A Tax Package That Stings

The new tax act limits business cash-flow, speeds up payment schedules, and scales back maximum contributions to company pension plans.

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If your company has a corporate pension plan, if you have a sizable number of employees, if you plan any major corporate investments, if yours is a closely held corporation -- in short, if you are running a small business in the United States today -- then you had better take a close look at the $98.3 billion Tax Equity and Fiscal Responsibility Act of 1982 that Congress passed last summer. Some of its provisions could pinch your business.

"This is an anti-cash flow act," says Abe Schneier, tax expert at the National Federation of Independent Business in Washington, D.C. "The impact on tax liability may not be tremendous, but it definitely will create some cash-flow problems." It is also complex and touches business in a host of little ways. "We're advising our members, 'Look, this is going to affect you. You better look at it closely," says John Fitch, vice-president for government relations at the National Association of Wholesale-Distributors in Washington.

The act orders changes in three important areas. First, it will raise corporate taxes, largely through increases in payroll taxes for unemployment compensation and by scaling back tax breaks for business investment. Second, it speeds up tax collections; money that was once available for corporate use will now have to go to the government in earlier tax payments. Third, it puts a squeeze on individual taxes in a variety of ways. For business executives, the most important individual-tax provisions are those that tighten up tax advantages relating to corporate pension plans

Tax Increases. The cost of doing business will rise significantly with two scheduled increases in the Federal Unemployment Tax (FUTA). But the actual increases could vary from state to state.

Currently, companies pay the federal government the equivalent of 3.4% of the first $6,000 of each worker's annual wages. Of that, a credit of 2.7% goes to employers in qualified states as a credit for payment made directly to the states to maintain their unemployment programs. For 1983 and 1984, the unemployment tax will rise to 3.5% of the first $7,000 in wages, with the offsetting credit staying at 2.7%.

Beginning in 1985, however, the tax rate shoots up to 6.2%. The credit for qualified states will rise to 5.4%, meaning that the net federal tax will remain at 0.8%. There is a possible out for businesr es operating in the economically healthier states: If a state shows it can maintain its unemployment program sufficiently with a lower tax, it can reduce the overall unemployment tax for certain qualifying companies. The justification must be on the basis of "experience rating" -- that is, on a calculation of a company's total unemployment benefits recently paid to former workers. Those companies with the worst experience rating would still be subject to a minimum federal tax of 5.4%.

Another major provision takes a slice out of the value of investment tax credits and depreciation. It scales back depreciation allowances to offset partially the tax credits that go to companies in the year of investment. Starting in 1983, companies must subtract half of a credit's value from an asset's value before taking depreciation write-offs. Thus, if they take a 10% investment credit they can write off only 95% of the asset's value over its depreciation schedule.

Under the old law, for example, if your company purchased a $100,000 machine, it would be entitled to a 10%, or $10,000, tax credit, and normally could depreciate the machine over a period of five years. The new law provides for the same $10,000 tax credit, but requires the company to subtract half of the value of the credit (in this example, $5,000) from the depreciable basis of the machine. So your company will be able to depreciate only $95,000 over the five years.

But there is also a new option in the law: If your company has no need for additional tax credits in the year in which you buy the $100,000 machine, you can elect to use a smaller investment credit instead of following the rules explained above. Instead of using the normal 10% credit on the machine, you can elect to take an alternative credit of 8% -- or $8,000 in this example -- without having to subtract any amount from the depreciable basis. This way the company can qualify for more tax benefits in later years when it may need them. For investments that qualify for depreciation over three years, you can elect a 4% tax credit rather than the usual 6%.

Cash-flow provisions. The act tightens provisions relating to corporate tax payments. To avoid penalties, companies previously had to pay 80% of their tax liability in estimated payments through the tax year. The remainder was due in two equal installments in the third and sixth months of the following year. As of January 1, 1983, corporations must pay 90% of their estimated tax through the tax year, with the rest payable in one installment in the third month of the following year.

The law also reduces tax-payment options available to so-called large corporations -- those with taxable income exceeding $1 million in any of the three preceding tax years. Formerly they could base the current year's estimated tax payments on the previous year's tax liability, so long as those payments turned out to be at least 65% of the current year's liability. But the 65% rises to 90% by 1984. There is a concession, however: Companies whose tax payments through the year were 80% to 90% won't be assessed the entire penalty, which amounts to a 12% interest payment on taxes owed. They will be required to pay only 75% of the normal assessment.

The problem is that it is very hard to predict the proper tax liability for a given year. Thus, many tax experts say they will advise clients to overpay their taxes to avoid penalty. The victim: cash flow.

Another feature of the act will diminish the value of so-called safe-harbor leasing under which companies with tax breaks they can't use may "sell" them to other companies for cash. But the act liberalizes the leasing rules for so-called closely held corporations, those with five shareholders or fewer holding 50% or more of the company's stock. Such companies, effectively barred from such transactions by the old law, will now enjoy the same leasing treatment as other companies. But they had better hurry: The act repeals safe-harbor leasing entirely after next year.

Individual taxes and pension plans. The act marks a profound turning point for corporate retirement plans. Harold Dankner, a partner in Coopers & Lybrand's actuarial, benefits, and compensation services group, calls the changes "the most significant development in the rules governing retirement planning" since passage of the 1974 law regulating private pension plans.

Previously, Dankner points out, the big question in determining benefit and contribution restrictions was whether the employer was a corporate or noncorporate entity. The act wipes out most of those distinctions. For corporate, defined-contribution pension plans, the tax-deferred contribution dollar limit has been slashed to $30,000 a year from $45,000. Meanwhile, the maximum taxdeferred pension contribution for the self-employed would rise from $15,000 to the same $30,000 level. For defined-benefit corporate plans -- those that allow contributions necessary to produce a specified benefit level at retirement -- the maximum benefit will fall to $90,000 a year from $136,425.

Under the new law, the big question is whether a plan is "top heavy." A defined-benefit plan is top heavy if the present value of accrued benefits of "key employees" exceeds 60% of the present value for all plan participants. Key employees are defined as officers, 5% owners, 1% owners earning more than $150,000 annually, and employees owning the 10 largest interests in a company. For defined-contribution plans, the top-heavy designation applies if 60% of the account balances have been accumulated on behalf of key employees.

Top-heavy plans are subject to special rules affecting vesting, contributions, and benefits. The vesting provision requires eitber 100% vesting after three years of service, with a participation requirement that doesn't exceed three years or a six-year graded vesting schedule (20% after two years of service and 20% for each subsequent year) with a participation requirement that doesn't exceed one year. The act also requires minimum benefits for non-key employees-for defined-benefit plans, 2% of average annual compensation per year of service not to exceed 20%; for defined-contribution plans, a contribution of 3% of compensation for each year in which a key employee receives a 3% allocation.

The impact these restrictions will have on corporate pension plans is open to dispute. Coopers & Lybrand believes that "the benefits for key employees will still be substantial in most situations," according to a published analysis by the firm. But others say that the restrictions, and the fact that there is a new parity between the contributions permitted to corporate and noncorporate plans, will dry up the incentive for corporate plans.

"I'm convinced," says James Conahan, a pension lawyer in Honolulu, "that tens of thousands of plans will simply shut down." Those now classified as key employees will channel their money into other retirement options. The cost of compliance alone -- hiring the expertise for making necessary changes -- will cost $2,000 to $4,000 for most small companies, he says.

Fitch, of the Wholesale-Distributors Association, says corporate decisions on whether to continue the plans will be based on why they were initiated in the first place. "The question," he says, "will be: Why did we want this plan -- for overall tax planning, for estate planning, or for cash flow?"

But the cash-flow factor also is severely affected. Previously, plan participants could borrow freely from their plans, and Fitch says executives at many small corporations took advantage of that provision to borrow for corporate purposes. But the new law restricts loans from plans to $10,000 at any one time, or half of vested benefits up to $50,000. Loans that aren't repaid within five years are treated as plan distributions, thus losing their preferential tax status. (Personal loans for a principal's residence would be accorded a "reasonable" repayment schedule.)

Thus the act is bound to affect capital availability for corporate executives and for small companies. Conahan suggests that the contribution restrictions and the plan terminations he anticipates will, taken together, limit capital availability far more than anyone now suspects.