Taxes: Up From Slavery (Somewhat)
We have a new tax law, and it's serious, folks.
Now, at year-end, it's time to rethink everything. I'm not talking about relatively trivial changes; I'd probably put you to sleep if I wrote about that stuff. You're reading REASON to learn about the big picture, and I won't disappoint you.
Everything is changed. Concepts you accepted as natural are now out the window. Your whole business strategy may have to be altered.
With a maximum tax rate of "only" 28 percent (effective in 1988; it's a bit more complicated in 1987), you can keep 72 percent of everything you earn—and for most people that's really 75 percent or so, because the tax on your first $29.75 K ($17.85 K if you're single) is only 15 percent, and the standard deduction and personal exemptions are going up too. So most of us can think of the new law as a tax cut that lets us keep around 75 percent of what we earn. We haven't had a situation like this since before the New Deal!
With tax rates like that, are you really interested in settling for less now in exchange for a pension later? Why wait? The tax is low enough that you'll want to take it all now, as current income. Obviously, if you work for an outfit that gives everyone a pension, that's fine. Take it. But if you run your own business, the pension plan may no longer make sense. Your earnings are 75 percent tax-free (!), so why bother with all that fine print?
Under the new law, there's nothing wrong with concentrating on earning a high wage. You don't need to divert your energy into setting up clumsy pension plans for your golden years or getting involved in gimmicky deals to get some after-tax income at the end of the year. Just work hard and save. Gods! The old-time virtues may come back.
You've already heard that an individual's capital gains will be taxed just like ordinary income, starting January 1, 1987. Think about that. All your life you, and your parents, have worked to get some of your income as stock options or stockmarket winnings. You sweat it out with your gains in the stock market, worrying about taking an extra market risk while you held on long enough for the gain to be long term. But now—who cares? If it makes economic sense to take a profit, you'll do it.
And how about those IRAs? If you've lost the deduction for your annual contribution, it's not the end of the world. Not quite. The income earned on the money you put away is still tax free. But consider this: without the deduction, what you're left with isn't much better than a mutual fund that invests in municipal bonds, and a mutual fund is a lot easier to work with and to withdraw from. Sure, municipals earn a point or so less than you're probably getting in your IRA, but really, is the IRA that big a deal any more? It's tempting to regain control of your own money.
Speaking of municipal bonds: starting with your 1987 return you'll have to report your tax-exempt interest. Some of you (I imagine) have a lot of unreported loot in the form of municipal bonds, so start thinking how you'll get yourself out of this one. You've been warned.
The next couple of items are boring but important. The accounting rules are changing too. Most corporations grossing over $5 million are now prohibited from using the cash method of accounting. No more rolling income into the next year by means of prepaid expenses or delayed billing.
Partnerships, S corporations, and personal service corporations (PAs) are going to have to be on a calendar year. So if you have a fancy fiscal-year PA for your medical practice, the income you've been deferring will have to be picked up and taxed over the next four years.
Been deducting interest on your personal returns? Forget it now, unless it's on a first or second home mortgage—and even then (generally) it's deductible only if the debt doesn't exceed the purchase price and improvements. Phasing in for 1987–90, the deduction for interest on your investment debt is limited to your investment income. Sorry about that, but if your investments make economic sense, you won't be affected.
Been operating as a corporation to keep your tax bracket down? Time to rethink that one too. The top corporate bracket is 34 percent starting mid-1987 (down from 46 percent in 1986). Obviously, 34 percent is far higher than the top individual bracket of 28 percent. You'll save money by not incorporating. Entrepreneurs can save money and simplify their lives by operating as sole proprietorships, S corporations, or partnerships.
Want to unincorporate? It used to be that you could liquidate a corporation and there'd be just one tax—on the stockholders' capital gain. But for corporate liquidations completed after the end of this year, the corporation will be taxed as if it had sold its assets, and the stockholders will still be taxed on their individual gains. This double taxation is really bad news, but there's a relief provision for closely held small companies (worth less than $5 million) that liquidate before January 1, 1989. So it's not too late to start switching things around.
And speaking of tax rates, everyone's been grumbling about the loss of business tax breaks: no more investment tax credits, and longer depreciation schedules. Sure, some outfits are going to get slammed. But the 34 percent top rate on corporations makes the United States a tax haven compared to most industrial countries. That means we're going to be awash in foreign investment, which means more jobs, more production, more of everything.
Overall, is the new law good or bad? Well, all I know is that things are going to be really different from now on, and probably lots better.
Happy new year.
Warren Salomon is an attorney and tax specialist practicing in Miami.
This article originally appeared in print under the headline "Taxes: Up From Slavery (Somewhat)".