A Flood Of Tax Proposals: A Flood Of Opportunities

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President Reagan's landslide election and the unexpected change in power in the Senate has stirred up a lot of activity in both houses of Congress. As a result, numerous tax-cutting and tax reform proposals are circulating around Washington. Here are a number of the most important ideas for people running small companies:

GRADUATING THE CORPORATE INCOME TAX FURTHER

Corporate income taxes are now graduated up to $100,000 in earnings. At that point, the maximum rate of 46% is applied. Several bills now before Congress would reduce the tax rate on the lower end of the scale and raise the level of earnings at which the maximum rate applies.

The table below demonstrates how one such proposal affects companies' annual cash flow.

Maximum

accumulated

Earnings Current Proposed tax savings

($000) tax rate tax rate annually

0- 25 17% 12% $1,250

25- 50 20 15 2,500

50- 75 30 20 5,000

75-100 40 30 7,500

100-150 46 40 10,500

150-200 46 43 12,000

200-250 46 45 12,500

Over 250 46 46

RECREATING INCENTIVE STOCK OPTIONS

Tax law changes passed since 1964 reduced the value of stock options as employee compensation by increasing the tax liability of the employee. Congress could restore stock options as a valuable management recruiting tool for small, fast-growing public companies whose stock is most likely to appreciate rapidly.

Assume that a new manager is hired at $50,000 and is granted options on 1,000 shares of company stock. The options give the employee the chance to buy the shares at $15 each (exercise price).

If the employee exercises his options when the market value of the stock reaches $20, under current law he would incur an immediate tax liability:

1,000 shares at $20 $20,000

1,000 options at $15 15,000

Taxable gain at ordinary

income rates 5,000

Tax (assuming 49% marginal

rate) $ 2,500

Don't forget that the employee must also pay out $15,000 to exercise his options. His total outlay, therefore, is:

1,000 shares at $15 15,000

Income tax 2,500

$17,500

Under the incentive stock option proposals before Congress, however, the employee would incur no tax liability on the $5,000 gain shown above until he sold the stock, and, provided he had held the stock for at least one year, that $5,000 gain would be taxed at capital gains rates.

Gain $5,000

Less capital gain exclusion

(60%) 3,000

Taxable gain 2,000

Tax (assuming 49% marginal

rate) $1,000

The proposed incentive stock option would save the employee $1,500 in taxes, which is the equivalent of a 6% after-tax salary bonus.

ROLLING OVER SMALL BUSINESS EQUITY

To encourage equity investments in small businesses, several legislative proposals would indefinitely defer taxes on capital gains when the investment is "rolled over" into a small business. Several variations of this principle are being discussed (see Speaking Out, April, page 16). Under one, the gain must have been realized on the sale of an investment in a small company and the entire investment (principal plus realized gain) must be reinvested in another small company. Under another proposal, tax on the realized gain from any investment would be eligible for deferral provided the investment is rolled over into a small company. In all cases, the investment must be in equities of the small company.

EXTENDING SUBCHAPTER S CORPORATIONS

Shareholders in Subchapter S corporations enjoy the legal immunities of shareholders in any corporation, but the profits of Subchapter S corporations flow directly to the shareholders without being taxed first as corporate earnings. Consequently, this form of corporate organization is attractive to many small companies, but current law limits the number of shareholders in Subchapter S corporations to 15. Several legislative proposals would increase the maximum number of shareholders permitted for Subchapter S corporations to as many as 100.

REFORMING GIFT AND ESTATE TAXES

One bill, S. 360, sponsored by Sen. Lowell Weicker (R-Conn.), would make the following changes in gift and estate tax laws: Increase the present estate tax exemption from $175,000 to $600,000; provide an unlimited gift and estate tax marital deduction; increase the annual gift tax exclusion from the current $3,000 to $6,000 per donee; set the value of gifts made within 3 years of donor's death at the value at the time of the gift rather than at the value at the time of death; and permit a five-year extension for the payment of estate taxes, provided 35% of the gross estate or 50% of the taxable estate is a closely held business. Other bills would go so far as to eliminate the estate tax.

ACCOUNTING BY THE CASH METHOD

Under present law, only farmers and companies that do not maintain inventories can use the cash method, under which revenues are taxable only when cash is received and expenses are deductible only when paid. Several proposed bills would permit companies with less than $1 million in gross receipts that must now use the accrual method to elect the cash method.

This example illustrates the tax savings using the cash method for a hypothetical company during the company's first two years in business.

Balance Sheet

Year 1 Year 2

Accounts receivable $300,000 $400,000

Inventories 100,000 150,000

Current liabilities

(excluding short-term

debt) 350,000 450,000

Income statement

(Accrual method)

Year 1 Year 2

Sales $700,000 $900,000

Cost of sales &

overhead expense 600,000 750,000

Income before taxes 100,000 150,000

Income taxes payable 26,750 49,750

Net income 73,250 100,250

If the cash method had been used for both years, taxable income would have been reduced by increases in receivables and inventories and increased by increases in current liabilities (excluding short-term debt).

Year 1 Year 2

Sales

Accrual method $700,000 $900,000

Less increases in

receivables (300,000) (100,000)

400,000 800,000

Cost of sales and

overhead expenses

Accrual method 600,000 750,000

Add increases in

inventory 100,000 50,000

Less increases in

current liabilities (350,000) (100,000)

350,000 700,000

Income before taxes 50,000 100,000

income tax payable 9,250 26,750

Net income 40,750 73,250

Total taxes under the accrual method would be $76,500, but under the cash method taxes would be only $36,000 -- a saving of $40,500, or more than 50%.