategy for your business or investments? Pelletier cites one example: asset allocations. "It used to be if I have a dividend-paying stock, I should hold it in my IRA. But now with the rate cut I can hold dividend-paying stocks in a taxable account as well."
Rossi cautions: "Pay attention and consult with your tax advisor. There are limitations and a window of opportunity for many of these deductions, so the timing of deductions is critical. I can not overemphasize the tax planning aspect of this whole act."
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