Public Law 18-27, The Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA) was signed into law May 28, 2003. By the time this article goes to press, most taxpayers with qualifying children will have already received their Advance Child Tax Credit Payment. Home improvement stores have already begun advertising how you may “invest” your rebate check with them. Other substantial changes include accelerating the phase-in of individual income tax rate reductions retroactive to Jan.1, 2003; reduction of capital gain tax rates for certain transactions, and capital gain treatment for dividends received.

Although significant media attention has focused on how JGTRRA will benefit individuals, subtle changes made with respect to depreciation deductions significantly impacted and added to the complexity of business tax planning. With the exception of (regular) C-corporations and Personal Service Corporations, taxable income or loss and other items of tax significance are reported on the individual income tax returns of the owners/investors. Changes brought about by JGTRRA generally apply to all business entities, however, application may not be mandatory, and it could be advantageous to actually have your business “elect out” of certain accelerated and/or increased deductions.

Section 179 Depreciation

The most significant change affecting all businesses has to do with depreciation deductions and how much equipment you can “expense” in the year of acquisition. “Section 179” expense has increased from $24,000 to $100,000 for 2003. In addition, Luxury Auto Rules generally do not apply to sport utility vehicles (SUVs) with loaded gross vehicle weight greater than 6,000 pounds. Therefore, the increased Section 179 expense may be applied to certain vehicle purchases.

Special First-Year Depreciation

Since fixed assets have useful lives that extend over one year, the IRS requires the cost of these assets to be recognized over a period of years that reflects the estimated useful life of the assets. Most post “9-11” new (original use) asset acquisitions were allowed a special first-year depreciation allowance (expense) of 30 percent of the purchase price in the year of acquisition. JGTRRA has now increased the special first year allowance to 50 percent of the cost of the asset. The remainder is deducted over existing IRS prescribed useful lives.

Depreciable residential and commercial rental property is not eligible for Section 179 expense. The special depreciation allowance, however, does apply to new rental property that is depreciated under the Modified Accelerated Cost Recovery System (MACRS) with a recovery period of 20 years or less.

New vehicles purchased for use in a trade or business also qualify for an increased special depreciation allowance. The IRS limits the amount a business can deduct for the cost of a vehicle, if the price exceeds certain “luxury automobile” limits (approximately $15,300). JGTRRA now allows a special 50 percent depreciation allowance on this amount, or $7,650, in addition to the regular depreciation deduction for original-use vehicles.

Certain “qualified leasehold improvement property” is eligible for special depreciation allowances. Qualified leasehold improvement property is any improvement an interior portion of a building which is nonresidential real property, if the improvement is made under or pursuant to a lease; the portion of the building is to be occupied exclusively by the lessee, and the improvement is placed in service more that three years after the date the building was first place in service. Furthermore, the improvement cannot be attributable to any structural component benefiting a common area. Other restrictions may limit your ability to claim the special allowance, and decisions to invest in these leasehold improvements should be discussed with a qualified tax professional.

The Need to Plan Ahead

With professional year-end tax planning, business owners work with their Certified Public Accountant (CPA) to identify opportunities that minimize tax liabilities while in turn enhancing personal wealth.

A typical year-end planning session with a CPA includes updating the company’s financial information; an estimate of year-end profit or loss; an estimate of owner compensation and personal tax; an estimate of retirement plan funding; an estimate of owner vehicle expense reimbursements and most importantly, an estimate of after-tax cash flows. The process should begin well before December 31 (preferably early November). In addition to avoiding the year-end “crunch,” with an early start, your tax professional can help you identify savings and chart a course of action for your business that, among other things, might involve significant equipment acquisitions, the decision to defer equipment acquisitions, and/or the need to establish a retirement plan prior to December 31.

Dividends and Capital Gains

Business tax planning, however, cannot be done in a vacuum. JGTRRA changes affecting individual income taxes also may impact certain business decisions. For example, most closely-held C-corporations do not pay dividends, since the distribution of previously taxed income is not deductible, and is taxed to the recipient at his highest marginal tax rate. (The concept of “double-taxation.”) Dividends received by individuals are now taxed at capital gain rates, which have also been reduced to five percent and 15 percent. If the corporation has projected year-end net income and cash, this may be the year to actually declare and pay a dividend to the owners, as opposed to reducing year-end profits to zero by paying out the balance of net income to the corporate officers in the form of compensation subject to Social Security and Medicare taxes.

If you are thinking about retirement, this might be an excellent time to sell your business. Allocation of the purchase price attributable to “Goodwill” may be taxed at the reduced capital gain rates. Many businesses are also sold on installment contracts where gain is only recognized to the extent of principal payments. Installment treatment is not mandatory, and it might make more sense to recognize the entire gain in the year of sale while the capital gain rates are so low.

Allowable Losses

When business deductions exceed business income, a Net Operating Loss (NOL) may occur. An NOL may be caused by deductions from a trade or business or rental property and are carried back 2 years (5 years for 2001 and 2002 NOL’s) to offset taxable income. Individual taxpayers have the election to disregard the NOL carryback and only carry the loss forward to future years. Tax planning requires analysis of prior and anticipated individual income tax liabilities to ascertain whether such an election would be advantageous.

As discussed previously, generous depreciation deductions are now available when qualified property is acquired during the tax year. Although businesses now have the ability to write off $100,000 of certain depreciable assets during the year, if the full election is made, a deduction can only be made to the extent of net income, and “un-used” Section 179 deductions can only be carried forward. It may be best to not to elect Section 179 altogether and only utilize the 50 percent special depreciation allowance for the purposes of generating an NOL. You would then carry back the NOL to a year in which you paid taxes at a higher marginal rate.

Instead of the 50 percent allowance, taxpayers also have the option to elect to claim the 30 percent allowance, or elect not to claim any special allowance at all. (If the election is made, it applies to all property in the same property class placed in service during the year.) Since the phase in of reduced tax rates has been accelerated to 2003, it just might make sense to retain income this year, accrue the taxes at lower tax rates, and let depreciation deductions be taken in future years where you anticipate increased net income or marginal tax rates.

Deductions for losses associated with rental properties are limited due to the Passive Activity Loss rules. Although the ability to write off 50 percent of the price a new qualifying rental property may appear attractive, tax benefits may not materialize in the current year. Investment decisions in this type of property should include an income projection of all passive activities to ascertain whether any tax benefit will be realized.

Depreciation “Recapture”

If qualifying property is sold, disposed of or falls below 50 percent business use anytime during its recovery period, ordinary income must be recognized to the extent Section 179, or any special depreciation allowance recognized in prior years exceeds depreciation that would otherwise had been recognized under MACRS. Automobiles and computers are most susceptible to depreciation recapture.

Disclaimer

Information provided in this article is of a general nature only, and application of certain tax law provisions may or may not apply to your family-owned business situation. Understanding tax law and application of the new provisions (and elections) that relate to depreciation requires proactive planning with a qualified tax professional order to maximize tax savings for businesses and their owners. As you can see, a few subtle changes brought about by JGTRRA placed a burden on family business owners to take a serious look at how investment decisions can impact their bottom-line taxes. Tremendous opportunities are available to those who understand and can apply these provisions and/or elections to their advantage. Until then, avoid investing significant company resources for the sake of depreciation deductions until you are certain tax advantages will materialize.

(Editor’s Note: Chris Mutchler is a Certified Public Accountant and associate member of the Certified Fraud Examiners. He is a team member with the Firm of Southard, Beckham, Atwater and Berry, CPA, PS. in Port Orchard and can be reached at (360) 876-4491, or cmutchler@sbabcpa.com).