FEDERAL
Will They Stay or Go? Battle Lines Are Drawn in Fight To Make Tax Cuts Permanent

When President George W. Bush signed Public Law 108-27 into existence on May 28, 2003, The Job and Growth Tax Relief Reconciliation Act of 2003 became the third-largest tax cut in U.S. history. Its intent was to reduce taxes paid by individuals and businesses and thus stimulate the economy.

To fully achieve these goals, its proponents argue, the cuts must be made permanent. However, with strong opposition to such a move existing in some quarters, that outcome is by no means guaranteed. How this battle plays out could have significant implications for businesses and high-net-worth individuals.

The 10-year, $350 billion tax-cut bill includes several components of particular interest to that constituency. Among them are cuts in the tax rates for capital gains and shareholder dividends, across-the-board reductions in tax-rate brackets, relief from the Alternative Minimum Tax’s broadening reach (for more information on the Alternative Minimum Tax, click here), elimination of the so-called “death tax,” and changes in depreciation allowances on equipment and capital purchases. However, all of the cuts are scheduled to expire by the end of 2010—some of them much sooner than that.

In his fiscal year 2005 budget proposal ¹ sent to Congress on February 2, 2004, President Bush requested the permanent extension of tax cuts signed into law in 2001 and 2003. While President Bush and his supporters continue to lobby for making the tax cuts permanent, as well as extending certain expiring tax provisions (e.g., the research and experimentation credit is scheduled to expire June 30, 2004), political analysts do not expect Congress to take any action in that regard until after the November elections, at the earliest. The focus of the debate on both sides of the issue is the impact that the tax cuts will have on the economy as a whole. There is also much concern about the affect the changes—or lack thereof—will have on individuals and corporations that are subject to these new rules.

Opponents of making the tax cuts permanent argue that doing so would exacerbate an already worsening federal deficit. Supporters counter that the cuts would generate enough economic growth to replace the lost revenue, and an influential financial leader recently came down on their side. Arguing in favor of permanence, which would result in the equivalent of $1.7 trillion in tax cuts, Federal Reserve Chairman Alan Greenspan told both the Senate Banking Committee and the House Budget Committee in February that he was in favor of continuing the tax cuts. He also said that the U.S. economy was poised for vigorous growth (projecting a 5% expansion rate for the current year), that allowing tax rates to resume an upward climb could hobble that growth and that Congress should find ways to balance the budget by cutting expenditures (i.e., social security and Medicare benefits) instead.

One area that has become something of a flashpoint in this debate is capital gains and dividends, where the top tax rate has been reduced to 15%. Unless these cuts are extended or made permanent, the top rate on dividends will shoot-up to 35% in 2009, while the tax on capital gains will climb to 20%. Extending these cuts is decried by opponents as “tax relief for the rich,” but the White House argues it will mostly help retirees and families investing for their future.

Proponents also counter that such cuts often lead to dramatic increases in economic growth and corresponding improvements in financial markets. That scenario could provide a boost to merger-and-acquisition activity over the near term. “For sellers, an improved economy will allow for better business results, which typically implies higher valuations,” according to The Tax Cut of 2003: A Gift to Private Business Owners?, a report prepared by The Geneva Cos., a subsidiary of Citigroup.

“Furthermore, an upturn in the economy could boost CEO confidence among buyers, a key factor contributing to their level of M&A activity and the price they are willing to pay for companies,” the report continues. “Additionally, gains in the financial markets could bolster the stock prices of public companies. Since such buyers often prefer to use their stock as M&A currency, robust share prices could renew these buyers’ interest in mergers and acquisitions.”

Current expiration dates for other tax cuts include:

• December 31, 2004, for the increased child credit, 15% income tax bracket marriage penalty relief and expanded 10% individual income tax bracket.
• December 31, 2005, for the tax-rate cuts, AMT relief, 50% bonus depreciation for equipment and leasehold improvements and increased expensing for small businesses.
• December 31, 2010, for all remaining tax cuts in the 2001 and 2003 bills, including the estate tax repeal.

¹ President Bush’s proposal calls for a $1.2 trillion net tax cut over the next 10 years. The budget includes a number of corporate revenue raisers. One of the most significant is a proposal to limit abusive leasing transactions known as sale-in, lease-out transactions (SILO). The budget also seeks to repeal the Extraterritorial Income Exclusion (ETI) rules that the World Trade Organization deemed an inappropriate subsidy to U.S. taxpayers in favor of a number of different proposals. Currently, the European Union has adopted a sanctions plan to be phased in during March 2004 if the ETI provisions remain. However, on Feb. 13, 2004, the EU stated that it might consider a transition period like the one under consideration in the two bills (S. 1637 and H.R. 2896) already before Congress.

STATE & LOCAL
States Continue to Eye Cyberspace for Revenue Enhancement

Many consumers and businesses have come to think of catalogs and online merchants as a cost-effective alternative to making purchases from local vendors, who are required by law to collect sales tax and remit it to the state and, sometimes, the local municipality. State governments, not surprisingly, have a decidedly different perspective of such transactions, viewing them instead as lost revenue. While in most cases their tax-levying authority on consumers is clear-cut, states often find it difficult to collect those taxes from end-users, particularly individual end-users.

New York Changes its Income Tax Form
Nonetheless, many states are getting smarter and more aggressive in their attempts to collect such taxes from end-users. New York, for example, has made a small change in its form for filing 2003 individual income tax returns, but it is one that has stirred up a storm of protest. One newspaper editorial has described the new “Line 56” on the form as “a creeping indignity clawing at the pocketbooks and consciences of New Yorkers.”

Line 56 requires New Yorkers to record the amount of sales tax they owe from online, catalog and out-of-state purchases. Of course, state residents have always been technically liable to pay these taxes in the past, but Line 56 marks the first time New York has come after these revenues in such a straightforward manner. For those who have neglected to keep receipts of their Internet purchases, the state has provided a table “suggesting” an appropriate amount for taxpayers to include based on their adjusted gross income. Other states, such as Connecticut and New Jersey, had already included use tax lines on their individual income tax returns.

According to Carolyn Makuen, who leads state and local taxes at Geller & Company ¹, “based on comments made by a technician at the New York State Department of Taxation and Finance, New York will consider, for purposes of sales/use tax, a return as non-filed if Line 56 is ignored.”

New York is also among the states looking to tap the Internet for additional revenue streams in other ways, including the levying of use taxes on Internet access—something that had been precluded by the recently expired Internet Tax Freedom Act (ITFA).

Congress Weighs In
Ultimately, both the states’ authority to assess a tax on Internet access and issues related to the collection of sales and use taxes on online purchases are likely to be decided at the federal legislative level.

Since the ITFA expired last November, Sen. Ron Wyden (D-OR) and Sen. George Allen (R-VA) have led the fight to have its ban on Internet access taxes made permanent as co-sponsors of the Internet Tax Nondiscrimination Act (S. 150). The U.S. House of Representatives passed its own version of the bill (H.R. 49 Internet Tax Nondiscrimination Act) last September, but the Senate bill was not voted on before Congress adjourned for the year. On February 11, 2004, Sen. Thomas Carper (D-DE) and Sen. Lamar Alexander (R-TN) introduced a bill (S. 2084) that would renew the moratorium for at least two years.

Separate legislation introduced in both the House and the Senate last year would authorize states that adopt streamlined sales tax simplification provisions to mandate collection of sales taxes on purchases by state residents from online and catalog merchants. The Simplified Sales and Use Tax Act (H.R. 3184) would allow states to enforce sales taxes on online transactions only if they remove many of the exemptions, inconsistent definitions and tangled rates that currently make compliance extremely difficult. This bill would particularly help small companies that do business in many states via the Internet. The legislation would not apply to companies doing less than $5 million a year in remote sales, and it would require states to compensate merchants for costs related to collecting those taxes.

¹ Geller & Company is a leader in finance, accounting and tax outsourcing services, as well as a provider of tax consulting services to corporations, individuals and private equity firms.

INDIVIDUAL
AMT’s Broadening Reach: A New Twist on “Bracket Creep”

A few years back, large numbers of taxpayers of relatively modest means found themselves victimized by “bracket creep,” a situation where inflation pushes income into higher tax brackets, but with no real increase in the taxpayer’s purchasing power. Inflation may be tame, at least for the moment, but a growing number of middle-class wage earners are now threatened by a new tax demon: the broadening reach of the alternative minimum tax (AMT).

The Emergence of AMT
Even Nina Olsen, the nation’s taxpayer advocate, has been blindsided by AMT, which BusinessWeek Online recently described as “the nastiest tax lurking in the code.” It didn’t start out that way. AMT’s predecessor was created in 1969 in response to 155 U.S. citizens with incomes in excess of $200,000, who got away with paying no federal income tax in 1966, setting off a political firestorm. Members of Congress received more letters about that issue in 1969 than about the Vietnam War, which was then at its height. The original law was replaced with AMT (IRC Sections 55-59) in 1978.

The trigger point for AMT is not indexed for inflation, so its reach has expanded over the years, even in a low-inflation environment. It now affects the returns of more and more middle-class taxpayers, with some 3 million expected to be subject to AMT levies this year. The tax is widely despised as being hidden, difficult to plan for and Draconian in the consequences that can result from failing to abide by its complicated instructions and regulations.

Unless Congress acts to change the law, worse could be yet to come. A group of noted tax policy researchers have predicted that AMT will evolve from a “class tax” to a “mass tax” by 2010 unless something is done ¹. At that point, they project, the one million taxpayers subject to AMT will have skyrocketed to 36 million (one-third of all taxpayers), and virtually all upper middle-class families with two or more children will be paying AMT.

Understanding AMT
AMT, in the opinion of many experts, is exceedingly complex and has a mixed record—at best—in terms of fairness and efficiency. Taxpayers who may be subject to AMT must, in effect, do their tax returns twice. First, they calculate their tax liability using standard tax rules; then they do it again using IRS Form 6251, which incorporates AMT rules. If their tax liability is greater under AMT, that is the method they must use to file their federal income tax return. Fewer deductions, income exclusions and credits are allowed under AMT rules than under standard tax rules.

AMT has two rates: 26% if AMT income minus the exemption amount ($58,000 for married couples filing jointly, $40,250 for single filers) does not exceed $175,000, and 28% for each dollar above that amount. However, the exemption amount begins to phase out when income exceeds $150,000 and disappears completely at $382,000. The AMT exemption drops in January 2005 from $58,000 to $45,000 for joint filers and from $40,250 to $33,750 for single filers, if this provision is not extended. In contrast, the regular income tax has five rates. As a 2001 report by the Joint Economic Committee of Congress pointed out, “AMT allows fewer ways to reduce tax liability than the regular income tax.” ²

According to the Urban-Brookings Tax Policy Center Microsimulation Model, just under 11% of taxpayers with adjusted gross income between $100,000 and $200,000 were subject to AMT rules in 2002. Under current law, 94% would be hit with the more restrictive formula in 2010. With the recent cuts in the regular tax rates, and the disallowance of personal exemptions for dependents, as well as deductions such as state and local income and property taxes, the AMT has crept up on unsuspecting tax payers. For taxpayers and their tax preparers it boils down to more work and bigger tax bills on the horizon, unless the law is changed.

While some political pundits are projecting capital gains and dividends to be the hot-button tax issue in the coming elections, AMT may well assume that role post-April 15th. The 3 million or so taxpayers likely to get blindsided this year may just represent the advance guard in a full-fledged revolt against AMT as its reach continues to spread.

¹Policy Watch: The Expanding Reach of the Individual Alternative Minimum Tax,” by Leonard E. Burman, William G. Gale and Jeffrey Rohaly, Journal of Economic Perspectives, Vol. 17, No. 2, Spring 2003.

² “The Alternative Minimum Tax for Individuals: A Growing Burden,” a white paper by Jim Saxton (R-NJ), Chairman of the Joint Economic Committee of the United States Congress, May 2001.

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