Small Business Taxes & ManagementTM--Copyright 2006, A/N Group, Inc.
Introduction
The House and Senate have passed (May 11, 2006) the Tax Increase Prevention and Reconciliation Act. The bill is noteworthy for what was not included. Many provisions that would have extended expired benefits such as the research credit, work opportunity credit, etc. were included in either the House or Senate, but not the final version. Also excluded were a number of provisions related to charitable contributions and the reformation of charitable organizations, changes in the rules for penalties and fines, and miscellaneous provisions. Some professionals believe Congress will try to pass some of these provisions in upcoming tax legislation.
Reduced Rates on Capital Gains and Dividends Extended
For individuals, this is probably the most important provision. The reduced rates on long-term capital gains and dividends were scheduled to expire at the end of 2008. The new law extends the reduced rates of 0%, 5% and 15% on dividends and long-term capital gains to taxable years beginning on or before December 31, 2010. As under prior law, capital gains and dividends that would otherwise be taxed at a 5% rate will be taxed at 0% for taxable years beginning after 2007.
Comment--The extension of the lower rates was expected. Taxpayers no longer need worry about the expiration of the lower rates and have a longer horizon for investment planning. More than likely, the lower rates will be extended again in 2010.
Kiddie Tax
Special rules (generally referred to as the "kiddie tax") apply to the unearned income of a child who is under age 14. The kiddie tax applies if: (1) the child has not reached the age of 14 by the close of the taxable year; (2) the child's unearned income was more than $1,700 (for 2006); and (3) the child is required to file a return for the year. The kiddie tax applies regardless of whether the child may be claimed as a dependent on the parent's return. For these purposes, unearned income is income other than wages, salaries, professional fees, or other amounts received as compensation for personal services actually rendered.
The new law increases the age to which the kiddie tax provisions apply from under 14 to under 18 years of age. The kiddie tax does not apply to a child who is married and files a joint return for the taxable year. The provision also creates an exception to the kiddie tax for distributions from certain qualified disability trusts.
Comment--Since this provision is in effect for 2006, you may want to talk to your tax advisor if you have children who have unearned income over the threshold amount ($1,700) who are subject to the kiddie tax under the new rules. If the unearned income is significant, you might want to rethink some tax strategies. For example, gifting appreciated stock to your children may no longer produce a tax saving if they sell the stock while subject to the new rules, nor would holding dividend paying stocks or interest from bonds. You might also want to review their estimated tax payments.
Extend and Increase Alternative Minimum Tax Exemption Amount
You don't have to have tax preference items to find yourself subject to the alternative minimum tax. Even taxpayers taking the standard deduction can find themselves liable. The law provides an exemption amount (which is phased out for married couples filing jointly with alternative minimum taxable income (AMTI) of $150,000 or more or unmarried individuals with AMTI of $112,500 or more). The exemption amount was scheduled to decrease from $58,000 to $45,000 (married filing jointly; from $40,250 to $33,750 for unmarried individuals) for tax years beginning after December 31, 2005. Instead, under the new law, for taxable years beginning in 2006, the exemption amounts are increased to:
Comment--If you didn't get hit by the AMT in the past, your chances get better every year. One of the reasons is that the exemption amount isn't indexed for inflation. While the higher exemption amount in the new law will help, the $4,550 increase is hardly a solution and for many taxpayers will only lessen the impact. Moreover, the change is only a stopgap measure and only applies to the year 2006.
Allowance of Nonrefundable Personal Credits Against Minimum Tax
The law provides for certain nonrefundable personal tax credits (i.e., the dependent care credit, the credit for the elderly and disabled, the adoption credit, the child tax credit, the credit for interest on certain home mortgages, the HOPE Scholarship and Lifetime Learning credits, the credit for savers, the credit for certain nonbusiness energy property, the credit for residential energy efficient property, and the D.C. first-time homebuyer credit). The Energy Tax Incentives Act of 2005 enacted, effective for 2006, nonrefundable tax credits for alternative motor vehicles, and alternative motor vehicle refueling property. The new law extends the allowance of nonrefundable credit against both the regular and the alternative minimum tax for one year through 2006.
Extension of Increased Expensing for Small Business
Instead of capitalizing and depreciating assets, a business taxpayer may elect to expense a stated maximum amount of the cost of qualifying property placed in service during the taxable year. This Section 179 expense option is generally limited to depreciable tangible personal property used in the active conduct of a trade or business. For years beginning after 2003 and before 2008, the maximum amount that can be expensed is $100,000 (indexed for inflation). This limit was scheduled to drop back to $25,000 for tax years beginning in 2008. The new law extends for two years the increased amount that a taxpayer may deduct and the other Section 179 rules applicable in taxable years beginning before 2008. Thus, under the provision, these present-law rules continue in effect for taxable years beginning after 2007 and before 2010.
Comment--The extension of this provision was expected. Using the Section 179 option not only provides an immediate tax saving, it simplifies accounting for many taxpayers. As always, don't automatically use the option. In some situations sticking with depreciation can make more sense from a tax standpoint.
Capital Expenditure Limitation for Qualified Small Issue Bonds
Qualified small-issue bonds are tax-exempt State and local government bonds used to finance private business manufacturing facilities (including certain directly related and ancillary facilities) or the acquisition of land and equipment by certain farmers. In both instances, these bonds are subject to limits on the amount of financing that may be provided, both for a single borrowing and in the aggregate. In general, no more than $1 million of small-issue bond financing may be outstanding at any time for property of a business (including related parties) located in the same municipality or county. Generally, this $1 million limit may be increased to $10 million if all other capital expenditures of the business in the same municipality or county are counted toward the limit over a six-year period that begins three years before the issue date of the bonds and ends three years after such date. For bonds issued after September 30, 2009, the Code permits up to $10 million of capital expenditures to be disregarded, in effect increasing from $10 million to $20 million the maximum allowable amount of total capital expenditures by an eligible business in the same municipality or county. The new law accelerates the application of the $20 million capital expenditure limitation from bonds issued after September 30, 2009, to bonds issued after December 31, 2006.
Comment--This higher limit on small issue bonds could enable some businesses to obtain additional funding from local development agencies.
Modification of Treatment of Loans to Qualified Continuing Care Facilities
Present law provides generally that certain loans that bear interest at a below-market rate are treated as loans bearing interest at the market rate, accompanied by imputed payments characterized in accordance with the substance of the transaction (for example, as a gift, compensation, a dividend, or interest). An exception to this imputation rule is provided for any calendar year for a below-market loan made by a lender to a qualified continuing care facility pursuant to a continuing care contract, if the lender or the lender's spouse attains age 65 before the close of the calendar year. The exception applies only to the extent the aggregate outstanding loans by the lender (and spouse) to any qualified continuing care facility do not exceed $163,300 (for 2006).
The new law modifies the present-law exception under Section 7872(g) relating to loans to continuing care facilities by eliminating the dollar cap on aggregate outstanding loans and making other modifications. The provision provides an exception to the imputation rule of Section 7872 for any calendar year for any below-market loan owed by a facility which on the last day of the year is a qualified continuing care facility, if the loan was made pursuant to a continuing care contract and if the lender or the lender's spouse attains age 62 before the close of the year.
Partial Payments Required with Submissions of Offers-in-Compromise
The IRS has the authority to compromise any civil or criminal case arising under the internal revenue laws. In general, taxpayers initiate this process by making an offer-in-compromise, which is an offer by the taxpayer to settle an outstanding tax liability for less than the total amount due. The IRS currently imposes a user fee of $150 on most offers, payable upon submission of the offer to the IRS. Taxpayers may justify their offers on the basis of doubt as to collectibility or liability or on the basis of effective tax administration. In general, enforcement action is suspended during the period that the IRS evaluates an offer. In some instances, it may take the IRS 12 to 18 months to evaluate an offer. Taxpayers are permitted (but not required) to make a deposit with their offer; if the offer is rejected, the deposit is generally returned to the taxpayer.
The new law requires a taxpayer to make partial payments to the IRS while the taxpayer's offer is being considered by the IRS. For lump-sum offers, taxpayers must make a down payment of 20 percent of the amount of the offer with any application. For purposes of this provision, a lump-sum offer includes single payments as well as payments made in five or fewer installments. For periodic payment offers, the provision requires the taxpayer to comply with the taxpayer's own proposed payment schedule while the offer is being considered. Offers submitted to the IRS that do not comport with these payment requirements are returned to the taxpayer as unprocessable and immediate enforcement action is permitted. The provision eliminates the user fee requirement for offers submitted with the appropriate partial payment. The provision also provides that an offer is deemed accepted if the IRS does not make a decision with respect to the offer within two years from the date the offer was submitted. Any user fee imposed by the IRS for participation in the offer-in-compromise program must be submitted with the appropriate partial payment. The user fee is applied to the taxpayer's outstanding tax liability. In addition, under the conference agreement, offers submitted to the IRS that do not comport with the payment requirements may be returned to the taxpayer as unprocessable.
The provision is effective for offers-in-compromise submitted on and after the date which is 60 days after the date of enactment.
Information Reporting Requirements for Interest on Tax-Exempt Bonds
Generally, gross income does not include interest on State or local bonds. State and local bonds are classified generally as either governmental bonds or private activity bonds. Governmental bonds are bonds the proceeds of which are primarily used to finance governmental facilities or the debt is repaid with governmental funds. In the past, brokerage firms, banks, etc. were exempt from the information reporting requirements (i.e., From 1099-INT) on interest paid on tax-exempt bonds. That exception is eliminated effective for interest paid on such bonds after December 31, 2005.
Comment--In the past, failure to report such interest probably would have gone unnoticed for many taxpayers. With the new IRS reporting requirements, that's no longer true. Most taxpayers still won't see an effect on their federal tax liability since the amounts affect only certain items such as the taxability of Social Security benefits, the earned income credit, and the alternative minimum tax. However, since most states exchange information with the IRS, failure to include such income could generate a nasty letter from your state tax department.
Modification of Wage Limit for Purposes of Domestic Product Activities Deduction
The law provides a deduction from taxable income (or, in the case of an individual, adjusted gross income) that is equal to a portion of the taxpayer's qualified production activities income. For taxable years beginning after 2009, the deduction is nine percent of such income. For taxable years beginning in 2005 and 2006, the deduction is three percent of income and, for taxable years beginning in 2007, 2008 and 2009, the deduction is six percent of income. However, the deduction for a taxable year is limited to 50 percent of the wages paid by the taxpayer during the calendar year that ends in such taxable year.
Under the new law the wage limitation is modified such that taxpayers may only include amounts which are properly allocable to domestic production gross receipts. Thus, the wage limitation is 50 percent of those wages which are deducted in arriving at qualified production activities income.
In addition, the law repeals the special limitation on wages treated as allocated to partners or shareholders of passthrough entities. Accordingly, for purposes of the wage limitation, a shareholder, partner, or similar person who is allocated components of qualified production activities income from a passthrough entity is treated as having been allocated wages from such entity in an amount that is equal to such person's allocable share of wages as determined under regulations to be prescribed, even if such amount is more than twice the qualified production activities income that actually is allocated to such person for the taxable year. The shareholder, partner, or similar person will then include in its wage limitation only those wages which are deducted in arriving at qualified production activities income.
The new law is effective with respect to taxable years beginning after the date of enactment.
Comment--These changes could reduce the benefits of the domestic product activities deduction.
Withholding on Certain Payments made by Government Entities
Under the law all business and governmental entities have to report on Form 1099 payments made to vendors of services. No information reporting is required for payments made to corporations (except medical corporations and attorneys). The new law requires withholding on certain payments to persons providing property or services made by the Government of the United States, every State, every political subdivision thereof, and every instrumentality of the foregoing (including multi-State agencies). The withholding requirement applies regardless of whether the government entity making such payment is the recipient of the property or services. Political subdivisions of States (or any instrumentality thereof) with less than $100 million of annual expenditures for property or services that would otherwise be subject to withholding under this provision are exempt from the withholding requirement.
The rate of withholding is three percent on all payments regardless of whether the payments are for property or services. Payments subject to withholding under the provision include any payment made in connection with a government voucher or certificate program which functions as a payment for property or services. For example, payments to a commodity producer under a government commodity support program are subject to the withholding requirement. The provision imposes information reporting requirements on the payments that are subject to withholding under the provision. The provision does not apply to any payments made through a Federal, State, or local government public assistance or public welfare program for which eligibility is determined by a needs or income test. For example, payments under government programs providing food vouchers or medical assistance to low-income individuals are not subject to withholding under the provision. However, payments under government programs to provide health care or other services that are not based on the needs or income of the recipients are subject to withholding, including programs where eligibility is based on the age of the beneficiary. This provision applies to payments made after December 31, 2010.
Eliminate Income Limitations on Roth IRA Conversions
Contributions to Roth IRAs are not deductible, and taxpayers with AGIs above the AGI limit cannot make contributions to a Roth. But qualifying distributions from Roth IRAs are not taxable. And there is no requirement for a minimum distribution after reaching age 70-1/2 as there is with other IRAs. Taxpayers have the option of converting a traditional IRA into a Roth IRA, but the amount converted is treated as a distribution for income tax purposes (but not subject to the 10% additional tax on early withdrawals) and a taxpayer with an AGI of more than $100,000 is not allowed to make such a conversion.
The new law eliminates the income limits on conversions of traditional IRAs to Roth IRAs beginning in 2010. Thus, taxpayers may make such conversions without regard to their AGI.
For conversions occurring in 2010, unless a taxpayer elects otherwise, the amount includible in gross income as a result of the conversion is included ratably in 2011 and 2012. That is, unless a taxpayer elects otherwise, none of the amount includible in gross income as a result of a conversion occurring in 2010 is included in income in 2010, and half of the income resulting from the conversion is includible in gross income in 2011 and half in 2012. However, income inclusion is accelerated if converted amounts are distributed before 2012. In that case, the amount included in income in the year of the distribution is increased by the amount distributed, and the amount included in income in 2012 (or 2011 and 2012 in the case of a distribution in 2010) is the lesser of: (1) half of the amount includible in income as a result of the conversion; and (2) the remaining portion of such amount not already included in income. The following example illustrates the application of the accelerated inclusion rule.
Example--Fred has a traditional IRA with a value of $10,000, consisting of deductible contributions and earnings. He does not have a Roth IRA. Fred converts the traditional IRA to a Roth IRA in 2010, and, as a result of the conversion, $10,000 is includible in gross income. Unless he elects otherwise, $5,000 of the income resulting from the conversion is included in income in 2011 and $5,000 in 2012. Later in 2010, Fred takes a $2,000 distribution, which is not a qualified distribution and all of which, under the ordering rules, is attributable to amounts includible in gross income as a result of the conversion. Under the accelerated inclusion rule, $2,000 is included in income in 2010. The amount included in income in 2011 is the lesser of (1) $5,000 (half of the income resulting from the conversion) or (2) $7,000 (the remaining income from the conversion), or $5,000. The amount included in income in 2012 is the lesser of (1) $5,000 (half of the income resulting from the conversion) or (2) $3,000 (the remaining income from the conversion, i.e., $10,000 - $7,000 ($2,000 included in income in 2010 and $5,000 included in income in 2011)), or $3,000.
This provision is effective for taxable years beginning after December 31, 2009.
Comment--Does converting make sense? You'll be paying taxes currently on proceeds you won't see for a number of years. While the amounts will now grow completely tax free and you'll have greater flexibility on distributing the funds, you'll have less to invest after paying the taxes. But the real danger is that you may pay taxes on an amount and see that decrease. That happened to a number of individuals who converted in the late 90's. They paid tax on say, $100,000 of income only to see the market wipe out much of that amount. You should convert only the safest assets that are sure to appreciate such as real estate. In any event, you'll have a couple of years to think about it since the provision isn't effective until 2010.
Foreign Earned Income Exclusion
A U.S. citizen or resident living abroad may be eligible to exclude from U.S. taxable income certain foreign earned income and foreign housing costs. This exclusion applies regardless of whether any foreign tax is paid on the foreign earned income or housing costs. To qualify for these exclusions, an individual (a "qualified individual") must have his or her tax home in a foreign country and must be either (1) a U.S. citizen who is a bona fide resident of a foreign country or countries for an uninterrupted period that includes an entire taxable year, or (2) a U.S. citizen or resident present in a foreign country or countries for at least 330 full days in any 12-consecutive-month period.
The new law adjusts for inflation the maximum amount of the foreign earned income exclusion in taxable years beginning in calendar years after 2005 (rather than, as under prior law, after 2007). The limitation in 2006 therefore is $82,400.
Under the new law, the base housing amount used in calculating the foreign housing cost exclusion in a taxable year is 16 percent of the amount (computed on a daily basis) of the foreign earned income exclusion limitation, multiplied by the number of days of foreign residence or presence (as previously described) in that year.
Reasonable foreign housing expenses in excess of the base housing amount remain excluded from gross income (or, if paid by the taxpayer, are deductible) under the conference agreement, but the amount of the exclusion is limited to 30 percent of the maximum amount of a taxpayer's foreign earned income exclusion. The Secretary is given authority to issue regulations or other guidance providing for the adjustment of this 30-percent housing cost limitation based on geographic differences in housing costs relative to housing costs in the United States. The law allows the IRS to adjust the 30-percent amount upward or downward on an annual basis.
Under the new law, if an individual excludes an amount from income under Section 911, any income in excess of the exclusion amount determined under Section 911 is taxed (under the regular tax and alternative minimum tax) by applying to that income the tax rates that would have been applicable had the individual not elected the Section 911 exclusion. For example, an individual with $80,000 of foreign earned income that is excluded under section 911 and with $20,000 in other taxable income (after deductions) would be subject to tax on that $20,000 at the rate or rates applicable to taxable income in the range of $80,000 to $100,000.
The new provision is effective for taxable years beginning after December 31, 2005.
Other Provisions
There are several other provisions, not covered above. The new law also:
Copyright 2006 by A/N Group, Inc. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is distributed with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional should be sought. The information is not necessarily a complete summary of all materials on the subject.--ISSN 1089-1536
--Last Update 05/12/06