This release gives you a broad overview of a significant new tax law, the “American Jobs Creation Act of 2004,” that Congress passed on October 11, 2004, just before adjourning for the election recess.

Although mainly directed toward large businesses, particularly multinationals, the wide-ranging law has several provisions affecting individuals and small or closely-held businesses.

On the plus side, the new law:

· creates a new deduction—with potentially widespread applicability—for businesses having income “attributable to domestic production activities”;

· extends previously-enacted increases in the small business “expensing” allowance;

· liberalizes the rules governing S corporations;

· permits itemizers to deduct their state and local sales taxes in lieu of state and local income taxes (effective for tax years 2004 and 2005).

On the minus side, the new law:

· limits the “expensing” allowance for sport utility vehicles (SUVs) placed in service after the new law’s enactment date to $25,000;

· starting January 1, 2005, imposes tighter rules on taxpayers who want to claim a deduction of more than $500 for motor vehicles, boats, or airplanes donated to charity;

· imposes tighter rules for documenting charitable contributions of property made after June 3, 2004;

· dramatically toughens the rules for “nonqualified” deferred compensation plans, which are used by business owners and other executives as a supplement to, or in lieu of, the “qualified” retirement plans generally available to a business’s employees.

Here’s a brief tour of the new law, followed by a little more detail about the above-mentioned changes.

Overview of the New Law

The impetus for the new law was a 2002 World Trade Organization ruling that the U.S. tax code’s “extraterritorial income exclusion” was a prohibited export subsidy. The law addresses that issue by repealing the exclusion—with generous transitional rules—and creating the new deduction mentioned above.

In addition, however, lawmakers used the new law as a vehicle for a variety of legislative initiatives that had been pending for, in certain cases, several years. Some of these could be called “special interest legislation,” but many enjoyed broad support and will have a broad impact.

Incentives and Other Taxpayer-Favorable Provisions
The law contains a package of pro-taxpayer changes in U.S. international tax rules. Among other things, the new law:

· simplifies the foreign tax credit rules;

· provides a 10-year carryforward and one-year carryback of the foreign tax credit;

· repeals the 90% limitation on using foreign tax credits against the alternative minimum tax (AMT);

· provides a temporary—and somewhat controversial—incentive in the form of an 85% dividends received deduction for corporations to “repatriate” their foreign earnings within a limited timeframe;

· repeals the foreign personal holding company and foreign investment company rules.

Other incentives are directed toward agriculture and small manufacturing. The list of about two dozen incentives includes:

· income and excise tax credits for biodiesel used in certain fuel mixtures;

· a provision allowing fishermen—in addition to farmers—to use income averaging, and providing that income averaging will not increase alternative minimum tax (AMT) liability (effective retroactively to January 1, 2004);

· a deduction for the first $10,000 of qualified reforestation expenditures (effective for expenditures paid or incurred after the date of enactment).

Finally, more than a dozen provisions are lumped into the “Miscellaneous” category. These include a provision extending and expanding the credit for electricity produced from renewable energy resources, as well as a provision that allows that credit and the alcohol fuels credit to be used against alternative minimum tax (AMT) liability.

Revenue Raising Provisions
To offset the projected revenue losses from the pro-taxpayer changes, the new law adds an extensive collection of revenue-raising measures, broken down into four broad categories: expatriation, tax shelters, fuel tax evasion, and “other revenue provisions.”

The new law adds expatriation rules for business entities and tightens the rules applicable to individuals. Broadly speaking, the effect of the rules is to limit or eliminate the intended tax benefits of certain actions that may be taken by individuals (e.g., renouncing U.S. citizenship) or corporations (e.g., becoming subsidiaries of a foreign parent) for the purpose of removing themselves from worldwide U.S. tax jurisdiction.

The “tax shelters” category comprises 30 provisions. Several are procedural in nature, e.g., a new penalty for failing to disclose “reportable transactions,” changes in the substantial underpayment penalty, and changes in certain reporting requirements.

Other “tax shelter” provisions change substantive tax rules. For example, one new rule prevents a taxpayer from excluding gain on the sale of a principal residence acquired in a tax-deferred like-kind exchange within the preceding five-year period. The most significant tax shelter provision seeks to curtail the tax benefits of certain leasing transactions with “tax indifferent parties” such as tax-exempt organizations and government entities, including foreign governments.

Provisions listed in the “fuel tax evasion” category modify a variety of excise tax rules.

Provisions affecting a variety of taxpayers, domestic and international, are scattered among the 30 miscellaneous measures in the “other revenue provisions” category.

One provision authorizes the IRS to hire private debt collection firms. Another requires a partnership to recognize (and pass through to its partners) cancellation of indebtedness income when it transfers a partnership interest to a creditor in satisfaction of a debt, whether recourse or nonrecourse. Still another seeks to prevent businesses from deducting the full costs of providing an aircraft to certain employees—in general, top-level executives, directors, and 10% owners—for personal purposes if those costs exceed the amount the employees must report as compensation income.

Provisions Affecting Individuals and Small or Closely Held Businesses

Dozens of provisions affect individuals and small or closely held businesses. Although day-to-day experience in working with the new law will undoubtedly reveal some implications that are not apparent at this point, we believe the provisions mentioned at the beginning of this letter are the most significant for the great majority of our clients. The remainder of this letter gives you a few more details about these provisions.

Deduction from Qualified Production Activities Income
As noted above the deduction replaces the “extraterritorial income exclusion,” which the new law repealed in response to the World Trade Organization ruling that the exclusion was a prohibited export subsidy. Although created because of an international trade dispute, the new deduction could be broadly applicable.

When fully phased in, the deduction could be as much as 9% of "qualified production activities income," which, in essence, is the net income attributable to “domestic production gross receipts.” The latter term encompasses much more than income from U.S.-based manufacturing activities. In addition to traditional manufacturers, any business might qualify if it:

(1) produces, grows, or extracts,
(2) “in whole or in significant part within the United States,”
(3) any tangible personal property, computer software, or sound recordings; and
(4) derives income from any “lease, rental, license, sale, exchange, or other disposition of” such property.

Other qualifying activities include:

· performing construction in the United States;

· performing engineering or architectural services in the United States for construction projects in the United States;

· producing electricity, natural gas, or potable water in the United States;

· producing films for which at least 50% of the total compensation was paid for services in the United States.

Taxpayers eligible for the deduction include individuals and passthrough entities such as S corporations, partnerships, and limited liability companies (LLCs), as well as C corporations.

More than 10% of small businesses will be affected by this provision, according to official estimates, and the Conference Committee report anticipates the need for “extensive additional regulatory guidance.” With the new rule set to go into effect in taxable years beginning after December 31, 2004, such guidance presumably will be high on the government’s priority list.

Nonqualified Deferred Compensation Rules Toughened
The new law significantly changes the law of nonqualified deferred compensation and imposes potentially large tax penalties for noncompliance. Unless a nonqualified deferred compensation (NQDC) plan meets the requirements of a new tax Code section, amounts deferred under the plan are includible in income back to the time of deferral or, if later, when no longer subject to a substantial risk of forfeiture, and are subject to interest at the underpayment rate plus 1% and a 20% additional tax.

The new law imposes requirements on NQDC plans with regard to participant elections, distributions, acceleration and funding that likely will necessitate amendments to most NQDC plans. A participant must make an election to defer compensation by the end of the taxable year preceding the year in which the employee will perform services for the company. Employees who are newly eligible must elect to defer within 30 days of becoming eligible. For performance-based compensation for services provided over a period of at least 12 months, the election must be made no later than six months before the end of the service period. The plan or the election must include the timing and form of a distribution.

Except as provided by regulations yet to be issued, distributions are permitted only upon the following triggers: (1) separation from service; (2) death of the participant; (3) a specified time or pursuant to a fixed schedule (but not upon a specified event); (4) change in control of the corporation; (5) an unforeseeable emergency; or (6) disability of the participant. Also except as provided by regulations, a plan may not accelerate a distribution. This provision negates such commonly used approaches as “haircuts,” which permit a participant to take a distribution at any time, but the participant must forfeit a portion of his or her account balance over the amount of the distribution.

The new law provisions apply to amounts deferred after December 31, 2004. Earnings on amounts deferred prior to that date generally are not subject to the new requirements. However, if a plan is “materially modified” after October 3, 2004, amounts deferred to a plan generally will be subject to the new law. The new law directs the Treasury to issue guidance within 60 days of the date of enactment that would provide for a limited period of time during which elections as to deferrals made after December 31, 2004, could be cancelled and plans could be amended to conform to the new requirements.

Small Business “Expensing” Increases Extended
Previous legislation increased the annual allowance for taxable years beginning after 2002 and before 2006 to $100,000 (from $25,000) and the “phaseout” threshold to $400,000 (from $200,000), with annual inflation adjustments, and added off-the-shelf software as eligible property. For taxable years beginning after 2005, the dollar amount was scheduled to revert back to $25,000. The new law extends the increased annual allowance through taxable years beginning before 2008.

S Corporation Rules Liberalized
Several new rules make it easier to qualify as an S corporation or to retain that status. Among other things, the new law:

· treats certain family members as one shareholder for purposes of the limit on the number of eligible shareholders;

· increases the number of eligible shareholders to 100;

· provides relief from inadvertently invalid qualified subchapter S subsidiary (“QSST”) elections;

Itemized Deduction for State and Local Sales Taxes

Individuals who itemize their deductions can now elect to deduct state and local sales taxes instead of state and local income taxes. Although the principal beneficiaries are residents of states that do not have an income tax, the new deduction provides an alternative for taxpayers living in states that impose both income and sales taxes. The amount of the deduction can be based on actual taxes paid or by using IRS-prepared tables.

This provision is retroactive to January 1, 2004. Therefore, the deduction will be available for individual returns due next April, and the IRS may have to scramble to incorporate this change. Taxpayers and return preparers should be alert for last-minute changes or corrections as the 2004 filing season approaches.

SUV Expensing Allowance Limited to $25,000
Previously, SUVs weighing more than 6,000 pounds were not subject to the limitations imposed on so-called “luxury” automobiles because their weight put them outside the limitation-triggering definition of “passenger” automobiles. The new law creates a separate category for such SUVs (including those rated at a gross vehicle weight of not more than 14,000 pounds) and imposes a $25,000 limit on the deduction. This limit will be effective for property placed in service on the date the President signs the legislation.

Charitable Deduction Rules Tightened
Obtaining a deduction for the charitable contribution of your car, or a boat or airplane, will be more difficult after December 31, 2004. After that date, you may no longer use the “Blue Book” value because your deduction is limited to the amount for which the charity later sells the vehicle. In addition to this limitation on the amount of your deduction, the charity must prepare, and you must attach to your return, a statement identifying the vehicle and stating the amount for which it was sold. Failure to attach the statement will result in disallowance of your deduction.

The legislation also includes new limitations on charitable donations of intellectual property, i.e., patents, copyrights and similar property, made after June 3, 2004. Rather than deducting the value of the intellectual property in the year of the contribution, you are now allowed to deduct only its cost, reduced by any amortization or depreciation deductions that you have taken. Then, over the next 10 years, you will be allowed to deduct a portion of any net income that the charity receives from its exploitation of the property, but only after offsetting the amount of the initial deduction.

Finally, the new law strengthens the requirements for substantiating contributions of property (excluding contributions of cash or publicly traded stock) made after June 3, 2004. The new law codifies existing IRS rules that require that: (1) certain information be provided on the return if the deduction exceeds $500; and (2) the taxpayer obtain a qualified appraisal for property with a value exceeding $5,000. There is also a new requirement that the appraisal be attached to the tax return when the deduction exceeds $500,000.

“Working Families Tax Relief Act of 2004”

Introduction

This release briefly summarizes the “Working Families Tax Relief Act of 2004,” enacted October 4, 2004.

True to its name, the new law primarily affects individual taxpayers, particularly families. Also, it contains several short-term extensions of business or investment tax benefits, plus technical corrections to previous legislation.

For most individuals, the new law means a continuation of the income tax rates, credits, and deductions that have applied in recent years, plus a one-year extension of alternative minimum tax relief. And for at least some businesses, the new law may provide tax-saving opportunities in 2004 and 2005.

For some individuals, the new law may affect eligibility for, or the amount of, several tax benefits relating to family members or others with whom the taxpayer has a close connection: the dependency exemption, the child tax credit, the earned income credit, the dependent care credit, and head-of-household filing status. These provisions, which are primarily intended to simplify the tax code, generally go into effect in 2005.

Highlights of the new law follow. Please feel free to contact our office for further information on any topic of interest to you.

Tax Cut Extensions for Individuals

The new law extends several previously-enacted tax cuts that were scheduled to be eliminated or reduced in 2005. Hence, these provisions will prevent many individuals from incurring increased tax liability in 2005 and perhaps in subsequent years as well.

Ten Percent Tax Bracket Increase Extended Through 2010

Tax cut legislation in 2001 created a new 10% income tax bracket below the 15% bracket, which previously had been the lowest tax bracket. In 2004, the amounts taxed at the 10% rate are (because of inflation adjustments)—

$7,150 for single filers,
$10,200 for heads of household, and
$14,300 for joint filers and surviving spouses.

These amounts were scheduled to drop to $6,000, $10,000, and $12,000, respectively, in 2005 and to stay at those levels until 2008. The result would have been higher taxes because more income would have been taxed at the next higher rate of 15%. The new law prevents this result by retaining the 2003 and 2004 levels, with inflation adjustments, through 2010.

Individual Alternative Minimum Tax Relief Extended Through 2005

The new law delays for one year a scheduled reduction in the exemption amounts for the individual alternative minimum tax (AMT). As a result, the following exemption amounts, which apply in 2004, will also apply in 2005:

$40,250 for unmarried taxpayers (versus $33,750),
$58,000 for joint filers and surviving spouses (versus $45,000),
$29,000 for married filing separately (versus $22,500).

The exemption amount for estates and trusts—$22,500—was not affected by the new law or previous tax cut legislation.

Note that the exemption amount is phased out at certain income levels. The new law does not change this rule.

The new law does, however, permit all nonrefundable personal credits to be used in full in calculating individual alternative minimum tax in 2004 and 2005. Previously, only the adoption credit, child credit, and IRA credit were to be allowed in full against the AMT in 2004 and later years.

Marriage Penalty Relief Extended Through 2005

Previous legislation provided temporary marriage penalty relief for joint filers by increasing both the standard deduction and the amount of income taxed at the 15% rate to twice the comparable amounts for single taxpayers. Thus, in 2004, the standard deduction for joint filers and surviving spouses is $9,700 (versus $4,850 for single filers) and the amount taxed at 15% is $43,800 (versus $21,900 for single filers).

These differentials were scheduled to drop in 2005 and not return to the 200% level until either 2008 (15% bracket) or 2009 (standard deduction). Under the new law, the differentials will remain at 200% through 2010.

$1,000 Per Child Tax Credit Retained

The child tax credit for 2004 is $1,000 per qualifying child. The credit was scheduled to decrease to $700 in 2005 and gradually increase to $1,000 again in 2010. The new law retains the $1,000 amount through 2010.

Note that the new law does not change the rule that the maximum credit amount is phased out for taxpayers with income exceeding certain levels. For example, in 2004, the phase-out range for joint filers begins at $110,000 of “modified adjusted gross income” (gross income plus certain nontaxable income).

The new law does, however, accelerate a scheduled increase in the refundable amount of the child tax credit. Also, nontaxable combat pay is treated as earned income for purposes of calculating the refundable amount.

Thus, in 2004, the refundable amount will be 15% (versus 10%) of earned income—including nontaxable combat pay—in excess of $10,750. The 15% rate will continue through 2010 and the $10,750 amount will be indexed for inflation.

Teachers’ Out-of-Pocket Classroom Expense Deduction Extended Through 2005

Previous legislation permitted teachers and other “eligible educators” in grades kindergarten through 12 to take an “above-the-line” deduction in 2002 and 2003 of up to $250 for certain unreimbursed classroom expenses. The new law extends this provision through 2005, effective retroactively to the beginning of 2004.

Therefore, teachers, instructors, counselors, principals, or aides in a school for at least 900 hours during a school year may deduct up to $250 of eligible out-of-pocket expenses in 2004 and 2005 without having to itemize and without being subject to the limitation on “miscellaneous itemized deductions.” Eligible expenses include books, certain supplies, computer equipment (including related software and services), other equipment, and supplementary materials that the taxpayer uses in the classroom.

Qualified Electric Vehicles and Clean-Fuel Vehicle Property

Previous legislation provided temporary tax incentives for “qualified electric vehicles” and “clean-fuel vehicle property” placed in service before 2007. A credit of up to $4,000 was available for qualified electric vehicles purchased before 2004. A deduction of $2,000 ($5,000 or $50,000 for certain trucks and vans) was available for “qualified clean-fuel vehicle property” purchased before 2004. These maximums were scheduled to drop by 25% in 2004, 50% in 2005, and 75% in 2006.

The new law repeals the scheduled reductions for 2004 and 2005. Thus, the full credit or deduction will be available in those years.

The new law did not change the 75% reduction scheduled for 2006, or the termination of these special incentives thereafter.

Uniform Definition of Child

The new law seeks to simplify the tax code by applying a uniform definition of “child” for purposes of the dependency exemption, the child credit, the earned income credit, the dependent care credit, and head-of-household filing status. These provisions will not generally apply until after tax year 2004, and therefore will not affect individual returns to be filed next April.

In most cases, the new rules will produce the same or greater tax benefits than the pre-2005 rules. But this will not necessarily be the result in every case. Therefore, taxpayers need to consider the potential impact of the new rules and to plan accordingly.

A taxpayer’s “child” under the new rules is a natural or adopted child, a stepchild, or an “eligible foster child.” The latter term means an individual placed with the taxpayer by an authorized placement agency or an appropriate court order. A child is considered “adopted” when lawfully placed with the taxpayer for legal adoption by the taxpayer.

Dependency Exemption

The key definitions under the new rules are “qualifying child” and “qualifying relative.” An individual who fits either of these definitions is considered a “dependent” of the taxpayer. Note, however, that these terms are somewhat misleading, because, just as under the pre-2005 rules, certain individuals can qualify as dependents of a taxpayer even though they are neither children nor relatives of the taxpayer.

The most notable superficial difference from current law is that the “qualifying child” standard does not include either the “support test” or the “gross income test,” although it does bar a dependency exemption for any individual who is self-supporting.

These tests are replaced by a residency requirement, under which the individual being claimed as a dependent must have had the same “principal place of abode” as the taxpayer for more than one-half of the relevant taxable year. Note, however, that the new law retains the special rule under current law that, in certain cases in which the parents are divorced or separated, in effect permits the custodial parent to release the claim to the exemption in favor of the noncustodial parent.

The new law provides “tie breaker” rules for any taxable year in which an individual could be a qualifying child with respect to two or more taxpayers and those taxpayers each claim benefits based on the individual’s status as a qualifying child. For example, an individual who lived with his father and grandmother in the same residence could be a qualifying child with respect to each. Or, an individual who lived with her two aunts in the same residence could be a qualifying child with respect to each.

Under the tie breaker rules, a parent is preferred over other claimants. As between parents, preference is given to the parent with whom the child resided for the longest period of time during the year. If the child resided with each parent for an equal period of time, the parent with the higher adjusted gross income gets the exemption. If none of the claimants is a parent, the taxpayer with the highest adjusted gross income is entitled to the exemption.

If an individual is not a “qualifying child” with respect to the taxpayer (or any other taxpayer), the dependency exemption may be based on the individual’s status as a “qualifying relative.” In general, the new law incorporates the present-law dependency exemption rules for this purpose.

Thus, as under current law, the individual’s relationship to the taxpayer can be quite broad, including parents and stepparents, aunts and uncles, nieces and nephews, and certain in-laws, among others. More importantly, the present-law gross income and support tests continue to apply, including the special rules concerning multiple support agreements, income of handicapped dependents, and support of students.

Dependent Care Credit

Although the new law generally retains the current law rules for determining the dependent care credit, e.g., a child generally must be under age 13 in order to be a “qualifying individual,” the new law:

· eliminates the requirement that a taxpayer provide more than one-half of the cost of maintaining a household in order to claim the credit; and

· adds a requirement that, for a spouse or a dependent (other than an child under age 13) to be a qualifying individual, that individual must have the same “principal place of abode” as the taxpayer for more than one-half of the taxable year.

Child Credit

The new law generally retains the current law rules for determining the child credit. Thus, for example, the child tax credit is available only if the child is under age 17 (whether or not disabled). However, the new law eliminates the requirement that foster children and certain other children be cared for “as the taxpayer’s own” children.

Earned Income Credit

The new law generally retains the current law rules for purposes of determining the earned income credit.

Thus, for example, a child may be a qualifying child for purposes of the earned income credit even if the child is self-supporting or the taxpayer cannot claim the child as a dependent because of the special rule permitting the noncustodial parent to claim the exemption. Also, the new law retains the requirement that the taxpayer’s principal place of abode must be the United States.

However, the new law eliminates the requirement that foster children and certain other children be cared for “as the taxpayer’s own” children.

Head of Household Status

The new law generally retains the current law rules for determining head of household status. Thus, for example, a child may be a qualifying child for this purpose even though the taxpayer cannot claim the child as a dependent because of the special rule permitting the noncustodial parent to claim the dependency exemption.

Extensions of Business or Investment Tax Benefits

The new law extended several business or investment incentives through 2005. Some of these were scheduled to expire at the end of 2004. Provisions that had already expired were extended retroactively.

Research Credit. Extended through 2005, retroactive to July 1, 2004. Hence, “qualified amounts” paid or incurred before 2006 will continue to qualify for the credit.

Work Opportunity and Welfare-to-Work Credit. Extended through 2005, retroactive to January 1, 2004. Thus, these credits are available for wages paid or incurred for individuals beginning work in 2004 or 2005.

Enhanced Deduction for Corporate Donations of Computer Technology and Equipment. Extended through 2005, retroactive to January 1, 2004. Thus, the enhanced deduction applies to qualifying donations in taxable years beginning before January 1, 2006.

Expensing of Brownfields Environmental Remediation Costs. Extended through 2005, retroactive to January 1, 2004. Thus, taxpayers will be able to deduct (rather than capitalize) qualifying expenditures paid or incurred through 2005.

Credit for Electricity Produced from Certain Renewable Resources. Extended through 2005, retroactive to January 1, 2004. Thus, the credit will be available with respect to wind energy facilities, “closed-loop” biomass facilities, and poultry waste facilities placed in service before 2006.

Suspension of Taxable Income Limit on Percentage Depletion from Oil and Natural Gas Produced from Marginal Properties. Extended through 2005, retroactive to January 1, 2004. Thus, the net income limitation will not apply to production from qualifying properties in taxable years beginning in 2004 and 2005.

With respect to investments relating to the “New York Liberty Zone” provisions (created by legislation in 2002), the new law:

· extended the authority to issue “qualified New York Liberty Bonds” through 2009;

· extended additional refunding authority through 2005 and made bonds of the Municipal Assistance Corporation eligible for refunding.

Other provisions, generally extended through 2005, include:

Archer Medical Savings Accounts;
Qualified Zone Academy Bonds;
Tax Incentives for Investment in the District of Columbia;
Indian Employment Tax Credit;
Accelerated Depreciation for Business Property on Indian Reservations

We hope the preceding summary has been informative and useful. Please contact our firm for further details of interest to you.