What A Relief: The 2003 Tax Reductions are Finally Enacted

July 2003

BY: WILLIAM C. HUSSEY and STEPHEN C. ZIVITZ

On May 28, 2003, President Bush signed into law the Jobs and Growth Tax Relief Reconciliation Act of 2003 (the "2003 Tax Act") which accelerates the individual marginal income tax rate decreases originally enacted in 2001 by the Economic Growth and Tax Relief Reconciliation Act (the "2001 Tax Act"). The 2003 Tax Act also includes additional individual tax benefits in the form of dividend and capital gains tax rate cuts and an immediate (albeit temporary) increase in the child tax credit. For businesses, the Act also contains more generous expensing and bonus depreciation provisions designed to stimulate capital spending. Of equal importance, the 2003 Tax Act does not include any offsetting tax increases ("revenue raisers") for the purpose of passing muster under federal budgetary guidelines. The myriad of different tax provisions contain numerous tax saving and planning opportunities that will benefit nearly every taxpayer.

Individual Tax Provisions

Individual Tax Rate Reductions

The reductions of the individual (and estate and trust) marginal income tax rates for each tax bracket above 15%, which were scheduled to be phased in by 2006 under the 2001 Tax Act, will now take effect, retroactive to January 1, 2003. The top marginal income tax rate of 38.6% will now be 35%, and each other marginal income tax rate above 15% will be reduced immediately by 2% (i.e., the 27% rate falls to 25%, 30% to 28%, and 35% to 33%). In addition, the 10% marginal income tax bracket has been expanded for unmarried taxpayers (by $1,000) and for married taxpayers (by $2,000 if filing jointly, or by $1,000 if filing separately), but not for head of household filers (the 10% rate remains applicable to the first $10,000 of taxable income). The increase in the 10% bracket means that every person filing as unmarried who is taxable in the 15% or a higher tax bracket will save at least $50 per year, and each married couple in the 15% bracket or above will save at least $100 per year, in addition to any further tax savings realized from the decrease in higher marginal rates. A portion of the tax savings will be realized immediately in the form of increased take-home pay under recently revised withholding tax tables applicable to those taxpayers who receive a paycheck. Unfortunately, without further Congressional action, the 10% income tax bracket will be eliminated, and each of the marginal income tax rates above 15% will revert to pre-2001 levels, after 2010 under the sunset provision of the 2001 Tax Act.

Capital Gains Tax Relief

In addition to the decrease in marginal income tax rates discussed above that apply to ordinary income (and to net short term capital gains), the tax rates on net long term capital gains have also been substantially reduced for sales or exchanges occurring on or after May 6, 2003. The 20% capital gains tax rate has been reduced to 15% through the 2008 tax year. For taxpayers in the 10% and 15% income tax brackets, the 10% capital gains tax rate will be reduced to 5% through 2007, and will be further reduced to ZERO in 2008 only. The old capital gains rates of 20% and 10% will return in 2009. Unfortunately, the reduced capital gains rates will not apply to the sale of certain property, such as collectibles, or Section 1250 gains, which will continue to be taxed at the higher tax rates applicable under prior law.

Lower Tax Rates on Certain Dividend Income

Under the most dramatic change in the 2003 Tax Act, certain dividend income received from domestic and qualified foreign corporations will now also be taxed at the new capital gains tax rate of 15%, or at 5% (0% in 2008) for lower income taxpayers, rather than at ordinary income tax rates. The reduced tax rate for dividend income is retroactive to January 1, 2003, but, like the lower capital gains tax rates, will be repealed after the 2008 tax year. Numerous exceptions apply, including special rules applicable to regulated investment companies and Real Estate Investment Trusts (REITs). Therefore, we encourage all taxpayers to consult their personal tax advisers to verify that the dividend income received by them is eligible for the new, reduced tax rates. Regrettably, dividends received on stock held in a non-taxable account, such as a Section 401(k) or a qualified retirement plan, will continue to be non-taxable when received, but will be taxable at ordinary income tax rates when ultimately distributed from those accounts. Nevertheless, since dividends on stock held outside a non-taxable account were previously taxed at the recipient’s ordinary income tax rates, we expect many taxpayers to realize substantial (albeit temporary) tax savings.

Increase in the Child Tax Credit

Many individuals with children under the age of 17 will also realize immediate tax benefits in the form of rebate checks to be mailed out in late July and August as a result of the accelerated increase in the child tax credit to $1,000 (up from $600 under prior law). Rebate checks will be mailed to each individual who is eligible for the child tax credit based on his or her 2002 tax return information (the phase-out of the credit for high income filers still applies). Those parents with children born or adopted in 2003 will also be eligible to claim the additional credit on their 2003 income tax return. The increased child tax credit will apply only in 2003 and 2004 before reverting to $700 in 2005 under the phase-in schedule previously established under the 2001 Tax Act.

Marriage Tax Penalty Relief

For the 2003 and 2004 tax years only, the 2003 Tax Act accelerates the marriage tax penalty relief provisions of the 2001 Tax Act in two ways. First, the 15% income tax bracket for married filers will be increased to up to $56,800 of taxable income - twice that of unmarried filers. Second, the standard deduction will also be double that of unmarried filers ($9,500 for 2003). The latter provision is likely to influence the choice between the standard deduction and itemized deductions for certain married taxpayers. In 2005, both the 15% income tax bracket and the standard deduction will return to the levels previously established under the 2001 Tax Act.

Limited Alternative Minimum Tax (AMT) Relief

A significant shortcoming of the 2003 Tax Act is the meager AMT relief provided. For the 2003 and 2004 tax years only, the AMT exemption for unmarried filers is increased by $4,500 (from $35,750 to $40,250) and is increased by $9,000 for married filers (from $49,000 to $58,000). The current phase-out of the exemption amount for high-income filers remains unchanged. Unfortunately, we fully expect that for an increasing number of taxpayers, the AMT will effectively "take back" many of the tax benefits otherwise provided by the 2003 Tax Act unless further AMT relief is enacted.

Business Tax Provisions

Quadrupled Section 179 Expense Deduction

Small business owners can now immediately expense up to $100,000 of the cost of new depreciable property (including off-the-shelf computer software) that is purchased for use in an active trade or business. The phase-out threshold under Section 179 has also been increased to $400,000. Under the prior version of Section 179, the expense deduction was limited to $25,000 and benefits were phased out if more than $200,000 of purchases were made by the business. The new limits will apply in 2003, 2004 and 2005.

50%-Bonus Depreciation Deduction

The 2003 Tax Act also increases, for the 2003 and 2004 tax years only, the 30%-bonus depreciation deduction enacted in 2002. The additional bonus depreciation deduction is now equal to 50% of the adjusted basis of eligible property that is purchased after May 5, 2003 (but before January 1, 2005) and placed in service before January 1, 2005 (or 2006 for certain property). The first-year deduction limitation for luxury automobiles has also been increased to correspond to the new 50%-bonus depreciation limits. Businesses may elect out of the 50%-bonus as they could with the prior 30%- bonus depreciation deduction.

The 50%-bonus depreciation and the Section 179 Expense deductions can be combined for property purchased that is eligible under both provisions. By selectively choosing the assets that will receive the tax benefits of the respective provisions, businesses may minimize their recovery periods and maximize their tax benefits.

To discuss the impact of the changes outlined above, the planning opportunities that exist, or any other provision of the 2003 Tax Act on your particular tax situation, please feel free to contact William C. Hussey (215-864-6257) or Stephen C. Zivitz (215-864-6240).

About the Authors: William C. Hussey (215-864-6257, husseyw@whiteandwilliams.com) is an associate in the Tax and Estates Practice Group of the Business Department of White and Williams LLP. Stephen C. Zivitz (215-864-6240, zivitzs@whiteandwilliams.com) is a partner in the Business Department and chair of the Tax and Estates Practice Group.