Tax and Retirement Planning

The 2004 American Jobs Creation Act (AJCA) creates several tax breaks for businesses and made some other significant changes. This article highlights the more prominent provisions of the AJCA that affect businesses and individual taxpayers generally, and that to some extent have specific impact on law firms and other professional service providers. The Working Families Tax Relief Act, also enacted in 2004, primarily extended many expiring tax benefits. This latter Act is not covered in this article, but readers should note that detailed information on both of these Acts is available on the Internet and from your professional tax advisers.

New Tax Deduction

Using what appears to be a novel way to stimulate the economy, the AJCA legislation includes a new tax deduction for business income from domestic manufacturing and production, including income from farming and construction (but not from other types of businesses such as restaurants).

The deduction is allowed for incorporated and unincorporated businesses and applies for both the regular tax and the alternative minimum tax (AMT). This new deduction is phased in, with 3% of such income being excluded from income tax in 2005 and 2006; 6% excluded in 2007 through 2009; and 9% excluded in subsequent years. Tax practitioners anticipate a complex set of regulations and related guidance for measuring the income related to qualified activities, particularly in situations where there are multiple qualifying and nonqualifying activities as well as opportunities to allocate corporate overhead and direct production expenses to optimize the resulting benefit.

Section 179 Extension

What is often referred to as the “Section 179 deduction” refers to Internal Revenue Code section 179, which has been extended for 2 additional years (for 2006 and 2007). This provision allows businesses to take a first-year tax deduction for the first $100,000 of qualifying property placed in service, as opposed to applying the otherwise applicable depreciation rules to such assets.

This deduction is phased out when more than $400,000 in qualified property is placed in service in a given year by a specific taxpayer. Other recapture rules apply if the equipment is disposed of prior to the end of the normal depreciation life.

The AJCA also limits the section 179 deduction that can be claimed on SUV vehicles weighing more than 6000 pounds (eg, Chevy Suburban, Ford Expedition, GMC Envoy XLT, Hummer, etc.). Previously, such vehicles qualified for a full section 179 deduction, subject to further limits for business versus personal usage. Under this new legislation, the section 179 deduction is limited to $25,000 for such vehicles. More modest limits apply to other nonspecial purpose vehicles used for business activities.

Bonus Depreciation Expiring

Somewhat related to these section 179 rules is the allowance for “bonus” depreciation. The Jobs and Growth Tax Relief Reconciliation Act of 2003 increased this deduction, first enacted in 2002, from 30% to 50%, as additional depreciation on top of other allowable depreciation deductions. One of the few negative aspects of the two major 2004 tax Acts was that “bonus” depreciation was not extended beyond 2004.

Startup and Organizational Costs

Changes have been made to the deductibility of business startup and organizational costs. Under the AJCA, the first $5000 of each type of expense can be claimed in the first year of operations, subject to a phase-out of this early deduction when such costs exceed $50,000 in each category. Any amounts not eligible for deduction in the first year are amortized over 15 years, consistent with the amortization life for other section 197 intangible assets.

Subchapter S Corporations

After 2004, the 75-shareholder limit goes to 100 for Subchapter S corporations, and family members can elect to be treated as a single owner. This provision further enhances the use of S corporations by larger professional service providers as an alternative to the use of limited liability corporations and partnerships.

The IRS has indicated it will focus increasingly on the payment of reasonable compensation to S corporation shareholders in relation to profit distributions reported on their respective Schedule K-1s. Such profit distributions are not subject to the employment tax burdens imposed on compensation, which must be paid and reported as Form W-2 wages. [For background information on this topic, see Jim Cotterman's article on "Unreasonable Compensation in a Professional Corporation" in A&FP's October 2003 edition.]

Individual Taxpayers

The AJCA provides some tax benefits for individual taxpayers as well. For 2004 and 2005, individual taxpayers can elect to deduct sales tax using IRS tables in lieu of claiming an itemized deduction for payments of state income tax. Sales tax on purchased vehicles can be added on top of the rate table amount to the extent the rate on the vehicle does not exceed the general sales tax rate. This new provision will primarily help residents in states with no income tax (eg, Florida, Texas, Washington and Wyoming); taxpayers with relatively low state income tax rates will have the option to take whichever deduction is larger. Unfortunately, this break won't apply for calculation of the AMT.

A little publicized AJCA provision greatly assists law firm clients who seek damages for “nonphysical” injuries ' notably in wrongful termination and other employment cases, breach of contract cases and civil rights discrimination cases. The AJCA overrides prior IRS rules that required the contingent fee component of nonphysical damage awards to be included in plaintiffs' taxable income, notwithstanding the fact that such contingent fee payments ordinarily go directly to the attorneys, who then pay income taxes on them. U.S. appellate courts had been divided on suits seeking to block that IRS rule, which caused great hardship to some plaintiffs through its congressionally unintended interaction with other rules. (Actual damage awards to plaintiffs in these cases are often small or even nominal, with attorney fees being substantial ' and the cases therefore being feasible ' only thanks to federal fee-shifting statues. While the IRS technically allowed plaintiffs a Schedule A miscellaneous deduction to cancel out their contingent fee “income,” the size of the contingent fee often threw the plaintiff into AMT territory for the year, rendering the miscellaneous deduction inapplicable.) As a result, some plaintiffs prior to the AJCA could not proceed with their cases because their income taxes on the contingent fee would far exceed the value of their actual award; some cases where this actually happened are still under appeal. [For background coverage of this topic, see the November 2003 and November 2004 editions of A&FP.]

Tax Hikes

Some tax hikes applicable to a limited number of taxpayers were added as well. Deductions for donated vehicles, boats and planes have been reduced. If a charity sells an item of this type without rehabbing it or using it for their charitable purpose, the donor's deduction will be limited to the amount of the actual sale price. The charitable organization must report the selling price to the donor and the IRS for donations made after Dec. 31, 2004. Write-offs for personal use of company airplanes have been reduced for personal use by officers, directors and owners of 10% or more of the company. The company's deduction for operating costs of the airplane for these non business trips is limited to the amount of taxable income actually recognized by the executive for their use. This same rule also applies to company-owned vacation properties.

Retirement Plan Caps

Unrelated to the changes brought about by the AJCA, it is important for planning purposes to note the continuing upward adjustments to most qualified retirement plan limits for 2005. The 401(k) plan maximum deferral contribution will be $14,000 for 2005, a $1000 increase over 2004. Employees who were born prior to 1954 can contribute an additional $4000. These same contribution limitations apply to 403(b) and 457 plans as well.

Additionally:

• The cap for SIMPLE plans goes up to $10,000 and $12,000 for individuals born before 1954.
• For Keoghs and profit-sharing plans, the pay-in ceiling for defined-contribution plans will be $42,000 for 2005, a $1,000 increase.
• The eligible compensation limit for pension plans will be $170,000 in 2005.
• Employees earning more than $95,000 in 2005 will be deemed to be in the “highly paid” category for purposes of the nondiscrimination rules for retirement plans.

Social Security and Medicare

The 2005 Social Security wage base will be $90,000, up $2100 from 2004. The tax rates on employers and employees will remain the same at 6.2% for FICA on up to $90,000 of pay; and 1.45% for Medicare on all wages. Self-employed individuals will pay 15.3% on the first $90,000; and 2.9% above that with no upward cap.

Statistical Trends Policy Debates

Finally, it is interesting to note a few statistics with regard to the sharing of the tax burdens between individual income taxpayers. According the an IRS analysis of 2002, tax return filings, the most recent year available, the very highest earners are paying a lower share of income tax for the second consecutive year.

That said, however, the overall sharing of these tax burdens is dramatic:

• The top 1% of 2002 individual filers made an adjusted gross income (AGI) of at least $285,400; had 16% of all AGI; and paid 33.7% of all federal individual income taxes (down from 33.9% in 2001).
• The top 5% made an AGI of at least $126,500; had 31% of all AGI; and paid 54% of total income taxes.
• The upper 10% of taxpayers made an AGI of at least $92,600; had 42% of all AGI; and paid 66% of the federal income tax burden.
• In contrast, the bottom 50% of individual income tax filers paid only 3.5% of the overall total of income taxes in 2002. (Due to the allowance of negative AGI, the IRS finds it impractical to compute an AGI maximum for lower-end taxpayers. The above IRS figures do imply, however, that 58% of all AGI is made by the lower 90% of taxpayers.)

As I write this, I hear rumblings that the Bush Administration is already at work to propose legislation that will make permanent the 15% tax rate on corporate dividends, currently scheduled to expire after 2008, and to also make permanent the repeal of estate taxes. Estate taxes are currently scheduled to be phased out completely in 2010, but then revert to the prior limits in 2011. The debate and decisions on this latter item, together with growing calls for significant reforms to our social security system, will merit our close attention.

The 2004 American Jobs Creation Act (AJCA) creates several tax breaks for businesses and made some other significant changes. This article highlights the more prominent provisions of the AJCA that affect businesses and individual taxpayers generally, and that to some extent have specific impact on law firms and other professional service providers. The Working Families Tax Relief Act, also enacted in 2004, primarily extended many expiring tax benefits. This latter Act is not covered in this article, but readers should note that detailed information on both of these Acts is available on the Internet and from your professional tax advisers.

New Tax Deduction

Using what appears to be a novel way to stimulate the economy, the AJCA legislation includes a new tax deduction for business income from domestic manufacturing and production, including income from farming and construction (but not from other types of businesses such as restaurants).

The deduction is allowed for incorporated and unincorporated businesses and applies for both the regular tax and the alternative minimum tax (AMT). This new deduction is phased in, with 3% of such income being excluded from income tax in 2005 and 2006; 6% excluded in 2007 through 2009; and 9% excluded in subsequent years. Tax practitioners anticipate a complex set of regulations and related guidance for measuring the income related to qualified activities, particularly in situations where there are multiple qualifying and nonqualifying activities as well as opportunities to allocate corporate overhead and direct production expenses to optimize the resulting benefit.

Section 179 Extension

What is often referred to as the “Section 179 deduction” refers to Internal Revenue Code section 179, which has been extended for 2 additional years (for 2006 and 2007). This provision allows businesses to take a first-year tax deduction for the first $100,000 of qualifying property placed in service, as opposed to applying the otherwise applicable depreciation rules to such assets.

This deduction is phased out when more than $400,000 in qualified property is placed in service in a given year by a specific taxpayer. Other recapture rules apply if the equipment is disposed of prior to the end of the normal depreciation life.

The AJCA also limits the section 179 deduction that can be claimed on SUV vehicles weighing more than 6000 pounds (eg, Chevy Suburban, Ford Expedition, GMC Envoy XLT, Hummer, etc.). Previously, such vehicles qualified for a full section 179 deduction, subject to further limits for business versus personal usage. Under this new legislation, the section 179 deduction is limited to $25,000 for such vehicles. More modest limits apply to other nonspecial purpose vehicles used for business activities.

Bonus Depreciation Expiring

Somewhat related to these section 179 rules is the allowance for “bonus” depreciation. The Jobs and Growth Tax Relief Reconciliation Act of 2003 increased this deduction, first enacted in 2002, from 30% to 50%, as additional depreciation on top of other allowable depreciation deductions. One of the few negative aspects of the two major 2004 tax Acts was that “bonus” depreciation was not extended beyond 2004.

Startup and Organizational Costs

Changes have been made to the deductibility of business startup and organizational costs. Under the AJCA, the first $5000 of each type of expense can be claimed in the first year of operations, subject to a phase-out of this early deduction when such costs exceed $50,000 in each category. Any amounts not eligible for deduction in the first year are amortized over 15 years, consistent with the amortization life for other section 197 intangible assets.

Subchapter S Corporations

After 2004, the 75-shareholder limit goes to 100 for Subchapter S corporations, and family members can elect to be treated as a single owner. This provision further enhances the use of S corporations by larger professional service providers as an alternative to the use of limited liability corporations and partnerships.

The IRS has indicated it will focus increasingly on the payment of reasonable compensation to S corporation shareholders in relation to profit distributions reported on their respective Schedule K-1s. Such profit distributions are not subject to the employment tax burdens imposed on compensation, which must be paid and reported as Form W-2 wages. [For background information on this topic, see Jim Cotterman's article on "Unreasonable Compensation in a Professional Corporation" in A&FP's October 2003 edition.]

Individual Taxpayers

The AJCA provides some tax benefits for individual taxpayers as well. For 2004 and 2005, individual taxpayers can elect to deduct sales tax using IRS tables in lieu of claiming an itemized deduction for payments of state income tax. Sales tax on purchased vehicles can be added on top of the rate table amount to the extent the rate on the vehicle does not exceed the general sales tax rate. This new provision will primarily help residents in states with no income tax (eg, Florida, Texas, Washington and Wyoming); taxpayers with relatively low state income tax rates will have the option to take whichever deduction is larger. Unfortunately, this break won't apply for calculation of the AMT.

A little publicized AJCA provision greatly assists law firm clients who seek damages for “nonphysical” injuries ' notably in wrongful termination and other employment cases, breach of contract cases and civil rights discrimination cases. The AJCA overrides prior IRS rules that required the contingent fee component of nonphysical damage awards to be included in plaintiffs' taxable income, notwithstanding the fact that such contingent fee payments ordinarily go directly to the attorneys, who then pay income taxes on them. U.S. appellate courts had been divided on suits seeking to block that IRS rule, which caused great hardship to some plaintiffs through its congressionally unintended interaction with other rules. (Actual damage awards to plaintiffs in these cases are often small or even nominal, with attorney fees being substantial ' and the cases therefore being feasible ' only thanks to federal fee-shifting statues. While the IRS technically allowed plaintiffs a Schedule A miscellaneous deduction to cancel out their contingent fee “income,” the size of the contingent fee often threw the plaintiff into AMT territory for the year, rendering the miscellaneous deduction inapplicable.) As a result, some plaintiffs prior to the AJCA could not proceed with their cases because their income taxes on the contingent fee would far exceed the value of their actual award; some cases where this actually happened are still under appeal. [For background coverage of this topic, see the November 2003 and November 2004 editions of A&FP.]

Tax Hikes

Some tax hikes applicable to a limited number of taxpayers were added as well. Deductions for donated vehicles, boats and planes have been reduced. If a charity sells an item of this type without rehabbing it or using it for their charitable purpose, the donor's deduction will be limited to the amount of the actual sale price. The charitable organization must report the selling price to the donor and the IRS for donations made after Dec. 31, 2004. Write-offs for personal use of company airplanes have been reduced for personal use by officers, directors and owners of 10% or more of the company. The company's deduction for operating costs of the airplane for these non business trips is limited to the amount of taxable income actually recognized by the executive for their use. This same rule also applies to company-owned vacation properties.

Retirement Plan Caps

Unrelated to the changes brought about by the AJCA, it is important for planning purposes to note the continuing upward adjustments to most qualified retirement plan limits for 2005. The 401(k) plan maximum deferral contribution will be $14,000 for 2005, a $1000 increase over 2004. Employees who were born prior to 1954 can contribute an additional $4000. These same contribution limitations apply to 403(b) and 457 plans as well.

Additionally:

• The cap for SIMPLE plans goes up to $10,000 and $12,000 for individuals born before 1954.
• For Keoghs and profit-sharing plans, the pay-in ceiling for defined-contribution plans will be $42,000 for 2005, a $1,000 increase.
• The eligible compensation limit for pension plans will be $170,000 in 2005.
• Employees earning more than $95,000 in 2005 will be deemed to be in the “highly paid” category for purposes of the nondiscrimination rules for retirement plans.

Social Security and Medicare

The 2005 Social Security wage base will be $90,000, up $2100 from 2004. The tax rates on employers and employees will remain the same at 6.2% for FICA on up to $90,000 of pay; and 1.45% for Medicare on all wages. Self-employed individuals will pay 15.3% on the first $90,000; and 2.9% above that with no upward cap.

Statistical Trends Policy Debates

Finally, it is interesting to note a few statistics with regard to the sharing of the tax burdens between individual income taxpayers. According the an IRS analysis of 2002, tax return filings, the most recent year available, the very highest earners are paying a lower share of income tax for the second consecutive year.

That said, however, the overall sharing of these tax burdens is dramatic:

• The top 1% of 2002 individual filers made an adjusted gross income (AGI) of at least $285,400; had 16% of all AGI; and paid 33.7% of all federal individual income taxes (down from 33.9% in 2001).
• The top 5% made an AGI of at least $126,500; had 31% of all AGI; and paid 54% of total income taxes.
• The upper 10% of taxpayers made an AGI of at least $92,600; had 42% of all AGI; and paid 66% of the federal income tax burden.
• In contrast, the bottom 50% of individual income tax filers paid only 3.5% of the overall total of income taxes in 2002. (Due to the allowance of negative AGI, the IRS finds it impractical to compute an AGI maximum for lower-end taxpayers. The above IRS figures do imply, however, that 58% of all AGI is made by the lower 90% of taxpayers.)

As I write this, I hear rumblings that the Bush Administration is already at work to propose legislation that will make permanent the 15% tax rate on corporate dividends, currently scheduled to expire after 2008, and to also make permanent the repeal of estate taxes. Estate taxes are currently scheduled to be phased out completely in 2010, but then revert to the prior limits in 2011. The debate and decisions on this latter item, together with growing calls for significant reforms to our social security system, will merit our close attention.