JOBS AND GROWTH TAX RELIEF RECONCILIATION ACT OF 2003
After months of political debate, Congress has passed the “Jobs and Growth Tax Relief Reconciliation Act of 2003”-- its third major tax cut package in three years. President Bush signed the legislation on May 28, 2003. This tax relief package, touted as the third-largest tax cut in U.S. history, provides tax relief to virtually every person who pays federal income tax. For individuals, the 2003 Act accelerates previously-scheduled income tax rate reductions to January 1, 2003. Low-income and middle-income taxpayers who have children, not only benefit from these rate reductions, but also benefit from an increase in the child credit which is also retroactive to January 1, 2003. In fact, if you qualified for the child credit on your 2002 return, you may receive an IRS tax rebate check of up to $400 for each qualifying child as early as this July.
Businesses that buy depreciable property are provided substantial tax relief with the new law’s quadrupling of the immediate write-off allowance for qualified property, and the substantial increase in the first-year bonus depreciation deduction. If you are an investor, you may reap significant tax benefits from the lowering of the capital gains rate from 20% to 15%, and the reduction of the tax rate on dividends from 38.6% to 15%.
To help you take maximum advantage of this new law, this letter summarizes the changes made by the Jobs and Growth Tax Relief Reconciliation Act of 2003.
This tax legislation contains a roller coaster of effective dates. Few of the items contained in the 2003 Act are permanent. Consequently, timing is critical to ensure we take advantage of the many new tax benefits. As you read this letter, please pay special attention to the effective dates which change from one provision to another. To help you, we have highlighted the effective dates of each provision discussed. Furthermore, we offer planning ideas throughout this letter. However, you cannot properly evaluate a particular planning strategy without calculating your overall tax liability (including the alternative minimum tax) with and without the strategy. Please be careful! Call us before adopting any tax planning recommendation.
This letter is intended to be a summary of the 2003 Act provisions that we believe affect the largest number of our clients. Accordingly, we do not address every change made by the Act. If you are interested in a tax change that is not addressed here, or if you want more information on topics not discussed in this letter, please e-mail or call our office. Also, most states (including Georgia) have not adopted the provisions of the Jobs and Growth Tax Relief Reconciliation Act of 2003. So, state income tax implications of these changes are uncertain at this time.
At this point, the primary information we have regarding these new tax provisions is the statutory language of the 2003 Tax Act and the Congressional Committee Reports. The interpretations of these new rules are based primarily upon the information contained in those two documents. Additional clarifications will be issued later by the IRS in the form of regulations and other official pronouncements. Our firm will monitor these future developments.
TAX RELIEF PROVISIONS IMPACTING PRIMARILY INDIVIDUALS
MORE INCOME TAXED AT 10% EFFECTIVE JANUARY 1, 2003
ACCELERATION OF RATE REDUCTIONS TO JANUARY 1, 2003
ALTERNATIVE MINIMUM TAX EXEMPTION INCREASED
TAX RELIEF PROVISIONS IMPACTING PRIMARILY BUSINESSES
ADDITIONAL FIRST YEAR DEPRECIATION INCREASED FROM 30% TO 50%
§179 DEDUCTION INCREASED TO $100,000
PERSONAL HOLDING COMPANY TAX REDUCED FROM 38.6% TO 15%
ACCUMULATED EARNINGS TAX REDUCED FROM 38.6% TO 15%
25% OF CORPORATE ESTIMATED TAX PAYMENTS FOR SEPTEMBER DELAYED
“COLLAPSIBLE CORPORATION” RULES REPEALED
TAX RELIEF IMPACTING PRIMARILY INVESTORS
LONG-TERM CAPITAL GAINS TAX REDUCED
MAXIMUM TAX ON DIVIDENDS REDUCED FROM 38.6% TO 15%
AMT RELIEF FOR “QUALIFIED SMALL-BUSINESS STOCK”
KEY PROPOSALS THAT WERE DROPPED FROM THE FINAL LEGISLATION
TAX RELIEF PROVISIONS IMPACTING PRIMARILY INDIVIDUALS
More Income Taxed at 10% Effective January 1, 2003. Retroactive to January 1, 2003, the new law increases the amount of income taxed at 10% to $7,000 of taxable income for single filers (a maximum savings of $50) and $14,000 for joint filers (a maximum savings of $100). For heads of households, the 10% tax bracket was not changed and continues to apply to the first $10,000 of taxable income.
Planning Alert! The new expanded 10% tax bracket for joint and single filers only applies for 2003 and 2004. For 2005 through 2007, the 10% bracket reverts back to its original levels. In 2008, it will again return to $7,000 for single taxpayers and $14,000 for joint filers. The 10% rate does not apply at all to trusts or estates. The following is a summary of the modifications to the 10% bracket:
2002 2003-2004 2005-2007 2008-2010 After 2010
Size of 10%
Bracket:
Joint- $12,000 $14,000 $12,000 $14,000 No 10%
Single- $ 6,000 $ 7,000 $ 6,000 $ 7,000 Bracket
Acceleration of Rate Reductions to January 1, 2003. The new law accelerates individual marginal tax rate cuts that were, previously, scheduled to be fully effective in 2006. Effective January 1, 2003, the top four tax rates are reduced to 25%, 28%, 33%, and 35% (down from 27%, 30%, 35%, and 38.6%). For income taxed in the highest bracket, this is a 3.6% rate decrease. For income taxed in the 27%-35% tax brackets, it is a 2% rate decrease. However, due to the sunset provisions of the 2001 Act, these new rates will increase to 28%, 31%, 36%, and 39.6% after 2010.
Tax Tip. By mid June, the IRS is expected to mail updated wage withholding tables to employers that reflect these tax rate cuts. The revised tables are available now at the IRS website (www.IRS.gov).
Planning Alert! Certain itemized deductions and personal exemptions are reduced as your adjusted gross income exceeds certain thresholds. Therefore, your “effective tax rate” is usually greater than these “official rates.” Caution! Even though the tax rates for 2003 have been reduced, if your total tax liability for 2003 is greater than your total liability for 2002 (e.g., because your income is up or your deductions are down), you may wish to ask your employer not to change your withholding. Reducing your withholding without careful planning, could result in an underpayment penalty. If we worked with you to establish the amount of your 2003 withholding, please have your employer continue withholding the amounts we suggested until you talk with us! The following is a summary of the changes in the tax rates for individuals:
2002 2003-2010 After 2010
Top Bracket-------- 38.6% 35% 39.6%
Fifth Bracket--------- 35% 33% 36%
Fourth Bracket------ 30% 28% 31%
Third Bracket-------- 27% 25% 28%
Second Bracket----- 15% 15% 15%
Initial Bracket-------- 10% 10% No 10% Bracket
Alternative Minimum Tax Exemption Increased. We actually have two tax systems. The regular tax system and the alternative minimum tax system (AMT). Your tax is calculated under each system and you pay the higher amount. The AMT was originally enacted so individuals who reduced their taxes with aggressive deductions (e.g., tax shelter deductions, accelerated depreciation, etc.) would pay some “minimum tax.” However, each year the number of individuals paying the AMT increases. One reason more people are paying the AMT is that income levels are increasing, but, the amount of income exempt from the AMT has not increased significantly. For years beginning in 2003 and 2004, the AMT exemption amount is increased from $49,000 to $58,000 for married taxpayers, and from $35,750 to $40,250 for single taxpayers.
Planning Alert! These increased exemption amounts do not solve the alternative minimum tax problem. However, they provide a small amount of relief. The following is a summary of the AMT exemption amounts:
2002 2003-2004 After 2004
AMT Exemption
Joint Returns $49,000 $58,000 $45,000
Single Returns $35,750 $40,250 $33,750
Child Tax Credit Increased. For 2002, you were allowed a $600 tax credit for each child under age 17 and the credit was reduced if your "modified adjusted gross income" on a joint return exceeded $110,000 ($75,000 if single). Starting in 2005, this $600 credit was scheduled to increase until it reached $1,000 in 2010. For 2003 and 2004, the new law increases the child tax credit to $1,000.
Planning Alert! The new law does not change the income phase-out levels. Also, the credit will be reduced after 2004, but will again reach $1,000 in 2010. Tax Tip. Remember, you may be entitled to a refund of your child credit even if the credit exceeds your federal income tax liability. For 2003, you may receive a refundable credit to the extent of 10% of your “earned income” in excess of $10,500. The following summarizes the amount of the child tax credit:
2002 2003-2004 2005-2008 2009 2010 After 2010
Child Credit $600 $1,000 $700 $800 $1,000 $500
• You May Get a Tax Rebate Check This Year. If you claimed the child credit on your 2002 return and your child is not age 17 or older by the end of 2003, you may receive an IRS rebate check as early as this July for up to $400 per eligible child. The rebate will be determined based on the information you provided to the IRS on your 2002 return but will reduce the child credit otherwise allowed on your 2003 return.
• Tax Tip. If you did not qualify for the child credit in 2002, but you will qualify in 2003 (e.g., your child was born or adopted in 2003), you will not get this rebate check. You may, however, qualify for the $1,000 child credit when you file your 2003 return. Furthermore, if you do get a rebate check, and it turns out to be greater than the child credit that you are actually entitled to on your 2003 return, you will not be required to return the excess.
• Planning Alert! In the summer and fall of 2001, virtually all taxpayers received a rebate check from the IRS as a result of a retroactive decrease in tax rates for 2001. That is not the case with this tax bill. Only those taxpayers that qualified for the child credit on their 2002 return will be entitled to a rebate this year.
• Be Wary of Signing Away Your Dependency Exemption. Your child must be your dependent for you to receive the child credit. If you are the custodial parent in a divorce but waive the dependency exemption by executing Form 8332, presumably you will also be giving up the child credit.
Marriage Penalty Relief. If you are married and file a joint return with your spouse, you may be paying more income tax than the total you and your spouse would pay if you were each single. This so-called “marriage penalty” generally occurs when each spouse has significant income. Sometimes, this penalty makes it advantageous for engaged couples (both of whom have significant income) to postpone November or December weddings until January of the following year to save taxes. The new law reduces the tax penalty for marriage by increasing the standard deduction and the size of the 15% tax bracket on a joint return.
• Increased Standard Deduction for Married Taxpayers. For 2002, the basic standard deduction for a joint return was 167% of the standard deduction for a single taxpayer. For 2003 and 2004, the basic standard deduction for a joint return increases under the Act to 200% of the single return amount. As a result, for 2003, the standard deduction on a joint return will jump from $7,950 to $9,500. After 2004, the joint return standard deduction as a percentage of the single return standard deduction is reduced to 174% and increases each year until it once again reaches 200% in 2009.
Planning Alert! If your itemized deductions (e.g., home mortgage interest, state and local taxes, etc.) exceed this increased standard deduction, you will receive no tax benefit from this change. However, you may benefit from the increase in the 15% tax bracket for married taxpayers discussed below.
• Married Taxpayers Will Have More Income Taxed at 15%. Prior to the law change, the amount of income on a joint return taxed at the 15% tax rate was 167% of the amount of income on a single taxpayer’s return taxed at 15%. For 2003 and 2004, the amount of income on a joint return taxed at 15% will be double the amount taxed at 15% on a single person’s return. If you are a joint filer, this change could reduce your taxes by as much as $935 for 2003. After 2004, the size of the 15% tax bracket on a joint return is reduced to 180% of the size of the 15% bracket on a single return. However, the percentage increases each subsequent year until it once again reaches 200% in 2008.
TAX RELIEF PROVISIONS IMPACTING PRIMARILY BUSINESSES
Additional First Year Depreciation Increased from 30% to 50%. In 2002, in order to stimulate purchases of business assets other than real estate, Congress enacted a new first-year 30% additional depreciation deduction for the cost of “qualified property” purchased after September 10, 2001 and before September 11, 2004. This additional depreciation deduction is allowed for both regular and alternative minimum tax purposes. Under the 2003 Act, this first-year depreciation deduction is increased to 50% for qualifying property acquired after May 5, 2003 and before January 1, 2005. This 50% bonus depreciation deduction is, instead of, not in addition to, the 30% deduction.
Planning Alert! To qualify for this deduction, you must satisfy various requirements summarized below.
Qualifying Property. Like the 30% deduction, the 50% deduction generally applies only to MACRS property that has a MACRS depreciation period of 20 years or less. The following is a partial list of the types of property that could qualify for this deduction:
• 3-year, 5-year and 7-year Property. These three classes include tractor units for over-the-road trucks; breading hogs; cars and light general purpose trucks; taxis and buses; airplanes not used in commercial or contract carrying of passengers or freight; typewriters, calculators, adding and accounting machines, copiers, duplicating equipment, and similar equipment; computer-based telephone central office switching equipment; computers and peripheral equipment; breeding cattle; dairy cattle; office furniture and fixtures (e.g., desks, files, safes, overhead projectors, cell phones, fax machines); certain livestock 12 years old or less when placed into service; fishing vessels; and others.
• 10-year Property. This class includes (but is not limited to): vessels; barges; tugs; and single purpose agriculture or horticultural structures.
• 15-year Property. This class includes: land improvements (e.g., sidewalks, roads, shrubbery, sewers, drainage facilities, fences, landscaping, etc.); retail motor fuels outlets, service station buildings, car wash buildings, billboards and other depreciable land improvements associated with the marketing of petroleum products; modern golf course greens; municipal waste water treatment plants; telephone distribution plant and comparable equipment; and others.
• 20-year Property. This class includes: farm buildings (other than single purpose structures), utility distribution facilities, and others.
• Other Property Qualifying for 50% Bonus Depreciation. Other qualifying property includes: depreciable computer software; water utility property; and qualified leasehold improvement property. Planning Alert! If a business purchases computer software as part of the purchase of all or a substantial part of a business, the software will generally not qualify for the 50% immediate deduction. Instead, the software must be amortized over 15 years.
Qualified Leasehold Improvements. Certain leasehold improvements may also qualify for the 50% deduction. To qualify, the leasehold improvement must be made to the interior portion of a commercial building (i.e., nonresidential real property) pursuant to a lease (or a binding commitment to enter a lease). The lessor, lessee, or the sublessee may make the improvements, provided the leasehold improvement is placed into service more than 3 years after the building was first placed into service, and the improved portion of the building is occupied exclusively by the lessee (or any sublessee). Planning Alert! The following leasehold improvements will not qualify: improvements that enlarge the building; any elevator or escalator; any structural component benefitting a common area; and any cost relating to the internal structural framework of the building. Furthermore, improvements under a lease between “related persons” do not qualify. The definition of a related person is quite technical. Please call our office if you need further information.
• Tax Tip. Make sure you properly classify “land improvements” as “15-year property” (and not as part of the building) since land improvements qualify for the 50% additional depreciation, and buildings generally do not. Furthermore, recent court cases provide that “nonstructural” items in a building may be treated as “tangible personal property.” For example, some courts have held that carpeting; wallpaper; decorative fixtures and millwork; movable partitions; and other portions of a building that are not structural components qualify as tangible personal property. If you can effectively segregate these costs, you may qualify for three favorable depreciation benefits: (1) the asset may qualify as §179 property (discussed below), (2) you may qualify for the 50% additional depreciation deduction, and (3) you may qualify for more MACRS depreciation.
• Planning Alert! Like any other depreciation, the 50% additional depreciation will be subject to the ordinary income recapture provisions if the property is sold.
“Used Property” Generally Does Not Qualify for the Bonus Depreciation. You will qualify for the additional 50% depreciation deduction only if your business is the first taxpayer to actually use the qualified property. If your business purchases “used property,” it will generally not qualify for the 50% (or 30%) deduction. Moreover, “factory reconditioned” or “rebuilt” machinery or equipment will not qualify for the deduction.
Tax Tip. If your business incurs capital expenditures to recondition, rebuild, or refurbish qualifying property it acquires (or already owns), the capital expenditures will qualify for the new 50% deduction.
Example. Let’s say that on June 1, 2003, your business purchased $20,000 of used equipment. You then incur a $5,000 capitalized expenditure to recondition the equipment. The original $20,000 purchase price would not qualify for the additional first year depreciation, but the $5,000 capitalized expenditure should qualify. Planning Alert! Special rules apply if your business participates in certain sale-leaseback arrangements of otherwise qualified property.
You May “Elect Out” of the 50% First Year Depreciation. If a business purchases qualifying property, it has the option to elect out of the additional first year depreciation altogether (or it may opt for the 30% depreciation deduction rather than the 50% deduction). These elections may be made for any class of property for any taxable year. Tax Tip. In certain situations, you might decide to elect out of this 50% deduction if you determine you will get a greater tax benefit by deferring depreciation deductions to later years using regular MACRS depreciation. For example, your business might anticipate paying tax at a much higher rate in later years and decide to defer the depreciation deductions by forgoing all additional first year depreciation or by selecting the 30% rather than the 50% deduction.
Planning Alert! Careful calculations should be made before deciding to elect out of the new additional first year depreciation. For example, electing out of both the 30% and the 50% additional depreciation deductions, may have alternative minimum tax consequences.
Like-kind Exchanges and Involuntary Conversions. The 2003 Act Committee Reports clarify that the entire depreciable basis of qualifying property acquired in a like-kind exchange or an involuntary conversion qualifies for the first year 30% or 50% depreciation deduction. IRS had indicated that the 30% deduction only applied to the “boot” paid to acquire the new asset. If you failed to take this deduction, please call our office and we will help you determine whether you can take the deduction on an amended return, or by applying for a change in accounting method.
Additional First Year Depreciation on Passenger Automobiles. The maximum annual depreciation for passenger automobiles used in a business is capped at certain dollar amounts. For example, for 2001 and 2002, the maximum first year depreciation on a business automobile was originally capped at $3,060. Under last year’s tax legislation, for passenger automobiles purchased after September 10, 2001, the first year depreciation cap was increased by $4,600 if the additional 30% depreciation was taken for the auto. Consequently, the maximum first year depreciation on a qualifying passenger automobile placed in service after September 10, 2001 was $7,660 ($3,060 plus $4,600). Under the 2003 Act, for business automobiles purchased after May 5, 2003 and before January 1, 2005, and for which the 50% bonus depreciation is taken, the first-year depreciation limitation is increased by $7,650 (rather than $4,600). Therefore, the 2003 depreciation limit for these automobiles is $10,710. For qualifying electric vehicles, the first year depreciation cap is increased to $32,130.
Tax Tip. Trucks and vans used in a business are exempt from these “passenger auto” depreciation limitations if the “gross vehicle weight” exceeds 6,000 pounds (e.g., a full size pickup; a full size van; or a sport utility vehicle, including an: Expedition, Range Rover, Tahoe, Durango, Suburban, etc.). These vehicles may qualify for the full §179 deduction (discussed below), the increased 50% first year depreciation deduction, and the regular MACRS depreciation deduction.
§179 Deduction Increased to $100,000. For 2002, you could take an up-front deduction of up to $24,000 for the cost of qualifying §179 property (e.g., machinery, equipment, furniture, fixtures, etc.). This deduction was phased out dollar for dollar to the extent the total purchases of §179 property exceeded $200,000 for the year. For tax years beginning in 2003, 2004, and 2005, the 2003 Act increases the §179 deduction to $100,000 (and the phase-out level begins at $400,000, not $200,000). The deduction will be reduced to $25,000 for tax years beginning after 2005.
The following are several observations about the §179 deduction:
• Off-the-Shelf Computer Software Now Qualifies. Under prior law, no computer software qualified for the §179 deduction because it was not “tangible” personal property. For tax years beginning in 2003, 2004, and 2005, off-the-shelf computer software qualifies for the §179 deduction. Off-the-shelf software is, generally, software that is readily available for purchase by the general public.
• The §179 Deduction is Taken Before the 50% Deduction. Assume that on September 1, 2003, a calendar year business purchases $400,000 of computer equipment (5-year property), which represents the only §179 property purchased in 2003. Assume further that the computer purchases qualify for the maximum §179 deduction, the new 50% additional first year depreciation deduction, and the normal MACRS depreciation deduction. The total deductions in 2003 on the computer purchases would be $280,000, computed as follows: (I) a §179 deduction of $100,000, plus (ii) additional 50% first year depreciation of $150,000 on the remaining basis ([$400,000 - $100,000] x 50%), plus (iii) $30,000 of MACRS depreciation ([$300,000 - $150,000] x 20% [using half-year convention and 200% declining balance]).
Planning Alert! Like any other depreciation, the §179 deduction is subject to the ordinary income recapture provisions if the property is sold.
• The §179 Election May Allow You to Avoid the Mid-Quarter Convention. Generally, if a business purchases more than 40% of its equipment in the last 3 months of its tax year, it may only take 1½ months of depreciation (instead of 6 months of depreciation) for the property acquired in the last 3 months. This is commonly referred to as the “mid-quarter convention.” If you elect the §179 deduction for property purchased in the last three months of the tax year, that portion of the cost of the property will be excluded from the 40% test which might allow you to avoid the onerous mid-quarter convention and use the half-year convention instead.
• Select Your §179 Property Wisely. Since you can select the property that you want to qualify for the §179 deduction, it is generally preferable to allocate the §179 allowance to the qualifying property that has the longest depreciable life. Also, if you have more than $100,000 of qualifying §179 property acquisitions during 2003 and you acquired property both before May 6th and after May 5th, it may be preferable to select assets acquired before May 6, 2003 for the §179 deduction. That way, the §179 deduction will reduce the 30% additional up-front depreciation amount rather than the 50% additional depreciation amount.
• Don’t Forget the Taxable Income Limitation. Your §179 write off cannot exceed your business income, computed without regard to the §179 deduction.
Personal Holding Company Tax Reduced from 38.6% to 15%. If more than 50% of a regular, C corporation is owned by five or fewer individuals during the last half of the tax year, the corporation could be subject to a “personal holding company” penalty tax (in addition to the regular corporate tax) if the company has excessive personal holding company income. There is excessive personal holding company income if 60% or more of its ordinary adjusted gross income is from interest, dividends, specified levels of rents, royalties, or income from certain personal service contracts. Effective for tax years beginning after 2002 and before January 1, 2009, the 2003 Act reduces the personal holding company tax rate on personal holding company (PHC) income from 38.6% to 15%.
Accumulated Earnings Tax Reduced from 38.6% to 15%. If a regular, C corporation has accumulated earnings exceeding its reasonable business needs, it could be subject to a corporate accumulated earnings penalty tax, in addition to the regular corporate tax. However, a corporation can generally accumulate $250,000 ($150,000 for personal service corporations) of earnings before this penalty tax is triggered. Effective for tax years beginning after 2002 and before January 1, 2009, the Act reduces the accumulated earnings tax rate from 38.6% to 15%.
Tax Tip. Your corporation can accumulate an unlimited amount of earnings to the extent it can establish reasonable business needs for the accumulation. Earnings may be retained for bona fide business expansion, replacement of plant buildings and equipment, acquisition of another business enterprise through purchase of stock or assets, retirement of bona fide business debt, maintaining necessary working capital for business needs, and others.
Planning Alert! Proper documentation is vital to defeating an IRS assessment of the accumulated earnings tax. If your corporation is accumulating earnings, be sure to document the business reasons for the accumulations through corporate minutes, memoranda, and business studies. Your documentation should occur contemporaneously with the accumulation if possible.
25% of Corporate Estimated Tax Payments for September Delayed. The 2003 Act provides that 25% of any corporate estimated tax payments that would otherwise be due in September, 2003 will not be due until October 1, 2003. The purpose of this provision is to shift revenue from the fiscal year of the federal government ending September 30, 2003 to the year ending September 30, 2004.
“Collapsible Corporation” Rules Repealed–Finally! Effective for tax years beginning after December 31, 2002, the obscure and horribly complex “collapsible corporation” rules were repealed by this tax legislation.
TAX RELIEF IMPACTING PRIMARILY INVESTORS
In a bold move to help bolster Wall Street, Congress slashed the tax rates for individuals on dividends paid on stock and, somewhat unexpectedly, reduced the individual tax rates for most long-term capital gains. The capital gains rate reduction was generally unexpected because President Bush had not included capital gains tax relief in his original economic stimulus proposals. These rate reductions do not apply to capital gains or dividends received by C corporations.
Long-Term Capital Gains Tax Reduced. The new law generally reduces the tax rate on long-term capital gains from 20% to 15% for individual taxpayers above the 15% tax bracket. The new 15% rate applies only to capital gains “properly taken into account” after May 5, 2003. For pass-through entities (e.g., S corporations, partnerships, LLCs, etc.), the determination of when capital gains are “properly taken into account” is made at the entity level. If the long-term capital gains would otherwise be taxed in the 10% or 15% tax bracket, the long-term capital gain rate is reduced from 10% to 5% from May 6, 2003 through 2007. For 2008 only, the tax rate on qualifying long-term capital gains for taxpayers who would otherwise be in the 10% or 15% tax bracket is zero. Also, the 18% and 8% rates for assets held more than five years are repealed. All these rate changes sunset after 2008, and on January 1, 2009 the tax rates on long-term capital gains revert back to 20%, 10%, 18% or 8%. The following is a summary of the changes in the long-term capital gains rates:
Long-Term
Capital Gains 2002 Through After 5/05/03
Rates: 5/05/03 Through 2007 2008 After 2008
General 20% 15% 15% 20%
In 10% or 15% Bracket 10% 5% 0% 10%
The following are important points to keep in mind regarding these new rate reductions for long-term capital gains:
• The New 15%/5% Rates Do Not Apply to All Capital Gains. The new 15%/5% capital gains rates only apply to capital gains that would otherwise qualify for the 20% or 10% rates under the old rules. Therefore, the maximum capital gains rate on “collectibles” (e.g., artwork, antiques, etc.) and “qualified small-business stock” (which qualifies for a 50% capital gains exclusion) remains at 28%. Likewise, if you sell a depreciable building, the gain attributable to the straight-line depreciation you took on the building is taxed at a maximum capital gains rate of 25% and does not qualify for the new 15%/5% rates.
Tax Tip. Any gain on the sale of a building held for over one year that exceeds the portion allocable to previously-taken straight line depreciation (i.e., a building sold for greater than its original cost), will qualify for the new 15%/5% tax rate. Furthermore, if you sell the assets of an operating business, any gain attributable to sale of “goodwill” should also qualify for the new 15%/5% tax rates–provided that you have owned and operated the business for over one year.
Planning Alert! Long-term capital gains recognized by a regular, C corporation receive no tax rate break and may be taxed at a rate as high as 39%.
• Lower Income Taxpayers. If your capital gains would otherwise be taxed in the 10% or 15% ordinary income tax rate bracket, your capital gains rate is reduced to 5% (down from 10%) from May 6, 2003 through 2007. For 2008 only, the long-term capital gains rate will be zero for taxpayers in the 10% or 15% tax bracket. On January 1, 2009, this capital gains rate returns to 10% (assuming that your capital gains would otherwise be taxed in the 10% or 15% income tax bracket).
Tax Tip. If you sell an appreciated long-term capital gain asset before 2008, you might consider giving the property to a child over age 13 (who would be exempt from the “kiddie” tax) prior to the sale. If the child sells the property and the gain would otherwise be taxed in the child’s 10% or 15% tax bracket, you would reduce the tax on the sale of the property from 15% to 5% assuming your tax bracket is higher than 15%. If the child sells the property in 2008 and the gain would otherwise be taxed in the child’s 10% or 15% tax bracket, the tax on the long-term capital gain would be zero.
• Prior Year Installment Sales May Qualify for New Rates. The new 15%/5% capital gains rates apply to any long-term capital gains “properly taken into account” after May 5, 2003. Consequently, if you are reporting long-term capital gains on collections from a qualified installment sale of property that occurred prior to May 6, 2003, capital gains triggered by collections after May 5, 2003, may qualify for the new 15%/5% capital gains rates.
• New Capital Gains Rates Apply in Calculating AMT. The new law makes it clear that the lower capital gains rates apply for both regular tax and “alternative minimum tax” purposes.
• New Law Increases Spread between Ordinary Income Tax Rates and Capital Gains Rates. Prior to this law change, the difference between the maximum ordinary income tax rate (38.6%) and the general capital gains rate (20%) was 18.6%. With the new tax rates, the spread is increased to 20% (maximum ordinary rate of 35% minus general capital gains rate of 15%).
• No Capital Loss Relief. If you are an individual taxpayer, you are allowed to deduct your capital losses only to the extent of your capital gains for the tax year plus $3,000. Therefore, if you do not have sufficient capital gains to offset your capital losses, only $3,000 of the losses may offset ordinary income for that tax year. Any excess capital losses can be carried forward indefinitely to future tax years. Last year, President Bush suggested that he would support legislative changes that would allow taxpayers to offset more than $3,000 of capital losses against ordinary income. Unfortunately, this tax bill contains no such relief and the capital loss restrictions have not changed.
• New Law Eliminates 18%/8% Rates for Five-Year Property–for Now. Prior to May 6, 2003, the capital gains tax rate for property held more than five years was generally 18% (8% for taxpayers in the 10% or 15% bracket). These lower rates started in 2001 for taxpayers in the 10% or 15% bracket and were to become effective after 2005 for taxpayers in tax brackets above 15%. These 18%/8% tax rates were repealed by the 2003 Act until 2009, when they are scheduled to return. The repeal of the18%/8% rate is effective for capital gains properly taken into account after May 5, 2003.
Maximum Tax on Dividends Reduced from 38.6% to 15%. The crown jewel of President Bush’s tax relief proposal was the elimination of the double taxation of corporate dividends. His proposal would have exempted dividends from individual income tax to the extent they were paid from taxable corporate earnings. By contrast, the Senate would have exempted all dividends from income tax even if they were paid from corporate earnings that had never been taxed. The final bill adopted neither President Bush’s proposal nor the Senate proposal. Instead, the final legislation largely adopted the House proposal which taxes dividends (whether or not paid out of taxable corporate earnings) at a maximum rate of 15%. The new legislation provides that dividends paid to individuals in 2003 through 2008 will be taxed at a maximum rate of 15%. For 2003 through 2007, the rate is 5% for taxpayers who would otherwise be in the 10% or 15% ordinary income tax bracket. For 2008 only, the tax rate on dividends for taxpayers who would otherwise be in the 10% or 15% tax bracket is zero. After 2008, dividends will no longer qualify for these special rates and will once again be taxed at the regular individual tax rates. The reduced tax rate on dividends applies for both regular and alternative minimum tax purposes. The following is a summary of the changes to the tax rate for dividends:
Tax Rates For
Dividends: 2002 2003-2007 2008 After 2008
Brackets above 15%------ Ordinary Rates 15% 15% Ordinary Rates
10% or 15% Bracket--------- Ordinary Rates 5% 0% Ordinary Rates
The following are things to keep in mind concerning the new rules for taxing dividends:
• Closely-Held Corporation Stock Qualifies. Although earlier proposals would have allowed tax relief only to dividends paid by “publicly-traded corporations,” the final legislation generally applies the new lower tax rates to dividends paid by domestic corporations (closely-held as well as publicly-traded) and to publicly-traded foreign corporations.
• Certain Dividends Do Not Qualify. There is a laundry list of dividends that do not qualify for the new lower rates such as dividends from various tax exempt organizations and farmers’ cooperatives, certain dividends paid by mutual savings banks, dividends on certain stock that is held for 60 days or less, and deductible dividends paid on ESOP stock. Generally, dividend distributions from Regulated Investment Companies (RICs) and distributions from Real Estate Investment Trusts (REITs) will qualify for the 15%/5% rates to the extent that the RIC (mutual fund) or the REIT receives and distributes qualifying dividend income. The definition of “qualifying dividends” is extremely complex. Please call our firm if you want more information.
• Dividends and the Investment Income Limitation. If you borrow money to buy certain investment assets, your deduction for the interest you pay on those borrowed funds is limited to your “net investment income.” This is known as the investment interest limitation. Under this new legislation, dividends will be treated as “investment income” (which could allow you to deduct investment interest) only if you affirmatively elect to tax the dividends at ordinary income tax rates (i.e., foregoing the new 15%/5% rates). Prior to 2003, long-term capital gains were treated as investment income for purposes of the investment interest deduction limitation only if we elected to treat the capital gains as ordinary income. Now, this rule applies both to long-term capital gains and to dividends qualifying for the 15%/5% tax rates.
• Maximum $3,000 of Capital Losses Allowed Against Dividend Income. Although most long-term capital gains and qualifying dividend income are both taxed at the15%/ 5% tax rates, capital losses can generally be used only to offset capital gains. Unfortunately, capital losses do not offset dividend income in the same manner as capital gains. However, as under prior law, capital losses in excess of capital gains may reduce up to $3,000 of your taxable income.
• Dividends Distributed From Qualified Retirement Plans Will Not Get Preferential Tax Treatment. Taxable distributions from qualified retirement plans (e.g., profit-sharing plans, pension plans, §401(k) plans, regular IRAs, etc.) will be taxed at ordinary income tax rates even if the funds represent dividends paid on stock held in the retirement plans. Tax Tip. This might make it beneficial to hold a larger percentage of your interest generating investments in your retirement plan while holding a larger percentage of your dividend paying stock investments outside of the plan.
• Double Taxation of Corporate Income Reduced but Not Eliminated. Although the burden of double taxation on regular “C” corporations has been diminished by lowering the tax on dividends from a maximum of 38.6% to 15%, these corporations are still subject to a double tax regime. With the reduction in the individual income tax rates and no reduction in the corporate tax rates under the Act, it may still be advantageous to operate a business as a pass-through entity (e.g., sole proprietorship, partnership, LLC, S corp.) rather than as a separately-taxed C corporation.
AMT Relief for “Qualified Small-Business Stock.” If you sell “qualified small-business stock,” you can exclude 50% of the gain from your gross income. The remaining 50% of the gain is taxed at a maximum rate of 28% for regular tax purposes. Qualified small-business stock is generally stock of a C corporation that: 1) operates a “qualified business,” 2) meets certain active business requirements, and 3) owns assets at the time the stock is issued of $50 million or less. Also, the stock must be issued to you after August 10, 1993, and must be held for more than five years before the sale. Prior to May 6, 2003, 42% of the “excluded” gain was added back into income in calculating the alternative minimum tax. Under the new law, if you sell qualified small-business stock after May 5, 2003 and before 2009, only 7% (not 42%) of the excluded gain is included in your “alternative minimum taxable income.” Therefore, it is now less likely that a sale of “qualified small-business stock” will trigger the alternative minimum tax.
KEY PROPOSALS THAT WERE DROPPED FROM THE FINAL LEGISLATION
There were several tax proposals that did not make it into the final legislation. The following are some of the more publicized proposals that were dropped from the final tax bill:
• Extending the 5-year NOL carryback period to NOLs arising in 2003, 2004, and 2005.
• Codifying the “economic substance doctrine” for tax-shelter type transactions.
• Repealing the foreign earned income exclusion.
• Establishing a uniform definition of “child” for purposes of the dependency deduction, the child credit, the child care credit, etc.
• Various changes to the S corporation rules including expanding the number of S corporation shareholders to 100 and providing relief from the “passive investment income tax.”
• Increasing the maximum age for the “kiddie tax” from 13 years to 17 years.
• Placing limitations on transactions that combine like-kind exchanges and the home-sale exclusion rules.
• New tax relief provisions for armed forces personnel.
• Repeal of the 1993 tax increase on social security benefits.
Tax Tip. Although the above proposals did not make it into the final tax legislation, it is clear that these proposed changes (particularly those providing tax relief) will probably be high on the list for consideration if Congress considers another tax bill later in 2003 or in future years.