The Economic Recovery Tax Act of 1981 is the single biggest change in the American tax system since the introduction of wage withholding in 1942. By now a great deal has been written about the Act -- ERTA for short in the rest of this article -- more perhaps, than about any other new law in our history. This article will quickly summarize the changes important to smaller businesses. It deals primarily with those areas of ERTA that take effect this year or which require some action in 1981 to maximize your tax benefits.
A few points of perspective should be raised before getting to the heart of the matter. ERTA was drafted and passed in a great hurry, and it shows. In days gone by, tax bills took up to two years to wend their way through Congress. For most of the '50s and '60s, Arkansas congressman Wilbur Mills kept a steady hand on the tax tiller. His bills generally were well written, tightly constructed, and they meant exactly what they said. ERTA is not well written, and it is a big bill. More uncertainty will be added to an already complex system as a result, and some points in the law may take years to come into sharp focus because their effect will depend on Internal Revenue Service regulations. The IRS is years behind in issuing regulations now. ERTA won't help matters.
It's a safe bet that a "technical correction" act will follow ERTA in 1982. Such bills, meant to correct errors in the drafting process and to remedy unintended oversights, are common. They also offer a perfect opportunity for backdoor special interest additions to tax bills. So don't assume that ERTA is set in stone.
Finally, it's fair to say that little or no consideration was given to the issue of tax fairness by either side in the congressional debate. Capital- and equipment-intensive businesses are clearly ERTA's most favored constituents. In fact, it appears that for certain types of companies in this category, the corporate tax has been repealed entirely, so sweeping are the effects of the new law. On the other hand, labor-intensive and "service" businesses have far less to cheer about -- and that's the majority of small businesses.
But there are many positive aspects to ERTA, and for the majority of established small companies, some truly significant changes.
ERTA's revisions fall into two time frames: those that begin this year and those that don't begin until 1982 or subsequent years. There are three categories of revisions: business revisions, personal revisions, and changes in the estate and gift tax laws. In that order, let's look at the important points.
HOW THE NEW LAW AFFECTS YOUR BUSINESS
DEPRECIATION. There are only four write-off classifications under the new law for most businesses. These are:
* "3-year property," such as autos and property used in connection with research and experimentation;
* "10-year property," primarily restricted to public utility property and some other special cases;
* "15-year property," which generally is real estate;
* "5-year property," which applies to those things not covered above and includes everything from desks to computers to heavy equipment. If your business is equipment-intensive, you should be very happy, particularly when the new investment tax credit provisions are combined with these changes.
Here are some other critical depreciation rules changes, all of which apply to plant and equipment placed in service any time during 1981:
* New and used property. The same depreciation methods and periods now apply to both.
* Salvage value. This concept is no longer relevant. The entire cost of the property is depreciable.
* Special first-year write-off. Up to $10,000 per year of certain capital equipment can be expensed instead of depreciated. This provision will be phased in over five years; the limit is $5,000 in 1982.
* Personal property depreciation methods. For property placed in service between 1981 and 1984, the law prescribes the 150% declining-balance method, while 1985 property gets the 175% declining-balance method and 1986 property gets 200%. You can also elect the straight-line method and a longer write-down period for a slower write-off.
* Real property depreciation methods. The law prescribes the 175% declining-balance method. Component depreciation is no longer allowed. You may also elect the straight-line method and a longer write-off period.
* Recapture. Income from the gain on the sale of nonresidential real property will be taxed as ordinary income to the extent the property has been depreciated under the declining-balance method, which produces a relatively rapid write-off. If you use straight-line depreciation, all your profit will be taxed at lower capital gains rates.
* Churning. Special provisions aim to prevent related parties from making equipment or property used during 1980 eligible for the new faster write-downs by "selling" to each other in paper transactions.
INVESTMENT CREDITS. These are the critical new provisions:
* A credit of 6% is allowed for equipment with a three-year life. A 10% credit is allowed for equipment with a longer life. The new credits apply to any property placed in service after December 31, 1980.
* The limit on the amount of used property eligible for credit is increased from $100,000 to $125,000 per year from 1981 through 1984 and to $150,000 per year thereafter.
* A 2% credit is allowed for each year the property was held if investment credits already used are recaptured by the government when a piece of equipment is sold before the end of its write-off life (3, 5, 10, or 15 years) under the new law. If, for example, you acquire a piece of "5-year property" this year for $100,000 and claim a credit of $10,000 (10% X $100,000), then sell the property after two years, just $6,000 of your original $10,000 credit will be recaptured and must be repaid. You can keep $4,000 (2 years X 2% X $100,000).
* The investment credit carryover period is extended to 15 years from the present 7 years for credits earned but unused since December 31, 1973.
CORPORATE TAX RATES. The only changes are reductions from 17% to 15% of the first $25,000, and from 20% to 18% of the next $25,000 over the next two years. Thus taxes on a corporation's first $50,000 of income will be:
income Now 1982 1982
First $25,000 17% 16% 15%
Next $25,000 20% 19% 18%
On corporate income above $50,000 a year, there is no change in rates.
RESEARCH AND DEVELOPMENT CREDITS.There's a new tax credit equal to 25% of all R & D expenditures in excess of the average expenditures for such purposes during the previous three years. While 100% of "in-house" R&D expenses qualify, only 65% of outside, or "contract," R&D can be counted. The credit will expire on January 1, 1986, unless Congress renews it.
SUBCHAPTER S CORPORATIONS. The new act increases the maximum number of shareholders in Subchapter S corporations from 15 to 25 and allows certain types of trusts to be shareholders.
ACCUMULATED EARNINGS CREDIT. The law increases from $150,000 to $250,000 the amount of earnings a corporation can accumulate before the IRS may require it to declare a dividend.
HOW THE NEW LAW AFFECTS YOUR PERSONAL TAXES
RATE REDUCTIONS. The cumulative effect of the personal income tax reductions will be:
* a 1 1/4% reduction in 1981,
* a 10% reduction for 1982,
* a 19% reduction for 1983,
* a 23% reduction for 1984 and thereafter.
The new law reduces the maximum tax rate from 70% to 50%, a cut that will have significant effects on tax shelter techniques, which INC. will explore in future articles.
In general, the best short-term advice is to postpone realization of income until 1982 and pay deductible expenses this year to reduce the tax bite at this year's higher rates.
INDEXING. Personal tax rates and exemptions are to be indexed to inflation starting in 1985. In theory this should eliminate "bracket creep" -- the tendency of inflation to raise taxes automatically by pushing people into higher brackets.
CAPITAL GAINS TAX. The reduction of the maximum tax to 50% effectively reduces the maximum capital gains tax to 20%, since the first 60% of any long-term capital gain (in general, the gain on any capital asset held for more than one year) is tax-free. June 10, 1981, is the starting point for the new treatment.
GAIN ON SALE OF RESIDENCE.If you have sold your home, you now have up to 24 months to reinvest the gain without incurring any tax liability. The old limit was 18 months. For taxpayers age 55 or older, the one-time exclusion of gain on a residence sale rises from $100,000 to $125,000.
RETIREMENT SAVINGS. The upper contribution limit has been increased to $2,000 for an individual retirement account and $1,750 for a spouse's individual retirement account, starting in 1982. Participants in a qualified retirement plan will be permitted to contribute an additional $2,000 to an employer's plan or an individual retirement account.
COMMODITY FUTURES GAINS. An effective top rate on all commodity trading gains of 32% was established, along with a three-year loss carryback. Generally, the changes are effective June 24, 1981.
AMERICANS ABROAD. Starting in 1982, $75,000 of earned income is exempt from tax. After that the amount increases $5,000 per year to $90,000 in 1986.
CHARITABLE CONTRIBUTIONS. Under the new law, people who don't itemize their other deductions will nonetheless be able to deduct a portion of their charitable contributions in computing their taxable income.
HOW THE NEW LAW AFFECTS YOUR FAMILY
Changes in estate and gift taxes are farreaching and of major importance for almost any owner of a closely held business. It's critical, however, that you live until 1987. The exemptions and the maximum rates will be:
Year from tax rate
1982 $225,000 65%
1983 275,000 60%
1984 325,000 55%
1985 400,000 50%
1986 500,000 50%
1987 600,000 50%
The following specific points deserve additional comment:
MERITAL DEDUCTION. Beginning in 1982, ERTA allows an unlimited marital deduction. This means that every dollar of a transfer between husband and wife, whether during life or upon death, is tax-free. You and your wife or husband are considered one person under the new law. It sounds simple, but if your net worth is greater than $600,000 -- the new amount you can transfer to any of your heirs tax-free -- a careful estate plan is still a must for many reasons. Future articles will explore these vital techniques in light of the new law.
GIFT TAX EXCLUSION. Beginning in 1982, the annual amount you can give to any individual without creating a tax liability for him or her rises to $10,000 from the current $3,000. Combined with the gift splitting provisions of the current tax law, this means that a husband and wife can give $20,000 per year to each child, or any other person, tax-free. Another feature of the new law is that payment of a person's medical expenses or tuition qualifies for an unlimited exclusion of tax.
DON'T MISS THE NEXT THRILLING CHAPTER...
The ink is hardly dry on ERTA. There are no regulations attached to it and no rulings on points of contention. It is absolutely essential that you meet with you own tax professional as soon as possible -- if you haven't already done so -- to review the impact of the law on your own situation. And watch for news of further developments in the daily press and in INC.
CORRECTION-DATE: December, 1981
"How the Tax Cut Affects You" (October) was a fine nutshell analysis of the new tax law, but the explanation of the new gift tax exclusion is somewhat misleading. The statement on the increase in the annual amount which "you can give to any individual without creating a tax liability for him or her" conveys the false impression that a gift tax liability is the responsibility of the recipient. In fact, the primary legal incidence of a gift tax liability falls upon the donor. Moreover, since receipt of a gift is excluded from taxable income, there is no income tax liability to the recipient. The new exclusion of $10,000 is the annual amount that may be given to an individual without creating a gift tax liability to the donor.