When Congress passed the Deficit Reduction Act of 1984, it did small companies few favors The complex bill, signed into law by President Reagan in July, is a virtual declaration of war on business tax breaks and loopholes
The legislation takes aim at some 600 separate sections of the Internal Revenue Code. Among the victims: generous write-offs for fringe benefits and real estate, and liberal deductions for company cars and personal computers
The law also zaps favorable rules governing corporate accounting. It slaps new, miserly restrictions on the issuance of industrial development bonds, and it levies an extra 5% tax on corporate taxable income in excess of $1 million
The purpose of the two-part Deficit Reduction Act is what its name suggests -- to stem the flood of red ink from the federal budget. One section of the law, the Spending Reduction Act of 1984, addresses the problem by trimming federal expenditures by some $13 billion
The other part of the legislation, and the one that hits taxpayers hardest, is the Tax Reform Act of 1984 (TRA) It calls for an estimated $50 billion in additional revenues, much of it from the country's corporations and their employees
Whether the new law will actually reduce the federal budget deficit is anyone's guess But one point is clear. TRA extracts more than a pound of flesh from small business Take commonplace, related-party transactions as an example
Under the old rules, a small business could claim a deduction on its current tax return for a bonus due its controlling shareholder (a person who owns more than 50% of the company). Then it could shell out the money within two and a half months when the cash became available
The new tax law mixes this popular deduct-now-pay-later practice Corporations cannot claim the deduction until the bonus is actually paid
"What this does," says Robert L. Haddad, a small-business tax partner in the Boston office of Price Waterhouse, "is create a fire drill at the end of the year And virtually every single small corporation will be affected "
About the only positive note in the new law is a fresh set of rules governing employee stock ownership plans (ESOPs). These rules allow business owners to defer paying taxes on the profits they make when they sell company stock to an ESOP if the money is reinvested in other securities.
The law also permits lenders to exclude from their taxable income half of the interest they receive from loans to leveraged ESOPs. "The theory," explains Harold Dankner, a tax partner in the Washington, D.C., office of Coopers & Lybrand, "is that banks will lend funds to ESOPs at a lower rate."
Summaries of key provisions of the new tax law follow.
Fringe benefits. Since 1978, Congress has prohibited the Internal Revenue Service from issuing regulations on the incometax treatment of fringe benefits Consequently, the deductibility of most benefits, other than life, health, and disability insurance, has been open to question. Most companies have done more or less what they wanted -- with the knowledge that the IRS could one day call them on the carpet.
The new tax law ends the uncertainty. It lists several categories of fringe benefits that can be deducted by companies and that don't need to be reported as income to employees. The classifications are* Services provided to employees at no additional cost to the company Among other things, this rule allows airline employees to fly on a stand-by basis.
* Qualified employee discounts. This provision includes discounts on company products and services.
* Employee parking. Under the old law, corporations deducted the cost of employee parking generally if it was made available to everyone The new law eliminates this requirement. It allows companies to deduct the cost of parking that is provided to a select few executives if it meets three criteria The parking is provided near the place of employment (not at a yacht club 20 miles away), for the employees' convenience, and is restricted to cars used for business.
* Working condition fringes. These are items, such as protective clothing, that could be deducted by the employee if they weren t provided by the employer.
* De minimis fringes. De minimis ringe benefits are those whose value is so mall that they are insignificant -- free coffee, free photocopying, company picnics, and holiday turkeys, for instance.
* Subsidized eating facilities. A cafetera for all employees must be located on or near the company's place of business in order for its cost to be deducted by the corporation. Also, the revenues received must match or exceed operating costs
* Athletic facilities. To be deductible, a gym must be open to all employees
* Tuition reduction plans. Tuition plans are tax free only for employees of colleges and universities The rest of us are out of luck, unless the payments qualify as a working-condition fringe.
Besides these categories, the new tax law singles out a number of specific groups for special scrutiny -- employees of automobile dealerships, for example. It limits the tax-free personal use of demonstrator cars to full-time salespeople This benefit, says Edward M Gardner, a CPA based in Houston, is not tax free for other employees, such as mechanics, bookkeepers, and part-time salespeople.
The new rules for taxation of fringe benefits take effect January 1, 1985, except for tuition reduction. That applies to education furnished after June 30, 1985
Cafeteria benefit plans. With a cafeteria plan, employees choose fringe benefits from a preset menu. Under the old rules, employees could receive cash for benefits they didn't use. However, regulations proposed by the IRS last spring prohibit cash payments of the unused amounts, says Dankner of Coopers & Lybrand. What's more, the new law limits cafeteria plans to those offering cash or nontaxable benefits, such as day care and medical and life insurance. Taxable benefits, such as tuition assistance and the cost of commuting, can no longer be included in such plans.
The law provides relief from the IRS regulations with regard to existing plans, generally until January 1, 1985.
Voluntary employee benefidary assedations (VEBAs). Defined under section 501(c)(9) of the Internal Revenue Code, a VEBA is a separate account through which employees' fringe benefits are paid. The most common benefits are health and life insurance, but vacation, severance pay, and other benefits can be included, too.
In the past, the primary selling point of a VEBA was that contributions to it were fully deductible in the year they were made This rule allowed companies to prefund employee benefits and, therefore, boost current tax deductions. The new law sharply cuts back on this practice It also comes down hard on companies that have stretched the definitior of VEBAs far beyond their intended limits. The most talked about example is the abuse of severance benefits.
Under the old rules, companies would contribute as much as two times an executive's salary to a VEBA. The contribution was deducted by the company, but it was not taxed as income to the employee until the money was paid out. This didn't occur until the employee resigned or, in some cases, retired.
"That," says Alvin D. Lurie, a tax attorney in New York City and the author of a guide to VEBAs, "was seen as abusive of what severance benefits were all about." So the new law sets a ceiling on severance benefits paid through VEBAs. The figure, tied to pension rules, is currently $45,000 per person.
Although VEBAs still cannot disproportionately favor the company's officers, shareholders, and other highly compensated employees, stringent top-heavy rules were not enacted as threatened. "No matter how high the percentage of benefits going to key employees," says Lurie, "there will be no adverse statutory consequences from a top-heavy structure."
The new VEBA rules affecting timing of contributions and deductions don't take effect until 1986.
Golden parachutes. Golden parachutes are severance payments made to the management of a company that is acquired by another company. The new tax law imposes a cap on golden parachutes. The limit is three times an individual's average annual compensation over the past five years. The portion of parachutes that exceed that ceiling will be subject to a 20% excise tax, plus individual income taxes. The rules apply to golden parachutes provided for in agreements entered into or renewed after June 14, 1984.
Industrial development bonds (IDBs). State and local governments issue IDBs for many purposes -- among them, to help small companies purchase equipment and property. Small companies like tax-exempt IDBs because they carry a lower interest rate than most commercial loans.
Ironically, the new tax law imposes a cap on the amount of IDBs each state may issue at a time when small business interest in IDBs had just started to heat up. The new ceiling is $150 per resident or $200 million, whichever is greater. The move is bound to result in a sharp drop in the availability of new IDB funds.
Tax credits on used property. The law postpones scheduled increases in the amount of used property that qualifies for an investment tax credit. The ceiling remains $125,000 until 1988, instead of increasing to $150,000 in 1985.
Real estate. Old tax laws provided two mechanisms for depreciating buildings: the straight-line method and the accelerated cost recovery system (ACRS). Straight-line depreciation was the easiest. You divided the cost of the building by 15, the minimum number of years for writing off buildings, and deducted the result from your taxable income each year until you had written off the cost. The second depreciation method, ACRS, used the 15-year write-off and set the percentage of the building's cost you could deduct. The write-off or annual tax deduction was "accelerated," thus providing large deductions in the early years.
The new law changes the minimum recovery period for buildings from 15 to 18 years, except in the case of low-income housing. This provision means it will take three years longer for companies to recover their investments in buildings. The new rules apply to buildings placed in service after March 15, 1984.
Company cars. Under the old rules, if a car was used solely for business, the entire purchase price -- no matter how large -- was deductible. Your choices were to depreciate the whole amount over three years (using ACRS) or to expense up to $5,000 of the cost currently and depreciate the remainder.
You were also entitled to a 4% or 6% investment tax credit. With the 4% credit, ACRS could be applied to the full cost of the car. With the 6% credit, you had to subtract half the amount of the credit from the sum you depreciated.
If you used your automobile for a variety of purposes, the law mandated that you separate business and personal usage. And it permitted you to depreciate only that portion attributable to business.
Under the new law, there are more stringent standards. TRA limits depreciation deductions for cars used only for business to $4,000 in the first year and $6,000 for any subsequent year. And it imposes a $1,000-per-car cap on investment tax credits. Since most companies keep automobiles only three years, the move, in effect, eliminates the tax advantages of providing officers and employees with cars that cost $16,000 or more.
The purpose of this particular provision is, of course, to curtail the tax advantages of owning so-called luxury cars. The problem is, you don't have to own a Mercedes-Benz to have a luxury automobile.
"There are a lot of people out there," says S. Theodore Reiner, director of client tax communications in the national tax office of Ernst & Whinney in Washington, D.C., "who drive Chevies, Fords, and Plymouths and who don't consider them luxury automobiles."
TRA also imposes new rules when business usage falls below 50%. Among these: The depreciation schedule is extended from three years to five. You must depreciate the car's cost using the straight-line method, rather than ACRS. And you are not entitled to the investment tax credit.
Also, you are subject to new, strict record-keeping rules. It is anticipated that the regulations will require, at a minimum, that you keep a daily log listing the mileage, date, place, and the business purpose. And you must confirm in writing for your tax preparer that you have maintained adequate records to back up your deductions. Claiming a deduction or credit without supporting records may leave you subject to penalties.
Finally, TRA imposes new strict rules on what constitutes business usage. "Commuting is not business use," explains Gardner of Houston, "even if you install a telephone and use it to transact business while commuting."
Reiner of Ernst & Whinney takes note of another sticky point: "Congress has suggested that if a business car is housed at a garage so that it can be used for personal reasons over the weekend, then a maximum of only five-sevenths of the car's time can be considered as business use."
Depreciation and tax credit rules apply to cars bought or leased after June 18, 1984. rhe record-keeping requirements take effect in 1985.
Personal computers. The old law required people to separate business and personal usage of their computers. If the machine was utilized exclusively for business or investment management, the entire cost could be written off. But if you used the computer for a variety of purposes, you were allowed to write off only that portion attributable to business.
In the year of purchase, you could choose to write off the total cost of the computer (up to $5,000), depreciate it over five years, or use a combination of depreciation and write-offs. However if you elected the first-year write-off, you weren't entitled to an investment tax credit on that amount.
The investment tax credit, which equaled 10% of the amount you depreciated, could be claimed in the year you acquired the computer and was in addition to depreciation deductions. After subtracting half the amount of the tax credit, you could depreciate 15% of the cost of the computer in the first year, 22% in the second year, and 21% in each of the third, fourth, and fifth years. Or, instead of electing the 10% credit, an 8% credit could be taken and ACRS applied to the full purchase price.
Under the new law, the number of people who may write off their PCs is cut back, says Ira H. Shapiro, a partner in the Washington, D.C., office of Coopers & Lybrand. The rules say that employees may take deductions only if they meet these three tests:
* The computer is "required for the convenience of their employer."
* Using the computer is "a condition of employment."
* The personal computer is "necessary to the performance" of their jobs.
What these three rules actually mean is up for debate. Accountants are assuming that a simple letter from an employer to an employee, stating that the computer is necessary for his or her job, will not lie acceptable in all cases. The IRS, no doubt, will clarify the issue.
Also under the new tax law, if you use the machine less than half the time for business, excluding investment management you are not entitled to any investment tax credit. What's more, you must depreciate that portion of the cost of the machine equal to business use, including investment management applications, over 12 years, rather than 5, and use the straight-line method of depreciation, instead of ACRS.
In addition, starting in 1985, you must keep a daily log of computer usage to back up your tax claims. The IRS needs to clarify log requirements, but will probably require, at a minimum, that the log list the date, time, and business purpose. Tax return preparers must obtain written confirmation from the taxpayer that adequate records have been kept before the preparer signs the returns.
Depreciation and tax credit rules apply to personal computers purchased after June 18, 1984. The record-keeping requirements take effect in 1985 for all property, regardless of date of purchase.
If you would like more information about TRA, write to one of the national accounting firms. They have produced detailed booklets on the subject. One word of warning, however: Don't ask for a copy of the legislation itself. It is more than 1,000 pages long.