2004 Tax Legislation
As you may know, Congress has recently passed two significant tax acts, The Working Families Tax Relief Act of 2004 and The American Jobs Creation Act of 2004. Together, the two tax acts extend certain otherwise expiring tax provisions, create new deductions, close some perceived loopholes, and provide for new or increased penalties for certain acts. Highlights of the legislation include:
Extension of expiring tax breaks – The research tax credit, the work opportunity tax credit, the welfare-to-work tax credit, and the increased alternative minimum tax exemption ($58,000 for married couples and $40,250 for singles) are extended through December 31, 2005. Partial marriage penalty relief and the $1,000 child tax credit are extended through 2010.
Repeal of the exclusion for extraterritorial income (ETI) – This tax break for exporters, which the World Trade Organization ruled to be an illegal subsidy, has been repealed for transactions after 2004, and is replaced with the much broader deduction for U.S. production activities discussed below.
New tax deduction for business income from domestic production activities – This new deduction applies to net income derived from U.S. manufacturing, production, growth, extraction, film production, construction, software development, and architectural and engineering services. The deduction, subject to some limitations, will, in general, be 3% of the net income from such activities for 2005 and 2006, 6% for 2007 – 2009, and 9% for 2010 and beyond. These deduction amounts roughly equate to a reduction in the otherwise applicable tax rate of 1%, 2% and 3%, respectively. The deduction is available for all types of business entities (C-corps, S-corps, partnerships, LLCs, sole proprietorships, etc.)
Temporary reduction in effective tax rate on repatriation of foreign earnings – In order to encourage U.S. companies with earnings retained in foreign subsidiaries to repatriate such earnings, the legislation provides a temporary election (generally 2004 and 2005) whereby the U.S. parent company can claim an 85% dividends received deduction on such dividends, thus paying an effective Federal tax rate of only 5.25% or less on such repatriated earnings.
Deduction of sales tax in lieu of deduction of state income tax – For 2004 and 2005, individual taxpayers will be able to elect to deduct their sales tax instead of their state income tax. This provision is likely to be very beneficial to taxpayers who reside in states with no individual state income tax (e.g. Florida and Texas), but may also benefit taxpayers who have minimized their state income tax with state tax credits or who make major purchases subject to sales tax. You will be able to deduct either the actual amount of sales tax paid or use tables to be published by the IRS and add to the amount from the table the sales tax on major purchases like cars and boats. The IRS is to publish tables based on the average consumption by taxpayers, on a state-by-state basis, of items other than motor vehicles, boats, etc., taking into account filing status, number of dependents, adjusted gross income and rate of state and local general sales taxation. Like the deduction for state income tax, the deduction for sales tax will have to be added back for purposes of the “alternative minimum tax”, so it is possible that your benefit from this new deduction may be limited if you are otherwise in or near the AMT posture.
Enhanced Section 179 deduction extended – The amount of fixed asset purchases that a business can elect to immediately expense for income tax purposes (rather than capitalizing and depreciating over a number of years) will remain at $100,000 (plus inflation adjustments) through 2007. Likewise, the level at which the benefit begins to be phased out will continue at $400,000 (plus inflation adjustments) of annual fixed asset additions.
Limitation on deduction for charitable donation of autos, boats, and planes – For tax years after 2004, your deduction will generally be limited to the amount that the charity receives when it sells the asset, and the charity will be required to report such to the IRS.
SUV loophole partially closed – Large SUVs (those with a GVWR in excess of 6,000 pounds) have been exempt from the “luxury automobile limits”, and thus up to $100,000 of the cost of such could be immediately expensed if used predominantly for business. Effective upon the President’s signing of the legislation, the deduction for the purchase of an SUV with a GVWR between 6,000 and 14,000 pounds will be limited to $25,000.
Restriction on combining like-kind exchange with residence gain exclusion – The home gain exclusion (up to $500,000 for a married couple) will no longer be available for the sale of a property which you acquired via a Section 1031 like-kind exchange within 5 years of the sale.
Increase in number of permissible shareholders for S-corps – Beginning in 2005, the number of permissible shareholders for an S-corp will be increased from 75 to 100, and you may elect to count all family members as one shareholder.
New civil penalty for failure to report foreign bank accounts – Taxpayers with a foreign bank or financial account which has in excess of $10,000 of value at any time during the calendar year must file a Form TD F 90-22.1 by June 30 of the following year. While there has long been a penalty for failure to do so, the penalty was based on a willful failure. This newly enacted penalty of up to $10,000 can apply regardless of whether the violation is willful.
Above-the-line deduction for attorney’s fees in discrimination claims – In the past, individuals who were winners of unlawful discrimination claims sometimes found that on an after-tax basis they were the real losers. This was because some jurisdictions had ruled that the full amount of the judgment or settlement had to be included in income while the attorney’s fees and other expenses were deductible only as miscellaneous itemized deductions not allowable for purposes of the alternative minimum tax. In extreme cases, this could mean that the income tax owed exceeded the net amount received. Under the new legislation, the attorney fees and other expenses will be an above-the-line deduction, such that you essentially net these against the amount of the judgment or settlement.
FICA and FUTA will not apply to ISOs and ESPP stock – Contrary to regulations proposed by the IRS, FICA and FUTA tax will not apply to the exercise or sale of Incentive Stock Option (ISO) shares or Employee Stock Purchase Plan (ESPP) shares.
Withholding rate on bonuses in excess of $1,000,000 increased – Federal tax withholding on bonus amounts in excess of $1,000,000 will have to be at a rate of at least 35%.
Nonqualified deferred compensation plan rules tightened – In order to avoid inclusion in income (and a new 20% penalty) a deferred compensation plan will have to meet new requirements pertaining to the timing of distributions, acceleration of benefits, and timing of deferral elections.
Leasehold improvements and restaurant property – Qualified leasehold improvements and restaurant property placed in service after the enactment date and before 2006 will be eligible for depreciation over 15 years, rather than the 39 year depreciation period that might otherwise apply.
Agricultural tax relief and incentives – The legislation contains a variety of tax breaks for farmers and other agricultural interests, including an extension of ethanol subsidies through 2010, an expansion of the provision permitting ranchers to defer gain on livestock sold as a result of weather-related conditions, an extension of the income averaging option and coordination of such with the alternative minimum tax, and several relief provisions for timber including expanding the situations in which timber sales qualify for capital gains treatment and providing for increased expensing of reforestation costs.
Tax shelter crackdown – The legislation provides new penalties for failure to disclose reportable transactions (i.e. those transactions that the IRS has identified as potentially abusive tax shelters) and understatement of tax as a result of such transactions, and curtails specific types of shelters such as the lease-in-lease-out (LILO) and sell-in-lease-out (SILO) transactions.
The analyses of these two tax acts provided by one of our publishers run well over 2,000 pages, so the above is obviously a very high level summary. If you have any questions about this new legislation and its impact on you or your business, give me a call.