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GT Alert

President Bush Signs H.R. 2, Containing Major Tax Cut for Businesses and Individuals

May 2003
By Richard J. Melnick, Jennifer H. Weiss and Stephen A. Mihaly, Greenberg Traurig

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On May 28, 2003, President Bush signed the third-largest tax cut in U.S. history, The Jobs and Growth Tax Relief Reconciliation Act of 2003. The centerpieces of the Act are the general reductions in marginal tax rates, further reductions in the tax rates on capital gains and dividend income, and a significant increase in the amount of equipment that businesses can expense immediately. Although most of the Actís provisions directly affect individuals and not corporations, we expect the Act to have a powerful effect on numerous industries, as well as on various forms of investing and doing business. While most companies and individuals should benefit from the Act, there will be losers as well.

Richard Melnick
"We expect the Act to have a powerful effect on numerous industries, as well as on various forms of investing and doing business."

Set forth below is a brief summary of the main provisions of the Act that can be expected to affect our clients, as well as some thoughts about the Actís impact on the type and form of post-Act investments.

1. Acceleration of Individual Tax Rate Reductions and Increase of Alternative Minimum Tax Exemptions Amount

Effective retroactive to January 1, 2003, most of the marginal tax rates are reduced. In particular, the highest marginal rate falls to 35% from 38.6%; and other rates drop to 32% (from 35%), 28% (from 30%) and 25% (from 27%). While the lowest marginal rates of 10% and 15% are not reduced, the Act does expand the 10% tax bracket. These rate reductions expire on January 1, 2011.

The alternative minimum exemption amounts are increased to $58,000 and $40,250 for joint and single filers, respectively, but only for 2003 and 2004.

2. Reduction of Taxes on Capital Gains and Dividends Derived by Individuals

a. Individual Capital Gain Tax Rate Reduction

The Act reduces the maximum tax rate for long-term capital gains to 15% (from 20%), effective for capital gains recognized or installment payments received on or after May 6, 2003. In 2009, the maximum tax rate on capital gains reverts to the pre-Act (20%) level. The lower rate applies for both the "regular" tax and the alternative minimum tax. The rate reduction does not apply to depreciation recapture on personal property (subject to a maximum tax of 35%) or real property (subject to a maximum tax of 25%), or to sales of collectibles (subject to a maximum tax of 28%).

b. Individual Dividend Tax Reduction

The Act reduces the maximum tax rate on "qualified dividend income" received by individuals (and not corporations) to 15%, which is 20 percentage points lower than the 35% maximum rate that would otherwise apply. This new 15% rate applies retroactively to the beginning of 2003 for both the regular and alternative minimum tax, but expires after 2008, at which time all dividends will be taxed at ordinary income tax rates. For this purpose, "qualified dividend income" is dividend income which is paid from either (i) a domestic corporation (except for dividends received from a tax-exempt organization, or deductible dividends paid by a mutual savings bank or to an ESOP), or (ii) a foreign corporation that meets one of the following three tests: (1) it is incorporated in a U.S. possession, (2) it is eligible for U.S. income tax treaty benefits which the Treasury approves, or (3) the securities on which the dividend is paid are publicly traded on a U.S. securities market. However, dividends paid from a "foreign personal holding company," a "foreign investment company" or a "passive foreign investment company" will not be eligible for the rate reduction. It is not clear whether deemed distributions from "controlled foreign corporations" will qualify for the dividend rate reduction.

The rate reduction will not apply in two potentially abusive situations: (i) where the stock is held for less than 60 days during a 120-day period commencing 60 days before the stock becomes ex-dividend; and (ii) where the dividend recipient is under an obligation to make payments related to the dividend with respect to positions in substantially similar or related property.

"Qualified dividend income" will not include any amount that a taxpayer takes into account as investment income under section 163(d)(4)(B). Section 163(d) limits investment interest deductions to the amount of an individual taxpayerís "net investment income," thereby preventing individuals from using interest deductions from investments to offset wage income. It will also not include dividends paid by mutual funds in excess of the amount of dividends received by the fund, unless at least 95% of the fundís gross income (as specially computed) is comprised of "qualified dividend income."

As a corollary to these changes, the Act repeals the "collapsible corporation" rules, and reduces the accumulated earnings tax and personal holding company tax rates to 15% (from 35%).

c. Special REIT Considerations

Capital Gains and Dividends. As described above, the Act generally reduces the maximum individual tax rate on capital gains and "qualified dividend income" to 15%. Capital gains on sales of REIT stock and "capital gain" dividends will be eligible for the reduced 15% rate (except to the extent of the portion of a capital gain dividend attributable to depreciation recapture on sales of real property which will continue to be taxed at a rate of 25%). REIT dividends will be treated as "qualified dividend income" and eligible for the 15% maximum rate only to the extent attributable to REIT income on which a corporate level tax has been imposed, e.g., dividend income received by the REIT from a non-REIT U.S. "C"-corporation including taxable REIT subsidiaries, REIT income subject to a "built-in gains" tax in the prior taxable year (net of the taxes paid), and REIT taxable income retained in the prior taxable year (net of the taxes paid).

REIT dividends received by a "C" corporation will not be eligible for the dividends received deduction.

Tenant Improvements. The Act also permits taxpayers to expense 50% of the cost of specified "qualified property" in 2003 and 2004, including so-called "second-generation" tenant improvements to nonresidential real property. "Second generation" tenant improvements are leasehold improvements made by a lessor, lessee, or sublessee pursuant to a lease of real property, provided that the improvements are placed in service at least three years after the date on which the building was first placed in service. The Act extends the provisions of the prior law, generally permitting "bonus depreciation" with respect to qualified property acquired after May 5, 2003 and before January 1, 2005 (previously September 11, 2004), but only if a binding written contract for the acquisition was not in effect as of May 6, 2003. In addition, the Act increases the first year depreciation to 50% of the eligible costs incurred (previously 30%).

Closely-Held REITs. The Act does not include a proposed provision which would have generally precluded any "person" other than another REIT or a pension trust from owning 50% or more of a REITs shares.

3. Increase in Expensing/Bonus Depreciation

The Act increases the amount that businesses may expense for machinery and equipment to $100,000 (from $25,000). The new rule applies retroactively to equipment acquired in the 2003 tax year through the 2005 tax year, and includes (for the first time) purchases of "off the shelf" software. The deduction is phased-out for taxpayers placing up to $400,000 of machinery and equipment into service. As noted above, the Act also increases the "bonus" depreciation provisions allowing small and larger business taxpayers to expense 50% (up from 30%) of the cost of new machinery in the year of purchase for property placed in service after May 6, 2003 but before December 31, 2004.

4. Planning Considerations

As noted above, the Actís provisions can be expected to have a significant impact on both the type and form of investment. At this point, the Actís ramifications on tax strategies are only beginning to emerge. Here are a few initial observations.

  • Despite the reduction in taxes on dividend income, most non-publicly traded businesses will continue to be organized as partnerships, LLCs and S corporations because these entities permit capital gains to be taxed one time, at a maximum rate of 15%; "C" corporations still have to pay corporate tax (up to 35%) on both net capital gains and ordinary income before making dividend distributions of the net proceeds of their capital gain transactions and any ordinary income to shareholders (both of which will generally be taxable at a maximum rate of 15%).
  • Investments in publicly traded stock will probably gain favor at the expense of bonds (both taxable and tax-exempt), CDs, REIT stock and pension-type investments such as IRAs, 401(k) plans and qualified pension plans. Expect more corporations to issue preferred stock with a regular dividend.
  • Tax-deferral techniques, such as like-kind exchanges and tax-free corporate reorganizations, will have to be analyzed carefully to see how they compare to a taxable transaction.
  • Investments in foreign corporations may prove to be very attractive, particularly those foreign corporations that are able to reduce their corporate-level taxes. Look for public stock offerings from corporations incorporated in low- or no-tax jurisdictions (and that do not qualify as a "foreign personal holding company" or a "foreign investment company"). Also, for those treaty country companies that would qualify for the reduced dividend tax rate but for their status as a "foreign personal holding company" or a "foreign investment company," expect to see such companies engage in business outside the U.S. to avoid such status and therefore be eligible for the dividend rate reduction.
  • "C" corporations that have converted to S corporation status are generally unable to make significant investments in passive assets such as stocks and bonds unless they distribute all of their accumulated earnings to the shareholders. At a current toll charge of 15% (plus applicable state taxes), many S corporations may choose to make actual or consent distributions in an amount sufficient to eliminate accumulated earnings. Also, "C" corporations with substantial investment assets should consider distributing accumulated earnings to shareholders and electing S corporation status, in order to lock in a single level of tax on future investment income (other than capital gains) at a tax "cost" of 15% (plus applicable state taxes).
  • The Act will affect tax planning for estates with assets (such as real estate and corporate stock) that are likely to appreciate. For large estates in particular, expect to see more gifting or intra-family sales to take advantage of the low capital gains tax rate.
  • The Act is also notable for those proposals that did not pass. These include, among others, stricter rules on tax shelters; elimination of so-called "inversion" transactions; repeal of the special exemption for wages earned by US citizens working abroad; and reform of the foreign export tax incentives. It is expected that these provisions will reappear in an omnibus foreign tax bill to be introduced in the near future.

Greenberg Traurig has over 75 tax professionals (including a number of tax attorneys in our European offices), and we will be spending a large amount of time in the days to come analyzing the consequences of the Act and developing investment, estate planning and other strategies that are designed to maximize the benefits of the Act for our clients. We also have a number of governmental affairs professionals who monitor and influence tax legislation. We urge you to call us to review your personal situation or that of a company of which you are a significant equity-holder or executive, to see how you or your company can benefit from the Actís provisions.

 

© 2003 Greenberg Traurig


Additional Information:

For more information, please review our Tax Practice description, or feel free to contact one of our attorneys.


This GT ALERT is issued for general purposes only and is not intended to be construed or used as legal advice. Greenberg Traurig attorneys provide practical, result-oriented strategies and solutions tailored to meet our clientsí individual legal needs. The Firmís responsive approach to client service often cuts across legal subject matter, applying the right experience and resources to provide cost-effective solutions.