Provisions of the New Tax Law

Introduction

The Tax Increase Prevention and Reconciliation Act of 2005 (the Act) was signed into law on May 17, 2006 by President Bush. The new law affects a wide variety of taxpayers, including individuals and corporations. It contains $90 billion in tax benefits that retroactively extend a number of existing tax credits and provide several new tax breaks. It also contains $20 billion in new revenue-raising legislation, thereby resulting in $70 billion in net tax cuts. This article discusses some key provisions contained in the Act that will affect attorneys, their firms and their employees.

Tax Benefits Provided Under the New Tax Act

Temporary Relief from
The Alternative Minimum Tax (AMT)

The AMT was created in 1969 to prevent wealthy taxpayers from paying zero tax. It is a parallel tax system to the regular tax and determines the minimum amount of tax that an individual should pay. Taxpayers would calculate their income tax under both the regular and AMT tax systems and pay the higher of the two taxes.

The AMT tax system does not allow several of the itemized tax deductions allowable under the regular tax system such as state, local and property tax deductions or most miscellaneous deductions. In addition, some deductions, such as medical expenses, are subject to different income limitations based on an individual's adjusted gross income. The AMT also taxes various tax preference items such as tax-exempt municipal bond interest associated with 'private activity' bonds that are not taxed under the regular tax system. Finally, there are timing differences that are includable at different times under each tax system. An example of a timing difference is depreciation taken on business property.

Over the last several years, there has been a drastic increase in the number of Americans subject to the AMT. This increase is largely attributable to the fact that the AMT has not been indexed for inflation, whereas the regular income tax has. In addition, the regular income tax rate reductions attributable to tax legislation passed over the last several years, as compared to an unchanged AMT tax rate, has reduced the differential between the two taxes, thus increasing the number of individuals subject to the AMT. The only way to significantly reduce the number of individuals subject to the AMT is to reduce the AMT tax rates below the current percentages of 26% and 28%.

The Act provides a 1-year temporary fix to the problem of having an estimated 15 million additional taxpayers subject to the AMT in 2006. For 2006 only, the AMT exemption amounts are increased to $62,550 for married couples filing a joint return and surviving spouses, $42,500 for single taxpayers and $31,275 for married individuals filing separately. The 2005 exemption amounts were $58,000, $40,250 and $29,000 respectively. The increase in the 2006 exemption amounts is even more dramatic in that before passage of the new law for 2006, they were scheduled to be rolled back to the 2000 amounts. The 2000 exemption amounts were $45,000 for married couples filing a joint return and surviving spouses, $33,750 for single taxpayers and $22,500 for married individuals filing separately.

The increased exemption amounts should benefit those middle-income taxpayers whose financial situation remained the same in 2006 as in 2005 and were slightly into AMT in 2005. However, since the phase-out rules relating to the AMT exemption amounts have not been changed by the new legislation, most wealthy taxpayers will not be affected by the tax law change. For 2006, the AMT exemption amount is completely phased out when an individual's alternative minimum taxable income is $382,500 for married couples filing a joint return or qualifying widowers, $273,500 for single taxpayers and $191,000 for married individuals filing separately.

The Act also extends through 2006 the provision allowing individual taxpayers to offset nonrefundable personal tax credits against their AMT liability as well as their regular tax liability. Nonrefundable personal tax credits include the dependent care credit, child tax credit and education credits such as the hope and lifetime learning credits.

Extension of the Dividend and
Capital Gains Rate Cuts

The original legislation lowering the tax rates on most dividends and net long term capital gains incurred by individuals was passed in 2003 amid much controversy. It was labeled as an additional benefit for the wealthy. The 2003 legislation lowered the tax rates to 15% for qualifying taxpayers (5% for individuals in the 10% and 15% regular tax brackets). These lower rates also applied for AMT purposes.

The lower tax rates apply to adjusted net capital gains that include qualified dividend income. Adjusted net capital gain is the excess of long-term capital gains over short-term capital losses. Certain types of long-term capital gains such as from the sale of collectibles are taxed at a higher 28% tax rate. Qualified dividend income in-cludes dividends received during the year from domestic corporations and 'qualified foreign corporations' subject to holding period requirements for the securities involved.

These tax cuts, that were scheduled to expire at the end of 2008, were extended for 2 more years, through Dec. 31, 2010, by the Tax Act.

Extension of Code Section 179 Expensing Deduction

The Act extends, for 2 years through Dec. 31, 2009, the Internal Revenue Code Section 179 small business expensing election (including cost of living adjustments) available to all taxpayers except estates and trusts. These elections enable taxpayers to expense a certain amount of the cost of new or used tangible personal property, such as office equipment placed in service during the year in the taxpayer's trade or business. The portion of the cost that could not be expensed would be depreciated based on the life of the asset. For 2006, the maximum dollar amount that may be deducted is $108,000, as adjusted for inflation. This amount was scheduled to drop to $25,000 in 2008.

One of the limitations imposed on the deductibility of the section 179 expense is its reduction by the cost of eligible property placed in service during the year in excess of a certain amount. For 2006, the section 179 expense starts to be phased out for every dollar of property placed in service in excess of $430,000, as adjusted for inflation. This amount was scheduled to drop to $200,000 for property placed in service in tax years beginning after 2007.

Provisions Raising Revenue Under the New Tax Act

Kiddie Tax Age Limit Raised

Beginning in 2006, Congress has raised the age at which minor children are subject to the 'kiddie tax' rules from under age 14 to under age 18 at the end of the taxable year. The kiddie tax rules were originally enacted to prevent the shifting of income from the parents to the children who were taxed at a lower rate. The kiddie tax begins to apply when the child has more than $1700 in unearned income, such as interest and dividends, with the excess amount taxed at the parents' highest marginal tax rate. However, a child's earned income, such as wages, are taxed at their own rate. The new law does not apply to children who are married and file a joint tax return.

Planning Idea to Reduce Child's Tax Liability

Taxpayers with one or more qualifying children may be entitled to a child tax credit of $1000 per child. This credit applies to children under age 17 at the end of the taxable year. Since the credit starts phasing out for married filing joint taxpayers with modified adjusted gross income over $110,000, it is not beneficial for most high-income earners.

Congress enacted legislation in 2004 streamlining the definition of 'child' for five different tax breaks, including the child tax credit. The new definition of 'child,' that includes brothers and sisters, allows siblings to claim each other as a qualifying child for purposes of the child tax credit beginning with the 2005 tax year. For those siblings taking a credit for someone who is not claimed as a dependent on their return, Form 8901 (Information on Qualifying Children Who are not Dependents) must be attached to their Form 1040.

Elimination of Income Limitations on Roth IRAs

Beginning in 2010, all taxpayers will have the opportunity of converting their traditional IRA account balances into a Roth IRA. Currently only those taxpayers with $100,000 or less in adjusted gross income were eligible. This change provides a great planning opportunity for those individuals who expect their accounts to appreciate substantially and expect to be in a higher tax bracket upon retirement.

Taxpayers who contribute to a regular IRA get an upfront tax deduction, with the earnings growing tax free. However, upon withdrawal, the full amount of the distribution is subject to tax at ordinary income tax rates. In addition, distributions from a regular IRA are subject to required minimum distribution rules. Active participants in an employer sponsored pension plan with adjusted gross income over certain levels can make non-deductible IRA contributions with only the earnings subject to tax upon withdrawal. In contrast, although contributions to a Roth IRA are not deductible, the earnings grow tax free and qualified distributions are not subject to income tax. Also, Roth IRA distributions are not subject to the required minimum distribution rules.

A conversion to a Roth IRA is treated as a taxable distribution, with taxpayers subject to ordinary income tax on converted amounts. The new law allows all taxpayers, not withstanding their income levels, to convert from a traditional to a Roth IRA in 2010 and include the income ratably over 2 years beginning in 2011. Alternatively, the taxpayer can elect to include the full amount of conversion income in 2010.

Other Provisions

Information Reporting for Tax-Exempt Interest

Beginning in 2006, interest paid on tax-exempt bonds will be subject to information reporting in the same manner as taxable interest. Payers of tax-exempt interest aggregating $10 or more will be required to file an information return on Form 1099-INT with the Internal Revenue Service providing the amount of interest payments, name, address and taxpayer identification number of the person to whom interest is paid.

Hot Off the Press

Repeal of Federal Excise Tax
On Long-Distance Phone Calls

The U.S. Treasury department abolished the excise tax on long-distance phone calls effective July 31, 2006. This decision, which applies to cell phones and Internet phone service as well as some land lines, will generate approximately $15 billion in refunds for individuals and businesses on their 2006 tax returns.

Refunds will be issued for the past 3 years for telephone excise tax that was billed after Feb. 28, 2003, and before Aug. 1, 2006. Internal Revenue Service Notice 2006-50 was issued to provide guidance on how to request the refunds. Individual taxpayers will be given the option of getting a safe harbor refund, presumably around $20, on their 2006 income tax returns without providing documentation of the actual amount of taxes paid. However, law firms doing business as P.C.s, Partnerships or LLCs must apply for a refund of the actual taxes paid on their 2006 tax returns irrespective of the fact that refund claims may have been previously filed. The refund will be taxable as presumably it was deducted as an ordinary and necessary expense in prior years.

Additional Legislation On the Way

A trailer package is expected to be added to the pending pension reform bill which will extend several tax cuts which were not extended as part of the Tax Increase Prevention and Reconciliation Act of 2005. The tax cuts expected to be extended include the deduction for state and local sales tax, the research and development credit and some employment tax credits. The length of the extension is expected to be for 1 year.

Introduction

The Tax Increase Prevention and Reconciliation Act of 2005 (the Act) was signed into law on May 17, 2006 by President Bush. The new law affects a wide variety of taxpayers, including individuals and corporations. It contains $90 billion in tax benefits that retroactively extend a number of existing tax credits and provide several new tax breaks. It also contains $20 billion in new revenue-raising legislation, thereby resulting in $70 billion in net tax cuts. This article discusses some key provisions contained in the Act that will affect attorneys, their firms and their employees.

Tax Benefits Provided Under the New Tax Act

Temporary Relief from
The Alternative Minimum Tax (AMT)

The AMT was created in 1969 to prevent wealthy taxpayers from paying zero tax. It is a parallel tax system to the regular tax and determines the minimum amount of tax that an individual should pay. Taxpayers would calculate their income tax under both the regular and AMT tax systems and pay the higher of the two taxes.

The AMT tax system does not allow several of the itemized tax deductions allowable under the regular tax system such as state, local and property tax deductions or most miscellaneous deductions. In addition, some deductions, such as medical expenses, are subject to different income limitations based on an individual's adjusted gross income. The AMT also taxes various tax preference items such as tax-exempt municipal bond interest associated with 'private activity' bonds that are not taxed under the regular tax system. Finally, there are timing differences that are includable at different times under each tax system. An example of a timing difference is depreciation taken on business property.

Over the last several years, there has been a drastic increase in the number of Americans subject to the AMT. This increase is largely attributable to the fact that the AMT has not been indexed for inflation, whereas the regular income tax has. In addition, the regular income tax rate reductions attributable to tax legislation passed over the last several years, as compared to an unchanged AMT tax rate, has reduced the differential between the two taxes, thus increasing the number of individuals subject to the AMT. The only way to significantly reduce the number of individuals subject to the AMT is to reduce the AMT tax rates below the current percentages of 26% and 28%.

The Act provides a 1-year temporary fix to the problem of having an estimated 15 million additional taxpayers subject to the AMT in 2006. For 2006 only, the AMT exemption amounts are increased to $62,550 for married couples filing a joint return and surviving spouses, $42,500 for single taxpayers and $31,275 for married individuals filing separately. The 2005 exemption amounts were $58,000, $40,250 and $29,000 respectively. The increase in the 2006 exemption amounts is even more dramatic in that before passage of the new law for 2006, they were scheduled to be rolled back to the 2000 amounts. The 2000 exemption amounts were $45,000 for married couples filing a joint return and surviving spouses, $33,750 for single taxpayers and $22,500 for married individuals filing separately.

The increased exemption amounts should benefit those middle-income taxpayers whose financial situation remained the same in 2006 as in 2005 and were slightly into AMT in 2005. However, since the phase-out rules relating to the AMT exemption amounts have not been changed by the new legislation, most wealthy taxpayers will not be affected by the tax law change. For 2006, the AMT exemption amount is completely phased out when an individual's alternative minimum taxable income is $382,500 for married couples filing a joint return or qualifying widowers, $273,500 for single taxpayers and $191,000 for married individuals filing separately.

The Act also extends through 2006 the provision allowing individual taxpayers to offset nonrefundable personal tax credits against their AMT liability as well as their regular tax liability. Nonrefundable personal tax credits include the dependent care credit, child tax credit and education credits such as the hope and lifetime learning credits.

Extension of the Dividend and
Capital Gains Rate Cuts

The original legislation lowering the tax rates on most dividends and net long term capital gains incurred by individuals was passed in 2003 amid much controversy. It was labeled as an additional benefit for the wealthy. The 2003 legislation lowered the tax rates to 15% for qualifying taxpayers (5% for individuals in the 10% and 15% regular tax brackets). These lower rates also applied for AMT purposes.

The lower tax rates apply to adjusted net capital gains that include qualified dividend income. Adjusted net capital gain is the excess of long-term capital gains over short-term capital losses. Certain types of long-term capital gains such as from the sale of collectibles are taxed at a higher 28% tax rate. Qualified dividend income in-cludes dividends received during the year from domestic corporations and 'qualified foreign corporations' subject to holding period requirements for the securities involved.

These tax cuts, that were scheduled to expire at the end of 2008, were extended for 2 more years, through Dec. 31, 2010, by the Tax Act.

Extension of Code Section 179 Expensing Deduction

The Act extends, for 2 years through Dec. 31, 2009, the Internal Revenue Code Section 179 small business expensing election (including cost of living adjustments) available to all taxpayers except estates and trusts. These elections enable taxpayers to expense a certain amount of the cost of new or used tangible personal property, such as office equipment placed in service during the year in the taxpayer's trade or business. The portion of the cost that could not be expensed would be depreciated based on the life of the asset. For 2006, the maximum dollar amount that may be deducted is $108,000, as adjusted for inflation. This amount was scheduled to drop to $25,000 in 2008.

One of the limitations imposed on the deductibility of the section 179 expense is its reduction by the cost of eligible property placed in service during the year in excess of a certain amount. For 2006, the section 179 expense starts to be phased out for every dollar of property placed in service in excess of $430,000, as adjusted for inflation. This amount was scheduled to drop to $200,000 for property placed in service in tax years beginning after 2007.

Provisions Raising Revenue Under the New Tax Act

Kiddie Tax Age Limit Raised

Beginning in 2006, Congress has raised the age at which minor children are subject to the 'kiddie tax' rules from under age 14 to under age 18 at the end of the taxable year. The kiddie tax rules were originally enacted to prevent the shifting of income from the parents to the children who were taxed at a lower rate. The kiddie tax begins to apply when the child has more than $1700 in unearned income, such as interest and dividends, with the excess amount taxed at the parents' highest marginal tax rate. However, a child's earned income, such as wages, are taxed at their own rate. The new law does not apply to children who are married and file a joint tax return.

Planning Idea to Reduce Child's Tax Liability

Taxpayers with one or more qualifying children may be entitled to a child tax credit of $1000 per child. This credit applies to children under age 17 at the end of the taxable year. Since the credit starts phasing out for married filing joint taxpayers with modified adjusted gross income over $110,000, it is not beneficial for most high-income earners.

Congress enacted legislation in 2004 streamlining the definition of 'child' for five different tax breaks, including the child tax credit. The new definition of 'child,' that includes brothers and sisters, allows siblings to claim each other as a qualifying child for purposes of the child tax credit beginning with the 2005 tax year. For those siblings taking a credit for someone who is not claimed as a dependent on their return, Form 8901 (Information on Qualifying Children Who are not Dependents) must be attached to their Form 1040.

Elimination of Income Limitations on Roth IRAs

Beginning in 2010, all taxpayers will have the opportunity of converting their traditional IRA account balances into a Roth IRA. Currently only those taxpayers with $100,000 or less in adjusted gross income were eligible. This change provides a great planning opportunity for those individuals who expect their accounts to appreciate substantially and expect to be in a higher tax bracket upon retirement.

Taxpayers who contribute to a regular IRA get an upfront tax deduction, with the earnings growing tax free. However, upon withdrawal, the full amount of the distribution is subject to tax at ordinary income tax rates. In addition, distributions from a regular IRA are subject to required minimum distribution rules. Active participants in an employer sponsored pension plan with adjusted gross income over certain levels can make non-deductible IRA contributions with only the earnings subject to tax upon withdrawal. In contrast, although contributions to a Roth IRA are not deductible, the earnings grow tax free and qualified distributions are not subject to income tax. Also, Roth IRA distributions are not subject to the required minimum distribution rules.

A conversion to a Roth IRA is treated as a taxable distribution, with taxpayers subject to ordinary income tax on converted amounts. The new law allows all taxpayers, not withstanding their income levels, to convert from a traditional to a Roth IRA in 2010 and include the income ratably over 2 years beginning in 2011. Alternatively, the taxpayer can elect to include the full amount of conversion income in 2010.

Other Provisions

Information Reporting for Tax-Exempt Interest

Beginning in 2006, interest paid on tax-exempt bonds will be subject to information reporting in the same manner as taxable interest. Payers of tax-exempt interest aggregating $10 or more will be required to file an information return on Form 1099-INT with the Internal Revenue Service providing the amount of interest payments, name, address and taxpayer identification number of the person to whom interest is paid.

Hot Off the Press

Repeal of Federal Excise Tax
On Long-Distance Phone Calls

The U.S. Treasury department abolished the excise tax on long-distance phone calls effective July 31, 2006. This decision, which applies to cell phones and Internet phone service as well as some land lines, will generate approximately $15 billion in refunds for individuals and businesses on their 2006 tax returns.

Refunds will be issued for the past 3 years for telephone excise tax that was billed after Feb. 28, 2003, and before Aug. 1, 2006. Internal Revenue Service Notice 2006-50 was issued to provide guidance on how to request the refunds. Individual taxpayers will be given the option of getting a safe harbor refund, presumably around $20, on their 2006 income tax returns without providing documentation of the actual amount of taxes paid. However, law firms doing business as P.C.s, Partnerships or LLCs must apply for a refund of the actual taxes paid on their 2006 tax returns irrespective of the fact that refund claims may have been previously filed. The refund will be taxable as presumably it was deducted as an ordinary and necessary expense in prior years.

Additional Legislation On the Way

A trailer package is expected to be added to the pending pension reform bill which will extend several tax cuts which were not extended as part of the Tax Increase Prevention and Reconciliation Act of 2005. The tax cuts expected to be extended include the deduction for state and local sales tax, the research and development credit and some employment tax credits. The length of the extension is expected to be for 1 year.