Jobs and Growth Tax Relief Reconciliation Act of 2003
 
July 15, 2003
 
Alvin Geske - Washington
Alban "Alby" Salaman- Washington
Richard Sills - Washington

On May 28, 2003, President Bush signed into law the Jobs and Growth Tax Relief Reconciliation Act (referred to as the “Act” or the “2003 Act”), which provides immediate tax benefits to millions of taxpayers. Many provisions provide only temporary tax relief, since they expire after a few years. The Act accelerates reductions in income tax rates first enacted in the 2001 Tax Act. It also contains important provisions regarding business-related taxes, taxation of dividends, the alternative minimum tax, the child tax credit and the marriage penalty. It does not change the estate and gift tax provisions of the 2001 Tax Act.

Income Tax Rates

Acceleration of Marginal Rate Reductions. The Act’s most broad-reaching provision is the acceleration of the phased-in reductions in marginal income tax rates enacted in 2001. Previously, income tax rates were to be reduced in 2006-2010. Under the Act, the reductions begin this year. Thus, for 2003, the 38.6-percent rate falls to 35 percent; the 35-percent rate falls to 33 percent; the 30-percent rate falls to 28 percent; the 27-percent rate falls to 25 percent; and the 10-percent and 15-percent rates are unchanged. The 10-percent bracket, however, is expanded for 2003 and 2004 only.

Effects on Tax Planning. First, you may revise estimated tax payments for 2003 to reflect the new, lower rates. You may want to discuss this option with your accountant. Employers will adjust withholdings after receiving the new withholding tables, which are now being mailed. In the interim, the Internal Revenue Service (IRS) has posted the new withholding tables on its Web site, http://www.irs.gov/newsroom/article/0,,id=109816,00.html.

Second, it is noteworthy that the highest individual rate now equals the top corporate rate of 35 percent. This may affect the use of so-called “pass-through entities,” such as partnerships and limited liability companies (LLCs). When the individual rate was higher than the corporate rate, there was an advantage to use corporations rather than pass-through entities in some cases, because of the extra tax burden (resulting from the higher individual rate) on the income paid to individual shareholders. The alternative to paying the higher individual rate was to retain earnings in the corporation and pay the 35-percent corporate rate. Now, this advantage is eliminated, which will often make the use of pass-through entities more attractive.

The reduction of the income tax on dividends (discussed below) provides a break to corporate shareholders. However, corporations are still unable to deduct dividends for income tax purposes, so when the business intends to distribute its earnings, there is still an advantage to using pass-through entities.

Example: Corporate earnings distributed as dividends will be taxed at a total rate of about 45 percent (consisting of the 35-percent corporate income tax, and the 15-percent income tax to the shareholder on the 65 percent paid out). By contrast, earnings distributed through a “pass-through entity” will be taxed at the maximum individual rate of 35 percent.

The above example assumes maximum rates apply, and does not take into account state or local income taxes. Because state and local income taxes vary substantially – and some states tax corporate income at a higher rate than individual income – you or your accountant should review the example with state and local taxes in mind in order to make an appropriate comparison. In addition, the effects of the alternative minimum tax must be considered, and these will depend on other items on your tax return.

Investor Tax Cuts

Dividends. Recognizing that dividends are subject to double taxation - that is, they are taxed first at the corporate level and again at the shareholder level - the Act reduces the personal income tax rate on dividends received by shareholders. Under prior law, dividends were taxed at the shareholder’s marginal rate. In other words, dividends were taxed as regular income. The Act lowers the income tax rate on dividends to 15 percent for most taxpayers, and to five percent for taxpayers in the 10-percent and 15-percent income tax brackets for both regular tax and alternative minimum tax purposes. The Act’s reduced dividend rates apply retroactively to January 1, 2003, and remain in effect through December 31, 2008, at which point the relief provisions terminate, and prior law goes back into effect.

Some investment advisers expect this relief provision to spark a renewed interest in stocks that pay dividends, now that the investor will be able to keep a larger percentage of the amount received.

Capital Gains. The Act generally reduces the 20-percent rate on long-term capital gains recognized on or after May 6, 2003, for non-corporate taxpayers to 15 percent through 2008, after which it reverts to 20 percent. (Note that unlike some other tax cuts, this is not retroactive to the beginning of 2003.) The Act also reduces the rate on long-term capital gains paid by non-corporate taxpayers in the 10-percent or 15-percent bracket from 10 percent to five percent through 2007. For 2008, the rate for 10-percent or 15-percent bracket taxpayers falls to zero. In 2009, the rate reverts back to 10 percent for taxpayers in this bracket. The reductions apply to assets held for more than one year.

For clients who have conducted their closely held businesses through corporations, this may be an appropriate time to consider substantial dividends, redemptions or liquidations, especially if the corporation does not own significant appreciated property.

Alternative Minimum Tax

The alternative minimum tax (AMT) was originally designed to ensure that wealthy taxpayers who qualify for large tax deductions pay some tax. However, because the exemption was not indexed for inflation, the AMT applies to more and more middle-income taxpayers – adding greatly to the complexity of their tax returns, and often raising their tax bills.

The Act increases the exemption from AMT for this year and next year. The rates remain the same, 26 percent and 28 percent respectively, but the exemption is increased for 2003 and 2004 to $58,000 (a $9,000 increase) for married joint filers and to $40,250 (a $4,500 increase) for single filers. Lower exemptions apply to estates and trusts.

In 2005, the pre-Act AMT exemptions will return in the absence of future legislation. Critics of the AMT believe the Act provides only temporary pain relief to a tax provision that needs a full-scale reconsideration.

Business Tax Incentives

Increased Small Business Expensing. Before the Act, a business could deduct (or “expense”) up to $25,000 per year for property placed in service that year. The Act increases this amount to $100,000 for property placed in service in 2003, 2004 and 2005. Also, the amount of investment qualifying for this immediate deduction does not begin to phase out until a taxpayer’s investment in eligible property reaches $400,000 — a $200,000 increase over the pre-Act level.

Among other assets, computer software acquired for business purposes and placed in service in 2003, 2004 or 2005 now qualifies for this first-year deduction.

Additional Depreciation Deductions. The Act increases to 50 percent the “bonus” depreciation deduction allowable for a business asset in the first year it is placed in service, in addition to the regular depreciation deduction that would be allowable.

This essentially expands the 30-percent depreciation “bonus” given to businesses in the Job Creation and Worker Assistance Act of 2002 (JCWAA). Assets for which the new, 50-percent “bonus” is claimed are not also eligible for the JCWAA 30-percent, additional, first-year depreciation deduction. However, businesses may elect to take the 30‑percent depreciation in lieu of the 50‑percent bonus, or may elect to decline additional, first-year depreciation altogether.

This “bonus” applies only within a narrow window of time. To qualify, the asset must generally be acquired between May 6, 2003, and January 1, 2005, and the business must not have had a binding contract to acquire it prior to May 6, 2003. For certain classes of assets, the cut-off date for acquisition is January 1, 2006 (rather than 2005).

Caveat: You may wish to obtain advice as to whether the “bonus” depreciation is available for state income tax purposes. Some states that previously followed federal depreciation rules will not conform to the bonus provision, because of revenue concerns.

Family Tax Breaks

Child Tax Credit Increase. The Act increases the child tax credit from $600 per child to $1,000 for 2003 and 2004. The $400 per child increase in the credit for 2003 will be paid almost immediately. In some cases, the $400 difference will be paid out this summer to qualifying families in the form of a rebate check. After 2004, the child tax credit reverts back to the scheduled, gradual increase from the 2001 Act, which will be $700 for 2005, eventually reaching $1,000 in 2010, after which the increase expires. The child tax credit begins to phase out when adjusted gross income reaches $110,000 for married couples and $75,000 for single taxpayers.

Marriage Penalty Relief. When both spouses work, the second income is usually taxed at a higher marginal rate than would apply if the couple was not married. The Act provides some relief from this so-called “marriage penalty” in the form of a higher standard deduction for married couples filing jointly, and an expansion of the 15-percent tax bracket for married couples. In 2003 and 2004, married couples may elect a standard deduction twice that available to single taxpayers, and may earn twice the income as a single taxpayer while remaining in the 15-percent bracket. In 2005, this relief expires, and the prior law applies, unless a future Congress takes additional action.

No Changes to Estate and Gift Taxes

The 2003 Act does not affect the major changes in estate and gift taxes enacted in the 2001 Tax Act. The 2001 Act reduces estate tax rates gradually, and increases the exemption amount for both gift and estate taxes through 2009. In 2010, the estate tax, but not the gift tax, is repealed. In 2011, the estate and gift taxes revert to the pre-2001 tax rates and the $1-million exemption for each person, unless Congress enacts new legislation.

Caveat: As is true of most tax law changes, it would require a small book to explain every detail of the 2003 Act. Consequently, this article covers only the general rules and some of the most significant changes. Before making any decision as to how the new law will apply to you, obtain advice that takes into account your overall tax situation as well as the applicable state and local taxes.

For more information, contact Alban Salaman, Richard P. Sills or Alvin J. Geske, via e-mail at asalaman@hklaw.com, richard.sills@hklaw.com, and alvin.geske@hklaw.com, respectively, or call toll free 1‑888-688-8500.