Risk & Compliance

Tax Cut Benefits: Fuzzy

It's not yet clear whether President Bush's $330-billion tax cut will stimulate the economy -- or drag it down. Plus: The IRS shutters a stock opti...
Marie Leone and Kris FrieswickJuly 7, 2003

The Bush Administration is hoping that the third- largest tax cut in U.S. history, signed into law in May, will charm the economy out of its current funk. The Jobs and Growth Tax Relief Reconciliation Act of 2003 will slice taxes by $330 billion and provide $20 billion in aid to states.

While many economists expect the cut to jolt the economy in the short term, the long-term picture is fuzzier.

One of the criticisms is that the act does little to stimulate business investment directly. Instead, it puts the emphasis on consumer spending by accelerating tax reductions, increasing the child credit, and eliminating the marriage penalty. “It doesn’t address the immediate problem,” says Ken Goldstein, an economist at The Conference Board. “The slow economy is not because consumers haven’t been spending. The real question is, how do you get businesses to invest?”

The act addresses this question only nominally. Just $10.1 billion of the total cuts are earmarked for companies, with an increased write-off for small businesses and accelerated depreciation on some equipment purchases. “There is not much here for medium and large businesses,” say Timothy McCormally, executive director of the Tax Executives Institute.

Instead, Congress opted to trim the maximum capital gain and dividend income rate to 15 percent. Experts don’t expect the changes to have a drastic impact on the dividend strategies at most companies, but businesses are hopeful that consumers will spend the windfall, providing a spark to the economy. “My view is that the economy was already in recovery mode; this practically guarantees it,” says Daniel Laufenberg, chief U.S. economist at American Express Financial Advisors Inc.

David Wyss, chief economist at Standard and Poor’s, counters that the big danger is that interest rates will spike and deficits will handcuff the economy just when baby boomers are putting a strain on Medicare and Social Security. He thinks that could lead to a return of the slow-growth, low-productivity period of the 1970s and early ’80s. “My guess is that this is going to have to be fixed in five years,” he says.

Congress will get that chance. The act uses a neat trick called “sunset provisions” that expire many of the changes in periods ranging from two to five years. But the maneuver has largely been viewed as a ploy to get the cuts Bush wanted at a cost that was palatable to moderate Republicans.

The reality is that once cuts are in place, they are hard to roll back. “There are questions about the mechanism that Congress used to get the numbers to work out,” says McCormally. “At a time when Congress has come down hard on companies for creative bookkeeping, you have to ask if there is not some creative bookkeeping being used here.”

No Stock Option Pain, No Gain

New rules from the Treasury Department have shut down a tax shelter created to defer tax gains on stock options.

According to IRS officials, stock option gains are generally taxed at exercise. However, shelter promoters — touting the advantages of the deals — sought to defer the tax on the option gains beyond the exercise date.

According to IRS staff members, the now outlawed shelters worked like this: An executive would transfer stock options to a related party — such as a family member or a family limited partnership in which the executive or the executive’s family has a substantial interest. In exchange, the executive received a long-term unsecured note. The related party would exercise the option, and claim that it does not recognize gain until the stock is sold — and then only if the sale price exceeds the amount paid for the option plus the exercise price.

Promoters of the shelter contended that the executive wouldn’t be on hook for taxes until after payments were made on the note, even though the executive retained control over the exercise of the options through the family member or limited partnership. But the new regulations make it clear that tax payments cannot be postponed.

The regulations razing the shelter amend Sec. 83 of the Tax Code (26 CFR part 1) and are announced in IRS Notice 2003-47. The new rules went into effect on July 2.

“Executives cannot defer income taxes on a stock option exercise by purporting to sell their stock options to a family member or family limited partnership,” asserted Treasury Assistant Secretary for Tax Policy Pamela Olson. She pointed out that such transation — or similar ones — would be classified as “listed transactions” by the IRS. In other words, the executive and related party would be subject to disclosure rules, as well as list-keeping and registration requirements.

Neither the notice nor the regulations affect transactions between the executive and the company that issued the options.