Tax Relief Act Is A Boon for VC –

The second most astounding aspect about the Jobs and Growth Tax Relief Reconciliation Act of 2003 (the “Act”) is its remarkable brevity. The most astounding aspect, of course, is the fact that it was passed at all. The final law, weighing in at a scant eight pages, is perhaps the shortest piece of major tax legislation in modern U.S. history: As a standard of comparison, the Tax Reform Act of 1986 was touted as a law promoting “tax simplification,” yet it managed to offer up a mind-numbing 1,200 pages of “simplifications.” The 2003 Tax Act, by contrast, is exactly what it purports to be-a remarkably focused and succinct tax bill that is short, sweet and to the point.

The Act contains an estimated $330 billion in tax cuts, and in the process implements several basic but revolutionary changes to the Internal Revenue Code that are extremely good for investors. First, the maximum federal personal income tax bracket is cut from the current 38.6% to 35%, and the lower brackets are each trimmed by 2-3 percentage points, retroactive to Jan. 1, 2003. These changes effectively accelerate the scheduled tax reductions enacted by the 2001 Tax Act, except that the tax cuts now take effect immediately instead of over a fairly lengthy period of years.

The biggest changes introduced by the Act are a reduction in the long-term capital gains rate from 20% to 15% and a cut in the dividends tax rate from the current ordinary rate of up to 38.6% to a rate equal to the long-term capital gain rate of 15%. The tax on dividends is effectively cut from almost 40% to just 15%-an amazing sea change in the taxation of C corporations.

The Act also contains a variety of broadly popular tax incentives and benefits, including an increase in the child tax credit from $600 to $1,000 for many taxpayers, relief for the so-called “marriage penalty,” some alternative minimum tax relief and an increase and the extension of the “bonus depreciation rules,” which basically allow a 50% bonus depreciation for certain property placed in service after May 5, 2003 and before Jan. 1, 2005.

The unequivocal winners under the Act are people who invest in the stock of domestic C Corporations-which is to say, venture capitalists investing in venture-financed businesses, plus all investors investing in publicly traded stocks that pay significant dividends.

On the venture capital side, a typical arrangement calls for investors to invest in a preferred stock of a C corporation, paying a specified preferred return, but convertible into equity on an initial public offering or in a variety of other circumstances. For years, the Internal Revenue Code has been relatively hostile to C corporations in general and to venture capital investors in particular, with a host of rules designed to ensure that C corporation income was subjected to a brutal double tax-first at the corporate level as income, and second at the shareholder level as a dividend. Moreover, the Code was regularly amended to prevent investors from using various stratagems to convert dividend income into capital gain. (For more on the tax disadvantages of C corporations, see Joseph Darby’s Viewpoint in the March issue. -Ed.)

The new Act makes this hostility toward capital gains entirely moot by setting both the capital gains tax rate and the dividend tax rate at 15%. Therefore, whether a corporate stock transaction is characterized as a redemption or as a dividend distribution suddenly has no effect on the tax costs borne by the recipient. This means that the large and sophisticated (but economically valueless) industry of recharacterizing dividends as capital gains is suddenly rendered irrelevant. Some investment bankers may even be forced to get real jobs.

How should investors take advantage of this tax law change? To begin with, the Act creates greater incentives to invest in equity and obtain capital gains treatment and/or dividend treatment, rather than lending funds and receiving interest income. The Act should ensure that U.S. corporations are better capitalized in the future.

Bear in mind that before the Act a C corporation borrowing capital and then paying interest to lenders or bond purchasers was allowed to deduct interest payments against its corporate level income. It was effectively able to “mimic” a single level of pass-through taxation. Although the Act does not exactly eliminate the distortions between debt and equity, the distortions have been reduced quite substantially.

Briefly explained, since the 1986 Tax Act, almost all privately owned U.S. business entities have become so-called “pass-through” entities, entities that are not taxpayers but pass the profits on to their equity owners, which are either S Corporations or LLCs. In 2003, but for this Act, the only parties that were likely to invest in C corporations were venture capitalists, who typically want preferred stock for a variety of business and tax reasons, or publicly traded companies, which are required by law to be taxed as C corporations. The effect was that the only businesses left in America that were C corporations were those that were either publicly traded or hoping to be publicly traded, and so the exorbitant double tax of corporations was, in effect, an efficient “proxy” tax on the deep and liquid U.S. capital markets.

To illustrate the economic drag created by double taxation, compare the level of pre-tax income that a C corporation was required to earn before and after the Act in order to give a capital provider $1 of after-tax return.

Simple math highlights the pre-Act disparity between debt and equity, and the incentive to both capital providers and capital seekers to use debt rather than equity to finance a C corporation. Under a debt scenario assuming a corporate-level income tax rate of 34%, a corporation that borrowed its capital pre-Act had to earn $1.66 and pay this amount out to its bondholder, in order for a bondholder (in the 39.6% federal tax bracket) to net $1 after taxes. In contrast, under an equity scenario, a pre-Act corporation had to earn $2.51 in order to pay a corporate-level tax of 34% and then distribute a dividend of $1.66, which, subject to a tax rate of 39.6%, would leave an after-dividend tax return of $1.

Under the new rules, the cost for a corporation to provide an after-tax return of $1 on a dividend basis is now reduced to $1.78, based on a 34% corporate tax rate and a 15% dividend tax at the shareholder level. This is still not as good as the amount needed to provide a $1 after-tax return on a loan-a C corporation following the Act must earn and pay $1.54 in interest (taxed at a 35% individual rate) to produce $1 in after-tax return-but the gap between borrowed capital and invested capital has been reduced dramatically.

Likewise, investments such as real estate investment trusts (“REITs”) that currently enjoy a single level of taxation, have not been altered or damaged in any way by the Act. However, to the extent that the pre-Act market recognized the inherent advantages of REITs, the reduction in the penalty on stocks means that there should be some shift from both REITs and from debt in the direction of equities.

It’s hard to say whether the Act will jump start the economy as promised, but the practical realty is that, in the face of a recessionary economy, political expedience led Republicans to emphasize the Act’s recession-fighting benefits rather than its inherent efficiency in the capital markets. Basically, President Bush and his minions touted the Act not as a good policy for the long-term prospects for American capitalism (which it emphatically is), but rather for its short-term salubrious effects on the job market.

The Act may in fact create an impetus for investment, a positive new attitude among investors and other good things. What it really does, however, is eliminate substantially the distortions in the capital market-which may or may not have an immediately positive effect on an economy that is still digesting a massive over-investment of capital in the late Clinton era. Basically, cheaper capital formation is good for capitalism in the long run, but, in the short run, in the face of a recent glut of capital spending, cheap capital may do little to prime the economic pump.

Still, the Act should have a positive effect on stock markets. The only question is: When? The answer requires more than recondite tax analysis, calling for crystal balls and tea leaves. The hope of most people, especially the Republicans who passed this new tax law, is that the economic recovery happens quickly. The informed opinion is that when the economy finally recovers and the equities market heats up again, the benefits of the Act will become apparent. Still, there is a fear that the economy may stagger along, political winds may shift, and the Act may be gutted by a Democratic Congress before it ever gets a fair test.

One final thought: A 15% capital gains rate is so low that anyone holding capital gains will be tempted to churn his portfolio while the rates are so low. Thus, fear that the 15% rate is transient may, ironically, provide an unexpected surge in tax revenue and make the Act a surprisingly successful revenue raiser. After all, when it comes to tax legislation, the only law that always applies is the law of unintended consequences.

Joseph “Jay” Darby is a partner in the Boston office of law firm Greenberg Traurig (