Many small-business owners may feel left out by the new tax act, but several provisions in the act, some big, some small, do affect financial planning for owners.

No doubt for many small-business owners and their families, the most far-reaching aspect of the new act is the gradual lowering of the estate tax rates, the increase in the exemption amount and the eventual repeal of estate taxes. Starting in 2002, estates valued at $1 million or less won’t face federal estate taxes, and the top estate-tax rate for assets above that exemption amount will drop from the current high of 55 percent to 50 percent. The $1 million exemption amount gradually rises to $3.5 million by 2009, while the top tax rate gradually declines to 45 percent. Because of the higher exclusion rates, Congress also eliminated, starting in 2003, the much-criticized deduction for qualified family-owned business interests.

These changes should make it easier and less expensive for owners to pass their businesses on to family members. However, there is already much debate as to whether Congress will modify the tax rates and exclusions between now and 2010, when full repeal of the estate tax is scheduled to occur. Even more worrisome for many is that the full repeal is scheduled to end a year later, in 2011, at which point the estate-tax system would revert to its current form unless Congress acts between now and then.

Beyond the estate tax provisions, several other changes affect small-business owners. One major area involves retirement plans. Contribution maximums by employees and owners to employer-sponsored defined contribution plans such as 401(k)s, 403(b)s and simplified employee pension (SEP) plans gradually increase to $15,000 in 2006. After that, maximums will be adjusted for inflation in $500 increments. Maximum annual SIMPLE plan contributions will rise to $10,000 by 2006. (Plan discrimination testing may still preclude higher-paid employees from contributing the maximum.)

Congress also raised the cap on the total employer and employee contributions to a plan to100 percent of pay or $40,000, whichever is smaller. Employers also will be able to deduct more for contributions to their employees’ retirement plan, for both defined benefit and defined contribution plans. This not only should encourage greater contributions that help employees, but should increase funding for plans for owners such as those in a partnership.

Furthermore, to encourage small businesses to establish retirement plans for their owners and employees, the act allows a tax credit of up to 50 percent of start-up costs or maintenance costs for the first three years of a new plan started in 2002 or later.[CCH book, p248] The dollar limit for the credit is $500. To qualify, the business must employ 100 employees or fewer, and not have had a qualified retirement plan during the previous three years.

Perhaps on the downside for business owners, the act allows workers to claim the right to their employer’s matching contributions faster than before. Cliff vesting is shortened to three years and graduated vesting to six years. This may make it more difficult for employers to retain workers who can now leave sooner with their employer’s contributions in hand.

The act also provides new incentives for business owners to establish or maintain day care for their employees. Starting in 2002, businesses can take a 25 percent tax credit for direct qualified child care expenses, and an additional 10 percent for qualified child care resources and referral expenses. The total dollar amount of credit that can be claimed is $150,000.

Congress made permanent the law that employers (though not closely held businesses) can deduct the cost of educational assistance to employees (up to $5,250), and extended that deduction to assistance for graduate courses. The act also makes permanent a worker’s ability to exclude from personal income assistance an employer provides for adoption expenses, and raised the amount of the exclusion to $10,000.

Other aspects of the tax act also may have a more indirect impact on small-business owners. For example, the gradual reduction in the personal income tax rates may prompt some C corporations, whose top rate is 38 percent, to consider reorganizing as partnerships, sole proprietorships or S corporations to take advantage of the lower rates, though nontax issues such as liability and benefit deductions should also be considered before changing.

August 2001— This column is produced by the Financial Planning Association, the membership organization for the financial planning community, and is provided by McGuire & Co., LLP a local member in good standing of the FPA.