December, 2003 Newsletter
Note: The items in this newsletter are provided to bring certain information
or opinions to the attention of the reader in capsulized form. The information
is generally not complete and has been oversimplified for the sake of
brevity. Readers should therefore not make decisions based solely upon
the information in these newsletters without first contacting
us or other sources of more complete information.
INCOME TAXES
THE JOBS AND GROWTH TAX RELIEF RECONCILIATION ACT OF 2003 (THE
ACT)
This latest tax act, as its predecessor, was enacted primarily with a
view to igniting our faltering economy. Its principal focus was to stimulate
both consumer spending and business purchases of capital equipment. Its
chief provisions: reduce the long term capital gain rates and dividend
tax rates; increase bonus depreciation rates and the allowable amount
of Section 179 (immediate expensing of) qualifying depreciable property;
increase the child tax credit from $600 to $1,000 for years 2003 and 2004;
offer relief for the marriage penalty and the Alternative Minimum Tax
(AMT); accelerate the marginal tax rate reductions from the last tax act;
and broaden the 10% tax bracket. Some of these provisions that we believe
to be of primary interest to broker/dealers are:
Long-term capital gain rates have been reduced from 20% to 15%
for higher income taxpayers and from 10% to 5% (and lower in
years 2004 through 2008) for lower income taxpayers. The reduction for
higher income taxpayers from 20% to 15% applies to gains realized after
May 5, 2003 and on or before December 31, 2008. This reduction does not
apply to all gains: the rate of 25% on Section 1250 gains (sorry for the
code section reference) and the 28% rate on collectibles remain unchanged.
Based upon the foregoing, this may be an excellent time to transfer property
that has increased in value to one’s children (14 years of age or
over) who may be taxed on the gain at the lower 5% capital gain tax rate.
Tax rates on qualifying dividends have been reduced to the same rates
as the long-term capital gain rates. This means that the maximum
tax rate on qualifying dividends will be 15% for the period January
1, 2003 through December 31, 2008. Qualifying dividends are those received
from U.S. domestic corporations (other than those exempt from income taxes
and other specified entities) and certain qualified foreign corporations.
A foreign corporation may be qualified if their stock is traded in a U.S.
securities market. The Act has also increased the holding period
for those stocks issuing dividends from 45 days to 60 days. Naturally,
in many instances, this particular provision of the Act makes income stocks
more attractive than growth stocks – at least from a tax perspective.
Bonus depreciation enacted under the previous tax act of 30% has been
increased to 50% for qualifying property acquired after
May 5, 2003 and on or before December 31, 2004. Qualifying property includes
property eligible for MACRS depreciation that is required to be depreciated
over 20 years or less and certain other specified property. It should
be noted that “bonus depreciation” is limited to purchases
of new property.
The amount businesses are allowed to immediately expense of qualifying
depreciable property (Section 179 expense deduction) has been increased
to $100,000 for years beginning during 2003 and ending during
or before 2005. The limitation on the amount of
Section 179 property businesses are allowed to acquire (and still be
eligible for all of the immediate expensing provisions) has increased
from $200,000 to $400,000. In addition, software purchased “off
the shelf” now qualifies as Section 179 property.
The exemptions for the Alternative Minimum Tax (AMT) have been increased
to $40,250 for single taxpayers and $58,000 for married taxpayers for
years 2003 and 2004.
Remember that all of the Act’s provisions disappear at some time
during the years 2005 through 2008, depending upon the particular item.
The decreases in the long term capital gain rates and the tax
on qualifying dividends go away after the year 2008.
OTHER TAX NOTES
Reasonable compensation – At the end of a profitable
year for a closely held C Corporation, the tendency is to increase compensation
in order to avoid double taxation of profits. For this reason, we would
like to remind our readers of some factors used to determine if the compensation
of the company’s principal officers/shareholders is reasonable.
These factors are: the nature of the business; the officer/shareholder’s
qualifications; the conditions under which the business currently operates;
wages of individuals in similar positions in comparable companies; wages
paid in relation to dividends paid; wages paid in prior years; the company’s
policy regarding wages; contributions made to pension or profit sharing
plans. Principal officers and shareholders of closely held C Corporations
should take proper care to ensure the deductibility of their wages. The
consequences of the IRS reclassifying any wages as dividends would result
in their not being deductible by the company and their also being taxable
to the officer/shareholder. In essence they will be faced with double
taxation on these amounts.
Withdrawals from IRA’s and 401(k) Plans to Cover Medical
Expenses – Although it may not be desirable to pay for
medical expenses with retirement savings, necessity may dictate otherwise.
One detriment to premature withdrawals from an IRA is the early withdrawal
penalty of 10%. However, under certain circumstances, all or at least
some of these withdrawals may be exempt from this penalty. In addition,
401(k) plans may be used to cover medical expenses if the taxpayer establishes
immediate and extreme financial need. This hardship withdrawal is permitted
according to regulation section 1.401(k)-1(d)(2) if it will pay for current
or prior medical expenses that are (or were) necessary for the taxpayer
or their dependents.
Late or invalid S Corporation elections – This
item was previously mentioned in an earlier newsletter, but it’s
worth repeating. The IRS now has the authority to grant S Corporation
status to prior elections that for some reason or another were determined
to be invalid, or that were filed late. Previously, taxpayers had until
the 15th day of the third month after the tax year began to file an S
Corporation election that would be effective retroactively back to the
beginning of the year, or, in the case of a new corporation, to the time
that the corporation was deemed to have begun doing business. In addition,
if the original election was determined to be invalid, even though it
was timely filed, the IRS had no authority to grant retroactive S Corporation
status. Now, pursuant to IRS Code Sections 1362(f) (for invalid elections)
and 1362(b)(5) (for elections filed late), the IRS may treat the elections
as having been timely filed, if the shareholders filing the election meet
the conditions stated in those code sections.
SECURITIES REGULATORY NOTES
EXPENSE SHARING AGREEMENTS WITH HOLDING COMPANIES
Since the broker/dealer industry is one of the most regulated industries
in the U.S., it is the desire of many of its members to “keep things
as simple as possible” in their firms and to retain and record in
the broker/dealer only those things that pertain to the securities brokerage
business. Primarily for this reason many registered broker/dealers have
utilized holding companies (an entity owning 100% or slightly less of
the broker/dealer and commonly referred to as the broker/dealer’s
“parent” company) or another affiliated entity (any other
entity under the same ownership or control as the broker/dealer). This
holding company or affiliate (hereafter both referred to as the non-broker/dealer
affiliate) might also be a registered investment advisor or an entity
marketing insurance or other non-securities products. Since the non-broker/dealer
affiliate was not subject to the strict supervision, financial and non-financial
reporting requirements of the SEC, NASD and various other federal and
state securities regulatory agencies, as well as being subject to an annual
certified audit requirement; it became common practice for the non-broker/dealer
affiliate to enter into all commitments and other contractual agreements
and pay all expenses that the broker/dealer was not required by law to
do. When the CPA’s prepared the broker/dealer’s annual certified
audit it was part of their job to insure that the broker/dealer’s
management disclosed this “related party” relationship and
disclosed certain information regarding the expenses and other items paid
by the non-broker/dealer affiliate on the broker/dealer’s behalf.
For quite some time the securities regulatory agencies required a written
agreement between the broker/dealer and the non-broker/ dealer affiliate
to detail exactly what expenses and other overhead items were to be paid
by which entity, how these items were to be recorded and what reimbursements
for these expenses or services were to be made.
Naturally this policy of non-broker/dealer affiliates providing services
and paying expenses on behalf of broker/dealers led to abuses. In extreme
situations broker/dealers were able to enhance their operating results
and financial position by recording virtually all non-securities activity
in the non-broker/dealer affiliate and not on their own books –
even if the broker/dealer was the sole beneficiary of the activity. So,
during July of this year, in a letter issued to both the NASD and NYSE,
the Securities and Exchange Commission (SEC) significantly restricted
the ability of broker/dealers to allow non-broker/dealers affiliates to
provide any services and pay for any expenses of the broker/dealer and
not record both the expense and related liability on the books of the
broker/dealer. Based upon our reading of the aforementioned SEC letter
and the additional information provided in NASD Notice to Members 03-63
(available on the NASD’s website) a broker/dealer may not be required
to record expenses and liabilities associated with services or expenses
provided by a non-broker/dealer affiliate if all of the following conditions
exist:
1) The non-registered broker/dealer affiliate must enter into a written
agreement with the broker/dealer to pay such expenses without anticipating
any reimbursement from the broker/dealer.
2) The non-registered broker/dealer affiliate must be self-supporting.
It must have some other source of income other than fees or dividends
paid to it by the broker/dealer. This requirement may be satisfied if
the non-broker/dealer affiliate is a registered investment advisor or
provides other services or products not requiring securities registration,
such as providing financial planning services or selling non-securities
insurance products.
3) For any expense paid to a vendor or other third party, all or part
of which benefits or is paid on behalf of the broker/dealer, the vendor
or other third party must agree in writing that the broker/dealer is not
directly or indirectly liable to the third party for the expenditure or
service(s) provided.
4) There is no indication that the broker/dealer is directly or indirectly
liable to the vendor or other third party for the expenditure or service(s)
provided.
5) The liability for the expense or service(s) provided is not a liability
of the broker/dealer according to Generally Accepted Accounting Principals
(GAAP).
It is important to note that even if all of the above conditions are
met and the securities regulatory agencies do not require the broker/dealer
to record these items as expenses and liabilities, the new requirements
still mandate that broker/dealers keep a record of all expenses paid and
services performed on its behalf by the non-broker/dealer affiliate. Since
it is already necessary to report this information in a “related
party” footnote included with the broker/dealer’s annual certified
financial statements, this additional condition should provide no significant
additional burden to the broker/dealer, other than possibly necessitating
that this information be accumulated and retained on a more frequent basis
than annually for its incorporation into the certified financial statements.
According to NASD Notice to Members 03-63, broker/dealers were to be
able to demonstrate compliance with the new expense-sharing requirements
no later than December 1, 2003. It is also important
to note that the notice contains many other restrictions regarding
relationships with affiliated entities, such as capital contributions
made by non-broker/dealer affiliates to broker/ dealers. We strongly
recommend that this notice be read in its entirety with care. We would
also like to request that those readers with affiliated entities that
are clients of ours please contact us as soon as possible if they have
not already done so.
REGISTRATION OF BROKER/DEALER AUDITORS
The Sarbanes-Oxley Act was directed toward auditors of publicly held
companies. Section 205 of that act contains a provision amending Sections
17(e) and 17(f) of the Securities and Exchange Act of 1934 to substitute
the term “registered public accountant” for the term independent
public accountant”, meaning a public accounting firm registered
with the Public Company Accounting Oversight Board (PCAOB). All auditors
of registered broker/dealers are therefore required to register with the
PCAOB whether or not the broker/dealer they audit is publicly held. At
the time of this change, it was estimated that due to the greater expense
that it is assumed will be incurred by accounting firms registering with
the PCAOB, the estimated 700 accounting firms currently performing audits
of broker/dealers would be reduced to the largest 50 public accounting
firms. However, during the year a stay of execution was granted. All accounting
firms conducting audits of non-publicly registered broker/dealers are
not required to register with PCAOB until 2005.
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