AJCA

Lesli S. Laffie, J.D., LL.M.

Legislation

AJCA

In October 2004, President Bush signed into law the American Jobs Creation Act of 2004 (AJCA), which changes the taxation of foreign income and provides incentives for manufacturers. It also contains other provisions affecting individuals and businesses, particularly S corporations. Most of the AJCA takes effect in 2005 or later, but there are exceptions. Some of the provisions most important to individuals and small businesses are discussed below. (For details of the AJCA changes to extra-territorial income taxation, tax shelters, accounting methods and partnerships, see Tax Clinic,  this issue; other AJCA provisions will be covered in future issues).

Deducting sales and use taxes: For tax years 2004 and 2005, taxpayers can deduct state and local sales and use taxes in lieu of state income taxes, based on either actual taxes or IRS published tables that will be based on income, number of dependents and other factors. Sales taxes on motor vehicles and boats can be added to the IRS table amounts.

Principal residence exclusion disallowed five years after like-kind exchange: The $250,000 exclusion ($500,000 for married couples filing jointly) of gain on a sale or exchange of a personal residence will not apply if the taxpayer(s) received the residence in a like-kind exchange within five years before the sale. This new rule applies to exclusions for sales or exchanges after Oct. 22, 2004.

U.S. production activities deduction: The AJCA repeals the extraterritorial income (ETI) exclusion for transactions occurring after 2004 and replaces it with a new deduction for taxpayers with qualified production activities income (QPAI). The QPAI deduction equals the lesser of a percentage of a taxpayer’s (1) QPAI for the tax year or (2) taxable income (adjusted gross income, with modifications, if an individual). While the percentage is 3% in 2005 and 2006, 6% in 2007 through 2009, and 9% in 2010 and thereafter, generally, a taxpayer cannot deduct more than 50% of the W-2 wages it paid for the year.

The law provides some transitional relief through 2006, allowing certain taxpayers to retain a portion of their old ETI benefits. The old ETI exclusion also remains in effect for certain transactions existing as of Sept. 17, 2003.

Nonqualified deferred compensation: The AJCA provides rules to discourage a plan participant’s inappropriate control of or access to deferred compensation without income recognition. A participant’s non-qualified deferred compensation for the tax year (and all previous tax years) will be includible in income to the extent (1) not subject to a substantial risk of forfeiture, (2) not previously included in gross income and (3) the plan fails specified requirements for distributions, acceleration of benefits and elections at any time during the year. Includible income will be subject to reporting and withholding requirements.

Previously, inclusion depended on the facts and circumstances and legal doctrines. For unfunded arrangements, the nonqualified deferred compensation generally was included when it was actually or constructively received. For funded arrangements, it was includible when the individual’s rights were transferable or not subject to a substantial risk of forfeiture.

A nonqualified deferred compensation plan is any plan other than a qualified plan or vacation leave, sick leave, compensatory time, disability pay or death benefit plan. For example, nonqualified plans could include salary and bonus deferral plans, stock options and appreciation rights, but not incentive stock options and options granted under employee stock purchase plans.

The restrictions on distributions, acceleration of benefits and elections are complicated; plans generally must comply for amounts deferred after 2004. However, IRS guidance will allow a limited opportunity to amend plans existing before 2005, so that an individual can terminate plan participation or cancel a deferral election.

Expanded expense election: The Sec. 179 election to expense up to $100,000 of depreciable tangible personal property is extended. The annual $100,000 cap now applies through the end of 2007. In addition, the reduction in the annual cap for the amount of qualifying property in excess of $400,000 is extended until 2007. Both the $100,000 limit and the $400,000 phaseout will continue to be indexed for inflation. Also, the election is extended to off-the-shelf software, and taxpayers can revoke the election without IRS consent, through 2007.

SUV expensing: For sport utility vehicles (SUVs) placed in service after Oct. 22, 2004, the amount one may expense under Sec. 179 in the first year is subject to a $25,000 cap, not indexed for inflation. Previously, SUV expensing was subject only to the $100,000 limit, indexed for inflation ($102,000 for 2004).

Deducting organizational/start-up costs: A corporation or partnership can elect to deduct up to $5,000 of its organizational expenditures in the year it begins business, if paid or incurred after Oct. 22, 2004. This limit is reduced (but not below zero) by the amount of such expenditures over $50,000. Any remaining organizational expenditures may be ratably deducted over 15 years. Previous organizational expenditures could be ratably deducted over a 60-month or more period. However, pre-Oct. 22, 2004, expenditures are still included in applying the $50,000 reduction rule.

The same rules apply to start-up expenditures by individuals, corporations and partnerships, which include the costs of investigating the acquisition or creation of an active trade or business and its actual creation.

S corporation provisions: The following six reforms are generally effective for tax years beginning after 2004.

Election to treat family members as one shareholder: Family members can elect to be treated as one shareholder in determining the overall number of S shareholders. For purposes of computing the number of shareholders, S corporations can treat all members of a family (up to six generations) as one shareholder.

Increase in maximum number of eligible shareholders: The maximum number of eligible S shareholders is increased from 75 to 100.

Transfers of suspended S losses to spouse or former spouse: Any loss or deduction not allowed to a shareholder of an S corporation, because it exceeds the shareholder’s basis in stock or debt, is treated as incurred by the S corporation with respect to that shareholder in the subsequent tax year. Under the AJCA, if a shareholder’s S stock is transferred to a spouse or former spouse in a divorce, any suspended loss or deduction relating to that stock is transferred to (and may be carried over by) the transferee spouse.

Relief from inadvertently invalid QSub elections and terminations: The IRS can waive inadvertently invalid qualified subchapter S subsidiary (QSub) elections and terminations. To obtain relief, the QSub and the S corporation parent must, within a reasonable time after discovering the circumstances causing the invalidity, (1) take steps so that the corporation qualifies as a QSub and (2) agree to IRS-prescribed adjustments consistent with the treatment of the corporation as a QSub during the relevant period.

SESOP’s payment of loans for stock: An S corporation’s employee stock ownership plan (SESOP) may use distributions on the S stock it owns to repay loans used to purchase the stock. If the SESOP’s provisions provide for such use of the distributions, the SESOP will not be treated as violating the Code’s qualified plan requirements or prohibited transaction rules. In general, the securities cannot be allocated to participants, unless the SESOP provides that employer securities with a fair market value greater than the distribution amount are allocated to the participant for the year in which the distribution would have otherwise been allocated. The new law applies to distributions on S stock after 1997. Previously, only C corporations had been allowed to repay such loans with dividends.

QSub information returns: A corporation whose stock is held by an S corporation is treated as a QSub if the S corporation so elects. The QSub’s assets, liabilities and items of income, deduction and credit are treated as the parent’s. Under the new law, the IRS may require QSubs to file information returns.

Abusive vehicle charitable deductions: The charitable deduction for a post-2004 contribution of a motor vehicle, boat or airplane resold by a charity is limited to the gross proceeds received by the charity, instead of the full “Blue Book” value. There is an exception if the charity made significant use of the item in conducting its activities or material improvements to it before sale.

Increased reporting for noncash charitable contributions: C corporations will now be subject to a rule that if a charitable gift of property other than cash, inventory or publicly traded securities exceeds $5,000, a qualified appraisal is required. In addition, if a contribution by any taxpayer of such property exceeds $500,000, the donor must attach a qualified appraisal to its return. A donor that fails to substantiate a charitable contribution of property will be denied the deduction. These rules are effective for contributions after June 3, 2004.

Installment agreements for partial payments of tax: The IRS can enter into installment agreements with taxpayers that do not provide for full payment of the taxpayer’s liability over the life of the agreement. It is required to review partial payment installment agreements at least every two years to determine whether the taxpayer’s financial condition has significantly changed, so as to warrant an increase in the amount of the payments being made. Further, the IRS need not accept mandatory installment agreements providing less than full payment. This provision is effective for installment agreements entered into after Oct. 21, 2004.