Tax-Reform Delay Causes Confusion : Planners Forced to Play Game Without Knowing Final Rules

Jeffrey Barefoot and his five clients were all ready to become Tax-Reform Busters.

The Toledo, Ohio, financial planner had arranged for the clients to exploit a loophole in President Reagan’s tax-reform plan of last May to limit deductions for mortgage interest on vacation homes.

Under Barefoot’s plan, the investors were to borrow against their primary homes and use the cash to pay for vacation homes. That way they would reduce or eliminate interest payments on the vacation homes, while the added interest on their primary homes would be fully deductible.

But last month, the House Ways and Means Committee approved a tax-reform plan that would retain full interest deductibility on second homes. It’s not surprising that Barefoot and his clients dropped their plan, although not completely.

“If Reagan has his way . . . there’s still a chance that it (the interest limitation) will get stuck back in there” in a final tax bill, Barefoot says.

So goes the confusing, flip-flop world of year-end tax planning, 1985-style. The uncertain prospects for tax reform next year have made tax planning a dizzying task for individuals and businesses alike.

An Array of Options

From investing in tax shelters to buying computer equipment or life insurance, taxpayers have been facing a confusing array of options. While some individuals and businesses are accelerating purchases of cars or other equipment, others are waiting. Interest in tax shelters is reviving, but many investors are finding their choices limited.

In some cases, what was expected to happen is not happening. The expected boom in solar-energy systems, fueled by the ending or phasing out of energy tax credits, has not occurred, solar-industry officials say. Life insurance sales are up, but not because of fears among taxpayers that future policies will be taxed, industry officials say.

Some taxpayers, confused by the plethora of effective dates proposed for various tax-law changes, are simply not doing anything. In the Ways and Means plan, some tax-law revisions would be retroactive to earlier this year while others would not go into effect until early next year.

Adding to the uncertainty this past week was yet another tax-reform proposal, this one by House Republicans. And there’s also the likelihood that the full House, Senate and Reagan still will be wrangling about tax reform deep into next year.

‘Decision Paralysis’

“A lot of people are doing absolutely nothing. It’s as if it’s decision paralysis,” says Alec Berkman, chief executive of Benefit Concepts, a Diamond Bar employee benefits consulting firm.

“Everyone is just holding their breath and waiting to see what next shoe will drop,” says Stuart J. Brahs, executive director of the Assn. of Private Pension & Welfare Plans, a trade group based in Washington.

Such uncertainty has fueled a brisk business for tax preparers, accountants and lawyers. Many are using sophisticated computer modeling to aid their clients in determining how their taxes and investments would fare under numerous tax proposals. Often these computer models project several years ahead.

“You no longer can plan for just the next year, but now you have to look at least two or three years ahead,” says Stan Ross, co-managing partner of Kenneth Leventhal & Co., a Los Angeles accounting firm.

However, because maximum tax rates are likely to fall no matter which tax-reform plan is passed, the traditional year-end strategies of deferring income and accelerating expenses still apply as much as ever, tax advisers say. Lower tax rates mean that next year’s income will be less heavily taxed while next year’s deductions will be worth less in tax savings.

The House Ways and Means plan, for example, would lower the top individual tax rate to 38% from 50%, providing a strong incentive to push income into next year.

“Basic year-end tax strategies are not at all different than in previous years,” says Harvey S. Gettleson, a tax partner with the accounting firm of Ernst & Whinney. “It’s still a good idea to prepay state and local taxes, prepay expenditures and make charitable contributions.”

Bart A. Stoner, a Los Angeles advertising executive, may be typical of higher-income taxpayers responding to such advice. He says he has prepaid state and local taxes, boosted charitable contributions to schools and church, and bought real estate tax shelters.

“I’ve done these things before, but this year I’ve paid a lot more attention to implementing year-end decisions than in the past” because of possible reductions in tax rates, Stoner says.

Here’s a look at some of the key strategies that individuals and businesses have been pursuing or considering this year:

Accelerating charitable deductions.

This traditional strategy appears to be popular again this year, to the benefit of at least some Southern California charities.

Ronald J. Kensey, director of development at the Los Angeles office of the American Heart Assn., says the organization has received more unsolicited calls this year from taxpayers interested in contributions of cash or property.

The threat of reductions in the mortgage-interest deduction on second homes also has spurred more inquiries about donations of second homes, he says.

Ben Horowitz, executive director of the City of Hope, a Los Angeles-based charitable health-care organization, reports a “slight trend” in increased year-end contributions, mainly because donors are paying pledges more rapidly this year. But, he says, he won’t know the full extent of the trend until mid-December, when year-end donations are more likely to come in.

Brad Sales, news bureau manager with the United Way in Los Angeles, also says it is too early to tell. But he adds that “there is a feeling that some of the larger donors that have pledges outstanding might go ahead and pay” before year-end.

Prepaying state and local taxes.

This traditional strategy has taken greater importance this year, advisers say, because of the continuing doubt as to whether state and local taxes will continue to be fully deductible as they are under current law. Reagan’s reform plan proposed to eliminate deductions for state and local taxes, although the Ways and Means plan and the House Republican plan would retain them.

Some advisers believe that an eventual tax bill could compromise on the issue, by imposing a dollar limit on such deductions, for example.

But to what extent taxpayers are following this strategy remains to be seen. Will Bush, a spokesman for the California Franchise Tax Board, says it is too early to tell whether more state taxpayers are prepaying state and local taxes, because they have no incentive to pay until the last week of December.

He has noticed, however, that a few taxpayers who owe taxes and interest from previous years have requested to pay the portion due in taxes first and the interest portion later, reasoning that the interest portion would be fully deductible in future years under any tax-reform plan.

Buying personal or business equipment this year.

Taxpayers buying cars, computers, office furniture or other equipment this year for business use would be assured of receiving the investment tax credit and more favorable depreciation rates.

Both the Reagan and Ways and Means plans would repeal the investment tax credit and impose longer depreciation schedules, reducing write-offs in each year. The House Republican plan would retain the investment tax credit, although at a 5% rate instead of the current 10%.

Taxpayers making such purchases this year also would be assured of writing off the sales tax. Reagan wanted to eliminate the sales-tax deduction, although the Ways and Means and House Republican plans would retain it.

A rush by businesses and individuals to take advantage of the favorable tax treatment this year is a major factor behind retailer and analyst projections that personal computer sales will rise 20% in the fourth quarter over the year-ago period.

Other businesses also are accelerating capital spending. Barefoot, the Toledo financial planner, says he is buying $10,000 worth of office furniture before year-end instead of next March or April as he had originally planned.

Thermo Electron, a Waltham, Mass., maker of energy systems, sped up a co-generation project to assure receiving more favorable tax treatment, says George N. Hatsopoulos, chairman and chief executive.

But not all businesses are accelerating capital spending. Heritage Communication, a Des Moines, Iowa, cable-television firm, says uncertainty about tax changes and when they will take effect contributed to its decision to slow work on a $5-million cable system in the Los Angeles area north of Compton. The firm had hoped to finish work by year-end but now plans to finish sometime next year.

“The worse problem is the uncertainty the whole (tax reform) thing has created,” says James M. Hoak, Heritage’s president and chief executive. “It’s hard to make decisions with this thing hanging around.”

Businesses and individuals are finding other ways to accelerate deductions, by paying rent, insurance premiums, investment advisory fees and other expenses this year instead of next.

Deferring bonuses or other income.

Unfortunately, tax experts admit, deferring salary and bonuses is easier said than done for many employees. Few large employers are willing to go through the administrative headaches of complying with employee requests to defer paychecks until next year.

And executives must tell their employers to defer bonuses long before they actually receive them, under the Internal Revenue Service doctrine of “constructive receipt,” which maintains that employees must be taxed on a bonus once they have been notified that they will receive one.

However, it is easier to defer investment profits by postponing sales of securities on which a gain would be recorded--or accelerate losses by selling securities at a loss.

William G. Brennan, who publishes a Valley Forge, Pa., tax newsletter, says another lesser-used income-deferring strategy is to move money out of savings accounts or money-market funds into Treasury bills or bank certificates of deposit that mature and pay interest after Dec. 31 so that the interest income will not be taxable until next year.

Businesses may also delay closings of sales, billings or completions of contracts until 1986.

Investing in a 401k plan or individual retirement account.

Individual retirement accounts continue to be touted as one of the best ways to shelter income until later years.

Meanwhile, some tax advisers say, proposed tax-law changes have increased the importance of investing this year in a 401k savings plan if your company offers one. A 401k allows employees to defer part of their before-tax pay in a separate account that accumulates income on a tax-deferred basis until withdrawn.

Some tax advisers are telling clients to put as much income as possible this year into a 401k plan, because tax reform is likely to reduce the maximum annual contribution in 401k plans from the current $30,000.

The Ways and Means plan would reduce that amount to $7,000, while Reagan wanted to eliminate 401k plans altogether. Many tax experts believe that an eventual tax bill will compromise between the Ways and Means plan and current law.

However, pension expert Brahs says he “doesn’t get the sense that people are loading up this year” and boosting 401k contributions above normal. He says there is a “sense of cynicism” among individuals that few, if any, changes will be made to limit 401k contributions.

By contrast, the threat of ending or curtailing 401k plans has discouraged some firms from starting them, experts say. Beverly Orth, a staff counsel at the Los Angeles office of William M. Mercer-Meidinger, a major employee-benefits consulting firm, says her office has not helped to start a single 401k plan in the last three months. On the other hand, she says, start-up activity in the first six months of this year was “normal.”

Receiving early distributions from a Keogh or other pension plan.

Many tax advisers say they are advising clients who are retiring or changing jobs to consider taking a lump-sum pension distribution this year instead of next year or later to ensure that they qualify for 10-year income averaging, which would be discontinued under the Reagan plan and reduced to five years under the Ways and Means bill.

Ten-year averaging allows the taxpayer to spread the income from the pension distribution over 10 years for tax purposes, reducing the tax burden considerably.

One taxpayer, a 73-year-old retiring executive with a Southland manufacturing company, took a $100,000 lump-sum distribution this year. Normally, his adviser says, the executive would have postponed the distribution until early next year so he wouldn’t have had to pay tax on it until 1987.

“Whether a taxpayer should do this really depends on his age and what he wants to do,” pension expert Brahs says. He contends that any tax-reform plan is likely to retain 10-year averaging for taxpayers who are now over the age of 59 1/2.

Investing in tax shelters.

Tax experts report a year-end surge in purchases of tax shelters, particularly those offering a higher proportion of write-offs in the first year, such as equipment-leasing shelters.

“A rebirth has occurred in the tax-shelter market,” writes tax adviser Brennan in a recent edition of his newsletter. “Sponsors are hoping to make some gains for lost sales early in the year. . . . “

“Business is booming,” says Carl C. Roba, tax-shelter coordinator in the Beverly Hills office of Prudential-Bache Securities, noting that his firm’s volume is expected to increase 25% this year over last.

Unfortunately, the supply of shelter investments is not as good this year as in previous years, Brennan and other advisers say. That is because slow sales earlier in the year caused many sponsors to reduce their offerings.

Buying tax-free municipal bonds.

Bond industry officials report a surge in purchases of municipal bonds this year, partly because of attractive yields and because tax reform has threatened to end or restrict federal tax-exempt status for certain types of municipal bonds, particularly those issued to finance private projects such as hospitals, sports stadiums and industrial parks.

This threat has spurred municipalities to bring more bond offerings onto the market this year, resulting in a 15% increase in volume so far this year over all of last year, according to the Public Securities Assn., a trade group based in New York.

The flood of supplies is creating “a buyers’ market, forcing prices down and yields up,” one Los Angeles tax adviser says. And by being free from state and local taxes, municipals would be even more attractive if deductions on those taxes are later curbed or eliminated, experts say.

Buying a life insurance policy.

Some taxpayers say they are opening policies before year-end, fearing that policies opened next year and thereafter might be penalized under a Reagan proposal to tax the increase in cash value of policies. One of financial planner Barefoot’s clients, a Toledo doctor, accordingly put $250,000 into a single-premium variable life insurance plan this year.

However, the doctor may be an exception. Life insurance sales overall are expected to rise 9% this year over last, the same increase as in 1984, but little, if any, of the increase has been due to the Reagan proposal to tax the increase in cash value, says Walter Bussewitz, manager of media information for the American Council of Life Insurance. “Tax reform didn’t make much of a difference,” Bussewitz says.

Although the industry was very alarmed at such a proposal, consumers “did not perceive it as a major threat,” says James Dederer, senior vice president and general counsel for Los Angeles-based Transamerica Occidental Life Insurance Co. Strong lobbying by the industry was a factor in the proposal being dropped by the Ways and Means panel.

Buying energy-saving devices.

Tax advisers are urging clients planning to buy insulation, storm doors or certain other types of home energy-conservation devices to do so before year-end. That is because the 15% energy tax credit for energy conservation measures installed on a principal residence built before April 20, 1977, expires at the end of this year.

Certain other credits for solar and wind-energy projects also are scheduled to end this year, although the House Ways and Means Committee voted to extend certain credits until 1988, with the maximum credit dropping each year until the credits expire.

Such a prospect has helped spur a rush among taxpayers eager to invest in wind-energy systems in California. The number of installed megawatts for wind energy in California is expected to grow about 60% this year, according to estimates by the California Energy Commission.

The rush “wouldn’t be quite what it is if it wasn’t for the tax credits” expiring this year, says Sam Raskin, wind-energy analyst with the commission.

However, some industry experts say, no such boom is occurring in solar energy, which is dependent on consumer demand for at-home installation as opposed to wind energy’s reliance on tax-shelter-oriented investors.

“All of us felt that with the threat of tax reform there would be a substantial upturn in business, but that has not occurred,” says Terrill E. Buffum, a director of the California Solar Energy Industries Assn. and president of Alten Corp., a Mountain View solar-energy firm. He says many consumers have “become so used to the scare mentality that they have not given any credibility” to pitches from solar-system salespeople talking about the ending of solar credits.