2001 Tax Legislation Update
CHANGES IN TAX LAW OFFER SMALL BUSINESSES
RELIEF, OPPORTUNITY, SAYS CCH
More Chances to Save, Invest and Pass on Your Business Intact
(RIVERWOODS, ILL., June 1, 2001) – With its immediate income tax reductions, new retirement planning provisions, employee benefit tax relief and changes in the estate tax law, the Economic Growth and Tax Relief Reconciliation Act of 2001 provides small businesses with the opportunity to reduce their tax obligations and divert the savings to other activities that can help them prepare for the future, retain their employees and build their businesses, according to CCH Business Owner’s Toolkit (www.toolkit.cch.com), one of the nation’s most popular small business portals and publisher of CCH Business Owner’s Toolkit™ Tax Guide 2001.
One of the immediate benefits for both small business owners and their employees is the lower income tax rates. The legislation 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 should see more of their paycheck going into their pockets, essentially providing a raise that added no additional costs for the business to provide,” said Paul Gada, a tax attorney and small business analyst for CCH Business Owner’s Toolkit.
Incentives to Start and Maintain Retirement Plans
Longer term, however, among the most important changes in the new legislation are those related to encouraging small businesses to start and support retirement programs for their employees. Among these provisions are:
Small Business Tax Credit for New Retirement Plan Expenses. To help off-set 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 for establishing a new retirement plan. The credit amount is limited to $500 (50% of the first $1,000 of qualified start-up costs) incurred in the first year of the new plan and in each of the two following years.
Employer plans eligible for the tax credit include new qualified defined benefit plans, defined contribution plans (including 401(k) s), saving incentive plans for employees (SIMPLE), or simplified employee pension (SEP) plans. Small businesses that started a plan before 2002 are not eligible for the credit.
“Small business owners recognize the benefit of offering retirement plans both for themselves and their employees, but the costs of starting and administering the plans can be a real disincentive for owners. The new credit is designed to help reduce these concerns,” said Gada.
Elimination of IRS User Fees for Small Employer Plans. Also to help reduce the costs of setting up a plan, the legislation eliminates the fees for IRS review of small business retirement plans. Typically, if an employer puts in place a retirement plan that is later found not to meet IRS standards, the employer can be liable for all the back taxes, as well as penalties owed. As a result, most employers want the IRS to evaluate their retirement plan to ensure it qualifies.
The IRS will do this upon request, issuing a determination letter evaluating an employer’s retirement plan and providing its seal of approval if the plan qualifies. However, the IRS also charges a user fee for determination letters, which can run into the hundreds of thousands of dollars. For small businesses, in particular, this can be a further disincentive in sponsoring a retirement plan.
Starting next year, however, the new legislation eliminates the user fees for determination letter requests by small employers to further encourage small employers to establish retirement plans.
Retirement Plan Loans for Small Business Owners. Under current law, loans between a qualified retirement plan and a disqualified person are generally prohibited transactions – and small business owners are considered disqualified persons.
This changes, however, under the new legislation. Starting in 2002, 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 businesses will be exempt from the prohibited transaction rules, allowing these owner-employees to participate in loan programs from the retirement plan.
“The restrictions had been intended to prevent abuses like an owner-employee of a company raiding retirement plan funds,” said Gada. “But it also was putting small business owners at a disadvantage, because unlike other employees, they were precluded from taking loans from retirement plans for perfectly legitimate reasons. By eliminating the restrictions, Congress is hoping more owner-employees will establish retirement plans or modify their existing plans to include loan features.”
Increased Deductibility of Employer Contributions to Certain Plans. Under the new legislation, employer contributions to profit-sharing, stock bonus and money-purchase pension plans are deductible to 25 percent of an employee’s contribution (up from 15 percent currently) beginning in 2002.
Helping Your Employees to Save
While small business owners are being encouraged to sponsor and fund retirement plans, the key to their success is having employees participate in the programs. Among the provisions to help employees save are:
Credit for Low- and Middle-Income Individuals. For many retirement plans to qualify for special tax treatment, they must encourage participation not just from high-income earners, but also from employees across all income levels. However, budget constraints often prevent low- and middle-income earners from saving for retirement. Under the new legislation, a temporary, nonrefundable tax credit has been created for contributions made by eligible taxpayers to qualified plans for tax years 2002 through 2006. The maximum annual credit ranges from $200 to $1,000, depending upon the individual's adjusted gross income and retirement contribution amount (up to $2,000 each year). The credit is available for elective contributions to a 401(k) plan, 403(b) annuity, SIMPLE, SEP, traditional or ROTH IRA and other qualified retirement plans.
Increased Retirement Plan Contribution Limits. The new legislation also increases the amount taxpayers can contribute to a 401(k), 403(b) annuity or SEP from the current $10,500 to $11,000 in 2002, then increasing $1,000 each year to a maximum of $15,000 by 2006. Similarly, the maximum allowable SIMPLE plan contribution each year will increase to $7,000 in 2002, increasing each following year by $1,000 to a $10,000 limit in 2005.
Incentives for Employee 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 Day Care. A new tax credit creates an incentive for small- and mid-sized businesses to provide child care for their employees' children. Beginning in 2002, employers that provide day care for their employees’ children are eligible for a tax credit of 25 percent of the actual child care expenses they provide and 10 percent of the cost of child care resources and referral services they offer, with a cap of $150,000 per tax year.
Employer-Provided Educational Assistance and Above-the-Line Education Deductions. Small businesses offering employer-provided educational assistance will also see some benefits from the new legislation. The bill makes the exclusion for employer-supplied educational assistance a permanent part of the tax code and widens this benefit to include graduate as well as undergraduate course work. 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, meanwhile, can deduct the amounts on their returns and they are not liable for employment taxes on the payments.
An above-the-line deduction also provides a new and temporary way to cope with higher education expenses. For 2002 and 2003, the maximum deduction would be $3,000 and available to taxpayers with adjusted gross incomes of less than $65,000 for single filers and $130,000 for joint filers. For 2004 and 2005, the maximum deduction would rise to $4,000 for taxpayers under those income limits; while people with incomes above those limits, but under $80,000 for single filers or $160,000 for joint filers, could deduct up to $2000.
“If you’re a small business owner thinking of changing your career or getting into a new business that requires coursework outside your current field, the next few years – while this deduction is available – are an ideal time to go back to school and get the needed education,” said Gada.
Planning Your Estate
For small business owners, estate planning has significant ramifications that, if not addressed early and thoroughly enough, could jeopardize the transfer of the business to future generations.
Under the legislation, the amount of the estate excluded from taxes will be raised and the top estate tax rate will be lowered over the next 10 years, with full repeal of the estate tax in 2010. The exclusion amount will immediately jump to $1 million for 2002 (from the current $675,000); $1.5 million in 2004; $2 million in 2006; and $3.5 million in 2009.
Starting in 2004, the legislation also repeals the controversial qualified family-owned business (QFOB) deduction that was established in 1997. The QFOB deduction was criticized as being overly complicated and not very helpful to the estates of small family business owners. The elimination of this deduction is more than made up by the increased estate tax exclusion amounts.
Meanwhile the surtax on estates over $10 million will be eliminated and the highest estate tax rate will step down to 50 percent in 2002 (from the current 55-percent rate) and continue to decrease to 45 percent from 2007 through 2009. The generation-skipping tax also will be repealed in 2010. Currently, a transfer tax with a flat rate of 55 percent is imposed on cumulative transfers of over $1 million to “skip persons” such as grandchildren during a donor’s lifetime.
Also important to small business owners are provisions of the new legislation that expand the availability of installment tax payment provisions to estates that include holding companies for closely-held businesses.
“Establishing a holding company for a family-owned business has been an effective way for a founder to transfer the business over several years to his heirs while avoiding the gift tax,” said Gada. “However, if a sizable portion of the holding company has not been transferred before the founder’s death, the heirs historically would be forced to pay a significant lump-sum estate tax on the portion of the holding company's assets still remaining in the estate. Under the new law, they will be able to make installment payments on the taxes owed.”
Making Your Move
Small business owners waiting too long to decide exactly how beneficial these changes are may miss them all together: The law has a built-in sunset provision that means that, without intervention by Congress, the tax code will automatically revert back to its current 2001 version in the year 2011.
Gada also points out that the last time Congress gave a major tax break package, it took only four years before they started eliminating those breaks.
“The tax laws are constantly changing. If there are opportunities for your business to benefit from the tax changes, take advantage of those changes as soon as you can because they may not be available down the road,” said Gada.
About CCH INCORPORATED
CCH INCORPORATED, founded in 1913, has served four generations of business professionals and their clients. The company produces approximately 700 print and electronic products for securities, tax, legal, banking, human resources, health care and small business markets. CCH is a wholly owned subsidiary of Wolters Kluwer North America. The CCH web site can be accessed at www.cch.com. The CCH Business Owner’s Toolkit can be accessed at www.toolkit.cch.com.
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