If there was ever a time to question the adage "Nothing is certain but death and taxes," now is the moment. While death still seems a good bet, no one is certain when, and in what form, Congress will produce a workable tax code that has any chance of truly reforming the current system. President Reagan's latest proposal has already run into a barrage of criticism from nearly every sector of the business community, and it is clear that the President's overhaul of the present tax code will itself be overhauled before the year is out.
Despite the complexity of the Reagan proposal, the strategy outlined in its 461 pages is fairly straightforward: to correct inequities in the current tax system by restructuring tax brackets and capping or erasing deductions and exemptions. Only then, Reagan says, can he achieve his goals of fairness, growth, job creation, and technological innovation, among others.
Yet to many members of the small-business sector, those goals seem more elusive than ever. Already the plan, informally labeled "Treasury II," has been tarnished by charges that its drafters were not always aware of the impact that some proposals would have on different economic sectors. Provisions to change the way employee stock ownership plans (ESOPs) are regulated, for example, have come under such a barrage of criticism that their chances of approval are slim. "It's pretty clear from taling to Treasury staffers, among others, that the ESOP proposals require dramatic changes," states Corey Rosen, executive director of The National Center for Employee Ownership, in Arlington, Va. On a macroeconomic level, critics claim that rather than increasing revenues, Treasury II will instead reduce them, thereby contributing to the federal deficit and ultimately causing higher interest rates.
The plan clearly has its supporters as well, among them high-technology companies that applaud Reagan's proposal to extend the research and development tax credit an additional three years. "This industry will probably come out [of the tax revision process] as well-off as anybody," says John Mueller, economic counsel to Rep. Jack Kemp (R-N.Y.). Venture capitalists are equally pleased by the proposed capital-gains differential, whereby individual capital gains will continue to be taxed at a lower rate than ordinary income. Even though Reagan is proposing a somewhat smaller differential than the one that presently exists, its inclusion at all is a sign that the government is still interested in "maintaining the current favorable environment" for entrepreneurs, says Stanley E. Pratt, publisher of Venture Capital Journal, in Wellesley Hills, Mass. "What the government is saying is that you people who take the enormous risks and have the patience to build something should receive a special incentive." Some argue, moreover, that this capital-gains differential, along with new restrictions on real estate tax shelters, will encourage more investment in the entrepreneurial sector as a whole. Others, however, disagree: Any capital that is diverted from real estate tax shelters, they claim, will go to the Fortune 500 public equity markets and not into small companies, the majority of which are financed internally.
Some provisions in Treasury II are seen as bad news for businesses across the board. One example is the capping of direct-expensing allowances, which currently permit small companies to deduct 100% of the cost of a piece of equipment, up to $5,000. Another is the elimination of widely used investment tax credits (ITCs) for equipment. "Small businesses really use the investment tax credit," says Bill Nourse, small-business political activist. "They are consciously aware of it, plan for it, and make business decisions based on it. By removing ITCs, and capping direct expensing, the Reagan Administration is taking away the tools that small companies find most valuable." In addition, Treasury II would impose new and more stringent rules on depreciation allowances for certain types of assets, eliminate liberal deductions for life and health insurance and pension plans, and remove attractive write-offs for business travel and entertainment.
All of these provisions are, of course, still subject to change. Some observers predict a lessening of the restrictions on direct expensing, and a lowering of the corporate tax rate for the smallest companies. On the other hand, there are those who suggest that the maximum corporate tax rate may end up higher than the proposed 33%, and that a provision allowing shareholder dividends to be partially deducted from taxable income will be withdrawn.
Meanwhile, congressional leaders are reportedly aiming to place a final bill on President Reagan's desk by Thanksgiving at the earliest, by Christmas more realistically, but perhaps not until early 1986. If the debate drags on much beyond that point, chances for a new tax code grow dimmer. After all, 1986 is an election year, a time when parties tend to polarize more and compromise less.
Nor is there any guarantee that a revised tax code won't itself be revised in short order. "In the past decase, we have had a major tax rewrite almost every two years," says Ken Hagerty, vice-president of government operations for the American Electronics Association. In the past four years alone, Hagerty adds, "there has been a substantial change in the overall tax policy on depreciation. If you get swings . . . of this magnitude within a single administration, the odds of [the tax code] being stable for any length of time are pretty low."
So perhaps we can revise the old adage to note the certainty of death and tax debates. Certainly the Reagan tax proposal will be fair game for a host of fired-up congresspeople throughout the fall, and that should make for some fast and furious political action. With this thought in mind, we have put together the following guide to the provisions of Treasury II that would, if enacted, have the greatest impact on small to medium-size companies -- the better to keep track of who will win and who will lose.
New Rates: Companies that earn more than $100,000 annually stand to benefit handsomely from Reagan's proposal to slash the top corporate tax rate from 46% to 33%. But businesses with income below that level will find their corporate tax cut almost nonexistent. Under Reagan's program, the tax rate would remain at 15% for the first $25,000 of corporate income, and at 18% on earnings from $25,000 or $50,000. The current 30% tax on corporate income from $50,000 to $75,000 would be cut by only 5%.
As a result, a company with income of less than $50,000 would realize no savings under the President's plan, while one with $75,000 in taxable income would gain only $1,250. "That ain't hay," points out Thomas P. Ochsenschlager, a tax partner in the Washington, D.C., office of Alexander Grant & Co. "But I'd hate to think that any business is going to rise or fall on that amount."
Obviously, companies that earn in excess of $75,000 might want to defer as much of their income as possible to take advantage of the proposed 33% rate. If you have a major new sales campaign planned for late this year, you might also consider delaying the launch until 1986. Some accountants even suggest that companies put off billing their clients or collecting late accounts until next year, provided that there are other compelling business reasons to do so.
Minimum Tax: Reagan has proposed a 20% corporate minimum tax to ensure that companies with large deductions pay their fair share. This measure is aimed at large, capital-intensive businesses, but it could be harmful to small manufacturers as well.
As it is currently structured, the new corporate minimum tax would resemble the alternative minimum tax now in place for individuals. It would generally require companies to compute their tax liabilities two ways. First, they would figure their taxes under the standard corporate income tax rules; then they would make a separate calculation for the minimum tax. That computation would involve subtracting $25,000 from taxable income, and adding back in so-called preference items, including, for example, 25% of net-interest expenses (subject to certain limits), intangible drilling costs for oil and gas, and a portion of depreciation costs. That figure would be multiplied by 20%, the minimum tax rate. Companies would then pay the higher of their two tax bills.
Real Estate Depreciation: Current law provides two mechanisms for depreciating buildings. One is the straight-line method. The other is the accelerated cost recovery system (ACRS), a procedure created by Reagan in his Economic Recovery Act of 1981.
The straight-line method is the simplest. A business divides the cost of the building by 18 (the minimum number of years required for recovery), then deducts the result from the company's taxable income each year until it has written off the cost. ACRS also uses 18-year write-offs, but allows for accelerated deductions to provide larger write-offs in early years of ownership.
Under Treasury II, the recovery period for buildings would balloon to 28 years. In addition, ACRS would be scrapped in favor of another mechanism -- the capital cost recovery system. CCRS would allow companies to figure inflation into the amounts they depreciate, an advantage over the current system, but not necessarily a big enough one to offset the loss of rapid 18-year write-offs.
Companies in the market for real estate might consider making their purchases before year's end to lock in depreciation deductions under the more favorable 18-year rules. Likewise businesses that are erecting new structures might want to start construction right away. "There is a distinct possibility that Congress will grandfather in these buildings," says Ochsenschlager.
Equipment and Machinery Depreciation: President Reagan's plan would stretch out, in most instances, the time required for companies to recover their investments in business equipment and machinery. For example, it would eliminate three-year write-offs for automobiles and light trucks -- mainstays for several million small retail and service businesses. In their place would be a new, lengthier schedule that calls for write-offs under this timetable:
* five years for trucks, office equipment, and computers;
* six years for construction machinery and airplanes;
* seven years for general machinery, furniture, and fixtures;
* ten years for railroads, ships, and engines.
It should be noted, however, that the accelerated rates for certain of the classes may be higher than the rates under the current ACRS.That could result in larger write-offs up front for some types of equipment.
Direct Expensing: Back in the 1970s, a capital investment "expense allowance" provided small businesses -- especially small sole proprietorships -- with a tax break. They could deduct as a business expense 100% of the cost of any piece of equipment. The only catch was that the limit on this allowance was $2,000.
In 1980, small-business groups began to push for a $25,000-a-year allowance, an amount that would benefit 90% of all small enterprises. They eventually compromised on a graduated allowance that began in 1982 at $5,000. Under the President's proposal, this allowance would be capped at $5,000, wiping out scheduled increases in 1988 (up to $7,500) and in 1990 (up to $10,000).
Corporate Investment Tax Credits: The U.S. Treasury would rake in an extra $37.4 billion in 1990 if President Reagan succeeds in his plan to kill investment tax credits outright. Although big public companies in the oil and steel industries are protesting the loudest, small companies, particularly capital-intensive ones, would also suffer.
The credit, which generally equals 10% of the equipment's purchase price, would be eliminated for property that was purchased after 1985. Property placed in service this year would still qualify for the investment credit.
CASH AND CAPITAL AVAILABILITY
Cash-Basis Accounting: If there is a smoking gun in Reagan's tax package, this is it: The plan would prohibit the use of cash-basis accounting by businesses that have sales of more than $5 million annually or that use accrual accounting in reports to shareholders or banks.
"It's that reports provision that is likely to trip up small companies," explains Stephen R. Corrick, a partner in Arthur Andersen & Co.'s Washington, D.C., office. "Most banks demand some kind of accrual-basis financial statements from borrowers. So while companies may pass the $5-million test, they could flunk the accrual test."
Under the President's plan, thousands of service businesses -- including insurance agencies, repair shops, freight lines, consultants, law firms, doctors, accountants, credit bureaus, motels, hotels, and restaurants -- would be forced onto the accrual accounting system. Since this would have a negative impact on cash flow, small businesses would find it much more difficult to finance expansion through internally generated funds.
Ronald S. Schacht, a tax attorney in New York City, suggests that companies stop preparing accrual-basis reports immediately, if possible. "I can't see the IRS forcing a business onto the accrual method if it's no longer doing accrual reports," he says.
In this regard, the Reagan plan does offer one tax break, a system whereby companies would be allowed to add up their uncollected accounts receivable (among other items) on January 1, divide that figure by six, then report that amount as income on their tax returns each year for six years.
Dividend Deduction: Current law doesn't allow companies to deduct from taxable income any dividends paid to shareholders. But Reagan would permit corporations to write off 10% of these payments, starting in 1987. Although this provision would primarily benefit big businesses, all dividend-paying companies stand to gain.
Installment Sales: Receivables financing is a technique used by many businesses to improve cash flow. A house builder, for example, will take out a loan from a bank or commercial finance company against money owed him by his customers. In the process, he will gain access to funds that are normally unavailable to him during collection periods. Under present law, he can borrow money on his accounts receivable, but not report that amount as income until his customers actually pay up.
The Administration's plan would change this practice. It calls for the recognition of income, for tax purposes, at the time receivables are pledged as security for a loan. An exception is made for receivables that are normally collected within one year -- for example, a revolving charge account. "This provision wouldn't hurt small retailers," Schacht explains. "But it would be a problem for house builders."
In addition to house builders, businesses that would be affected by this change include architectural firms and manufacturers of such big-ticket items as computer systems, automobiles, heating and cooling systems, and heavy equipment and machinery.
Bad Debts: President Reagan would limit deductions for bad debts to actual losses, and prohibit the common -- and long-standing -- practice of adding to a reserve for bad debts. This new rule would hit banks hard, but that means small companies could be affected as well.As Cary R. Mikles, a tax manager in the New York City office of Seidman & Seidman/BDO, explains, "If a bank's costs are going up, you can bet those costs will be passed on to customers. The change also could make banks more cautious in their lending to businesses, and it might even drive interest rates up slightly."
Index Inventories: Perhaps the most commonly used inventory method is FIFO -- first in, first out. It assumes that the oldest item in inventory will be the next item sold. But, during times of inflation, this method usually reflects a cost of sale that is below current replacement prices. For that reason, many businesses now use another inventory method, LIFO, or last in, first out. This complex mechanism assumes that the last item purchased is the next item sold, so current replacement costs are charged against current sales.
Reagan's plan would allow taxpayers to use a third inventory method. It would be more complicated than FIFO but less complicated that LIFO, and it would be indexed to inflation, thereby giving companies a greater opportunity for increased write-offs.
Industrial Development Bonds: Just when small companies' interest in industrial development bonds (IDBs) has started to heat up, Reagan wants to prohibit their use in financing private projects. If he succeeds, no private company will be able to use low-interest IDBs to finance construction of buildings or to buy new equipment.
Travel: The Reagan proposal would eliminate tax deductions for travel by ocean liner, cruise ship, or other forms of luxury water transportation if the cost exceeds the price of an airplane ticket. Also out are deductions for the cost of seminars held aboard cruise ships. Another restriction: Travel expenses would be disallowed for employees with travel assignments that extend for more than one year in one city -- a change that would force companies to relocate employees rather than dispatch them on long-term assignments.
Business Meals and Entertainment: Business meals would be capped at $25 a person for all meals, plus 50% of the excess. The proposal would impose no limit on the deductibility of meals furnished on company premises, and parties for employees could be written off, too. But all business-entertainment deductions, including sports tickets, fishing trips, and country-club dues, would be abolished.
Employee Awards: Current law treats most employee merit awards as nontaxable gifts. But Reagan wants these prizes reported as compensation, unless they fall into what is known as the "de minimis" category. These are items that are too insignificant to report, including free coffee, free holiday food, free photocopies, and the like.
Health Insurance: Employer contributions to health insurance plans would be included in the employee's taxable income, up to $120 per year for individual coverage, or $300 for family coverage. For small companies, this change would mainly mean additional paperwork.
Retirement and Profit-Sharing: The Reagan Administration's tax plan would impose a 20% excise tax on withdrawals from tax-sheltered pension plans prior to retirement, while disallowing favorable capital-gains treatment and 10-year averaging of lump-sum program withdrawals. In addition, the plan would also cap deductible contributions to profit-sharing and stock-bonus plans at 15% of an individual's total compensation, and would impose a new 6% excise tax on excess contributions to retirement programs.
The Reagan proposal would also deal a severe blow to 401(k) plans, a new fringe benefit that allows employees and business owners to put away a portion of their earnings for retirement and exclude that amount (plus any interest and dividends that accumulate) from current taxation. The President would cap contributions at $8,000 annually, minus any deposits made by the employee or business owner to separate individual retirement accounts. Moreover, the plan would prohibit withdrawals from 401(k)s in cases of financial hardship. "Given the President's proposal," says Steven J. Ross, general counsel for Corbel & Co., a consulting firm in Jacksonville, Fla., "employers should think twice before putting in 401(k)s."
Other retirement programs should be closely scrutinized as well. If Treasury II is enacted, employers would have to amend their pension plans to meet the law's requirements -- a process that involves expensive legal and accounting time. Some small companies may choose to dissolve their pension programs rather than cope with another round of changes. "This tax proposal is like the Chinese death of a thousand cuts," says Larry Richter, chief executive officer of Corbel. "You don't know which one is going to get you. If they keep slicing away, they may kill the entire animal."
Nondiscrimination Tests: Profit-sharing, stock bonus, pension, and annuity plans would be subject to strict new nondiscrimination tests. So would health-benefits plans, educational-assistance programs, dependent-care assistance programs, and welfare-benefit funds, such as voluntary employee beneficiary associations. The new rules would establish clear standards to ensure that benefits are not provided on a basis that is overly favorable to certain categories of employees. For example, contributions by key executives to a retirement plan could not exceed 125% of the deposits made by other employee groups.
Research and Development Credit: The present credit for research and development expenditures would be extended for an additional three years (until December 31, 1988) under Treasury II. This means that companies could still deduct 25% of their increased R&D costs from their total federal tax bill. President Reagan's proposal does call for a new definition of qualified research -- one that would target research activities that are likely to result in real technological innovations. However, this new definition has not yet been written.
Albert B. Ellentuck, a partner in the Washington, D.C., office of Laventhol & Horwath, suggests that companies review their accounting systems to make certain that all R&D expenditures are recorded as such. For example, if maintenance employees spend part of their time on research equipment, Ellentuck says," an allocation of a portion of their wages would be appropriate."
Employee Stock Ownership Plans: For a decade now, Congress has been encouraging employers to set up ESOPs, and last year's Tax Reform Act was no exception. It included new rules that allow business owners to exclude from their taxable income any profits they make when they sell stock to an ESOP if the money is reinvested in other securities. The Tax Reform Act also permitted banks and other lending institutions to exclude from their taxable income half of any interest they receive from loans made to an ESOP.
Now the Administration wants to provide such incentives only in the case of ESOPs that actually give employees immediate stock-voting rights. Also, stock would have to be distributed to employees annually, not held in trust until workers retire, and would be allocated to employees based only on the first $50,000 of salary. That way, key executives would not receive a disproportionate share of stock.
Most observers think these changes stand little chance of passage, however. As Ellentuck notes, "With Russell Long (D-La.) championing this cause, you can pretty much bet that ESOPs will be left alone."