Roaring into Tax Reform

By Janice Castro.

At the end of a year in which the stock market has taken one heart-stopping roller-coaster ride after another, the last thing that investors needed was a new element of uncertainty. But many of them are worried that the Tax Reform Act of 1986, which President Reagan signed two weeks ago, will bring on fresh dips and hairpin turns. By lowering tax rates but eliminating many deductions and preferences, the legislation has already changed the investment climate and forced people to take a hard look at their stock portfolios.

One threat is the possibility of a year-end market dive as investors sell off stocks in anticipation of a rise in the capital gains tax. Under current rules, only 40% of long-term capital gains, including profits from the sale of stock, is subject to taxation, which translates to a maximum rate of 20% on such income. Starting Jan. 1, however, all long-term capital gains will be taxed at a top marginal rate of 28%. Investors wishing to take advantage of the lower tax rate on these gains must unload their stock by Dec. 31.

Nonetheless, few Wall Street analysts expect the feared sell-off to materialize. One reason is that institutional investors control about one- third of all stock, and many of them, including most pension funds, are tax exempt and thus have no incentive to sell their holdings. Moreover, financial advisers are telling their individual clients to avoid indiscriminate dumping of shares. A stock should be sold, the experts caution, only if the investor thinks it has gone about as high as it will go. Otherwise the investor risks sacrificing hefty long-term profits in pursuit of modest tax savings. Says Barry Gordon, president of American Fund Advisors, a money-management firm: "If you have a stock that's worth holding, then hold it!"

Many investors are afraid to sell lest they miss out on the next leg of the bull market. Indeed, some Wall Street forecasters, encouraged by improving economic growth and a continuation of low interest rates, are predicting that the Dow Jones industrial average will pass the 2000 mark next year. For many shareholders, stocks remain the most attractive investments available, particularly since interest rates on bonds and bank accounts are relatively low at this time. Says James Campbell, an investor who heads a Manhattan photo-reproduction company: "Imagine I sold and took my profit and tax savings right now. What am I going to do with the money then? I don't see any better opportunities around." Andrew Lanyi, a top broker for the investment firm Ladenburg, Thalmann, says that only four of his 625 clients have sold stocks for tax reasons.

In contrast to the new capital gains provision, other parts of the tax law could help boost stock prices. It contains sections, for example, that will make mergers and acquisitions somewhat less attractive in 1987 by generally increasing the taxes that buyers of companies have to pay after the transactions. As a result, merger specialists are already reporting a flurry of activity as dealmakers try to beat the year-end deadline. "We are relaunching many merger and acquisition projects put on ice earlier," says Gordon Henderson, a partner with the Manhattan-based law firm of Weil, Gotshal & Manges. "Many acquisitions that commanded no urgency until passage of the new tax law have suddenly become most urgent."

As protection against the less favorable tax rules taking effect on Jan. 1, some acquisition contracts reportedly contain "drop-dead" clauses, which state that the deal is off if the transaction is not completed before year's end. In the midst of this merger activity, takeover speculation has driven up the stocks of some companies. Among them: Goodyear Tire & Rubber, whose shares rose from 34 1/2 on Oct. 1 to 48 1/4 at the end of last week, and the E.F. Hutton Group, which rose from 42 to 51 1/8 during the same period.

While the new law's short-term effect on the overall market is uncertain, it is sure to encourage investors to reshuffle the lineup in their portfolios, selling stock in companies that can be expected to pay higher taxes under the revised rules and buying the shares of firms that will benefit from the changes. The losers may include companies in such capital-intensive industries as utilities, chemicals, semiconductors and steel, which will relinquish numerous tax breaks. The investment tax credit will be dropped, for example, and depreciation schedules will be stretched out from 19 years to 31.5 years for commercial buildings, making plant expansion a more expensive proposition.

On the other side, tax reform will help many companies, including retailers and manufacturers of food and household products. Such firms have generally enjoyed few tax preferences. They stand to gain substantially when the top corporate tax rate falls from 46% to 34%. The makers of consumer goods will also benefit because the reduction in individual tax rates is expected to cause a $40 billion surge in personal spending.

In the long run, the new tax law is likely to be a boon to the stock market because it will sharply reduce the attractiveness of traditional tax shelters, ranging from real estate developments to cattle-ranching deals. One reason: investors will no longer be allowed to use so-called passive losses from these shelters to reduce their tax obligations on income from salaries and stock dividends. Says Norman Barker, a tax partner with Gibson, Dunn & Crutcher, a Los Angeles-based law firm: "I think it is safe to say that investors who once were in real estate and other tax shelters will turn to stocks."

One fast-growing industry that will undoubtedly reap a windfall from tax reform is the financial-advice business. "Congress has given us a supposedly simplified tax law," says Jean Hehn, a tax adviser in Port Washington, N.Y. "Well, there are so many ifs, buts and whens in it that it's going to bring our profession tremendous business for a long time." One sign of the trend: Shearson Lehman Bros. last week advised its clients to buy stock in H. & R. Block.

With reporting by Bill Johnson/Los Angeles and Raji Samghabadi/New York