| The Katrina Emergency Tax Act of 2005
provides tax relief for residents and businesses in the
hurricane-ravaged areas of Alabama, Florida, Louisiana and
Tax-friendly rules allow distributions and loans from retirement plans to those persons who lived in the disaster area and suffered economic loss.
The act allows the full deduction of casualty losses in the Hurricane Katrina disaster area and provides tax-free discharge of nonbusiness debts for victims.
Limits on the charitable contribution of cash and food inventory have been temporarily modified for all individuals and businesses.
Employers can claim new tax credits for hiring and retaining certain employees in the core disaster area.
The new act extends the tax filing and payment deadlines for those affected by Hurricane Katrina until February 28, 2006.
Mark P. Altieri, CPA/PFS, JD, LLM , is an associate professor of accounting at Kent State University, Kent, Ohio, and special tax counsel to Wickens, Herzer, Panza, Cook and Batista in Avon. His e-mail address is email@example.com . Jason A. Rothman, JD, is an associate at Wickens, Herzer, Panza, Cook and Batista. His e-mail address is firstname.lastname@example.org .
urricane Katrina, the costliest catastrophe in American history, caused widespread damage to four states: Alabama, Florida, Louisiana and Mississippi. In an effort to aid the areas hit hardest, President Bush signed into law the Katrina Emergency Tax Relief Act of 2005, and the House and Senate promised additional tax relief. This article discusses the tax relief provided under the act by examining general tax law and the effect the act will have upon it. Though most of the new provisions require a relationship to the disaster areas, CPAs must be aware of certain provisions that any taxpayer can take advantage of.
|A Real Whopper
Preliminary estimates put insured losses from Hurricane Katrina at $34.4 billion, making it the costliest U.S. catastrophe ever.
TWO IMPORTANT DEFINITIONS
Section 2 of the Tax Relief Act (as elaborated on by IRS Notice 2005-92) defines the Hurricane Katrina Disaster Area as including Alabama, Florida, Louisiana and Mississippi. Section 2(2) defines the Core Disaster Areas as those determined by the President, which include southeastern Louisiana, southern Mississippi and western Alabama. (You can view these areas at www.fema.gov/news/disasters.fema .) Except for the few exceptions noted below, all tax relief to individuals and businesses provided under the act requires a relationship to one of these two disaster areas.
Following is a list of the more prominent sections of the act, with a discussion of general non-Katrina tax law and a summary of the act’s modifications to that law.
THE OLD AND THE NEW REGULATIONS
Casualty losses—general law. Individuals can take an itemized deduction for casualty losses to property not connected to a trade or business. A major hurdle to this deduction, however, is that casualty losses must exceed two floors before they are deductible: a $100-per-casualty minimum and a much more significant 10% of adjusted gross income (agi). Under the normal rules, a taxpayer may deduct only casualty losses not reimbursed by insurance that exceed both of these amounts. IRC section 165(h) allows a taxpayer to treat the casualty losses as having occurred in the taxable year immediately preceding the year of the actual casualty in the case of presidentially declared disaster areas.
Casualty losses—Katrina. The timing rules stay the same, but casualty losses that arise in the Hurricane Katrina Disaster Area on or after August 25, 2005, that are attributable to Hurricane Katrina are fully deductible. Taxpayers must itemize their deductions (in lieu of taking the standard deduction).
Distributions from retirement plans—general law. Under IRC section 72(t), individuals who make withdrawals from IRAs, 401(k) plans and other retirement savings plans before age 59 are subject to a 10% income tax unless special circumstances exist (see “ Withdraw Without Penalty, ” JofA , Aug.05, page 48). Recipients of distributions have 60 days to roll over the distribution to an IRA or another plan to avoid federal income tax. A mandatory 20% federal income tax withholding applies to any eligible rollover distribution that is not transferred by a direct rollover. Loans from qualified plans may not exceed the lesser of $50,000 or 50% of the individual’s nonforfeitable accrued benefit under section 72(p).
Distributions from retirement plans—Katrina. The act establishes “qualified Hurricane Katrina distributions” of up to $100,000 without penalty from an eligible retirement plan made to an individual whose principal residence is located in the Hurricane Katrina Disaster Area and who has sustained an economic loss by reason of Hurricane Katrina. Qualified distributions are not subject to the 10% early distribution penalty or 20% mandatory withholding tax. The act also extends to three years the rollover period in which individuals who are able to repay the distributions can do so and qualify for rollover treatment. Taxpayers who cannot avoid income tax on the penalty-free withdrawals are allowed to spread the income evenly over three years. Those who withdrew funds for a first-time home purchase from an IRA or a hardship distribution to buy a home from a 401(k) or 403(b) plan, after February 28 and before August 29, 2005, but who cannot purchase or construct the home because of Hurricane Katrina, may pay the funds back to their IRAs or plans without penalty by February 28, 2006.
Individuals whose principal residence was in the Hurricane Katrina Disaster Area and who sustained an economic loss due to the hurricane also may borrow up to $100,000 from their pension plans. Any outstanding loan from a qualified plan that had a required payment due date between August 25, 2005, and December 31, 2006, will have its due date delayed for one year.
NOTE: IRS Notice 2005-92 (issued November 30, 2005) provides elaborate detail on implementing the retirement plan provisions of the Katrina legislation, including several required plan amendments to be made by plan years beginning on or after January 1, 2007.
E arned Income Tax Credit (EITC) and Child Credit—general law. Under IRC section 32, low-income working Americans can claim a credit against tax for a percentage of earned income up to a certain amount. That amount is $7,830 of earned income if supporting one child, or $11,000 if supporting two or more children in 2005. Taxpayers with incomes below certain threshold amounts are eligible for a $1,000 credit for each qualifying child under IRC section 24. The child tax credit may be refundable depending on the taxpayer’s earned income.
E arned Income Tax Credit (EITC) and Child Credit—Katrina. Qualified individuals can use their 2004 earned income amount to calculate the refundable child credit and the Earned Income Tax Credit on their 2005 tax returns. To be eligible, the taxpayer’s earned income for 2005 must be less than it was in 2004.
Discharge of indebtedness income—general law. Under IRC section 108, when a creditor forgives the indebtedness of a debtor, the economic value of the debt discharge is included in the debtor’s gross income.
Discharge of indebtedness income—Katrina. Qualified victims of Hurricane Katrina will not be subject to taxation for any discharge of indebtedness made between August 25, 2005, and January 1, 2007. This Katrina discharge of indebtedness rule applies only to nonbusiness debt forgiven by certain governmental and financial entities.
Involuntary conversion—general law. The involuntary conversion rules of IRC section 1033 provide that any gain realized on the receipt of insurance proceeds after an involuntary conversion may be deferred only if the proceeds are reinvested in good replacement property within two years of the end of the tax year in which the taxpayer realizes the gain. Generally, someone whose home suffers an involuntary conversion has four years to replace the home if it is located in a presidentially declared disaster area.
Involuntary conversion—Katrina. The period for the acquisition of replacement property has been extended to five years for both regular and personal residence property. The replacement property must be located in the Hurricane Katrina Disaster Area to qualify.
Mortgage revenue bonds—general law. A mortgage revenue bond is a tax-exempt bond issued by a state or local government to provide funds to assist low-income individuals to buy their first home.
Mortgage revenue bonds—Katrina. The Tax Relief Act waives the first-time home buyer requirement, so those whose homes were damaged by Katrina can qualify for low-interest-rate mortgages through 2007. The provision also allows up to $150,000 of loan proceeds to be used to repair Hurricane Katrina-damaged homes. The provision applies to any residence in the Hurricane Katrina Disaster Area or the Core Disaster Area that was rendered uninhabitable.
Dependency exemption—general law. IRC section 152 requires that dependent nonfamily members of the household have their principal place of abode with the taxpayer for the entire taxable year.
Housing assistance to dislocated persons—Katrina. The act creates a special tax deduction for individuals who provide rent-free housing in their principal residence to dislocated persons for at least 60 consecutive days. The deduction is $500 for each dislocated person, to a maximum of four exemptions. The deduction can be claimed in either 2005 or 2006, but cannot be claimed for the same person in both years.
Charitable contributions—general law. The IRC section 170 deduction for cash gifts by individuals to public charities in a given tax year cannot exceed 50% of their AGI, with excess contributions being carried forward. Also, taxpayers generally have the value of their charitable contributions and certain other itemized deductions reduced under section 68 by 3% of the extent to which their AGI exceeds $145,950 in 2005. Lastly, any unreimbursed expenses incurred while providing services to a charitable organization are normally deductible. Automobile expenses can be deducted at a standard rate of 14 cents per mile. With regard to C corporations, the deduction for charitable contributions is limited to 10% of the corporation’s taxable income for the current year, and any excess can be carried forward for five taxable years.
Charitable contributions—Katrina. The act removes the 50% limitation for cash donations by individuals to most public charitable organizations made between August 28 and December 31, 2005, whether related to Katrina relief or not. Contributions to donor-advised funds and supporting organizations don’t qualify. A deduction for qualified contributions is allowed up to the amount by which the taxpayer’s contribution base (AGI) exceeds the deduction for other charitable contributions. Excess contributions are carried over to succeeding tax years. Those donations also are exempt from the application of the phaseout of itemized deductions for high-AGI taxpayers.
With regard to the deduction for mileage, the standard mileage rate for charity work related to Hurricane Katrina is 70% of the standard business mileage rate (currently 48.5 cents per mile), or 34 cents per mile, for the period between August 25 and December 31, 2006. Volunteers who are reimbursed at the 48.5 cents rate will not have taxable income. The act also removes the 10% limitation for Hurricane Katrina cash donations made by C corporations to charitable organizations during the period from August 28 to December 31, 2005.
Gifts of inventory—general law. Under IRC section 170(e), C corporations are entitled to a charitable contribution deduction not available to other taxpayers. To the extent the corporation gifts inventory to be used in a manner related to the exempt purpose of the donee and solely for the care of the ill, the needy or infants, the corporation can deduct 50% of the appreciation (the difference between fair market value and tax basis), but not exceeding twice the basis of the inventory. Non-C-corporation taxpayers can deduct only charitable contributions equal to the basis of the inventory they give to charity.
Katrina donations of food or books. Any taxpayer engaged in a trade or business—not just C corporations—may claim an enhanced deduction for contributions of food inventory to IRC section 501(c)(3) organizations made between August 28 and December 31, 2005, that are (1) used consistent with the donee’s exempt purpose solely for the care of the ill or needy or infants; (2) not transferred in exchange for money, other property or services; and (3) substantiated by a written statement that their use will be consistent with such requirements. The deduction is the lesser of (1) the basis of the property plus one-half of the excess of fair market value over the basis or (2) two times the basis.
For qualified book contributions, C corporations may claim a deduction equal to the lesser of (1) the basis of the property plus one-half of the excess of fair market value over the basis or (2) two times the basis. A qualified book contribution is a charitable contribution of books to a public school that provides elementary or secondary education (K-12), that normally maintains a regular facility and curriculum, and that normally has a regularly enrolled body of students in attendance. The deduction is allowed only if the donee school certifies in writing that the books are suitable in terms of currency, content and quantity for use in the school’s education programs and that the school will actually use the books. Deductions apply to contributions made between August 28 and December 31, 2005.
Work Opportunity Tax Credit (WOTC)—general law. Under IRC section 51, the WOTC provides an incentive for employers to hire economically disadvantaged individuals including qualified ex-felons, food-stamp recipients, veterans, summer youth employees and persons receiving certain welfare benefits.
Work Opportunity Tax Credit (WOTC)—Katrina. The WOTC is expanded to include individuals whose principal place of living on August 28, 2005, was in the Core Disaster Area. Employers in the Core Disaster Area can claim the WOTC for two years, but only on new hires, not those hired by August 28, 2005.
Special Katrina provisions. The new law created a tax credit equal to 40% of the first $6,000 in wages paid to eligible employees by employers located in the Core Disaster Area for the period the business is rendered inoperable as a result of the damage caused by Hurricane Katrina.
Extension of tax deadlines. Qualifying taxpayers have until February 28, 2006, to file any returns and pay taxes for periods that had not expired before August 28, 2005.
CPAs will have to be aware of the Katrina Emergency Tax Relief Act of 2005 and its special tax provisions, and also keep their ears open for further disaster-oriented tax relief Congress has promised. New tax benefits are available for those affected directly and for the many individuals and companies that contributed time and goods to help the survivors.