PROFESSIONAL ADVISOR SEMINAR
Planning Opportunities Under the 2003 Tax Act
November 12, 2003

Learn how to help clients take advantage of recent tax law changes. This seminar highlights a broad range of planning opportunities under the Job and Growth Tax Relief Reconciliation Act of 2003. Hosted by the East Bay Community Foundation and Morgan Stanley.

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What Advisors Need to Know
About the New Tax Act
By Joe DeGirolamo, CPA, JD
Wealth and Tax Advisory Services, Inc.

Last spring, President Bush signed into to law the "Jobs and Growth Tax Relief Reconciliation Act of 2003" (the Act), a $350 billion package of tax cuts and state assistance. Representing the third largest tax reduction in the history of the United States, the Act is intended to stimulate the economy and should be welcome news for many taxpayers. This update on some of the more significant aspects of the legislation will highlight potential planning opportunities. Developed effectively, appropriate strategies can generate substantial tax savings for the taxpayer.

CAPITAL GAINS AND DIVIDENDS

For investors in securities, the most significant income tax provision of the Act involves rate reductions for individual taxpayers affecting both dividend and long-term capital gain income.

For most, the new law will tax qualified dividend income and net long-term capital gains at a maximum rate of 15 percent. This is a significant reduction from current law, where dividend income was taxed in 2002 at up to 38.6 percent (a reduction of over 60 percent!) and where long-term capital gains were taxed at up to 20 percent (a reduction of 25 percent). The new 15 percent rate applies to sales of most capital assets (stocks, bonds, and other securities) that are held for more than one year before disposition. Short-term transactions involving sales of capital assets held for less than one year continue to be taxed at an individual’s marginal rate (a maximum of 35 percent under the Act). These rate reductions apply to qualified dividends received – retroactive to January 1, 2003 – and capital gains realized on or after May 6, 2003. The 15 percent top rate also applies for alternative minimum tax (AMT) purposes.

Dividends received by individuals, trusts and estates from: (1) U.S. domestic corporations incorporated in any U.S. state or possession; (2) “qualified foreign corporations;” or (3) other foreign corporations whose stock is readily tradable on an established U.S. securities market qualify for the new preferential rates. The Act also contains a holding-period provision, which denies the preferred rate for any dividend unless the taxpayer held the security for more than 60 days during the 120-day period beginning 60 days before the ex-dividend date.

Dividends on American Depository Receipts (ADRs) qualify as shares tradable on an established U.S. securities market. Further guidance is expected from the Treasury on which foreign corporations will be considered “qualified,” based on whether the U.S. has entered a comprehensive income tax treaty with the country of incorporation. Foreign personal holding companies, foreign investment companies, and passive foreign investment companies (PFICs) are all expressly excluded from the Act’s “qualified foreign corporation” definition.

As is true for long-term capital gains under current law, dividends that qualify for the preferred rate are treated as investment income for purposes of determining the amount of deductible investment interest only if the taxpayer elects to treat the dividend as not eligible for the reduced rates.

Dividend income and long-term capital gains flowing through a mutual fund will retain their character and quality for the preferential rates.

Overall, this portion of the act is good news, although somewhat short lived, for individuals with regular investment income. As with other recent tax legislation subject to “sunset” provisions, the preferential rate structure is scheduled to expire on January 1, 2009.

From a pure after-tax yield perspective, the 15 percent rate on dividends and long-term capital gains may make dividend-paying equities more attractive. Municipal tax-exempt bonds may look less attractive, unless their coupon rates begin to reflect the now more competitive after-tax environment that equities may offer. Taxpayers in high-tax jurisdictions, such as New York City, may find in-state tax-exempt bonds to be more attractive. Taxable bonds will likewise require the same analysis.

Variable annuities, which offer tax-deferred accumulation but ordinary income tax treatment for withdrawals, may look less attractive, particularly where the underlying investments are securities whose income and gains would otherwise qualify for the more favorable 15 percent.

Investors will need to pay particular attention to their asset allocations inside and outside of tax-exempt or tax-deferred retirement plans. Other things being equal, fully taxable corporate bonds and fixed-income securities would appear to make more sense inside tax-favored retirement plans, whereas it is more tax efficient to hold dividend-paying equities and those that produce capital gains outside of those retirement plans.

Investors with margin interest expense may experience a decrease in the amount of deductible interest, unless they elect to have their dividend income taxed at the higher 35 percent rate. Except in unusual situations, this generally is not advisable.

Companies may also need to rethink their compensation packages. Qualified incentive stock options afford the employee the potential for long-term capital gain treatment (15 percent) while nonqualified stock options, restricted stock, and phantom stock generally result in ordinary income treatment (35 percent).

Stock-option exercise strategies may need to be reevaluated, particularly for qualified stock incentive stock options. Starting the holding period to obtain long-term capital gain treatment should be weighed against the cost to exercise and the related lost opportunity cost.

One interesting aspect of the reduced rate on dividend income and long-term capital gains is that it can also reduce the benefit of itemized deductions. For example, an individual with only (or primarily) dividends and capital gains would obtain only a 15 percent tax benefit from itemized deductions such as mortgage interest and charitable contributions. This could effect decisions about continuing home mortgages and the timing of large charitable gifts.

INDIVIDUAL PROVISIONS

Individual Rate Reduction

The new law accelerates previously enacted individual rate reductions, making the new tax brackets effective as of January 1, 2003. The reduction in the top bracket represents a decrease of approximately 10 percent. The top four rates for 2003 will be 35, 33, 28 and 25 percent. Those are down from 38.6, 35, 30 and 27 percent in 2002. The new law also includes an expansion of the 10 percent rate bracket to include more income.

These reduced rates will expire for tax years beginning after December 31, 2010.

Paying attention to your holding period when selling securities can reap additional gains. While both the short-term and long-term capital gain rates have been reduced, the long term rate reduction represents a 25 percent reduction versus a 10 percent reduction in the short-term rate.

Increase the AMT Exemption

The AMT is an obstacle that has recently been affecting a growing number of taxpayers. When it applies, the added tax cost can be substantial. Although the maximum AMT rate remains unchanged at 28 percent, the reduction of the maximum regular tax to 35 percent will likely cause more taxpayers to incur the AMT.

AMT is basically an “alternative” set of rules for calculating taxable income and the associated tax. The Act increases the AMT exemption amount for married taxpayers filing a joint return to $58,000, and for unmarried taxpayers to $40,250, for taxable years beginning in 2003, 2004, and 2005. This provides an additional $9,000 of relief for married filing joint taxpayers (and $4,500 for single taxpayers). The exemption amounts are phased out when an individual’s AMT income exceeds (1) $150,000 in the case of married individuals filing a joint return, (2) $112,500 in the case of other unmarried individuals, and (3) $75,000 in the case of married individuals filing separate returns.

The increased exemption amount will help some, but not many. Taxpayers with significant long-term capital gains, dividend income and state tax deductions will continue to be plagued by AMT. Careful planning with regard to the timing of income and deduction recognition is critical to minimizing the multi-year tax liabilities. The penalty for improper planning is a permanent tax increase, in many cases.

The timing of stock option exercise can also significantly affect the imposition of the AMT as well as utilization of credits created by the imposition of the AMT.

INTERNATIONAL IMPLICATIONS

Both foreign and domestic investors are feeling the effects of the Act. One problem faced by non-residents is that they are still subject to a 30% withholding on all U.S. dividend income received. The same dividends would generally be taxable to a U.S. resident at 15%.

The 30% withholding can be reduced if the non-resident is a resident of a treaty country. An election is made to “treaty it out” and the withholdings are reduced. However, for the unlucky few that are not residents of treaty countries, their tax rate is effectively double that of a U.S. resident on the same income.

A similar problem confronts Americans investing overseas. If an U.S. citizen invests in a foreign entity or invests in an ADR, any income received from those investments may have foreign tax withheld in excess of 15%. When the U.S. investor files his or her U.S. tax return, a foreign tax credit is given for the amount withheld. However, the credit is limited to the amount of tax paid in the U.S. on those investments. If any of that income is from dividends or long-term capital gains then the U.S. tax is 15% so the tax credit would be limited to 15% Therefore, the extra 15% that was withheld is irretrievable.

FALLOUT

While the Act represents a major tax reduction with anticipated economic stimulus, savings and investment opportunities, not all of the President’s proposals made the final cut. Originally, his plan called for complete elimination of the double tax on dividends, as well as two different savings vehicles, the Retirement Savings Account and the Lifetime Savings Account that would have permitted families to make significant contributions to tax-favored plans. Additionally, his plan called for the complete and permanent repeal of estate taxes.

Tax Package Review

The Community Foundation Value Proposition

California Trusts & Estates Quarterly featured an article about community foundations co-written by Chris Nicholson from the East Bay Community Foundation and Terence Mulligan from the Peninsula Community Foundation. The authors review recent changes in the charitable giving marketplace, provide a background on the community foundation field in California and illustrate the services that these organizations offer to estate planners and their clients.

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