The disappearing surplus makes it unlikely Congress will pass any significant tax cuts, especially for businesses, before 2002. Surprisingly, however, the tax bill passed early in 2001 that was hyped as being primarily a break for individual taxpayers, offers relief for many horse professionals.
Thanks to immediate tax reductions, new retirement planning provisions, employee benefit relief and changes in the estate tax, the Economic Growth and Tax Relief Reconciliation Act of 2001 offers many farm owners the opportunity to reduce their tax bills. It also allows them to divert the resulting tax savings to other activities that can help them better prepare for the future, retain good employees and continue to build their businesses.
The subject matter is difficult to understand, so to figure out the intricacies of the new rules, we suggest you go over them with a professional tax accountant. We hope this article will serve as a starting point and provide you a basis from which to ask questions.
One of the immediate benefits of the new tax bill is the lower income tax. The new tax law lowers ordinary income tax rates for the first time in nearly 15 years, with an initial rate reduction this year and further decreases in 2004 and 2006.
The lower tax rates translate into lower withholding, meaning employees will keep more of their paycheck. In essence, every employee gets a pay raise at no additional cost to the horsefarm or operation.
Many owners of small horsefarms are aware that estate planning can have significant ramifications. If not addressed early and thoroughly enough, procedures for handing down farm and ranch assets could jeopardize the transfer of the business to future generations.
“The upshot is. . . you’ll save money on estate taxes, but wind up paying more in capital gains taxes...”
Under the new legislation, if a farm owner dies, the amount of his or her estate that can be excluded from taxes is being increased as the top estate tax rate is being lowered over the next 10 years with eventual full repeal in 2010. While that’s good news, in 2010 a provision that saved heirs a significant amount in capital gains when selling inherited property will be eliminated. The upshot is that if you inherit property after 2009, you’ll save money on estate taxes, but wind up paying more in capital gains taxes if you sell that property.
Beginning next year, the amount of an inherited estate that may be ignored for estate tax purposes jumps to $1 million from the current $675,000. That increases again to $1.5 million in 2004, $2 million in 2006 and $3.5 million in 2009.
Starting in 2004, the new bill also repeals the controversial family-owned business deduction that was established in 1997. This deduction was criticized as being overly complicated and not very helpful to the estates of owners of small family businesses. The elimination of this deduction should be more than made up for by the increased estate tax exclusion amounts.
Also important to small business owners are provisions of the new legislation that make it possible to pay taxes in installments on estates that include holding companies.
Establishing a holding company for a family-owned business has traditionally been a way to avoid the gift tax by transferring business assets to heirs over several years. The problem was that if a big chunk of the holding company was not transferred before the founder’s death, a large lump-sum tax came due on that remaining portion. Under the new law, if a significant portion of the holding company’s assets are still part of the estate when the owner dies, his or her heirs will be able to make installment payments on any taxes owed.
No More Step-Ups
Since the government is completely eliminating the estate tax by 2010, it is making arrangements to recoup some of that loss in taxes by eliminating the “stepped-up basis” rule in 2010. The step-up currently and automatically hikes the value of an inherited asset to fair market value from its book value. While those assets rest in an estate, they are typically valued on the books at their original cost. The automatic step-up in value can save an heir a significant amount in taxes when inherited assets are later sold.
For example, if a farm owner purchases land for $1,000 per acre and the owner dies before the end of 2009—say, when the fair market value of the land has doubled—the estate would value that land at $2,000 per acre. That means if the land is then sold, any capital gain realized from the sale would be based on that value. After 2009, however, inherited assets will not be stepped up in value. The result is that the heir will receive the land valued at its “basis” or book value; the value it had when in the hands of the deceased horse professional, or at $1,000 per acre. When the land is then sold by the heir, he or she would be taxed on the difference, meaning a capital gains calculation would begin at the $1,000 per acre value, and result in a higher tax bill. (For the record, land is not depreciated or amortized and is usually carried on the operation’s books at its original price.)
Because of this, it’s important for the horse professional—even if they estimate their estate will amount to less than the exemption amount in all years—to talk to an accountant about estate planning and what the eventual repeal of the estate tax will mean to their families. It’s an important point to consider, because with the repeal of the estate tax, the entire tax burden—including amounts previously sheltered or protected by the various exemptions—will soon be borne by their heirs.
Although there are conflicting reports from our lawmakers about the short-term impact of the disappearing budget surplus, no horse professional can ignore estate planning. Any business owner who waits too long to decide how beneficial these changes are may miss them altogether.
And if you thought any of that was confusing, the law will automatically revert back to its current—pre-2002 version—in the year 2011 without intervention by Congress. In fact, the last time Congress passed a major tax break package, it took only four years before they started eliminating those breaks.
Take advantage of these changes as soon as possible (short of dying at the most favorable time for estate tax rates), because they may not be available down the road.
Start a Retirement Plan
Aside from the estate tax implications, among the most important changes in the new tax law are those that encourage small businesses to start and support retirement programs for their employees. Don’t forget that in many cases the horse professional is considered to be an employee of his or her own business. Among those new provisions are:
• Small Business Tax Credit For New Retirement Plan Expenses. In order to help offset the costs of starting a retirement plan for employees, beginning in 2002, small businesses with no more than 100 employees will receive a tax credit (a direct reduction in the tax bill as opposed to a tax deduction that reduces the amount of money that the tax bill is computed on), for establishing a new retirement plan.
Unfortunately, the credit amount is limited to $500 (half of the first $1,000 of qualified startup costs) incurred in the first year of the new plan and each of the two following years. Small businesses that started a plan before 2002 are not eligible for this credit.
• Elimination of IRS User Fees. In an effort to further help reduce the costs of setting up a small employer plan, the legislation eliminated the fees for IRS review of small business retirement plans. Typically, if an employer starts a retirement plan that is later found not to meet IRS standards, the employer can be liable for back taxes and penalties. As a result, most employers want the IRS to evaluate their retirement plans to ensure that they qualify.
• Retirement Plan Loans. Under current law, loans between a qualified retirement plan and a disqualified person are generally prohibited transactions—and the owners of small horsefarms or businesses are considered disqualified persons. Starting in 2002, however, the types of owner/employees who can take advantage of loans from retirement plans will be expanded. Subchapter S shareholders, partners in partnerships and sole proprietors of unincorporated horse operations and businesses will be exempt from the prohibited transaction rules, allowing these owner-employees to participate in loan programs from the retirement plan.
• Increased Deductibility of Employer Contributions to Certain Plans. Under the new tax law, employer contributions to profit-sharing, stock bonus and money-purchase pension plans are deductible up to 25 percent of an employee’s contribution (up from 15 percent under current law) beginning in 2002.
Incentive and Fringe Benefits
In addition to provisions dealing with retirement plans, the new legislation also calls for additional tax savings for employers that offer certain employee benefits.
• Employer-Provided Educational Assistance. The bill makes the exclusion for employer-provided educational assistance a permanent part of the tax law and expands this benefit to include graduate as well as undergraduate coursework. Employees can receive up to $5,250 a year from their employers to meet tuition and certain other educational expenses without having to declare the amounts as income or have any taxes withheld on the amounts.
Employers, in the meantime, can deduct those amounts on their returns and they are not liable for employment taxes on the payments. And remember, in many cases these benefits extend to the owner of the business as well. —MB