THE WORKING FAMILIES TAX RELIEF ACT OF 2004
extends the alternative minimum tax exemption of
$58,000 (married filing jointly) and $40,250 (single) through
THE WFTRA PROVIDES A UNIFORM DEFINITION OF “qualified child” that applies for purposes of head-of-household filing status, the child care credit, the dependency exemption and the earned income credit.
IN ELIMINATING THE EXTRATERRITORIAL INCOME exclusion for certain export receipts, the American Jobs Creation Act of 2004 implements a new manufacturer’s deduction. The deduction, phased in over six years, essentially reduces the maximum manufacturing income tax rate to 31.85% for domestic corporations.
THE AJCA OFFERS AN ITEMIZED DEDUCTION for state sales tax to individuals living in states that do not levy a state income tax. The deduction also is allowed for taxpayers in states that do levy an income tax to the extent of the greater of the state sales tax amount or state and local income taxes paid.
CPAs SHOULD ENCOURAGE CLIENTS TO GIVE SPECIAL attention to the extended increases in section 179 immediate expensing and accelerated cost recovery allowances for leasehold improvements.
|RAYMOND A. ZIMMERMANN, PhD, and PAT EASON, CPA, PhD, are associate professors of accounting at the University of Texas at El Paso. Their e-mail addresses are firstname.lastname@example.org and email@example.com .|
wo new tax laws have serious implications for taxpayers and carry an assortment of effective dates that will keep tax practitioners on their toes. Intending to stimulate the economy and create new jobs, Congress passed the Working Families Tax Relief Act (WFTRA) and the American Jobs Creation Act (AJCA) in 2004. This article describes their major provisions and offers planning tips to help CPAs get maximum advantage for their clients and employers.
WORKING FAMILIES TAX RELIEF ACT OF 2004
Known as the Extender Act, WFTRA continues tax cuts from the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) and the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA). The most important provisions are as follows:
|The Cost of Tax
The estimated cost of the Working Families Tax Relief Act of 2004 is $146 billion.
The American Jobs Creation Act’s $140 billion in temporary tax cuts and offsetting revenue provisions will have an overall zero cost effect on the federal budget.
Tax brackets. The WFTRA extends the current 10% tax bracket for married filing jointly (MFJ) and single taxpayers, the expanded 15% MFJ tax bracket and the MFJ standard deduction designed to eliminate previously existing marriage penalties. Bracket ranges for both the 15% MFJ tax rate and the MFJ standard deduction remain twice that allowed for single taxpayers. Although they were originally scheduled to expire beginning in 2005, these tax breaks now continue through 2010.
Child tax credit. Originally scheduled to revert to $700 in 2005, the child tax credit now will remain at $1,000 through 2010; in 2011, it will revert to $500. The credit is available only to taxpayers able to claim the dependency exemption, so it is of particular importance in the event of a divorce.
Planning tip. Accountants advising clients on the tax implications of a divorce should address in settlement negotiations the issue of who will claim the dependency exemption and child tax credit.
Alternative minimum tax. EGTRRA and JGTRRA tax cuts threatened to make many new taxpayers subject to the alternative minimum tax (AMT). To address this unintended pitfall, the AMT exemption was raised to $58,000 (MFJ) and $40,250 (single) from $49,000 (MFJ) and $35,750 (single) through 2004. The WFTRA extends the increased exemption amounts one year, through 2005, to allow Congress time to reengineer the AMT system. In 2006 the AMT exemption will revert to $45,000 (MFJ) and $33,750 (single).
Planning tip. Examine items that might affect the triggering of AMT in 2005 or 2006, such as deductions for local income tax, sales tax and property tax; capital gains; qualified dividends; accelerated depreciation; and tax-exempt income. A taxpayer may want to shift income and/or deductions between years because of the higher AMT exemption in 2005. Taxpayers not subject to AMT in 2005 may consider paying property taxes during that year to prevent a lower, albeit insufficient, exemption amount—resulting in AMT—in 2006.
Uniform definition of a child. The WFTRA defines a new uniform standard for determining who is a “qualified child” for purposes of head-of-household filing status, the child care credit, the dependency exemption and the earned income credit. Essentially a three-pronged test, it focuses on the age, residency and relationship of the child to the taxpayer. Under the WFTRA, a child is a person younger than 19 (24 for full-time students). There is no age limit for persons totally and permanently disabled. The dependent care credit and the child tax credit age limits remain unchanged at 13 (unless disabled) and 17, respectively.
The relationship test under WFTRA requires the child to be a son or daughter, stepson or stepdaughter, brother or sister, stepbrother or stepsister or descendent of the taxpayer. Individuals adopted by the taxpayer qualify, as well as anyone placed in the taxpayer’s home as the result of a legal proceeding. Foster children qualify if they live with the taxpayer for the entire tax year.
The residency requirement also has been relaxed. The child must live with the taxpayer for more than half the year, except for temporary and excused absences such as military service, confinements due to illness, educational efforts, business absences and vacations. This uniform definition can be ignored when pre-WFTRA criteria for a particular provision have been met. However, the new test should make it easier for accountants, as it provides fewer standards with which to comply. Tiebreaker provisions also have been enacted to address situations where a child qualifies as a dependent for multiple taxpayers under the new definition.
Miscellaneous provisions. WFTRA provisions affect many types of taxpayers. For individuals, the act extends provisions relating to contributions to Archer Medical Savings Accounts and the deduction for educator expenses. With respect to the refundable portion of the child tax credit and the earned income credit, WFTRA also expands the earned income definition to include combat pay.
Business provisions also have been extended through 2005, including an enhanced charitable deduction for post-2003/pre-2006 contributions of qualified computer technology by C corporations to schools and libraries. The deduction equals the donor’s basis plus one-half of the ordinary income that would have been realized had the property been sold, limited to twice the donor’s basis. For example, assume a computer manufacturer builds a computer for $400 and sells it for $1,000. If the manufacturer contributes the computer to a local high school, it can take a deduction of $700—that is, $400 + 0.5 x $600 (the manufacturer’s profit had the computer been sold). If the basis had been $300, the calculation would equal $650—that is, $300 + 0.5 x $700—but the company could deduct only $600, twice the $300 basis. In both situations the deduction allowed is substantially higher than the donor’s basis.
Finally, the WFTRA extends many other credits, including welfare-to-work, work opportunity, and research and development credits. It repeals the phaseout for the 10% credit for purchasers of hybrid automobiles or qualified electric vehicles originally scheduled for 2006, though it limits the credit to $2,000 through 2005 and only $500 in 2006.
Planning tips. CPAs can make a number of suggestions to clients with respect to the new WFTRA provisions.
Taxpayers considering the purchase of a qualified electric vehicle should consider doing so before yearend.
Examine clients’ current tax withholdings. The act retroactively extends many provisions that might not have been accounted for in 2004 withholdings. If clients’ taxes were overwithheld in 2004, file a new W-4 to reduce amounts withheld for 2005. Take care to ensure taxpayers claim only the appropriate number of exemptions.
Recommend that high-bracket taxpayers gift appreciated assets (such as stock, real estate, artwork and collectibles) to their low-bracket children (over age 13). High-bracket taxpayer capital gains are taxed at 15% vs. 5% for low-bracket taxpayers.
Suggest that taxpayers elect to have a sufficient amount of dividend income taxed at the normal rate to allow any offset against investment interest expense. “Qualified dividend” income taxed at 15% does not qualify as investment income and cannot be used to offset investment interest expense.
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THE AMERICAN JOBS CREATION ACT OF 2004
The AJCA directly addresses the issue of export subsidies that were ruled to be illegal by the World Trade Organization and subject to sanctions by the European Union. The act repeals the foreign sales corporation/extraterritorial income system of taxation and generally reduces tax rates for domestic manufacturers. Additionally, it provides special expensing and depreciation schedules for small businesses, implements new S corporation provisions, allows individuals a deduction for state sales taxes paid, reforms international tax provisions and provides tax breaks for farmers, restaurant owners and manufacturers.
Manufacturer’s deduction. A new manufacturer’s deduction, to be phased in over six years, essentially reduces the maximum income tax rate for domestic manufacturing corporations to 31.85%. It maxes out in 2010 at 9% of the lesser of the manufacturer’s “qualified production activities income” or taxable income for the year. What constitutes a manufacturer or manufacturing activities is broadly defined and unclear, but appears to include activities such as traditional manufacturing, construction, architectural fees associated with construction, engineering, energy production, filmmaking, software design and agricultural production.
Accelerated cost-recovery provisions. The AJCA also addresses increased accelerated cost-recovery provisions. Originally scheduled to expire at the end of 2005, increased acquisition limits ($410,000 in 2004) and overall immediate expensing ceilings with annual inflation adjustments ($102,000 in 2004) under IRC section 179 have been extended through 2007. The act also shortens the statutory life for leasehold improvements to nonresidential property and for qualified restaurant property. Qualifying expenditures on these types of properties placed in service prior to 2006 are now subject to straight-line depreciation over 15 years.
Planning tip. CPAs should advise clients to consider accelerating leasehold expenditures into 2005.
State sales tax deduction. For the first time in almost 20 years, a temporary provision for tax years 2004 and 2005 offers an itemized deduction for state sales tax to individuals living in states that do not levy an income tax. In states that do levy an income tax, taxpayers can deduct the greater of the state sales tax amount or the state and local income taxes paid.
Taxpayers can document the sales tax paid through their receipts or use an amount based on adjusted gross income in a sales tax table published by the IRS. But CPAs should review 2004 returns to ensure the new deduction was taken to the extent allowable, especially if taxpayers made large purchases during the year.
Planning tip. Given the new state sales tax deduction allowance, CPAs should advise taxpayers purchasing new vehicles or other large items to keep track of all sales tax receipts.
Charitable donations. Beginning in 2005 charitable contributions of vehicles resulting in deductions of more than $500 are limited to the gross proceeds the charity receives from the sale of the vehicle. The charitable organization must provide the donor with a contemporaneous, written acknowledgement of the donation.
The act also requires corporations to obtain an appraisal for charitable donations of property (other than cash, publicly traded securities or inventory) whose value exceeds $5,000. If the amount of the contribution exceeds $500,000, the appraisal must be attached to the corporation’s tax return on which the deduction is claimed.
Other provisions. The AJCA addresses major tax reform for multinational businesses, excise taxes, tax shelters and compensation plans. In the international area, one provision reduces the number of income baskets for foreign tax credits from nine to two—one passive income basket and one general one. New restrictions on nonqualified deferred compensation plans now trigger immediate taxation of previously deferred amounts. Beyond the scope of this article, these AJCA components place major restrictions and limitations on taxpayers and require careful study by affected parties.
Planning tips. The new AJCA provisions create many opportunities for CPAs to help taxpayers reduce tax liabilities.
2004 Individual Tax Returns Videocourse (DVD/text/manual, # 113600JA; VHS/text/manual, # 113601JA).
2004 Tax Acts: Making Them Work For You (# 732780JA).
AICPA’s Complete Tax Update for Individuals and Sole Proprietors: Includes 2004 Tax Acts (2004–2005 edition; # 731581JA).
AICPA’s Federal Tax Update by Biebl and Ranweiler: Includes 2004 Tax Acts (2004–2005 edition; # 731133JA).
For more information about any of the above products or to order, go to www.cpa2biz.com or call the Institute at 888-777-7077.
AICPA Tax Membership Section
The latitude regarding the terms manufacturer and manufacturing activities will allow many businesses that never qualified for benefits under the foreign sales corporation/extraterritorial income exclusion provisions to qualify for the new manufacturer’s deduction. However, CPAs should take care in classifying taxpayer activities under the new deduction. The roasting of coffee beans qualifies as a production activity, but a taxpayer that roasts beans and then serves coffee made from them in the store is engaged in both manufacturing and nonmanufacturing activities. The taxpayer, therefore, must separate “manufacturing activity” receipts from those of other activities that do not qualify in determining the allowable deduction.
Taxpayers making expenditures qualified under the extended increased section 179 expensing ceilings should elect expensing against properties with longer depreciable lives to allow higher acquisition-year depreciation rates to be preserved for shorter statutory life properties and to maximize total acquisition-year, cost-recovery deductions. Also, while section 179 expensing has been extended to include computer software, many software programs have useful lives of less than one year. These properties are currently deductible, and expensing them under section 179 serves only to absorb already limited statutory acquisition and deduction ceilings.
Section 179 expensing of SUVs is now limited to $25,000 a year unless the vehicle weighs more than 14,000 pounds.
S corporations now can have up to 100 shareholders, and family members in a six-generation range can be treated as one shareholder. The provisions now allow taxpayers to transfer losses from one former spouse to another incident to a divorce. The rules also permit suspended losses to be used by beneficiaries of qualified subchapter S trusts. Practitioners who represent small C corporations may want to consider an S corporation option.
Lower long-term capital gains tax rates make compensation planning critical. Exercising incentive stock options on shares held longer than one year may be more attractive, but CPAs should caution clients to take care to avoid triggering the AMT. Also, section 83 elections against restricted stock may be more beneficial as postelection long-term stock appreciation will be taxed at lower long-term capital gain rates.
Recommend that individuals whose medical insurance plans have high deductibles consider establishing medical savings accounts (MSAs). Employee contributions to MSAs are deductible in determining AGI, and employer contributions are excluded from income. Unlike medical flexible spending accounts (FSAs), MSAs carry balances from one year to the next, and unused amounts can be passed to surviving spouses without any federal estate tax liability. Taxpayers should examine funding in FSAs to avoid forfeiture of any unused deposits.
The AJCA also imposed a new limitation on taxpayers who sell their principal residence. Normally up to $250,000 of gain for single taxpayers ($500,000 for MFJ) who sell their principal residence may be excluded from income. Under this new restriction, any gain on a home acquired in a like-kind exchange within five years prior to the date of sale is not eligible for the exclusion. Advise clients that the five-year requirement must be met to qualify for the exclusion.
While the Working Families Tax Relief Act of 2004 and the American Jobs Creation Act of 2004 provide significant opportunities in tax planning, a maze of new risks, effective dates, penalties and reporting requirements require increased attention by CPAs and taxpayers. This article highlights the more common tax issues addressed in these acts; other, more extensive, AJCA provisions in international, tax shelter and compensation areas require a more in-depth review. Tax professionals and taxpayers must devote both time and resources to understanding the impact and opportunities of the new provisions.