The corporate provisions of the Omnibus Budget Reconciliation Act of 1993.

• Author: Lerner, Herbert J.

Editor's note: This article was adapted from a chapter of Ernst & Young's Guide to the New Tax Law, published by John Wiley & Sons, Inc., New York, N.Y., 1993.

On Aug. 10, 1993, President Clinton signed into law the Omnibus Budget Reconciliation Act of 1993 (the "1993 Act"). The 1993 Act promises to reduce the deficit by $500 billion over five years. Of that, $16.4 billion will be raised by increasing the top corporate tax rate for corporations earning more than $10 million, and additional revenue will be raised from other provisions affecting corporations. This article will highlight the major aspects of the new legislation as they affect corporations.

Corporate Tax Rates

The new tax rates on corporate taxable income are as follows:

Taxable income Tax rate Up to $50,000 15% $50,001 - $75,000 25% $75,001 - $10 million 34%(*) Over $10 million 35%(**) (*)The phaseout of the benefits of the 15% and 25% rates still applies. Thus, taxpayers with taxable income between $75,001 and $100,000 still pay a 34% rate, and an additional 5% tax not to exceed $11,750 is imposed on corporate taxable income over $100,000, up to $335,000. (**)An additional 3% tax not to exceed $100,000 is imposed on corporate taxable income over $15 million. This increase in tax phases out the benefits of the 34% rate. Therefore, corporations with taxable income over $18.333 million pay a flat rate of 35%.

The income tax rate for personal service corporations and the maximum capital gain rate for corporations have been increased from 34% to 35%.

Effective date: The new rates apply to tax years beginning on or after Jan. 1, 1993. A fiscal year corporation is required to use a blend of the old and new rates for a tax year that includes but does not begin on Jan. 1, 1993. Accordingly, the corporation's applicable tax rate will be a weighted average of the rates.

Penalties for the underpayment of estimated taxes are waived for underpayments attributable solely to the changes in tax rates.

A fiscal-year taxpayer, who is required to use a blend of the old and new rates for a tax year that includes but does not begin on Jan. 1, 1993 (e.g., a Jan. 31, 1993 year-end), that may have filed or extended a tax return will be required to pay the additional tax imposed. However, for purposes of determining whether a valid extension exists, taxpayers are required to remit the estimated unpaid tax liability with the extension request. The determination of the required amount will be made under prior law.

* Commentary

In addition to the impact of increased corporate tax rates on cash flow, there may also be an impact on financial statements under Financial Accounting Standard (FAS) 109, "Accounting for Income Taxes." Under FAS 109, deferred tax assets or liabilities are measured using the enacted tax rates expected to apply to taxable income in the period in which the deferred tax asset or liability is expected to be settled or realized. In cases in which there has been a change in the tax rate or laws, the balance sheet is adjusted for the effect of the change. This change is recorded as a component of income tax expense relating to continuing operations in the period in which the law is enacted. For some companies, the increase in the corporate tax rate to 35% may result in a higher tax provision due to the adjustment of the deferred taxes. For example, a company has net deferred tax liabilities of $340,000 at the beginning of the year, applying a 34% rate. During the year, assume the company has no change in its temporary differences, but the tax rate increases to 35%. Under FAS 109, deferred tax liabilities would be adjusted to $350,000. The $10,000 difference reflects the rate change that will flow through the tax provision as a component of income tax expense, thereby reducing net income for financial statement purposes.

Also, as rates increase, the incentive for accelerating deductions increases. Thus, techniques used to accelerate deductions and defer income should provide greater benefits in the future.

The corporate alternative minimum tax (AMT) rate has not changed and remains at 20%. Since the spread between the AMT rate and the top regular tax rate increased by one percentage point, certain taxpayers may be able to benefit further by taking certain deductions that would be included in alternative minimum taxable income (AMTI), such as accelerated depreciation or utilization of certain credits, without paying AMT.

AET and PHC Tax

The accumulated earnings tax (AET) is a penalty tax imposed on C corporations that accumulate earnings beyond reasonable business needs. There is a presumption that such accumulations are made to avoid the imposition of a second level of tax on the earnings of a C corporation when the earnings are distributed to the shareholders (e.g., the income tax paid by an individual shareholder on dividends received from a corporation). Reasonable business needs include working capital and funds for expansion and diversification. The AET is imposed on accumulated taxable income, which consists of taxable income with certain adjustments, reductions and an accumulated earnings credit. The AET rate was 28%. The personal holding company (PHC) tax was also imposed at 28% on undistributed earnings of certain closely held companies with largely passive investments or personal service income. The 1993 Act increases AET and PHC tax rates to 39.6%.

Effective date: The new rates apply for tax years beginning after Dec. 31, 1992.

* Commentary

The 11.6 percentage point rate increase underscores the importance of establishing and documenting reasonable business needs, including working capital needs, in order to avoid the AET. The AET has taken on added significance as the IRS has made it a hot issue in audits of public companies in recent years.

Corporate Estimated Taxes

Under prior law, for tax years beginning before Jan. 1, 1997, to avoid penalties for underpayment of estimated taxes, a corporation was required to make quarterly estimated tax payments that totaled at least 97% of the tax liability shown on the corporation's return for the current tax year. A corporation may estimate its tax liability for the current year by annualizing its income through the period ending with either the month or the quarter ending prior to the estimated payment due date. For tax years beginning after Dec. 31, 1996, the 97% requirement would have become a 91% requirement.

Under a safe harbor rule, any corporation that is not a large corporation may still avoid penalties for underpayment if it makes four timely estimated tax payments each equal to at least 25% of the tax liability shown on its return for the preceding tax year (otherwise known as the prior-year tax exception). A large corporation may also use this rule but only for the first quarter of its current tax year. A large corporation is one that had taxable income of $1 million or more for any of the three preceding tax years.

Now a corporation that does not or may not use the prior-year tax exception is required to base its estimated tax payments on 100% of the tax shown on its return for the current year. The amount required to be paid per installment is as follows:

Installment Percent of tax due 1 25% 2 50% 3 75% 4 100% There is no change to the prior-year exception (safe harbor) for either small or large corporations, but the income annualization methods used to determine estimated tax payments have...