Updates for Fall 2006
Michael E. Parmelee - Partner, August 1, 2006
Dear Client:
There have been some recent changes in the tax law that might affect some of you. We have summarized below some of the changes. If you would like more information on any provisions or specific information as to how they might affect you, be sure to contact us and arrange an appointment to discuss your situation. We have separated the main provisions into two sections. The first deals with provisions related to individuals. The second provides information related to businesses. Many of these provisions are extensions into the future of existing provisions.
Individual Provisions:
AMT relief. Congress originally enacted tax law to make sure that wealthy Americans did not escape paying taxes, particularly if they had investments in tax shelters. The provisions for alternative minimum tax (AMT), which is a parallel tax system to the regular system, do not permit several of the deductions permissible under the regular tax system, such as state and local taxes. The AMT affects more middle-income taxpayers every year, in part due to the fact that the AMT parameters are not indexed for inflation. There is an exemption based on income. However, for 2006, the exemption amounts were scheduled to return to lower amounts. Rather than eliminate the AMT, Congress has once again relied on a temporary fix to the problem, this time a one-year extension of the old exemption amounts, increased slightly. For taxpayers with significant income, the AMT will still be a reality.
Another provision in the new law extends AMT relief for those who have personal tax credits. The tax liability limitation rules generally provide that certain nonrefundable personal credits (including dependent care, elderly and disabled, and education) are allowed only to the extent that a taxpayer has regular income tax liability in excess of the tentative minimum tax. The new law extends the use of the credits against AMT to tax years beginning in 2006. (Cost $34 billion over 10 years).
Investor tax breaks extended. In 2003, Congress passed a measure to lower the tax rate on most dividends to 15 percent from as high as 38.6 percent, and to lower the rate on most capital gains from 20 percent to 15 percent. That measure was due to expire at the end of 2008, but the new law extends the favorable tax rates through 2010. (Cost $50 billion over 10 years).
Income limitations on Roth IRA conversions eliminated, beginning in 2010. A taxpayer who makes deductible contributions to a regular individual retirement account (IRA) gets a tax break now for the dollars he puts in and his earnings grow tax free, but he pays ordinary income tax on every dollar he takes out, and withdrawals are subject to significant restrictions. In a Roth IRA, the taxpayer gets no tax deduction for contributions, but his money grows tax free and there's no tax, and few restrictions, on qualifying withdrawals.
Under prior law, only taxpayers with $100,000 or less in modified adjusted gross income can convert a regular IRA into a Roth IRA. A taxpayer making the conversion generally must pay tax on money he takes out of his regular IRA, but once it's in his Roth IRA, he won't pay tax on that money or the money it earns. Generally speaking, Roth conversions appeal to taxpayers who either think their tax rate will go up in retirement, or believe that the value of their account will rise significantly, and thus are willing to make an upfront tax payment when they convert in order to reap tax savings later.
Under the new law, beginning in 2010, taxpayers with more than $100,000 of modified adjusted gross income also will be able to convert a regular IRA into a Roth IRA. To make such conversions more attractive in 2010, the new law permits taxpayers who convert in 2010 to spread the income and resulting tax payments on the converted funds over two years—2011 and 2012. (Cost $6 billion over 10 years).
Kiddie tax age limit raised from under 14 to under 18. At one time, wealthy parents could significantly lower their family's tax bill by transferring investment assets to minor children. This tax technique, called income shifting, worked by taking income out of the parents' higher tax bracket and placing it in the lower tax brackets of their children. To curtail the use of this tax technique, Congress enacted the “kiddie tax” rules, which said that children under 14 who had more than a small amount of unearned (investment) income had to pay tax at their parents' marginal tax rate (the rate of tax on the last dollar earned). The threshold amount at which the kiddie tax kicks in is two times the amount allowed as a standard deduction for a dependent who has only investment income. For 2006, that amount is $850, so the kiddie tax begins to apply when the child has more than $1,700 in unearned income.
Under the new law, the age limit below which a child's income from investments is taxed at the parents' rates is raised from 14 to 18. The new law specifies, however, that the kiddie tax does not apply to a child who is married and files a joint return for the tax year. It also adds an exception to the kiddie tax for distributions from certain qualified disability trusts. The new provisions apply to tax years beginning after Dec. 31, 2005. (Revenue $2 billion over 10 years).
Capital gain treatment for self-created musical works. Under pre-Act law, capital assets do not include copyrights, literary, musical, or artistic compositions, letters or memoranda, or similar property held by a taxpayer whose personal efforts created the property. As a result, when a taxpayer sells copyrights he owns in, for example, books, songs, or paintings that he created, gain from the sale is treated as ordinary income, not capital gain, which is generally taxed at a lower rate.
Under the new law, at the election of a taxpayer, the sale or exchange before Jan. 1, 2011 of musical compositions or copyrights in musical works created by the taxpayer's personal efforts is treated as the sale or exchange of a capital asset. The change applies for sales or exchanges in tax years beginning after May 17, 2006. (Cost $20 million over 10 years).
Changes to the foreign earned income exclusion and housing allowance for U.S. citizens working abroad. The new law makes three changes to the foreign earned income exclusion and housing allowance. First, the income exclusion is indexed for inflation starting in 2006 (rather than 2008 under pre-Act law). Second, the base housing amount used in calculating the foreign housing cost exclusion in a taxable year is 16 percent of the amount of the foreign earned income exclusion limitation. Reasonable foreign housing expenses in excess of the base housing amount remain excluded from gross income, but the amount of the exclusion is limited to 30 percent of the taxpayer's foreign earned income exclusion. Third, income excluded as either foreign earned income or as a housing allowance is included for purposes of determining the marginal tax rates applicable to non-excluded income. (In other words the excluded income is excluded out of the lowest tax bracket, not the highest).
Trusts/Trustees. Before we discuss the business provisions of the new tax law, we want to remind you as we periodically do of two important actions for you to take. First, if you do not yet have a living trust through which you not only specify how things are to be handled at your death but also if you become incapacitated, we would strongly encourage you to see an attorney and set up your trust. For a married couple it can not only save you estate taxes at the second death, but it provides for an orderly and easy to administer method of handling your finances. You can also provide for grandchildren or beneficiaries resulting from second marriages. We encourage you to discuss with us some of the effects of the trust and some of the considerations for you.
Additionally, if you have no immediate family members whom you would prefer to act as a trustee for your trust, we remind you that service is one of the functions that our partners can perform for you. We encourage you to discuss these issues with us.
Business Provisions:
Extension of increased expensing for small business. A taxpayer, other than an estate, trust, and certain noncorporate lessors, may elect to deduct as an expense, rather than to depreciate, up to a specified amount of the cost of new or used tangible personal property placed in service during the tax year in his trade or business. The maximum dollar amount that may be deducted annually is $100,000 ($108,000 for 2006, as adjusted for inflation). Under pre-Act law, this amount was to drop to $25,000 for property placed in service in tax years beginning after 2007.
The taxpayer's maximum annual expensing amount is reduced dollar-for-dollar by the amount of qualified expensing-eligible property that he places in service during the tax year in excess of a phase-out amount. This amount is $400,000 ($430,000 for 2006, as adjusted for inflation). Under pre-Act law, this amount was to drop to $200,000 for property placed in service in tax years beginning after 2007.
Off-the-shelf computer software qualifies as property eligible for the expense election, but under pre-Act law, could not qualify in tax years beginning in 2008 and later.
An expense election or a revocation may be made, without IRS's consent, on an amended federal tax return for the tax year to which the election or revocation applies, but under pre-Act law, could not be so made in tax years beginning after 2007.
The new law extends the $100,000 expense election limit and the $400,000 phase-out ceiling (as inflation adjusted), the inclusion of off-the-shelf computer software in eligible “section 179 property,” and the right to amend or revoke an expense election without IRS's consent for two years, to tax years beginning before 2010. (Cost $7 billion over 5 years and $271 million over 10 years).
50% W-2 wage limit on the Code Sec. 199 domestic production deduction modified. The domestic production deduction is limited to 50% of the W-2 wages paid by the taxpayer. Under the new law, the W-2 wages taken into account for purposes of this limitation must be properly allocable to domestic production gross receipts—that is, the gross receipts from the activities that give rise to the deduction. In addition, the new law repeals the special limitation on the amount of W-2 wages that may be taken into account by partners and S corporation shareholders. The changes are effective for tax years beginning after May 17, 2006.
Amortization of expenses paid for musical works and copyrights. The new law allows taxpayers to elect to amortize over five years expenses paid or incurred in creating or acquiring certain musical works and copyrights. This five-year amortization method is an alternative to the income forecast method of accounting for these expenses.
Revenue offsets. The new law attempts to pay for the extended and new tax breaks highlighted above with a number of revenue-raising provisions, including the following:
- Corporations with assets of at least $1 billion face a modified schedule of estimated tax payments. If you have an interest in this area, please contact one of our partners.
- Information reporting will be required for tax-exempt interest paid on tax-exempt bonds after Dec. 31, 2005. (Savings $24 million over 10 years).
- Taxpayers will be required to make partial payments to the IRS with any offer in compromise. For lump-sum offers (which include single payments, as well as payments made in 5 or fewer installments), taxpayers will have to make a down payment of 20% of the amount of the offer with any application. Any periodic payment offer in compromise will have to be accompanied by the payment of the amount of the first proposed installment. User fees will be applied against tax, interest or penalties due under the offer in compromise.
- Limitations on tax-free spin-offs for Investment Corporations. The new law denies tax-free treatment to certain spin-offs where either the distributing corporation or the controlled corporation is a “disqualified investment corporation.”
Please keep in mind that we’ve described only the highlights of the most important changes in the new law. Please call us at your earliest convenience to set up an appointment for more details on the law or for discussions of specific questions or analysis of your particular situation.
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