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Federal Income Tax Update for 2004

Largest Tax Act Since 1997

THE AMERICAN JOBS CREATION ACT OF 2004, IS THE LARGEST TAX ACT SINCE 1997. IT PROVIDES $145 BILLION IN TAX CUTS, CONTAINS 274 CHANGES TO THE INTERNAL REVENUE CODE AND HAS A CONFERENCE REPORT THAT RUNS 663 PAGES. WHILE MANY OF THE MEASURES PROVIDE WELCOME RELIEF, THERE ARE $95 BILLION IN REVENUE RAISERS. HERE ARE SOME KEY PROVISIONS.

Changes for Individuals

Sales tax deduction. Taxpayers in no- or low-income tax states can opt to deduct sales tax as an itemized deduction. This option applies for 2004 and 2005. It is helpful to those in states such as Florida where there is no income tax as well as those in states with low income tax if an individual makes a big ticket purchase, such as a car, so that the sales tax is greater that his or her income tax. The IRS is directed to create tables to be used for the sales tax write-off. However, it is not clear whether they will be ready by the filing season. Caution: Only itemizers benefit from this change.

Car donations. For contributions made after December 31, 2004, new appraisal rules apply to vehicles valued over $500.

• Regardless of value, if the charity or its agent sells the vehicle without using it, the donation is limited to the gross proceeds

• from the sale. Presumably this information will have to be passed on to donors.

• All such donations must be appraised and the donor must receive a written acknowledgment from the charity.

• The charity is required to give the IRS a copy of the acknowledgment given to the donor (effective after December 31, 2004).

Enhanced charitable deduction for intellectual property donations. As under present rules, the donation of a patent or other intellectual property (other than certain copyrights or inventory) is initially limited to the taxpayer’s basis in the property or its fair market value, whichever is less. However, after 2004, donors can also claim an additional deduction for a percentage of the income that the charity receives from the donated property (either in the year of the contribution or in a subsequent year).

Deferred compensation. Amounts earned under nonqualified deferred compensation plans after 2004 are included in income to the extent not subject to substantial risk of forfeiture and previously included in income unless certain requirements are satisfied. In addition to income inclusion, an interest penalty (the underpayment interest rate plus one percentage point) will be applied.

Discrimination litigation. Individuals who win a discrimination suit can effectively net their attorney’s fees against the award. This applies to awards after the date of enactment. The new provision is not retroactive, which means taxpayers who incurred attorney fees and costs before the date of enactment will not be helped.

Home sale exclusion. The exclusion cannot be claimed if the sale of a main residence occurred within five years of the home being acquired in a like-kind exchange. This applies to homes sold after the date of enactment.

Changes for Small Businesses

First-year expensing. The first-year expensing deduction (Code Sec. 179) has been extended for two more years. As such it will expire at the end of 2007 (rather than the end of 2005).

Heavy SUVs. The opportunity to apply the full first-year expensing amount when writing off the cost of an SUV used for business that weighs more than 6,000 pounds no longer applies. Effective for purchases after the date of enactment, the first-year expensing limit on vehicles weighing over 6,000 pounds but no more than 14,000 pounds is fixed at $25,000.

Qualified leasehold improvements. Nonresidential property-related improvements placed in service after the date of enactment (and before January 1, 2006) qualify for a 15-year recovery period, using straight-line depreciation instead of being required to be depreciated over 39 years.

Also, a 15-year recovery period as well as bonus depreciation applies to qualified restaurant property. This is property placed in service more than three years after the building is placed in service. The restaurant must use more than half of the building’s square footage.

Note: If the leasehold and restaurant improvements qualify as tangible personal property (e.g., special wiring), they can be separately depreciated over their shorter recovery periods using accelerated depreciation.

Income averaging. The opportunity to use income averaging, currently available only to farmers, has been extended to fishermen. In addition, such averaging can now be used for alternative minimum tax (AMT) purposes.

Changes for S Corporations

Number of owners. The law raises the number of eligible shareholders to 100 (up from 75). Also family members are grouped together and treated as one shareholder. Family members include common ancestors, lineal descendants (not more than six generations removed) of common ancestors and spouses or former spouses of these relatives.

Other changes. There are more than half a dozen other changes to S corporation rules, including:

• Allowing traditional and Roth IRAs to hold shares in a bank that is an S corporation.

• Allowing suspended losses or deductions to be transferred along with stock in case of divorce.

• Making it easier to determine current beneficiaries of electing small business trusts (ESBTs).

• Relaxing the passive activity loss rules with respect to qualified subchapter S trusts (QSSTs).

Other key provisions

The list of important changes made by the new law is too broad to cover fully. However, here are some highlights:

• Foreign sales corporation/extraterritorial income regime. The regime is gradually repealed (only 80 percent of the benefits apply starting in 2005). The change was made in light of the European Union penalty of 12 percent in response to the World Trade Organization’s ruling that the regime constituted an illegal trade subsidy.

• Manufacturers’ deduction. “Manufacturers” (which includes construction, engineering, energy production, computer software, films and videotapes and processing agricultural products will, when fully phased in by 2010, be able to deduct 9 percent of the less of qualified production activities or taxable income for the year. The deduction is limited to 3 percent in 2005 and 2006 and 6 percent in 2007 and 2008. The deduction applies for AMT purposes as well. For corporations, the deduction effectively lowers the top corporate tax rate from 35 percent to 32 percent.

• Abusive tax shelters. The law provides tough new anti-tax shelter provisions. The sanctions would apply not only to taxpayers engaging in these shelters but also “material advisors”

• (those doing business with such taxpayers).

• User fees. The law allows the IRS to impose user fees when issuing rulings and determinations through September 30, 2013.

Courtesy NPA Magazine, November, 2004.

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