The continuing inability of Congress to agree on what to do with the expiring Bush tax cuts has real consequences, as small businesses remain stymied in their planning for the future.

And the picture won't get clearer anytime soon. Congress, back in session now for a brief period before the elections, is unlikely to resolve the situation before a "lame duck" session late in the year.

The National Federation of Independent Business reported that its Index of Small Business Optimism lost 0.9 points in July and reached 88.1 following a sharp decline in June. The index has been below 93 every month since January 2008, and below 90 for 24 of those 30 months. These readings are typical of a weak or recession-mired economy, according to the NFIB. Ninety percent of the decline resulted from deterioration in the outlook for business conditions in the next six months.

Dean Zerbe, former chief counsel to the Senate Finance Committee and national managing director for specialty tax services provider alliantgroup, labeled the uncertainty surrounding future tax rates, in part, a cause of the pessimism. "One big reason for the skittishness is that small-business owners have no earthly idea what their tax structure may be like next year," he said. "The top income tax rate, the small-business tax relief legislation and a host of credits and incentives are all being held hostage by election year politics - they're literally on edge."

Zerbe foresees two possible scenarios resulting from the November elections. "If the Republicans have a strong night, I think they are going to be pressing very hard for everything to be extended for a year, because they will feel, with justification, that they've won the issues," he said.

A "strong night" means that they take over the House and pick up seven or more Senate seats, according to Zerbe. "It could also mean that the Democrats say, 'Not today, we're still running the show.' That could bring the issue into a new Congress where Republicans control the House, and have a strong Senate. Then it's a real question as to whether the administration will come to the table and agree to an extension of the rates. I'm sure they'll remind the president of his quotes about not raising taxes in a down economy."

The other scenario, if the Republicans don't take the House and they win five or fewer Senate seats, would result in the Democrats feeling that they can go forward with a compromise position, Zerbe opined. "It might look something like the Kyl-Lincoln proposal for estate tax," he said.

"It's more than just an argument about the rates," Zerbe noted. "If the rates are allowed to expire, you're bringing back Pease and PEP as well."

PEP is the personal exemption phase-out for higher earners, while Pease is a similar phase-out of the benefits of most itemized deductions for earners above a certain limit. Both are absent for 2010, but will likely be re-instated next year.

THE EFFECTS OF SUNSETTING

If the tax cuts of 2001 and 2003 are allowed to expire, joint-filers with income above $250,000 and single-filers with income above $200,000 may face an increase in the top income tax rate, a higher tax rate on qualified dividends, an increase in the capital gains rate and a new Medicare tax on net investment income, according to Greg Rosica, tax partner at Ernst & Young and contributing author to the Ernst & Young Tax Guide.

"The certainty is that the Bush tax cuts are expiring based on current law, so if no one does anything we know what will happen," he said. "When you look at possible planning, there are a lot of other legislative proposals floating around."

"Our planning now is to move forward with ideas and analysis based on different scenarios, but we're not pulling the trigger on anything," he said. "We hope that there will be some clarity before the end of the year."

Rates will be going up one way or another, indicated Rosica. "The expiration of the cuts will bring about a rate increase, but there are other proposals out there that will bring this about as well," he noted. "An extension for a year puts off the inevitable. Capital gains will go to 20 percent if nothing else changes, while dividends will go from 15 percent to re-align with ordinary income rates, which will top out at 39.6 percent. Ordinary income brackets all ratchet up at every level, so every taxpayer will be impacted by a simple expiration of the Bush tax cuts. The expiration will raise the rates for everyone, contrary to what we've been hearing."

Health care reform further changes the landscape, but not until 2013. "The changes are significant and will continue to raise taxes on all income across the board," explained Rosica. "There will be a 3.8 percent rise added to capital gains, dividends and interest, and 0.9 percent on wages."

"Overall, the momentum is toward increasing rates, so we have to plan for that environment," he said. "The uncertainty has more to do with the timing, rather than the increase in rates. The timing of when we implement the plan will be updated by the kind of legislation we get between now and the end of the year."

FUTURE STRATEGIES

Among the moves that tax advisors should consider in the face of rising rates are accelerating some taxable items into 2010, Rosica said. These include:

Accelerating capital gains into 2010 and deferring capital losses until 2011;

Deferring certain itemized deductions into 2011;

Accelerating compensation into 2010 and reconsidering any deferred-compensation elections;

Accelerating the exercise of stock options into 2010;

Converting from traditional IRAs to Roth IRAs and paying for the tax conversion in 2010; and,

Revisiting estate plans.

The way that small businesses are impacted by increased tax rates can be at odds with the planning their employees may want to do, Rosica cautioned. "For example, S corporation or partnership employees may want to accelerate bonuses into 2010, but that would give the owner a deduction in a lower tax year. There might be a divergence of goals."

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