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Hailed as a major tax-reform package by both Congress and President Clinton, the Taxpayer Relief Act of 1997 promised to make long-overdue improvements to an ailing tax system. But three years later, it's clear the law made only a minor difference for businesses.
At least that's the consensus shared by most entrepreneurs and tax experts. Perhaps it's because the law is actually intended to provide more relief to middle-income parents with kids than to entrepreneurs running businesses. It created a special tax credit for each child parents have under age 16 and currently offers a number of education credits and deductions for college-bound kids.
Another major cornerstone of the law is a reduction in the top tax rate on capital gains for individuals, from 28 percent to 20 percent. (The reduction went to 10 percent for taxpayers in the lowest income bracket.) While it was the first time in 16 years that a new tax law provided some tax relief for both individuals and businesses, the size of that relief-some $95 billion in cuts-was relatively small compared to the 1981 tax law that provided $750 billion in tax reductions.
"Given the revenue constraints of a tax package that size, there's only so much that can be done," says Phil Wiesner, a partner in the Washington, DC, national tax office of KPMG. Even so, a handful of tax changes in the '97 law turned out to be steps in the right direction for businesses, he adds.
Joan Szabo is a writer in Great Falls, Virginia, who has reported on tax issues for more than 13 years.
One provision in the law especially beneficial to self-employed individuals increased the deduction they can take for the cost of health insurance for themselves, their spouses and their dependents. Under the change, the deductible amount gradually increases over a number of years, so that 100 percent of the cost is deductible by 2003. This year, self-employed individuals are allowed to deduct 60 percent of the amount paid for these premiums.
Although the change is helpful, it doesn't address an inequity in the tax code faced by the self-employed, says accountant Debbi-Jo Horton of DJ Horton & Associates in Warwick, Rhode Island. Namely, the fact that this group of entrepreneurs must still pay a hefty self-employment tax on the amount they pay for health coverage as compared to incorporated business owners not subject to the self-employment tax. (The self-employment tax of 15.3 percent consists of 12.4 percent for Social Security and 2.9 percent for Medicare.)
Horton explains how this works: The self-employed must deduct the cost of health insurance premiums on the front of their 1040 tax return, which in effect reduces the income tax they owe. But this deduction doesn't affect the self-employment tax they must pay, which is computed on Schedule SE. "If a self-employed individual is paying $10,000 annually for health insurance, he or she is paying the self-employment tax of 15.3 percent on the cost of the insurance," Horton explains.
Another important change for entrepreneurs with home offices is the liberalization in the deduction for those offices, says Horton. Under the '97 law, business owners who keep records, schedule appointments and perform other administrative or management activities from their home offices qualify for deductions as long as they don't have other fixed places of business where they perform a large amount of administrative or management work. However, the other requirements of the home-office deduction continue to apply, including the requirement for exclusive and regular use of the home office for business.
According to Horton, this change was especially beneficial. Before the change, many entrepreneurs thought that even though they had a home office, they didn't qualify for the deduction. With the liberalization, there is a clear definition of what constitutes a home office, making it possible for more business owners to qualify for deductions, she contends.
Another helpful change for small-business owners was an increase in the Section 179 expensing provision for equipment purchases. As a result of the '97 law, entrepreneurs can now take a larger deduction for the equipment they purchase. For property placed in serv--ice during 2000, the '97 law allows for a deduction of up to $20,000 in purchases of qualifying property. The expensing limit is scheduled to increase to $24,000 for 2001 and 2002, and to $25,000 for 2003.
This provision was especially beneficial for Cheryl Watkins Snead, president, founder and CEO of Banneker Industries in Lincoln, Rhode Island. Founded in September 1991, the company provides supply chain management services to manufacturers. Watkins-Snead, 41, says she took advantage of the provision to purchase material- handling equipment (like forklifts).
The expensing provision also benefited Terri Bowersock, owner of Terri's Consign & Design Furnishings in Mesa, Arizona. Her furniture business has grown into a franchised and corporate-owned chain with 16 superstores nationwide and sales of $26 million in 1999. Sales are expected to hit $30 million in 2000. Bowersock, 43, says she took advantage of the provision to purchase a few additional trucks.
Although the changes in the expensing provision were helpful, additional work needs to be done to improve the existing limit, says Horton. Under the expensing provision, if the total cost of qualifying property placed in service during a taxable year exceeds $200,000, the $20,000 limit is reduced dollar for dollar by the cost of qualifying property exceeding $200,000. For small manufacturing companies that spend hundreds of thousands of dollars on equipment annually, the $200,000 limit is a problem, Horton says, because it effectively scales back the deduction. The existing limit should be increased at least to take into account the rate of inflation.
The '97 law also expanded the availability of IRAs and established the Roth IRA. With a Roth IRA, contributions made to the accounts are nondeductible, but withdrawals are tax-free as long as certain conditions are met. Although Horton says the Roth IRA is attractive to many taxpayers, only time will tell whether these new retirement accounts are as beneficial as they appear to be.
The jury may be out on their effectiveness, but Roth IRAs have succeeded in causing confusion among taxpayers, says Horton. "Some taxpayers were trying to take their $2,000 contribution for a traditional IRA and then make another $2,000 contribution to a Roth IRA, which simply isn't allowed," she explains.
Nevertheless, Watkins-Snead says she recently established a Roth IRA for herself. This type of account is good for her, because she's not yet offering her 12 employees a retirement plan, on the other hand, Bower-sock provides her employees with a 401(k) plan, because unlike they would with a Roth IRA, her employees are able to make pretax contributions, which reduces taxable income.
All in all, the '97 law seems to have brought about "further complexity to a tax code that is already very complex," says Wiesner. Lawmakers have indicated they want to create a simpler tax code, but still haven't delivered. So although liberalization of the home-office deduction is beneficial, "It still created a new set of rules that have to be met," Wiesner continues. "As a result, the cost of getting limited relief is more complexity."
Looking to the future, both tax experts and business owners believe additional changes in the tax code are necessary. "For business owners to receive major relief, there need to be more across--the-board cuts," says Wiesner.
Bowersock would like to see serious consideration of tax laws that are beneficial for the economy and growing businesses. Proponents of such proposals say that by simplifying the tax system and cutting top rates, efficiencies would be gained for business owners. Such proposals seem appealing, but an overhaul of the tax system isn't likely to be considered until a new president and Congress are in place in January 2001.
- DJ Horton & Associates, 2008 Warwick Ave., Warwick, RI 02889, (401) 737-9355;
- Klyneld Peat Marwick Goerdler LLP, email@example.com;
- Terri's Consign & Design Furnishings, (480) 969-1121, fax: (480) 969-5052.