The 2001 Tax Act
Minimizing Your Taxes under the Economic Growth Tax Relief and Reconciliation Act of 2001 (EGTRRA)
We would like our clients to take steps to get even more out of the new tax law changes.
During the period of transition in which tax cuts are being phased-in over a period of years – one challenge is to initiate tax strategies to place clients in a position that will maximize their tax savings.
GRADUAL RATE REDUCTIONS
President George W. Bush's tax cuts include a gradual reduction and compression of individual income tax rates between 2002 and 2006, from 15, 28, 31, 35 and 36.9 percent to 10, 15, 25 and 33 percent.
The cumulative affect of the rate reduction over the five-year period promises to be large enough for many tax-payers to warrant a look at some income tax techniques that will defer income into their lower-bracket years and accelerate deductions into earlier, more highly-taxed years. Here are some of the major strategies that should be considered.
DEFERRED COMPENSATION
Deferring compensation into a lower bracket year requires particular tension to two variables: avoiding the constructive receipt doctrine and keeping an eye on time value of money principles. Deferred compensation traditionally has been advantageous to those who, because of upcoming retirement or other cyclical work or investments situations, know that they will be in a lower tax bracket in the future. During the years in which the tax-rate cuts our being phased-in, almost all higher-bracket individuals will find themselves facing lower rates in the future.
The time value of money always should be kept in mind when planning deferred comp, especially where a tax cut takes place in a small incremental steps over a series of years.
For example, the reduction of the 31 percent tax bracket to 25 percent by 2006 is a 6 percent savings or a 1.2 percent savings rate per year – not a very attractive interest rate to go through the bother of deferring compensation. However, if your client is now in the 39.6 percent marginal bracket and due to lower taxable income will be in the 25 percent level in 2006, deferring compensation now under the rate cut plan as a 6 percent bonus on top of the 8.6 percent savings that would take place under the current rate structure.
In addition, a quick deferment of income from December in one year to January of the next can yield a 1 to 2 percent savings under the phase-in tax-cut plan (depending on tax bracket and year) – a respectable rate of interest for one or two months.
Of course, tax payers who have the leverage to defer their compensation often also share in the business's savings in not paying out compensation until a future date, through either equity ownership or an ability to raise the amount of the compensation package payable in the future. Such leverage, however, can also trigger the second trap in deferred compensation: constructive receipt.
Deferred compensation arrangements, if properly structured, results in the deferral of income recognition for income tax purposes until the year in which the compensation is received or become non-forfeitable. Compensation may be constructively received if any employee has unrestricted access to it. Election to defer compensation must be made before it is earned, so any deferred compensation plan set up now should not include payment for services that were already performed during the year.
IRA STRATEGY
The Roth IRA conversion rules suddenly may take on a new use for some taxpayers during the 2001 to 2006 period. Tax savings may be realized by those who are qualified to make deductible contributions to traditional individual retirement accounts now, and who take advantage of the Roth IRA conversion rule when the rate cuts are fully phased in.
The technique would allow tax payers to deduct their $2,000 contribution against income taxed at a higher rate, while realizing income in that amount in the 2006 or later – when conversion of the traditional IRA to Roth IRA would take place – at the fully phased-in lower rate.
CHOICE OF ENTITY
To add to the complexity in the expanding universe of choice–of-entity considerations for operating a business, the impact of the proposed rate cuts must be considered. Only individual income tax rates, and not corporate rates, would be cut. Personal service corporations currently are taxed at a flat 35 percent, while regular corporations are taxed at graduate rates from 15 percent to 38 percent.
Many business owners will find that their individual tax rates must be significantly lower than the corporate rates. This should prompt reconsideration of whether operating as a sole proprietorship, partnership or S Corporation, rather than as a corporation, makes more sense in the future.
RE-EXAMINING INVESTMENTS
A lowering of the regular income tax rates also effects several related, "rate-sensitive" areas. An investor's existing tax-exempt investments will gradually become less valuable as the personal income rate reduction phase-in takes place. Tax-exempts that issue new securities may find that they must pay a higher interest rate.
For now, the alternative minimum tax will remain the same, so that many taxpayers will experience no rate cut at all. The capital gains rate is also unlikely to change this year, and a future reduction is problematic. Until the 20 percent rate on long-term capital gain is reduced, strategies to realize long-term capital gain instead of ordinary income will decrease in value as the regular income tax rate phase-in takes place.
FAMILY INCOME SHIFTING
Despite the general lowering of the income tax rates, the benefits of income shifting among family members – one of the mainstays of family tax planning – will remain about the same. For example, shifting from a parent's present top rate of 39.6 percent to a child's rate of 15 percent yields a 24.6 percent tax savings. In 2006, shifting from a top rate of 33 percent to 10 percent would yield a 23 percent savings.
ACCELERATING DEDUCTIONS
The tired-and-true year-end tax planning techniques of moving up any discretionary deductible expenses is also applicable during the phase-in period. Expenses such as charitable contributions, elective medical treatment, and state and local tax liability should be accelerated when possible. Business expenses that are reflected Schedule C of Form 1040 should also be accelerated. For example, business conferences and other "elective" business trips might be accelerated – a $3,000 deductible business trip, which would end up costing $1,812 after-tax in 2001, will cost $2,010 after-tax in 2006.
CONCLUSION
The Bush tax rate cut may end up being phase-in too slowly to make much of an appreciable impact on the additional savings that many taxpayer can achieve through tax planning. Others, however, may profit considerably from tax planning and the cumulative impact that a series of relatively minor strategies can have on their overall individual tax liability.
source: George G. Jones and Mark A. Luscombe, Accounting Today April 16-May 16,2001
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