By Bill Bischoff
November 4, 2004
OVER THE PAST few weeks, most Americans have been thinking a lot about President Bush. Most likely it wasn't in connection with the American Jobs Creation Act of 2004, which he signed into law on Oct. 22.
But now that the election has passed, it's a good time to take a peek inside this massive piece of legislation. Granted, most of the hundreds of changes included in this new code apply to large corporations. But there are some changes that will affect individuals as well as small-business owners. Here's what you need to know.
KEY CHANGES FOR INDIVIDUALS
New Writeoff for State and Local Sales Taxes
Attention big spenders: the new law gives you the option of claiming an itemized deduction for either general state and local sales taxes or state and local income taxes but not both. This is an overdue attempt to put residents of jurisdictions with low or no personal income taxes (like Texas, Florida and Washington) on a more equal footing with folks who've been able to deduct their state and local income taxes for many years.
Under the new rule, you could save every receipt on which you've paid sales tax, or take the easy way out and use predetermined figures from IRS tables. (The latter is going to be the strategy of choice for most folks in 2004, given than most won't have the receipts on hand from earlier in the year.) Unfortunately, this new break is available only to those who itemize deductions on Schedule A of Form 1040. Also, as is the case with state and local income taxes, you cannot deduct state and local sales taxes under the alternative minimum tax (AMT) rules.
Effective Date: This change applies for the 2004 and 2005 tax years only. It will expire after next year unless Congress takes further action.
Tightened Rules for Donated Vehicles
Starting next year, charitable donations of motor vehicles will fall under strict new rules if the claimed deduction exceeds $500. Your writeoff will now depend on how the donated vehicle is used by the charitable organization. If the organization sells it without using it significantly for charitable purposes or making material improvements, your deduction will generally be limited to the amount of gross sales proceeds received by the charity. This is a big (and unfavorable) change, because current law allows you to deduct the "full fair market value" of the donated vehicle. Whatever that is! Needless to say, the government suspects many folks have gasp! deliberately overstated values in order to claim excessive deductions. The new rules eliminate the opportunity to game the system in this fashion.
That said, the IRS is expected to issue regulations that will exempt vehicle sales that are considered to directly advance an organization's charitable purposes. For example, assume an organization fulfills its charitable purpose by selling donated cars to needy individuals at bargain prices. In this case, the exemption would apply, and you could deduct the donated vehicle's full fair market value even if it exceeds the gross sales proceeds received by the charity. (In other words, the outcome would be the same as under current law.)
Charities will also be required to issue detailed written acknowledgments to vehicle donors. The IRS can then require organizations to disclose the information included in these acknowledgments and check to see if it matches up with donors' tax returns.
Effective Date: These changes apply to vehicle donations made after 2004. The same unfriendly rules apply to donated boats and planes. So, if you're thinking about donating a vehicle (or a boat or a plane) worth more than $500, try to get it done before year's end.
Stricter Rules for Deferred Compensation
The new law includes a complicated set of guidelines that will make it much more difficult for employees to enter into nonqualified deferred compensation arrangements that defer federal income taxes. This affects a wide variety of arrangements including (but not limited to) supplemental executive retirement plans (SERPs), phantom stock plans, stock appreciation rights (SARs) and severance agreements. (Qualified retirement plans are not affected.)
Under the new rules, you generally must elect to defer compensation before the beginning of the year in which you will earn it. Under an exception, you can generally elect to defer performance-based compensation as late as six months before the performance period ends. The new rules also impose restrictions on when you can receive payments under a deferred compensation arrangement and when you can choose to change the form of payments or delay payments. Running afoul of these rules can trigger an immediate federal income tax hit on your deferred compensation balances.
Effective Date: The new rules apply to amounts that are considered to be deferred after 2004. Deferred compensation amounts earned and vested before Jan. 1, 2005 are generally considered to be deferred before 2005 and are therefore unaffected by the unfavorable new rules. However, an arrangement to defer compensation that will be earned in 2005 and beyond will generally fall under the new rules even if the deal predates the new law. Bottom line: tax lawyers and CPAs will be busily revamping deferred compensation schemes for a good while in reaction to the new law.
New Deduction for Contingent Attorney Fees
Some courts have opined that current tax law requires claimants to include 100% of certain legal judgments and settlements in taxable income including contingent attorney fees and costs that are actually subtracted from the amount the claimant receives. Under this exceedingly unfavorable view, the claimant must treat the contingent attorney fees and expenses as miscellaneous itemized deductions. Because these deductions are limited for regular tax purposes and completely disallowed for alternative minimum tax (AMT) purposes, the end result can be that the claimant is forced to pay federal income tax on most or all of the amount paid to the attorney.
In other words, if you win a $2 million civil suit and then fork over $800,000 as a contingent fee to your lawyer you might owe taxes only on the $800,000 you were never able to enjoy. Obviously, this is completely unfair.
Thankfully, the new law partially rectifies the problem (but only partially) by creating a new deduction for attorney fees and costs paid by or on behalf of claimants in legal actions involving claims of unlawful discrimination, certain claims against the federal government, and private causes of action under the Medicare Secondary Payer law. The new writeoff is "above-the-line" which means you don't have to itemize to benefit.
Unlawful discrimination actions are defined to include a wide variety of legal wrangles including actions that claim violations of the Civil Rights Acts of 1964 and 1991, the Congressional Accountability Act of 1995, the National Labor Relations Act, the Family and Medical Leave Act of 1993, the Fair Housing Act, the Americans with Disabilities Act of 1990, and various whistle-blower statutes.
Effective Date: This favorable change applies to legal fees and costs paid after Oct. 22, 2004 in connection with judgments and settlements occurring after that date.
KEY CHANGES FOR SMALL BUSINESSES
Extension of Generous "Section 179" Instant Depreciation Writeoff
The new law extends the current Section 179 instant deduction allowance ($100,000 with annual increases for inflation) for two more years through tax years beginning in 2007. Under this valuable break, many small businesses can immediately deduct the entire cost of most equipment and software additions.
For years beginning in 2008 and beyond, however, the maximum Section 179 deduction will fall back to only $25,000 unless Congress takes further action.
Reduced $25,000 "Section 179" Allowance for SUVs
In a bit of bad news for business taxpayers, the new law places a lower $25,000 limit on Section 179 deductions for "heavy" SUVs with gross vehicle weight ratings of 14,000 pounds or less. Under prior law, SUVs with gross vehicle weight ratings of more than 6,000 pounds were eligible for the full $100,000 Section 179 allowance ($102,000 for tax years beginning in 2004). The good news is that the reduced deduction rule doesn't apply to vehicles that aren't considered SUVs under the tax law.
- Vehicles designed to seat more than nine passengers behind the driver's seat (such as hotel shuttle vans).
- Vehicles with an open cargo area or covered box not readily accessible from the passenger compartment of at least six feet in length (many pickups with full-size cargo beds will qualify for this exception, but "quad cabs" and "extended cabs" with shorter cargo beds may not).
- Delivery vans.
- Ambulances, hearses, and for-hire vehicles used to transport passengers or stuff.
- Vehicles that fall under these exceptions with gross vehicle weight ratings in excess of 6,000 pounds remain eligible for the full Section 179 deduction ($102,000 for 2004).
Effective Date: The reduced $25,000 deduction applies to SUVs placed in service after Oct. 22, 2004.
New Deduction for Domestic Producers
The new law creates a new 9% federal income tax deduction for so-called "domestic production activities." The writeoff will be phased in between 2005 and 2010 according to the following schedule: 3% for tax years beginning in 2005 and 2006, 6% for years beginning in 2007 through 2009, and the full 9% for years beginning in 2010 and beyond. Once it's fully phased in, the deduction will be nearly equivalent to a 3% federal income tax rate cut for qualifying domestic production activities. This assumes the taxpayer pays the maximum 35% federal rate (9% deduction x 35% tax rate = 3.15% effective rate cut).
The new deduction is not limited to C corporations even though the writeoff is often described in the media as a corporate tax goodie. In fact, the break is available to S corporations, partnerships, LLCs, sole proprietorships, cooperatives, estates, and trusts that conduct qualified domestic production activities. The definition of eligible activities is very broad and includes (but is not limited to) the following:
- Traditional manufacturing of tangible personal property in the U.S.
- Many U.S. construction projects.
- Civil engineering and architectural services for many U.S. construction projects.
- Production of electricity, gas, and potable water in the U.S.
- Growing of agricultural products and food in the U.S. (that is, domestic farming).
- Processing of agricultural products and food in the U.S.
- Software production in the U.S.
- Most film and videotape production, renting, and licensing activities in the U.S.
VARIOUS AND SUNDRY OTHER CHANGES
The new law includes hundreds of other changes that probably won't affect you or your business. That said, beware of the following new provisions.
- More favorable depreciation rules for leasehold improvement costs and restaurant building improvements.
- Various taxpayer-friendly changes for S corporations.
- Different rules for business start-up expenses and costs to organize new corporations, LLCs, and partnerships.
- Curtailed deductions for costs to entertain and amuse business owners and bigshots (such as the cost of personal travel on company planes).
- Various tax breaks for the agriculture, fishing and timber industries.
- New rules and penalties intended to discourage various tax shelter schemes.
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