Important New Aspects of Financial Planning Following Tax Reform

By Block, Stanley | Journal of Small Business Management, October 1987 | Go to article overview

Important New Aspects of Financial Planning Following Tax Reform


Block, Stanley, Journal of Small Business Management


IMPORTANT NEW ASPECTS OF FINANCIAL PLANNING FOLLOWING TAX REFORM

As recently as 1981, the top marginal tax rate for individuals in the U.S. was 70 percent, while corporations were taxed at a maximum rate of only 46 percent. In spite of the double taxation of corporate income, there traditionally has been a strong incentive to incorporate small businesses in order to avoid the onerous tax rates applied to individuals in proprietorships and partnerships. The maximum individual tax rate was as high as 94 percent during World War II and was over 80 percent during most of the Truman, Eisenhower, and Kennedy administrations. In each instance, the maximum corporate tax rate was 30-35 percent lower (never exceeding the 50-55 percent range).

With the passage of the U.S. Tax Reform Act (TRA) of 1986, this relationship has changed. For the first time since federal income taxes were initiated in 1913, the maximum individual tax rate is lower than the corporate tax rate. As prescribed by the Tax Reform Act, the maximum corporate rate in 1988 will be 34 percent, while the maximum individual rate will be 28 percent (plus a potential five percent surtax, for a total of 33 percent). The tax-related plans for structuring a small business that were put in place prior to the Tax Reform Act of 1986 may now be largely irrelevant.

The Tax Reform Act of 1986 is arguably the most sweeping piece of tax reform legislation since the federal income tax was passed. The legislation and tax rates may be changed in the future, but the basic impact of the legislation is likely to be felt for some time. The philosophy of lowering marginal tax rates through the elimination of questionable deductions is now embedded in our way of thinking.

For the small business firm, the 1986 tax act, if ignored or improperly used, could have detrimental consequences. While all businesses, large and small, have lost numerous tax deductions, many small businesses will not enjoy a reduction in the marginal tax rate to compensate for the loss. For example, if a corporation has taxable income of $25,000 or less, the marginal tax rate will remain unchanged at 15 percent with the passage of the tax reform legislation.

The main topics addressed in this article include: the shift from the corporate form of organization, the change in executive compensation, influences on the asset purchase decision, and the configuration of industries most affected by tax reform. The last subject is discussed in the light of the results of a survey of 142 members of the Financial Analysts Federation.

THE SHIFT FROM THE TRADITIONAL CORPORATE FORM OF OWNERSHIP

While only 17 percent of U.S. business firms are corporations, over 80 percent of sales and 65 percent of profits can be attributed to the corporate form of organization. This pattern is likely to change. Because individuals now enjoy a lower marginal tax rate than corporations, the proprietorship or partnership form of organization is likely to increase in popularity. Actually, the shift is more likely to be from the C corporation to an S corporation. The C corporation denotes the traditional corporation in which there is limited liability, but double taxation: once at the corporate level and once at the stockholder level. The S corporation contains elements of both a corporation and a partnership. The security holders in an S corporation continue to enjoy the limited liability provisions of corporate stockholders, but and taxed directly as individuals, much as they would in a partnership. Under the new law they enjoy lower marginal tax rates than in a corporation and, of course, avoid double taxation.

1 Stanley Block and Geoffrey A. Hirt, Foundations of Financial Management, 4th ed. (Homewood, Illinois: Richard D. Irwin, 1987), pp. 11-12.

Advantages of the S Corporation

S corporations have always had some measure of popularity, but that popularity is likely to increase greatly. …

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