Congress Enacts $350 Billion Tax Cut

On May 28, 2003, President Bush signed the Jobs and Growth Tax Relief Reconciliation Act of 2003, containing the third-largest tax reduction in U.S. history, as well as $20 billion in federal aid to states and localities over a 10-year period. This alert outlines the key changes in the Act's tax reduction package, the impact of those changes, and the prospects for future developments on taxes in the wake of this bill.

The Act's tax reduction package is targeted primarily at individuals but also includes some business tax breaks, particularly for small businesses. The key elements are:

• Tax rate reduction for capital gains and qualifying dividends
• Acceleration of 2001 general tax rate cuts
• Expansion of 2001 increase in alternative minimum tax (AMT) credit
• Increased amount eligible for expensing treatment by small businesses
• Increased amount eligible for "bonus depreciation" treatment
• Acceleration of 2001 increase in the child tax credit
• Acceleration of 2001 "marriage penalty" relief

At the beginning of the year, President Bush proposed a complete exclusion from tax of all dividends received by individuals to the extent such dividends were paid out of earnings that had been fully taxed at the corporate level. That effort to end the double taxation of corporate earnings was not carried through to the final bill. The President also wanted the dividend tax exclusion and other tax benefits to be permanent. His proposal was estimated to cost $726 billion over a 10- year period. In order to obtain enough votes to pass the bill in the Senate, the Administration agreed to keep the net cost at $350 billion, including the amount of aid to states, which certain senators also required. To meet these revenue targets, the application of many provisions in the bill had to be limited to a short period within the 10-year window. Even with these concessions, however, passage of the bill required Vice President Cheney to break a 50-50 tie in the Senate.

The idea of applying a capital gains and dividend rate reduction, instead of the original dividend exclusion concept, came from Chairman Thomas (R-Calif.) of the House Ways and Means Committee. He succeeded also in stripping the bill of dozens of revenue-raising provisions (originally included in the Senate-passed version of the bill) that would have permitted the tax reductions to remain in effect for a longer period.

Prior to the Act, gains realized by individuals from the sale of capital assets held for more than one year ("long-term capital gains") were taxed at a maximum rate of 20 percent. The Act reduces the maximum rate of tax on an individual's long-term capital gains from 20 percent to 15 percent, for both regular tax and AMT purposes. The reduced rate applies to capital gains from transactions occurring on or after May 6, 2003. The new rate also applies to capital gains from installment sales that are recognized with respect to installment payments received on or after May 6, 2003.

The Act does not change the tax rate that previously applied to capital gains from the sale of certain assets, including collectibles and depreciable real estate (to the extent straight- line depreciation has been taken). Depreciation recapture on personal property also continues to be taxed at ordinary income rates.

Capital Gain/Ordinary Income Rate Spread. The reduction in capital gains rates, combined with the accelerated reduction of individuals' ordinary income rates, results in a spread of 20 percentage points between the highest marginal tax rate on ordinary income and the tax rate on long-term capital gains (increased from a spread of 18.6 percentage points under prior law). The higher spread under the Act increases the potential tax savings from structuring transactions to classify income as long-term capital gain rather than ordinary income. The higher spread also raises the tax stakes for avoiding "dealer" status with respect to gain received on the disposition of assets.

Reduced Benefit for Deferring Capital Gains. The reduction in the capital gains rate reduces in turn the tax benefit of transactions structured to defer or avoid the recognition of capital gains, such as like-kind exchanges and tax-free corporate reorganizations. Thus, taxpayers have less incentive to compromise business or investment objectives in order to defer or avoid taxes on long-term capital gains. In fact, because the reduction in rates is scheduled to sunset for tax years beginning after December 31, 2008, a deferral of taxes beyond that date could actually be counterproductive.

Limited Benefit for Real Estate. Gain from dispositions of depreciable real estate continues to be taxed at 25 percent to the extent of any straight-line depreciation taken with respect to the property, although gain in excess of the original cost of the property is eligible for the 15 percent rate. Thus, a significant portion of gains from real property will not be taxed at a lower rate under the Act. The greater spread between those two tax rates also increases the incentive to allocate a larger portion of the price received to the underlying land, rather than to the depreciable (and previously depreciated) improvements, to the extent such an allocation is factually supportable.

Prior to the Act, corporate dividends received by individual shareholders were taxed as ordinary income, at a maximum marginal rate of 38.6 percent (as of 2003). Under the Act, "qualified dividend income" received by individuals is taxed at the same rate as long-term capital gains - a maximum rate of 15 percent - for both regular income tax and AMT purposes.

The reduced tax rate applies to qualified dividend income from all U.S. corporations (other than S corporations) and "qualified foreign corporations," that is, any foreign corporation (i) the stock of which is readily tradable on an established securities market in the United States, or (ii) that is eligible for the benefits of an income tax treaty with the United States that includes an exchange of information program and that the Treasury Department determines to be satisfactory. Until the Treasury Department issues guidance specifying which treaties are satisfactory for this purpose, a foreign corporation will be a qualified foreign corporation if it is eligible for the benefits of a comprehensive income tax treaty with the United States that includes an exchange of information program. The sole exception to this positive presumption is the U.S. tax treaty with Barbados.

The Act also includes a holding period requirement, limiting igqualified dividend incomeld to dividends from stock held for more than 60 days during the 120-day period beginning 60€days before the ex-dividend date. For this purpose, the owner is not considered to have held the stock during a period in which his risk of loss has been eliminated or reduced through certain types of hedging transactions.

Special rules apply to dividends paid by a regulated investment company (RIC) or a real estate investment trust (REIT); in general, these rules allow a RIC or REIT to designate dividends as eligible for the reduced tax rate, but only to the extent of (1) the qualifying dividend income received by the RIC or REIT, and (2) in the case of a REIT, the amount of the REIT's income that is subject to corporate income tax, net of corporate income taxes paid.

Unlike some earlier proposals to reduce dividend taxation, the reduced rate is not limited to dividends paid from earnings on which the corporation has paid corporate income taxes, and the Act does not include a provision adjusting stock basis to reflect undistributed corporate earnings.

The reduced rate applies to qualified dividend income received in taxable years beginning after December 31, 2002, and before January 1, 2009. In the case of a RIC or REIT, only dividends received by the RIC or REIT after December 31, 2002, are treated as qualified dividend income for purposes of taxing dividends paid by those entities.

Corporate Tax Planning Simplified. Because the Act taxes individuals on both dividends and gains from the sale of stock held for more than one year at the same 15 percent rate, it reduces the importance of much of the tax planning under prior law that was devoted to structuring corporate transactions, such as stock redemptions and reorganizations, to ensure that any gain recognized by individual shareholders was classified as capital gain instead of dividend income.

Redemptions. The tax law contains a large and somewhat complicated body of law under which a repurchase by a corporation of its own stock may be treated as either a sale or a dividend. One context in which these rules often become important is in succession planning for a family-owned corporation. Under prior law, the only reliable way to liquidate stock held by a senior generation at capital gains rates was to terminate the stock ownership by the senior generation completely in a single transaction. Furthermore, to avoid dividend treatment, a terminating shareholder with family members continuing to own stock could not remain an officer, director or even an employee of the corporation. The redemption rules can also become important outside of the family-owned corporation context, particularly where less than all of the stock owned by a particular shareholder is redeemed.

Under the Act, cash distributed by a corporation to shareholders is taxed at the same maximum rate of 15 percent, whether the distribution constitutes a dividend or a sale of stock. Thus, the characterization as dividend or capital gain becomes less important; however, the distinction continues to have some significance. For example, if a redemption is treated as a dividend, the gross proceeds of the redemption are subject to tax. On the other hand, if the transaction is an exchange, only the gain, that is, the excess of the proceeds over the shareholder's basis in the stock, is subject to tax. This is likely to be particularly important where the redeemed shareholder has significant basis (for example, in the case of a redemption from an estate where the basis was stepped up at death). Furthermore, if any consideration is to be paid to the shareholder in later years, installment reporting is available only if the redemption qualifies as an exchange. Finally, if an individual taxpayer has capital losses in excess of $3,000, the losses can only be used to offset capital gains.

Reorganizations. Where "boot" - that is, cash or other non-stock property - is paid as part of the consideration in what is otherwise a tax-free reorganization, a selling shareholder recognizes an amount of gain equal to the lesser of (a) the amount of "boot" he receives, or (b) the amount of gain realized on the transaction. Under rules that are somewhat similar to those governing redemptions, any recognized gain may be characterized either as a dividend or as exchange gain. By eliminating the rate differential, the Act significantly reduces the importance of this characterization.

Increased Incentives to Invest in Dividend-Paying Stocks. Traditionally, tax-conscious investors have preferred growth stocks to the stock of corporations that pay dividends. While dividends were subject to current tax at ordinary income rates, an investor would not be taxed on appreciation in the stock's value until the stock is sold, and then at lower capital gains rates. With the same tax rate now applicable to dividends and long-term capital gains, the primary incentive to invest in growth stocks (rather than dividend-paying stocks) is the deferral of tax, not a lower tax rate. Furthermore, in light of recent fluctuations in stock market values and corporate accounting scandals, many investors now place greater value on current cash distributions than on stock market valuations. As a result, the value to many investors of dividend-paying stocks is increased as compared to stocks held for growth or appreciation. The same factors may lead corporations to begin paying dividends or increase their current rate of dividends.

Reduced Tax Rates Favor Dividends Over Interest Income. While corporate dividends received by individuals are now taxed at a maximum rate of 15 percent, interest income continues to be taxed at a maximum ordinary income rate of 35 percent. The reduced rate on dividends thus increases the attractiveness of corporate stock as compared with debt instruments for individual investors. For the corporate issuer, however, interest payments continue to be deductible, while dividends are not. The conflict between the issuing corporation and individual investors may complicate the choice between raising corporate capital in the form of debt or equity.

The tax advantage for dividends may encourage corporations to issue preferred stock or other forms of hybrid securities that will qualify as stock for federal income tax purposes but offer investors some of the non-tax benefits of holding debt. Note that the tax advantage for dividends applies only to individual investors. Tax-exempt investors will continue to be indifferent (from an income tax standpoint) between dividends and interest. Dividends will continue to enjoy a tax advantage over interest for corporate investors due to the dividends-received deduction.

Choice of Entity Calculus Is Altered. The reduction in tax rates applicable to dividends significantly reduces the tax imposed on C corporation earnings that are distributed to individuals. Thus, it narrows the tax difference between earning income through C corporations and through pass-through entities such as partnerships, S corporations, and limited liability companies. The table below shows the after-tax amount remaining after the payment of federal income taxes on $1,000 of taxable income earned in 2003 by a C corporation and by a pass-through entity, both before and after the Act. In each case, it is assumed that the entity distributes all of its earnings to individual owners subject to the maximum marginal rates.

While the overall tax cost of operating as a C corporation remains higher than that of using a pass-through entity, the gap has narrowed. Thus, at the margin, more businesses may consider operating as C corporations than was the case under prior law. However, for most non-publicly owned businesses, a pass-through entity will continue to be the entity of choice.

Relative Tax Advantage of REITs Is Reduced. A major advantage to investing in real estate through a REIT is that REIT income is not taxed at the entity level, provided the income is distributed to the REIT's shareholders. Because dividends paid by REITs will continue to be taxed at ordinary income rates (except to the extent paid from qualifying dividend income received by the REIT), the tax advantage to using a REIT as compared with a C corporation is narrowed. The relative tax cost of the REIT approximates the tax treatment of pass-through entities shown in the table above.

Investing in Non-Treaty Foreign Corporations Is Deterred. The reduced tax rate on dividends applies only to publicly- traded foreign corporations and foreign corporations that benefit from a comprehensive tax treaty with the United States. Dividends received by U.S. individuals from other foreign corporations will continue to be taxed as ordinary income, thus reducing the relative after-tax return on investing in such corporations. The exclusion of those foreign corporations from the dividend tax reduction benefit may be based on the assumption that they are likely to be located in tax havens, taking advantage of either minimal income taxes or local secrecy laws in their jurisdiction of incorporation. Nonetheless, the Act's restrictions apply even where a jurisdiction has been chosen for perfectly legitimate business reasons.

Hedging Transactions Are Less Attractive. Since certain types of hedging transactions preclude the ability to claim the reduced rate of taxation on dividends, these types of hedges may well become less attractive, at least in the case of companies that pay dividends.

The Act accelerates the tax rate reductions enacted in 2001 for the top four income tax brackets. The rate applied in 2002 for each of those brackets is reduced by 2 percentage points for all taxable years beginning after December 31, 2002, except that the top bracket is reduced by 3.6 percentage points, from 38.6 percent to 35 percent. In addition, the lowest individual tax bracket (10 percent) is expanded to cover a wider range of income. The accelerated rate reductions and bracket expansion will have the broadest impact among the Act's provisions, as they will affect virtually all taxpayers to some degree. The changes should be reflected in revised tax withholding starting in July 2003. Unlike the 2001 tax cut legislation, the Act will not generally result in individuals receiving tax rebate checks from the federal government, even though the rate reductions are retroactive to the beginning of the year. Instead, many taxpayers will receive larger refunds in 2004 (relating to overpayments of taxes in 2003) than they would otherwise have anticipated.

Taxpayers with substantial income in the highest bracket will reap the greatest benefit from these tax rate changes. The larger reduction in the rate for that bracket effectively returns those taxpayers to the position that they occupied relative to other taxpayers before the Clinton Administration imposed a 10 percent surcharge on taxpayers in the highest tax bracket, which at that time had a marginal rate of 36 percent.

The Act helps prevent its various tax reductions from pushing taxpayers into AMT status by increasing further the AMT credit amount that was temporarily increased by the 2001 tax legislation. The Act increases the AMT credit amount for 2003 and 2004 to $58,000 per year for joint returns and surviving spouses, and to $40,250 for other single filers. The Act does not extend the existing sunset of this increase beyond 2004.

Despite the $9,000 increase in the AMT exemption amount (for joint filers, $4,500 for single filers), the Act will cause many more taxpayers to be subject to the AMT. The AMT is an alternative calculation of income taxes designed to ensure that all taxpayers pay substantial tax on their income even if they have extensive deductions and credits. The AMT is imposed at a lower rate than the regular income tax (top rate of 28 percent) but permits fewer deductions, eliminating such items as deductions for state and local taxes and miscellaneous itemized deductions. For most taxpayers, the lower AMT tax rates offset the loss of deductions, but the reduction of the dividend rate to 15 percent means that fewer investors with substantial income received at that rate will have enough ordinary income tax on their overall income to avoid the application of the AMT. Similarly, the reduction of the maximum ordinary income rate to 35 percent will also contribute to broader application of the AMT. Accordingly, the AMT will reduce the benefit of the tax cut for many taxpayers, despite the limited AMT relief included in the Act.

On the business side, the Act increases the amount of capital expenditures a taxpayer can elect to deduct in a given year from $25,000 to $100,000Šbut only for property placed in service during the years 2003-2005. The previous ceiling of $200,000 for eligible expenditures has been doubled to $400,000; expenditures beyond that amount will reduce the $100,000 amount. The Act also adds off-the-shelf computer software to items eligible for this expensing treatment.

The increased expensing amount was one of the most highly- favored tax proposals in Congress during the first several months of this year, supported by members of both political parties. It was viewed as an immediate stimulus to the economy. For businesses that can afford to make the level of capital expenditures covered by this provision, it will be very helpful during this year and next.

In 2001, Congress provided an additional incentive to make capital expenditures by providing for "bonus depreciation" of 30 percent of the adjusted basis of "qualified property" in the year it is placed in service, subject to a specified window period. The Act increases the level of bonus depreciation from 30 percent to 50 percent and also extends the window period.

In order to qualify for the 50 percent bonus depreciation, (i) the original use of the property must commence with the taxpayer after May 5, 2003, (ii) the property must be acquired during the period starting on May 6, 2003, and ending on December 31, 2004, other than pursuant to a binding contract entered into prior to May 6, 2003, and (iii) the property must be placed in service before January 1, 2005 (with a one-year extension for certain types of property). In light of the large amount at stake, careful planning is warranted to ensure that all elements of this window period are complied with. For example, a taxpayer that places an order to acquire property in the expectation that the property will qualify for 50 percent bonus depreciation may need to negotiate specific contractual protections to ensure that the property will be delivered on time.

The Act also increases the amount of the bonus depreciation limitation for automobiles from $4,600 to $7,650.

For purposes of bonus depreciation, "qualified property" continues to be defined primarily as (i) property with a recovery period of 20 years or less, (ii) software for which a deduction is otherwise available, (iii) water utility property, and (iv) leasehold improvement property. With the exception of property to which alternative depreciation applies and New York Liberty Zone leasehold improvement property, property will be "treated as qualified property" for purposes of bonus depreciation if it would otherwise qualify under the definition of "qualified property" (except for the date placed in service), has a recovery period of at least 10 years (or is tangible property involved in the transportation of persons), and is subject to interest capitalization rules because of a long production period.

Like the increase in expensing, this bonus depreciation provision is designed to stimulate immediate purchases by businesses and provides a strong incentive to make such purchases during its relatively narrow window of time.

The sole basis on which taxpayers may receive immediate rebate checks from the Act is the acceleration of an increase in the refundable child tax credit that was scheduled by the 2001 tax legislation. Under the Act, the credit amount goes immediately to $1,000 (from $600 under prior law), although the Act does not change the 2010 sunset of this credit. The Act does not make the increased credit available to taxpayers with taxable income between $10,500 and $26,625, an omission that Congress is under pressure to correct.

The Act accelerates the application of two "marriage Penalty" provisions for joint filers from prior legislation, fully expanding application of the 15 percent tax bracket and increasing the standard deduction for tax years 2003 and 2004. The provisions then revert to the phase-in schedule previously specified, with sunset in 2010.

As noted above, Congress is considering proposals to apply the child tax credit to all income brackets. Senate Finance Committee Chairman Grassley (R-Iowa) has also introduced a bill to make the child tax credit increase permanent. More generally, the Administration and the Republican majority's leadership in Congress have expressed their intention to make all of the Act's tax reductions permanent as soon as possible. To the extent that the provisions of the Act are expected to phase out or sunset, tax planners will probably be hesitant to rely on them in creating structures designed to last for many years.

In addition to the contemplated expansions and extensions of the Act, Congress intends this year to pass tax-related bills that include energy incentives, charitable incentives, tax relief for military personnel, and pension reform. All of these projects will be expensive, and we anticipate that some of them will be paid for with anticipated revenue from provisions regulating tax shelters, corporate inversions; and individual expatriations. Last but not least, the WTO's authorization to Europe for $4 billion in retaliatory trade sanctions makes the repeal and replacement of the extraterritorial income exclusion regime (and related international tax reforms to compensate for its loss) an item high on the agenda of some congressional taxwriters.

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