Accountants and tax lawyers are still poring over numerous changes to the tax code made by the Taxpayer Relief Act of 1997. Besides the new family business exclusion and a gradual increase in the unified credit (see the preceding article), there are several changes of special interest to family firms. Here is a rundown of some of the changes affecting small and medium-sized firms, as well as key issues left unresolved.
The omissions
Accountants note that the legislation fails to address two issues that have dogged owners of closely held businesses for years. Congress, it seems, will have to tackle the matters directly if they are to be resolved.
The first issue concerns the definition of independent contractors. ÒThis often becomes the single greatest tax issue for small businesses,Ó says Michael Koppel, senior tax partner at Gray, Gray & Gray in Boston, which specializes in CPA services to closely held firms. While employees are eligible for benefits, and the employer must make payroll tax withholdings, an independent contractor working for the firm is not eligible for benefits, and the company does not have to pay withholding.
The IRSÕs nebulous definition of what constitutes an ÒemployeeÓ has been a bone of contention for some time. ÒIn the final analysis itÕs like beauty,Ó Koppel says, ÒItÕs in the eye of the beholder. The problem is that too often the beholder is the IRS.Ó Koppel says numerous companies have been put out of business when the IRS determined that a workerÕs classification was incorrect and the business owed payroll taxes, interest, and penalties.
Early in its negotiations over the Taxpayer Relief Act, Congress concluded that the worker classification problem could only be solved with legislation. But proposed changes didnÕt make the final tax bill.
The second omission concerns a better definition of limited partners involved in a limited liability company, or LLCÑa relatively new form of business structure that is rapidly becoming popular. An LLC combines the liability protection of a corporation with the tax flexibility of a partnership.
Koppel says the current tax law is unclear as to which partners are subject to self-employment tax. The IRS has issued several regulations to try to clear up the matter, including provisions in the spring of 1997 which politicians quickly dubbed the Òstealth taxÓ on some of the partners. The Taxpayer Relief Act forces the IRS to suspend its latest definitions and come up with a better regulation after July 1, 1998.
By imposing a holding pattern, Congress has sent a message to the IRS that it intends to determine the law that will govern self-employment taxes for partners in LLCs. Since Congress also intends to legislate a solution to the worker classification issue, family business owners and their advisers should keep an eye on Washington as the new year begins.
Meanwhile, itÕs wise to review your financial and estate plans in light of changes imposed by the new tax law. The following may be of special interest.
Gift tax exclusion. A father and mother can each gift up to $10,000 of assets annually to each of their children free of gift tax. The limit has remained constant for more than a decade. But beginning in 1999, it will be indexed to the annual cost-of-living increase determined by the Federal Government. While the increase is good news, there is a catch, notes Ross Nager, head of Arthur AndersenÕs Center for Family Business in Houston. The new rules round down any inflation adjustment to the nearest $1,000, so there will be no actual rise until cumulative, post-1997 inflation exceeds 10 percent. ÒDonÕt expect any increase until about 2001,Ó Nager says.
Generation-skipping tax. The $1 million generation-skipping tax exemption will also be indexed for inflation beginning in 1999. This adjustment is also rounded down, to the nearest $10,000, so once again, Nager says, itÕs unlikely any real increase will be seen for at least several years.
Excise tax. If estate taxes arenÕt burdensome enough, the IRS has levied an excise tax on excess balances in qualified retirement plans left in an estate. Essentially, this means that if you didnÕt take enough payout from your retirement plans before you died (and therefore paid tax on the income), the IRS would tax your estate to make up the ÒlostÓ income taxes it never received.
The 15 percent excise tax on excess distributions from qualified plansÑa penalty if you take too much of a payout each year from your retirement plans and IRAsÑhas also been repealed.
Deferred payout of estate taxes. Estate taxes are due within nine months of an ownerÕs death. Families who canÕt raise the cash can reach an agreement with the IRS to pay the taxes over a 15-year deferral plan. However, the amount due each year is calculated as the principal plus 4 percent interest on the first $1 million of value of the business. For the rest, the payments have been calculated at the normal IRS interest rate, which fluctuates each year, but over 15 years adds a substantial burden. Now, however, interest on the first $1 million is only 2 percent, and the rest is paid at 45 percent of the IRSÕs interest rate. This sounds better, but the advantage is mitigated because the interest payments are no longer tax-deductible, as they used to be.
Charitable remainder trusts. Because of perceived abusesÑnotably attempted avoidance of capital gains taxÑcharitable remainder trusts must now be structured differently. In the past, some grantors designed these trusts to give themselves an incredibly high payout, and the charity almost nothing. Now, the value of the charitable remainder interest (the portion going to charity) must have a present value of at least 10 percent of the initial fair-market value of the property transferred into the trust. In most cases, Nager says, this will require reducing the trustÕs payout percentage, or the term over which payments will be made to the grantor and spouse. While this enforces the intention of allowing these trustsÑto benefit charityÑNager says the rule Òunintentionally causes age discrimination. It prevents persons under age 25 from creating charitable remainder trusts with life terms. Even some folks older than Generation Xers will have trouble complying, except with very low payout rates.Ó
Private foundations. This item is short-term, to be sure, but could make a difference for 1998: The deductibility of the fair market value of contributions of qualified appreciated stock to private foundations, which was due to expire on May 31, 1997, is extended through June 30, 1998.
Capital gains. The changes above are the primary ones that may affect your wealth transfer strategies. However, owners should consider the implications of one other major change: a reduction in the capital gains rate. The new law reduces an individualÕs maximum tax rate on net capital gains from 28 percent to 20 percent. Net gains in the 15 percent tax bracket are reduced to 10 percent. The new rates apply to sales and exchanges made after May 6, 1997. CPAs at David Berdon & Co. in New York City note that there are several requirements for length of ownership of the assets in question, so check the fine print. - M.F.