INCOME TAX DEVELOPMENTS
For 2004
On October 22, 2004, President Bush signed the “American Jobs Creation Act of 2004" (Jobs Act) - a massive tax bill that impacts almost every facet of income taxation. This comes on the heels of the “Working Families Tax Relief Act of 2004" (a $146 billion tax relief bill signed into law on October 4, 2004). The American Jobs Creation Act of 2004 is being called the most significant reform of U.S. business taxation, in terms of both impact and number of provisions, since the Internal Revenue Code was revamped in 1986. The Jobs Act contains $145 billion of tax breaks. However, there are also $145 billion of revenue raisers in the bill to ensure that it is revenue neutral. So, taxpayers will see tax reductions in some areas and increased taxes in others.
Some of the significant provisions of these tax bills include: repeal of the controversial extraterritorial income (ETI) taxation regime; creation of a new business deduction for U.S. manufacturers and producers effectively reducing their income tax rate; extension of §179 expensing at the current levels for two more years; a reduction in depreciation for SUVs by limiting the §179 deduction to $25,000; increasing depreciation for qualified leasehold improvements and qualified restaurant improvements; changes in S corporation taxation rules (including expanding the permissible number of shareholders); tax relief for farmers and agricultural businesses; more stringent rules for deferred compensation plans; new penalties for tax shelters and other tax avoidance schemes (including leasing transactions); strict documentation rules and deduction limitations for charitable contributions of vehicles; deductions for state and local sales taxes in lieu of deductions for state and local income taxes; extension of many expired or expiring tax benefits; new rules reducing taxes for members of the military earning combat pay; and a new “qualifying child” definition for determining when a child and certain other relatives qualify as dependents.
This year has also produced many new regulations, rulings, and tax cases, including: final IRS regulations clarifying when an individual may use a portion of the home sale gain exclusion; rulings where IRS granted permission for an IRA rollover after 60 days; guidance on the new “health savings account;” tax relief for taxpayers in “presidentially declared disaster areas,” new regulations on student loan interest; depreciation relief for certain business trucks and vans weighing 6,000 lbs. or less; regulations allowing retroactive §179 elections; regulations explaining the depreciation calculation after a tax-free exchange; procedures for electing S status for LLCs and partnerships; and much more!
We are sending this letter to keep you abreast of these major tax developments. We have included those items we believe will affect the largest number of our clients.
Caution!
If you have heard or read about any recent tax development that is not discussed in this letter, feel free to call our office. We will help you research the matter to determine whether it will have a tax impact on you or your business.
This letter also contains many planning ideas. However, you cannot properly evaluate a particular planning strategy without calculating your overall tax liability (including the alternative minimum tax) with and without the strategy. You should also consider any state income tax consequences of a particular planning strategy. We recommend that you call our firm before implementing any tax planning technique discussed in this letter, or if you need more information.
AMERICAN JOBS CREATION ACT OF 2004
WORKING FAMILIES TAX RELIEF ACT OF 2004
THE MILITARY FAMILY TAX RELIEF ACT OF 2003
MEDICARE PRESCRIPTION DRUG MODERNIZATION ACT OF 2003
2004 TAX DEVELOPMENTS OTHER THAN NEW LEGISLATION
AMERICAN JOBS CREATION ACT OF 2004 [table of contents]
The “American Jobs Creation Act of 2004" (“Jobs Act”) is far too large and complex to cover in depth in this letter. Instead, the following summary highlights selected provisions we feel will have the greatest impact on individuals and small to mid-sized businesses.
BUSINESS PROVISIONS
New Deduction for U. S. Production Activities. The Jobs Act phases out the extraterritorial income (ETI) exclusion, which provides tax benefits for exporters. The ETI benefits will be reduced 20% in 2005, 40% in 2006 and will be repealed after 2006. To compensate U.S. producers, effective for tax years beginning after December 31, 2004, the Act creates a new deduction for eligible businesses which may include: manufacturers, U.S. construction companies, U.S. engineering and architectural firms, energy producers, extraction activities, U.S. film production, farmers, and those who process or store food products. This new deduction is based on the following percentages of the lesser of 1) “qualified domestic production income” or 2) taxable income: 2005-2006 (3%), 2007-2009 (6%), after 2009 (9%). The deduction cannot exceed 50% of the wages paid by the business. Planning Alert! The technical requirements for a business to qualify for this new deduction are too lengthy and complex to discuss in this letter. Please contact our firm and we will be glad to give you more details. Tax Tip. Any type of business entity can qualify for this deduction, including a C corporation, an S corporation, a partnership, an LLC, a sole proprietor, etc. However, it appears that a one-person sole proprietorship (with no employees) would not qualify for a deduction, because the income from that business is not paid to the owner in the form of wages. Consequently, with no wages, no deduction would be allowed because the deduction is limited to 50% of wages paid by the business. Therefore, it may be advantageous for a proprietor that is conducting qualifying activities, to become an S corporation and pay wages to the proprietor to qualify for the deduction for U.S. production activities.
S Corporation Changes. With strong support from the business community, the Jobs Act includes several pro-taxpayer changes to the S corporation rules, including:
More Depreciation for Certain Leasehold Improvements and Restaurant Improvements. Generally, if a lessor or lessee makes leasehold improvements to a commercial building, the improvements must be depreciated using a 39-year recovery period. However, a 50% additional depreciation deduction is available for “qualified leasehold improvements” placed in service before January 1, 2005. A qualified leasehold improvement is generally an improvement made to the interior portion of a commercial building (i.e., non-residential real property) by the lesser or the lessee pursuant to a lease. The leasehold improvement also must be placed in service more than three years after the building was first placed in service (so the building must be a commercial building more than three years old). In addition, certain leases between related parties will not qualify. Effective for property placed in service after October 22, 2004, and before January 1, 2006, the Jobs Act provides that “qualified leasehold improvements” will be depreciated over 15 years rather than 39 years. A “qualified leasehold improvement” has the same definition as used for the 50% first year bonus depreciation (explained above). Restaurant Property. The Jobs Act also allows “qualified restaurant property” to be depreciated over 15 years, if placed in service after October 22, 2004 and before January 1, 2006. Qualified restaurant property means any improvement to a building (whether or not a leasehold improvement), if the improvement is placed in service more than three years after the building was first placed in service. Furthermore, more than 50% of the building’s square footage must be devoted to the preparation of, and seating for, on-premises consumption of prepared meals. Tax Tip. If the qualified restaurant property is placed in service after October 22, 2004, and before January 1, 2005, it will also qualify for the 50% additional depreciation deduction.
§179 Deduction for SUVs Reduced. The maximum annual depreciation deduction for business passenger automobiles is capped at certain dollar amounts. However, trucks, vans and SUVs are exempt from these “passenger auto” depreciation limitations if the “gross vehicle weight” exceeds 6,000 lbs. (e.g., a full-size pick-up; a full-size van; or a sport utility vehicle, including: Expedition, Range Rover, Tahoe, Durango, Suburban, BMW X-5, etc.). Consequently, prior to the Jobs Act, if more than 50% of the use of one of these vehicles was for business purposes, you could have taken the §179 deduction (up to $102,000 in 2004) with respect to the business portion of the vehicle. For example, if the vehicle had 100% business use, you could have immediately deducted up to $102,000 of its cost in 2004 (if it otherwise qualified under §179). Under the Jobs Act, SUVs, vans and certain other vehicles that have a gross vehicle weight of 14,000 lbs. or less are limited to a §179 deduction of up to $25,000 (reduced from $102,000). This new rule is effective for vehicles placed in service after October 22, 2004. Example. Assume that on December 1, 2004, your business purchases an SUV (weighing 6,005 lbs.) for $70,000, which you use 100% for business. Assume further that this SUV qualifies for the maximum §179 deduction, the 50% additional first-year depreciation, and the normal accelerated depreciation deductions (using the mid-quarter convention). The total deductions in 2004 on this SUV would be $48,625, computed as follows: (i) a §179 deduction of $25,000, plus (ii) additional 50% first-year depreciation of $22,500 on the remaining basis ([$70,000 - $25,000] x 50%), plus (iii) $1,125 of MACRS depreciation ([$45,000 - $22,500] x 5% [using mid-quarter convention and 200% declining balance]). The remaining $21,375 of cost would be recovered in 2005 and later years under the general depreciation rules. Planning Alert! If the SUV is instead placed in service on January 2, 2005 (when the 50% depreciation is no longer available), the total depreciation deductions for 2005 would be only $34,000 (using the mid-year convention). Therefore, if you want maximum up-front depreciation deductions, you must place the SUV in service before 2005. Tax Tip. As you evaluate the impact of this new rule, please keep the following points in mind:
Increased §179 Deduction Extended Through 2007. The Jobs Act extends the increased §179 deduction ($102,000 for 2004) to taxable years beginning before 2008. Before this change, the §179 deduction was to revert to $25,000 beginning in 2006. Furthermore, the deduction amount will continue to be indexed for inflation through 2007 and taxpayers will be able to revoke or make an election to take the §179 deduction on amended returns for tax years beginning after 2002 and before 2008. Also, the $410,000 level (for 2004) at which the deduction begins to phase-out will continue (with indexing)through 2008.
50% Bonus Depreciation Generally Sunsets After 2004. As discussed above, the 50% bonus depreciation provision generally sunsets for any property placed in service after December 31, 2004. The placed-in-service date is extended one year (i.e., for property placed in service before 2006) for certain property with a recovery period of 10 years or longer and certain transportation property. To qualify, the property must have a production period exceeding 2 years or, if the cost of the property exceeds $1 million, the production period must exceed 1 year. However, the 50% deduction is only allowed for expenditures through December 31, 2004. The Jobs Act adds “qualified non-commercial aircraft” to the list of property that qualifies for an extended placed-in-service date. If your business acquires a “qualified non-commercial aircraft,” the entire cost should qualify for the 50% bonus depreciation, if the aircraft is placed in service before January 1, 2006 and certain additional requirements are met. A “qualified non-commercial aircraft” (which is entitled to the extended placed-in-service date) cannot be used for transporting persons or property (except for agricultural or firefighting purposes), must have an estimated production period exceeding 4 months, a cost exceeding $200,000, and there must have been a deposit of the lesser of 10% of the cost or $100,000 at the time the purchase contract was entered into. Generally, to qualify, you must also have a binding, written contract to purchase the aircraft by December 31, 2004.
Congress Closes Airplane Deduction Loophole. The Jobs Act closes a perceived tax loophole involving company owned aircraft. Here’s how it worked. A business would buy an expensive airplane, deduct all of the operating expenses with regard to the airplane, and allow employees to use the company airplane for personal travel. The company would include the value of the personal travel in the employees’ taxable compensation based on an inclusion formula (using the SIFL rates) established by the IRS. Based on recent case law, the company was allowed to deduct all of the operating expenses of the aircraft which related to the employees’ personal travel, as long as they included the personal use of the aircraft in employees’ incomes using the IRS formula. In one documented case, the actual expenses allocable to the personal use of the airplane were 10 times the amount included in the employees’ incomes for personal use. Effective for expenses incurred after October 22, 2004, the Jobs Act provides that a company’s deductions for the personal use of the aircraft by “specified employees” is limited to the dollar amount included in the W-2 of these specified employees for the personal flights. “Specified employees” generally include officers, directors, and 10%-or-greater owners of private and publicly-held businesses.
New Rules for Business Start-Up and Organizational Expenses. Expenses incurred to start a new business (start-up expenditures) or to set up a new corporation or partnership (organizational expenditures), are not immediately deductible. Instead, prior to the Jobs Act, if your business filed the proper election, it could amortize the start-up expenditures and/or organizational expenditures generally over a 60 month period (beginning with the month the business began operations). For “start-up expenditures” and “organizational expenditures” incurred after October 22, 2004, the Jobs Act extends the amortization period from 60 months to 180 months. However, under the Act, your business may elect to deduct up to $5,000 of start-up expenses and separately elect to deduct an additional $5,000 of organizational expenditures (if applicable) in the taxable year in which the business begins. However, each of these $5,000 amounts is reduced by each dollar the total start-up expenditures or organizational expenditures exceed $50,000, respectively. Planning Alert! These elections must be made by the due date of the return for the year in which the business begins. Missing this due date, in some situations, could cost your business the deduction entirely. Tax Tip! If you, as a shareholder of your corporation or partner in your partnership pay these expenditures out of your personal funds, make sure your corporation or partnership formally reimburses you. Otherwise, it is possible these deductions may be lost.
Amortization of Sports Franchises. Effective for acquisitions after October 22, 2004, the Jobs Act provides that the acquisition of franchises to engage in professional sports and any intangible assets acquired with respect to that franchise (including player contracts) are amortized over a 15-year period.
New Restrictions on Non-Qualified Deferred Compensation Plans. Non-qualified deferred compensation plans are frequently used as part of a compensation package providing financial incentives to executive and middle management employees. Congress believes that many companies are too aggressive with their non-qualified deferred compensation plans and are deferring compensation income without sufficient restrictions on the funds. Consequently, generally effective for compensation amounts deferred after 2004, the Jobs Act for the first time establishes comprehensive statutory criteria that must be satisfied to defer compensation income under non-qualified plans. Generally, amounts deferred under these plans before January 1, 2005, will not be subject to these new rules. However, if the plan is “materially modified” after October 3, 2004, amounts deferred prior to 2005 could be subject to taxation, an interest charge, and a 20% penalty. Caution! Materially modifying a deferred compensation plan after October 3, 2004 could result in serious tax consequences unless the plan already complies with the Jobs Act requirements! Planning Alert! If your company sponsors, or you are a beneficiary of, a non-qualified deferred compensation plan, it is imperative that this plan be reviewed by us and an attorney responsible for the plan. At least a preliminary review should take place before December 31, 2004 and before any additional deferrals are elected for 2005. Please call our office if you want us to assist you in this review.
Farmer and Fisherman Income Averaging. If you are an individual engaged in a qualified farming business, you are allowed to compute your current year regular tax liability using a special income averaging calculation. For taxable years beginning after December 31, 2003, the Jobs Act extends the benefits of this income averaging rule to qualified fishermen. Furthermore, the Act prevents farmers and fishermen from incurring additional alternative minimum tax liability because income averaging reduces their regular tax.
Partnership Cancellation of Debt Income. A corporation that satisfies a debt by transferring its stock to a creditor must recognize cancellation of indebtedness (COD) income to the extent that the satisfied debt exceeds the fair market value of the stock transferred. Effective for debt cancellations after October 22, 2004, the Jobs Act applies this same rule to a partnership that satisfies its partnership debt with an interest in the partnership. That is, if a partnership satisfies a recourse or non-recourse debt by transferring an interest in the partnership to a creditor, the partnership will recognize COD income to the extent the debt satisfied exceeds the fair market value of the transferred partnership interest. This COD income is allocated among the partners who held an interest in the partnership immediately prior to the satisfaction of the debt.
Modification of Definition of Controlled Group of Corporations. Historically, brother/sister corporations that are members of a controlled group, must apportion among themselves 1) the amount of income subject to lower tax rates (the surtax exemptions), 2) the §179 deduction amount, 3) the alternative minimum tax exemption amount, and 4) the accumulated earnings tax exemption amount. Before the Jobs Act, a corporation was a member of a brother/sister controlled group of corporations if stock owned by five or fewer persons, who are individuals, estates or trusts, possessed 1) at least 80 percent of the total combined voting power of all voting stock, or at least 80 percent of the total value of shares of all classes of the stock of each corporation, and 2) more than 50 percent of the total combined voting power of all classes of stock entitled to vote, or more than 50 percent of the total value of shares of all classes of stock of each corporation, taking into account the stock ownership of each such person only to the extent such stock ownership is identical with respect to each such corporation.
The Jobs Act, removes the 80% test of pre-Act law and keeps the 50% test in determining a brother/sister controlled group for purposes of allocating 1) the surtax exemptions, 2) the AMT exemption amount, and 3) the accumulated earnings exemption amount. For tax years beginning after October 22, 2004, "brother-sister controlled group,” for these purposes, means two or more corporations if five or fewer persons who are individuals, trusts or estates own stock possessing more than 50 percent of the total combined voting power of all classes of stock entitled to vote, or more than 50 percent of the total value of shares of all classes of stock of each corporation, taking into account the stock ownership of each such person only to the extent such stock ownership is identical with respect to each such corporation.
Planning Alert! Many closely-held corporations have been structured so that different individuals (who are not family members) own more than 20% of each corporation’s stock to intentionally fail the 80% test. However, most of these companies will pass the more than 50% test and will be considered a controlled group under these new rules. Therefore, these corporations will no longer qualify for multiple surtax exemptions, multiple accumulated earnings tax exemption amounts, or multiple AMT exemption amounts. If you believe this provision will affect your companies, we will gladly help you analyze the situation. Tax Tip. Certain brother/sister corporations are also required to share the §179 deduction ($102,000 for 2004). However, the Jobs Act retains the old test for purposes of allocating the §179 deduction. In other words, a group of corporations that do not pass the 80% or more ownership test of prior law are not required to allocate the §179 deduction.
INDIVIDUAL PROVISIONS
Excluding Gain on Sale of Principal Residence. For the past several years, Congress has been concerned that taxpayers were inappropriately combining the §1031 like-kind exchange rules with the §121 home-sale exclusion rules. For example, assume you own a highly-appreciated commercial building worth $500,000. You swap that building in a tax-free, like-kind exchange for a $500,000 beach resort home that you rent to an outsider for a reasonable period of time. Later, you move into the beach home and establish it as your principal residence for 2 years. Under prior law, you could then sell the beach home and exclude up to $250,000 of gain ($500,000 on a joint return) under the home-sale exclusion rules. To curb this perceived abuse, the Jobs Act provides a new rule. Effective for home sales after October 22, 2004, if you sell your residence and it was acquired in a tax-free, like-kind exchange within the five year period ending on the date of the sale, any gain on the sale is taxable. Tax Tip. The new rule doesn’t change the requirement that you must “use” the residence as your principal residence for 2 years out of the 5-year period ending on the date of the sale, it merely adds a new 5-year waiting period where the residence was acquired in a like-kind exchange.
Attorney Fees. After years of controversy, Congress has resolved the issue of how to deduct attorney fees relating to taxable damage awards. Unless you are recovering for a “physical” personal injury, most lawsuit recoveries are fully taxable. However, courts in some circuits (5th, 6th, 9th, and 11th Circuits) believe that an individual is taxed only on the damage award net of any attorney’s fees paid with regard to the lawsuit. In other circuits (2nd, 4th, 7th, 10th, and Federal Circuits), courts have held that an individual is taxed on 100% of the damage award, and is entitled to a “miscellaneous itemized deduction” for the resulting attorney’s fees. Unfortunately, a miscellaneous itemized deduction cannot be deducted for “regular” tax purposes, except to the extent all itemized deductions exceed 2% of adjusted gross income. Furthermore, these deductions are not allowed at all for alternative minimum tax (AMT) purposes. Consequently, individuals receiving payments in circuits that treat attorney’s fees as miscellaneous itemized deductions pay significantly more taxes than plaintiffs recovering in circuits that only tax the award net of attorney’s fees. Effective for fees and costs paid after October 22, 2004, with regard to any judgment or settlement taking place after October 22, 2004, the Jobs Act allows an “above-the-line” deduction for claims of unlawful discrimination, certain claims against the Federal Government, and certain claims under the Medicare Secondary Payer Statute. Good News! Because this deduction is now “above-the-line,” the attorney’s fees and court costs will no longer be subject to any percentage reduction applied to itemized deductions, and can be claimed fully for AMT purposes. Tax Tip. The United States Supreme Court is poised to settle this issue for judgments, settlements, and related fees before October 23, 2004. If you have settled a lawsuit in the past and treated the attorney’s fee as a “miscellaneous itemized deduction,” you should consider filing a protective claim for refund before the statue of limitation runs for that tax year. This could enable you to recover your taxes if the Supreme Court rules that taxable damage awards are included in income net of attorney fees. We will gladly help you prepare a protective claim for refund.
New Deduction for State and Local Sales Tax. Prior to 1987, you could deduct both your state and local income taxes and sales taxes as an itemized deduction. After 1986, however, Congress removed the deductibility of state and local sales taxes. Generally for 2004 and 2005, the Jobs Act allows you to “elect” to deduct “either” state and local income taxes or state and local sales taxes, as itemized deductions. If you elect to deduct sales taxes, your deduction is either 1) your actual sales taxes substantiated by receipts, or 2) an amount provided in IRS tables (based on your filing status, income, etc.), plus any sales tax you pay on the purchase of a motor vehicle, boat, or other items prescribed by the IRS. Tax Tip. This new election will be particularly beneficial to the residents of states with little or no state income taxes or states where the state income tax rate is generally lower than the sales tax rate. However, this option may also help individuals in any state where the state income tax liability has been significantly reduced because of state credits, etc. Also, taking the sales tax deduction rather than the state income tax deduction may avoid including a state income tax refund in federal taxable income in a subsequent year.
Auto Expenses of Rural Letter Carriers. Effective for tax years beginning after 2003, rural letter carriers may deduct the excess of their automobile costs over the government reimbursement as a miscellaneous itemized deduction.
CHANGES AFFECTING INDIVIDUALS AND BUSINESSES
Donations of Motor Vehicles, Boats, and Aircraft. Generally, if you contribute non-cash property to a charity, you are entitled to a charitable contribution equal to the fair market value of the contributed property. Items valued at more than $5,000 (except marketable securities) generally require a “qualified appraisal.” In recent years, the IRS has been concerned that some taxpayers were contributing automobiles, boats, etc. and deducting an inflated value as a charitable contribution. To curb these perceived abuses, the Jobs Act adds stringent reporting and documentation requirements, for the donor and the charity, that must be satisfied in order to claim a charitable deduction in excess of $500 for a “qualified vehicle”. A “qualified vehicle” generally includes motor vehicles designed for highway use, boats, or airplanes. The new rules are effective for contributions made after December 31, 2004. Generally, under the new rules, you will be required to receive a detailed, written receipt from the charity. If the charity sells the vehicle without any material improvement or significant use of the vehicle by the charity, your charitable deduction cannot exceed the gross sales price of the vehicle which must be listed on the receipt. The charity will be required to send a copy of the receipt to the IRS, and you will be required to attach a copy of the receipt to your tax return. Furthermore, significant penalties are imposed if the charity fails to provide a timely, accurate and complete receipt. Tax Tip. You will not be subject to these new stringent reporting requirements if you contribute a vehicle by December 31, 2004. However, if the vehicle has a value of more than $5,000, an appraisal is required.
New Limits on Charitable Contributions of Intellectual Property. The IRS has expressed concern that many businesses are taking inflated deductions for charitable contributions of patents and other intellectual property. For contributions after June 3, 2004, the Jobs Act limits the taxpayer’s initial charitable contribution deduction to the lesser of the taxpayer’s basis or the fair market value of the following property: patents, certain copyrights, trademarks, trade names, trade secrets, know-how, certain software, or similar intellectual property or applications or registrations of such property. However, the donor may be entitled to additional charitable contribution deductions if the donated intellectual property generates income to the charity. Planning Alert! These additional deductions are not allowed for contributions to certain private foundations.
Also, new reporting and documentation requirements are imposed on charities that receive “qualified intellectual property” contributions.
Non-Cash Charitable Contribution Requirements Expanded to C Corporations. Before this legislation, regular C corporations (other than closely-held corporations and personal service corporations) were exempt from certain charitable contribution reporting requirements that applied to all other taxpayers. To create parity among taxpayers, effective for contributions made after June 3, 2004, the Jobs Act extends charitable contribution reporting requirements of non-cash property (other than publicly-traded securities, inventory, and certain qualified vehicles) to all C corporations and adds a new rule for contributions in excess of $500,000. If the property is valued at more than $500, all taxpayers must attach to their return a written description of the donated property using Form 8283. If the property is valued at more than $5,000, all taxpayers must obtain a “qualified appraisal” and include a summary of the appraisal along with Form 8283. If the contribution is more than $500,000, the qualified appraisal must be attached to the tax return. Planning Alert! If you fail to meet these reporting requirements, your charitable deduction could be denied altogether.
Penalties for Failing to Disclose Shelter Transactions. For the last several years, IRS has been trying to curtail aggressive tax shelter deductions. There are many types of transactions that are now required to be disclosed on tax returns because the IRS has identified the transactions as “listed transactions” or other “reportable transactions.” Effective for returns and statements due after October 22, 2004, the Jobs Act contains several penalty provisions for taxpayers who invest in tax shelters and do not make the proper disclosures. For example, the penalty forfailing to report a “listed transaction” is $100,000 for individuals and $200,000 for corporations. Please contact us before you consider investing in any “tax shelter” transaction. These transactions must be handled very carefully.
Installment Agreements and Partial Payment of Taxes. Under current law, if you can establish reasonable cause, the IRS has the authority to allow you to pay your back taxes, interest, and penalties on an installment payment plan. This plan does not reduce the amount of taxes, interest, or penalties owed, it simply gives you more time to pay. However, the IRS has no authority allowing you to pay a portion of these reduced taxes under an installment plan. Effective for installment agreements entered into with the IRS after October 22, 2004, the IRS is now authorized to allow you to pay an agreed upon partial payment of your taxes under an installment agreement. This new pro-taxpayer provision should facilitate partial payments for taxpayers who qualify and are experiencing severe financial distress in paying their back taxes.
MISCELLANEOUS PROVISIONS
The Jobs Act contains many other provisions not covered in this letter. The following are a few of those provisions:
WORKING FAMILIES TAX RELIEF ACT OF 2004 [table of contents]
On October 4, 2004, President Bush signed the Working Families Tax Relief Act of 2004 (“Family Tax Act”) into law. This $146 billion tax bill not only extends tax breaks that were scheduled to expire, but also contains several tax relief provisions. The following is a summary of the provisions of The Family Tax Act.
INDIVIDUAL PROVISIONS
AMT Relief. Originally, the alternative minimum tax (AMT) exemption amount for joint returns was scheduled to drop from $58,000 to $45,000 ($40,250 to $33,750 for single taxpayers) for tax years beginning after 2004. The higher AMT exemption amount has now been extended through 2005.
Non-Refundable Personal Credits Will Apply Against Regular and AMT Tax. The ability of individuals to offset certain non-refundable personal credits against AMT was scheduled to sunset after 2003. The Family Tax Act extends the rule allowing non-refundable personal credits to the full extent of AMT for tax years beginning in 2004 and 2005.
Marriage Penalty Relief. In certain situations, if you are married and file a joint return, you may pay more income tax than you and your spouse would pay combined if each of you were single. Last year, Congress accelerated the effective date of earlier legislation that reduced (but did not eliminate) this “marriage” tax penalty for 2003 and 2004. The relief came in the form of increasing the standard deduction and the size of the 15% tax bracket on a joint return. The Family Tax Act extends this relief through 2010.
Expanded 10% Tax Bracket. Last year, Congress increased the amount of income taxed at the 10% rate for both single and joint filers for 2003 and 2004. The Family Tax Act extends this increase through 2010.
Increased Child TAX Credit. The $1,000 child tax credit was scheduled to drop from $1,000 to $700 in 2005. The Family Tax Act maintains the credit at $1,000 through 2010. Also, you may be entitled to a refund of your child tax credit even if your credit exceeds your federal income tax liability. Last year, you could have received a refundable credit to the extent of 10% of your “earned income” in excess of $10,500. For years beginning after 2003, the Act increases the refundable credit to 15% of your earned income in excess of $10,750. Moreover, starting in 2004, the Act includes tax exempt “combat pay” in the definition of “earned income” for purposes of the refundable child tax credit. Tax Tip. Last year, if you had one qualifying child, you had to earn at least $20,500 to be entitled to a full “refundable” child tax credit of $1,000. For 2004, you need earned income of only $17,417 to qualify for the full $1,000 refundable credit.
Uniform Definition of Child for Tax Purposes. Before the Family Tax Act, taxpayers with children could possibly qualify for five different tax benefits: the dependency exemption; the child tax credit; the earned income credit; the child dependent care credit; and head-of-household filing status. Each of these provisions had separate tests for determining whether the child qualifies the taxpayer for the tax benefit. Starting in 2005, the Act establishes a uniform definition of “qualifying child” that can be used for each of the above-listed tax benefits. Planning Alert! The Act also contains new rules for divorced or separated parents. For example, legal custody will not determine who is the custodial parent after 2004. Instead, the custodial parent will be the parent with whom the child lived for the greater portion of the year. As under current law, the custodial parent may allow the non-custodial parent to claim the child as a dependent.
Exempt Combat Pay Is Earned Income For Earned Income Credit Calculation. Low-income workers can qualify for a refundable earned income credit (“EIC”). The amount of the credit varies with the amount of their “earned income.” Prior to the Family Tax Act, “earned income” for purposes of the EIC did not include tax exempt combat pay paid to military personnel. For tax years ending after October 4, 2004 and before January 1, 2006, military personnel may elect to treat combat pay as earned income for EIC purposes. Planning Alert! If a taxpayer has “earned income” from sources other than combat pay, electing to treat the combat pay as earned income could actually cause the taxpayer to lose all or a portion of his or her earned income credit. In that case, the election should not be made.
Educators Classroom Expense Deduction. The Family Tax Act extends the above-the-line deduction for up to $250 for books, supplies, computer equipment, etc. used in the classroom by elementary and secondary school teachers through 2005. This deduction had been scheduled to sunset after 2003.
BUSINESS PROVISIONS
Research Credit. The credit for qualified research expired June 30, 2004. The Family Tax Act continues the 20% research credit for qualified research expenses paid or incurred after June 30, 2004 and before 2006.
Work Opportunity Tax Credit. A business employing certain targeted individuals (e.g. qualified veterans, members of families receiving food stamps, high-risk youth), might qualify for the “work opportunity tax credit” based on a percentage of first-year wages paid to those employees (see Form 8850 for a summary of qualified employees). This credit expired for individuals who began work after December 31, 2003. The Family Tax Act reinstates the credit and extends it to any amount paid or incurred to qualified individuals who begin work before 2006. Tax Tip. If a qualifying employee is hired no later than December 31, 2005, the wages paid to that employee for a period of 1 year after the date of employment will qualify for the credit, even if those wages are paid after December 31, 2005.
Welfare-to-Work Credit. The “welfare-to-work credit” is available to employers who pay eligible wages to qualified long-term family assistance recipients during the first 2 years of employment (see Form 8850 for additional information). This credit expired for wages paid to qualified individuals who began work after December 31, 2003. The Family Tax Act reinstates the credit and extends it to any amount paid or incurred to a qualified individual who begins work before 2006. Planning Alert! If a qualifying employee is hired no later than December 31, 2005, the wages paid to that employee for a period of 2 years after the date of employment will qualify for the credit, even if those wages are paid after December 31, 2005.
Qualified Computer Contributions. Corporations, other than S corporations, personal holding companies, and personal service organizations, get an enhanced charitable deduction for “qualified computer contributions.” This provision expired for tax years beginning after December 31, 2003. The Family Tax Act reinstates and extends this enhanced deduction rule for contributions made during any tax year beginning before 2006.
Electric Vehicle Credit. Generally, a 10% tax credit of up to $4,000 is allowed for the cost of “qualified electric vehicles” used for business or personal purposes. This credit was scheduled to be reduced beginning in 2004. Under the Family Tax Act, the full credit is available for qualified electric vehicles placed in service before 2006. The credit is reduced by 75% in 2006 and is scheduled to sunset after December 31, 2006.
Clean Fuel Vehicle Deduction. Generally, the cost of a “qualified clean-fuel vehicle” can be immediately deducted up to $2,000, $5,000, or $50,000, depending on the type of vehicle. These deductions were scheduled to be reduced beginning in 2004. However, the Family Tax Act extends these full deduction amounts for qualified clean-fuel vehicles placed in service before 2006. For 2006, the deduction amounts are reduced by 75%, and they are scheduled to sunset after 2006. This provision applies to individuals and businesses.
Miscellaneous Extenders. In addition to the above-listed items, the Family Tax Act extended the following tax benefits: suspension of the 100 percent-of-income limitation for depletion for oil and gas produced from marginal wells (for tax years beginning before 2006); expensing costs of cleaning up Brownfields (through 2005); credit for producing electricity from certain renewable resources (effective for facilities placed in service before 2006); Indian employment tax credit (through tax years beginning before January 1, 2006); accelerated depreciation for business property on Indian reservations (extended to property placed in service before 2006); District of Columbia incentives (extended through 2005); Qualified Zone Academy Bonds (extended through 2005); New York Liberty Zone Bonds (extended through 2009); and Archer Medical Savings Accounts (extended through 2005).
THE MILITARY FAMILY TAX RELIEF ACT 0F 2003 [table of contents]
On November 11, 2003, President Bush signed the Military Family Tax Relief Act (“Military Tax Act”). This new law provides tax relief to members of the Armed Forces. The tax relief includes:
Increased Death Benefits. The Military Tax Act doubles the military death benefit from $6,000 to $12,000 for those killed in combat or combat related activities, effective for deaths after September 10, 2001. Previously, the death benefit was $6,000, and only $3,000 was tax free.
Home-Sale Relief. If you are in the military and you are transferred due to a military assignment more than 50 miles away from your home, under the Military Relief Act, you may suspend the 2 out of 5 year testing period for excluding the gain on the sale of your home (i.e., the $250,000 or $500,000 gain exclusion rule) for up to 10 years. This new rule is effective for sales or exchanges after May 6, 1997. This generally means that if you meet the 2-year rule (or qualified for a pro ration of the 2-year rule) at the time you were placed on a qualified military assignment, you will continue to qualify for that exclusion while you are on that assignment for up to 10 years. This new rule is available to members of the Army, Navy, Air Force, Marine Corps, Coast Guard, Commissioned Corps of the National Oceanic and Atmospheric Administration, Commissioned Corps of the Public Health Service, and the Foreign Service. Tax Tip. This tax relief is retroactive, so, if you have previously sold your house while in the military and you were on a qualified long-term assignment and paid tax on the gain on the sale of the house, please contact our office. We may be able to file for a refund.
Tax Relief for Homeowners’ Assistance. The Department of Defense operates a special program to assist military homeowners when military bases close and home values decline. If you received a payment under this program after November 11, 2003, that payment is now tax free.
National Guard and Reserve Travel. If you are a member of the National Guard or Military Reserves, you may now take an “above-the-line” deduction for travel costs more than 100 miles from your home that requires you to stay overnight. Before this change, these travel expenses were required to be itemized and were reduced by 2% of your adjusted gross income. Tax Tip. This new rule applies to any amount paid or incurred for tax years starting after December 31, 2002. If you qualified for these deductible travel expenses and failed to take them as an “above-the-line” expense on your 2003 return, please call us. We will assist you in amending your 2003 return.
Tax-Free Child Care Benefits. For tax years beginning after 2002, all child care benefits provided to military employees are excluded from income (civilians can only exclude up to $5,000 annually for employer-provided childcare). Tax Tip. This complete exclusion is available to all members of the Uniform Services, including the Army, Navy, Air Force, Marine Corps, Coast Guard, the Commissioned Corps of the National Oceanic and Atmospheric Administration, and the Commissioned Corps of the Public Health Service.
Service Academy Appointments. For tax years beginning after 2002, you may make distributions from §529 plans and Education Savings Accounts penalty free (but not income tax free), up to the amount of tuition, fees, etc. incurred by the beneficiary of the §529 plan for attending a military academy (Westpoint, Naval Academy, Air Force Academy, Coast Guard Academy, and Merchant Marine Academy).
MEDICARE PRESCRIPTION DRUG MODERNIZATION ACT OF 2003 [table of contents]
In December, 2003, President Bush signed into law the “Medicare Prescription Drug Modernization Act of 2003.” This Act ushered in the new health savings account (HSA). Contributions to the HSA are deductible wether you itemize or not, and distributions for qualifying medical expenses are tax free. To qualify for an HSA, you must be covered by a qualifying “high deductible health plan” (HDHP). If you have “self only” coverage, your HDHP must have a minimum annual deductible of $1,000, and your maximum out-of-pocket exposure cannot exceed $5,000. If you have “family” coverage, your minimum annual deductible is $2,000, and your maximum out-of-pocket exposure cannot exceed $10,000. Over the past several months, the IRS
has released over 120 questions and answers providing guidance concerning various tax and administrative aspects of the HSA. Highlights of this guidance include:
If you need any further information on HSAs, please contact our office and we will be glad to assist you.
2004 TAX DEVELOPMENTS OTHER THAN NEW LEGISLATION [table of contents]
Tax Relief for Hurricane Losses. This year’s hurricane season has had a devastating impact on many southeastern and east coast states, including, Alabama, Florida, Mississippi, Louisiana, Georgia, Virginia, North Carolina and South Carolina. Many counties in those states have been declared “Presidential Disaster Areas” which qualify those counties for various tax relief provisions recently announced by the IRS. For an updated list of Presidential Disaster Areas by state, please consult the FEMA website at www.fema.gov. For the most recent IRS tax relief announcements, please consult the IRS website at www.irs.gov. Tax relief for these counties which have been declared as part of a Presidential disaster area include extensions of time to file tax returns and pay taxes, and special periods within which the IRS may waive penalties for failure to timely deposit payroll taxes and excise taxes. Tax Tip. If you or your business is in a county located in a Presidential Disaster Area, you will receive this relief whether or not you or your business suffered damage because of the storms.
If you have a loss from a casualty in one of these disaster areas (after considering any insurance claims), you have an option to deduct the loss on either your 2004 income tax return or on your 2003 return. You should generally take the deduction in the tax year that produces the greater tax reduction. Planning Alert! If the loss produces about the same tax benefit on the 2003 or the 2004 return, then you may wish to amend the 2003 return and take the loss in order to “speed up” the refund. Caution! Generally, if you wish to take the casualty loss deduction on the 2003 return, the return must be amended no later than April 15, 2005. We will gladly help you determine the amount of your deductible casualty loss and help you decide whether to take the loss in 2003 or 2004.
IRS Releases Final Home Sale Exclusion Regulations. If you have owned your home and used it as your “principal residence” for at least two out of the last five years, you can exclude up to $250,000 of the gain ($500,000 on a joint return) when you sell it. The IRS recently issued new regulations that, in several situations, expand this rule. For example, contrary to an earlier IRS position, the new regulations generally allow you to exclude gain that would otherwise be allocable to your “qualified home office” (except for depreciation taken on the home office after May 6, 1997). The new rules also allow you to exclude gain when you sell land adjacent to your residence so long as the land is sold within two years of the sale of your home and the land has been owned and used as part of your residence for at lease two years during the five year period ending with the date of the sale. The regulations provide rules that will automatically allow you to claim a portion of the exclusion when you have not owned and used the residence for the required two-year period, but you sell the home because of a change in place of employment, health reasons, or certain unforseen circumstances. For example, the regulations say that you are automatically entitled to pro rate the exclusion if you sell your home: for health reasons and pursuant to a physician’s recommendation; because of an employment change satisfying a 50-mile test; or because of a divorce, a legal separation, or a natural disaster. Tax Tip. These rules are retroactive (generally for three years) and may give you relief in many situations not discussed here. If you think that you have previously filed a return reporting a house gain that may be excluded under these new regulations, we can help you determine whether you should amend that return and recoup the taxes paid.
IRS Grants Relief for Late IRA Rollovers. If you receive a distribution from your IRA or qualified retirement plan, and you want to avoid taxation, you typically must roll the distribution over into a new IRA or qualified retirement plan within 60 days. Tax Tip. You generally are allowed only one tax-free rollover of an IRA each year. If an IRA account is rolled over more than once each year, the amount involved in the second rollover is taxed and could be subject to a 10% penalty. However, there are no limits on the number of times you may have direct “trustee-to-trustee” transfers of your account between IRA trustees. If you wish to change your IRA trustee (e.g., move your IRA from one financial institution to another), please call us and we will assist you with a trustee-to-trustee transfer.
If you have taken money from your IRA or a qualified plan and intended to roll over the funds within 60 days, but failed to do so, please give us a call. The IRS has issued special procedures for applying for an extension of the 60-day rollover period if you satisfy certain criteria and has granted several taxpayers extensions during 2004. We will help you apply for an extension of time to complete the rollover. Caution! The IRS generally allows extensions only where the taxpayer intended to rollover the funds at the time of withdrawal and illness, death, bad advice, or misunderstandings of the law caused the taxpayer to fail to complete the rollover within the 60 day period. Obtaining an extension of the 60-day rollover is a time-consuming process. The best policy is always to complete the rollover within the 60 day period. Or, better yet, don’t rollover at all. If you wish to change plan trustees, then simply transfer the funds using a trustee-to-trustee transfer. In a trustee-to-trustee transfer, the check for the amount transferred should be written to the new trustee, not to you.
IRS Releases Guidance on Investment vs. Theft Loss. Many taxpayers have seen the value of their investments tumble because of corporate misconduct. When the stock becomes worthless, the loss is generally a capital loss. This means you can only deduct the loss to the extent of your total capital gains, plus $3,000. On the other hand, if you can successfully argue that the loss is not an investment loss, but is instead a “theft loss,” your deduction would be an itemized deduction. This itemized deduction would not be reduced by 2% of your adjusted gross income, and the deduction would be allowed for alternative minimum tax purposes. Consequently, many investors are exploring the possibility of claiming their investment loss as a theft loss as opposed to a short-term capital loss. In a 2004 release, the IRS stated that a theft loss only occurs if the loss resulted from the taking of property that is illegal under state law and the taking was done with criminal intent. On the other hand, the IRS concluded that stock bought on the “open market” was not a theft loss even if it resulted from accounting fraud or other illegal misconduct of the officers and directors. However, a theft loss should be available if you can establish that your investment resulted from the criminal actions of promoters, brokers, etc.
Tax Court Says Stockholder’s Business Bad Debt is Limited. If you loan money to your corporation, and it later becomes uncollectible, you are typically entitled to a non-business bad debt. Non-business bad debts are classified as short-term capital losses, and can only be deducted to the extent of your total capital gains plus $3,000. However, if you are a stockholder and an employee of your corporation, and you can successfully establish that the primary reason you loaned the money to the corporation was to preserve your employment, you are entitled to a “business bad debt.” The Tax Court has recently held that, in this latter situation, the business bad debt is a “miscellaneous itemized deduction” which can be deducted only to the extent it exceeds 2% of adjusted gross income. Furthermore, as a miscellaneous itemized deduction, the bad debt would not be deductible at all for alternative minimum tax purposes.
IRS Releases Final Regulations for Student Loan Interest. You may deduct (whether or not you itemized deductions) up to $2,500 of interest on qualified student loans. Your deduction phases out as your adjusted gross income increases from $100,000 to $130,000 on a joint return (from $50,000 to $65,000 on a single return). In recently released regulations, the IRS says that loan origination fees or late fees on qualified student loans will generally be deductible as interest. The regulations also say that any payment you make on the loan will first be applied to interest that has accrued and remains unpaid before it will be applied to outstanding principal. Furthermore, if someone else pays your interest, the payment will be treated as a gift to you, and you will then be treated as paying the interest yourself. Tax Tip. If you paid any student loan interest in 2004, be sure to provide us with Form 1098-E. This will help us determine your interest deduction for 2004.
Tax Court Says Expenses Paid by Partner for Partnership May Not Be Deductible. It is not uncommon for a partner in a partnership to individually incur and pay business expenses of the partnership. Historically, the IRS has said a partner may deduct business expenses paid on behalf of the partnership only if there is an agreement (preferably in writing) between the partner and the partnership providing that those expenses were to be paid by the partner, and that the expenses would not be reimbursed by the partnership. The Tax Court recently denied a deduction for a partnership expense paid by a partner where the Court was unable to find any agreement between the partner and the partnership that the partner pay the expense. The Court concluded that a verbal agreement was not enough, where the Court found no routine partnership practice that rose to the level of an agreement. Tax Tip. If you are a partner paying expenses on behalf of your partnership, to be safe, you should have a written agreement with the partnership providing that those expenses are to be paid by you, and that they will not be reimbursed by the partnership.
IRS Certifies New Clean-Fuel Vehicles Allowing Deduction. If you purchase a “qualified clean-fuel auto” (certain new cars adapted to run on clean-burning fuels), you may be entitled to a $2,000 above-the-line deduction, whether or not you used the vehicle in your business. The IRS has certified the following vehicles as qualifying for this $2,000 deduction: Toyota Prius (for model years 2001, 2002, 2003, 2004 and 2005); Honda Insight (for model years 2000, 2001, 2002, 2003, and 2004); and Honda Civic-Hybrid (for model years 2003 and 2004). Tax Tip. Please let us know if you have purchased any of these vehicles during 2004 or a prior year, so we can make sure you get this deduction.
IRS Releases Procedures for Making Late S Elections for Non-Corporate Entities. If you are an owner of a general partnership, limited partnership, limited liability company, or limited liability partnership, the business income that passes through to you is generally subject to Social Security and Medicare taxes. By contrast, if you are a stockholder/employee of an S corporation, Social Security and Medicare taxes are only imposed on the “reasonable salary” paid to you from the corporation. Other income that passes through to you (or is distributed to you as a distribution on your stock) is not subject to Social Security and Medicare taxes. Tax Tip. You might save taxes if you elect to treat your general partnership, limited partnership, limited liability company, or limited liability partnership as an S corporation, and then pay yourself a “reasonable salary” for your services. If you wish to be an S corporation, please contact us. The proper forms must be filed to elect S corporation status. Planning Alert! There are many tax ramifications from making an S election and each of these should be carefully considered before filing the S election. For example, the election may not be advisable if the business has debts in excess of the basis of its assets.
IRS Explains How to Make Disability Payments Tax Free. Generally, if your employer provides you with disability insurance, and you become disabled, you will be taxed on disability payments you received from that coverage. However, there are two situations where the disability benefits will be tax free. First, you get tax-free treatment if the payments are for the permanent loss or loss of the use of a member or function of your body, and the payments are based on the nature of your injury and not on the period of your absence from work. Second, the disability payments are tax free if you have previously included the premiums paid by your employer in your taxable income. Tax Tip. The IRS has announced that your disability payments will be tax free if you made an election in writing prior to the beginning of the year you become disabled, to include the employer-paid premiums in your taxable income. So, if you are not currently disabled but you are suffering from health problems that may soon turn into a disability, check with your employer to see if you can elect to include the disability premiums in your income at the beginning of the plan year. If you make this election timely and in writing, you could convert future disability payments from taxable income into non-taxable income. Planning Alert! These elections are available only if your employer’s disability plan authorizes you to make these elections. If you think you might be confronting future disability, you should check with your employer to determine whether these elections are available.
IRS Allows §179 Election on an Amended Return. For 2003, you could take an up-front deduction of up to $100,000 ($102,000 for 2004) for the cost of qualifying §179 property (e.g., machinery, equipment, furniture, fixtures, etc.). Last year, this deduction was reduced for each dollar the total of your §179 property purchases exceeded $400,000 ($410,000 for 2004). Historically, the §179 election was required to be made on the originally filed return for the year the property was placed in service, and could not be made on an amended return. Good News! The IRS issued regulations in 2004 that allow you to elect or revoke an election under §179 on an amended return for the years 2003, 2004, 2005, 2006, or 2007. This new relief provision creates opportunities that have been previously unavailable. Example. Assume your business constructed a $500,000 commercial building in 2003, which you have depreciated over 39 years using the straight-line depreciation method. In 2004, you discover that $100,000 of the original $500,000 cost of the building represents nonstructural components of the building (tangible personal property) which qualify for §179 treatment. Also, assume that you had no other §179 property placed in service in 2003. Under these new rules, you should be able to amend your 2003 return and deduct under §179 the $100,000 portion of the building that represents tangible, personal property.
New IRS Rules For Computing Depreciation on Tax-Deferred Exchanges. The IRS has recently released a voluminous and complex set of regulations for determining MACRS depreciation on replacement property in a tax-deferred exchange (e.g., §1031 like-kind exchange, §1033 involuntary conversion). The tax basis of replacement property in a tax-deferred exchange is generally comprised of “carryover basis” (representing the old basis of the property you gave up) and “new basis” (comprised of additional amounts you paid for replacement property in excess of the value of the relinquished property). Basically, the new regulations state that the “carryover basis” is depreciated over the remaining depreciable life of the relinquished property or the replacement property, whichever is longer. Furthermore, the “carryover basis” is depreciated using the depreciable method of the relinquished property, or the replacement property, whichever is slower. By contrast, the “new basis” is depreciated using the depreciable life and the depreciable method of the replacement property as though it were newly purchased. Tax Tip. You can “elect out” of these regulations. In certain situations, electing out will produce a larger depreciation deduction. For example, if you are trading in a business luxury automobile for another business luxury automobile, it will generally work to your advantage if you elect out. If you are exchanging a business auto (e.g., a BMW 740 IL) for an SUV (e.g., a BMW X-5) electing out could produce substantially larger deductions. Planning Alert. If you are about to trade a luxury auto (e.g., a BMW 750 IL) for another luxury auto (e.g., a Lexus 400), please call us. Since the tax basis of the old vehicle is usually significantly greater than the fair market value at the date of the trade, a sale of the old car (and a purchase of the new one) could produce a deductible tax loss that will be deferred if you trade. However, the sales tax implications of a sale, rather than a trade, must also be considered.
If you plan to engage in a tax-deferred exchange (or trade-in), please contact us and we will assist you in planning for the exchange and in calculating maximum depreciation under these new regulations.
IRS Removes Depreciation Limits on Qualified Non-Personal Use Trucks and Vans. Generally, if you use a passenger vehicle in your business, you are required to keep a log or other documentation to support your business mileage. However, if you make certain modifications to your business pick-up or van, the IRS says that, for tax purposes, the vehicle will be deemed to be used 100% for business, even though you have some non-business use. For example, a pick-up truck that has either permanently affixed decals or special painting advertising your business, and is equipped with either a hydraulic lift gate, permanently installed tanks or drums, or permanently installed side boards, is deemed to be used 100% business. The same is true of a van that has the company name permanently affixed to the vehicle, has only seats for the driver and one passenger, and the back of the van is generally filled with shelving or merchandise during on-duty and off-duty hours. However, if this specially equipped pick-up or van has an unloaded gross vehicle weight of 6,000 lbs. or less, the IRS historically said that the depreciation was limited by the luxury automobile caps ($10,610 for 2004 if the vehicle qualifies for the 50% bonus depreciation). Good News! IRS now says that these specially equipped business vehicles are not limited by the passenger automobile depreciation caps even if they do not have a GVW of more than 6,000 lbs. Furthermore, the IRS says this rule is retroactive, and we may correct prior year returns (if we limited the depreciation) by filing an amended return on or before December 31, 2004. Otherwise, we may use the automatic accounting method change procedures to correct prior year’s returns.
Tax Court Finds Taxable Portion of Non-Taxable Physical Personal Injury. Generally, damage awards for a “physical” personal injury are fully tax free (except to the extent allocated to “punitive damages”). So, for example, damage payments to a taxpayer for medical malpractice or for injuries sustained in an auto accident are typically tax free. However, in a recent case, the Tax Court held that a professional photographer who was intentionally kicked by an NBA basketball player during a game, and received a $200,000 settlement for his “physical” personal injury, must pay tax on a portion of the settlement agreement. In the settlement, the photographer expressly agreed not to disclose the terms of the settlement. The Tax Court held that the portion of the damages that could be reasonably allocated to the non-disclosure provision was taxable, even though the original claim constituted a physical personal injury. Tax Tip. If you anticipate receiving a payment for a physical personal injury, please call us before agreeing to the structure of the settlement. A proper allocation in the agreement can maximize the tax-free amount of the settlement.
IRS Explains How the New 15% Rate Applies to Charitable Remainder Trust Distributions. Charitable remainder trusts (CRTs) have been used as estate and income tax planning tools since the 1960s. Here is how they generally work. Assume Jane bought ABC stock several years ago for $100,000 and it had a value of $500,000 when she contributed the stock to the CRT. When Jane transferred the stock to the CRT, she retained the right to the payment of a set percentage (say 5%) of the value of the trust corpus each year for the rest of her life. At her death, the trust corpus will go to her named charity. Upon funding the trust, Jane received an income tax charitable deduction for the present value of the $500,000 that will go to charity at her death. Upon receiving payments back from the trust during her lifetime, the payments pull out the trust income which is taxed to Jane in the following order: first – ordinary income (including qualified dividends); second – capital gains; third – tax exempt income (e.g., municipal bond interest); and fourth – recovery of principal. Good News! The IRS says that any distributions from the CRT to Jane that pull out “qualified dividends” or long-term capital gains will be taxed to Jane at the tax rates for dividends and long-term capital gains for the year of the distribution. For example, for 2004, Jane will get the benefit of the 15% maximum tax rate for qualified dividends and long-term capital gains distributed even if the dividends or capital gains were earned by the CRT before the 15% rate was enacted.
FINAL COMMENTS [table of contents]
Please contact us if you are interested in a tax topic that we did not discuss. Tax law is constantly changing due to new legislation, cases, regulations, and IRS rulings. Our firm closely monitors these changes and will gladly discuss any current tax developments and planning ideas with you. Please call us before implementing any planning ideas discussed in this letter, or if you need additional information.