Small Business Taxes & Management^TM--Copyright 2004, A/N Group, Inc.

Introduction

The Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA) reduced the tax rates on capital gains and dividends, increased first-year depreciation, increased the Sec. 179 expense option and accelerated a number of tax cuts enacted under prior law and scheduled to take effect in later years. The new law extends many of the individual tax cuts accelerated into effect last year, changes the definition of a qualifying child for the dependency exemption, earned income credit, etc. and extends a number of expiring tax provisions such as the research credit. In addition, the law makes a number of technical corrections to prior law as far back as 1996. It does not extend the bonus depreciation or higher Sec. 179 expense option.

In the text below we've covered the provisions of interest to most of our readers.

Child Tax Credit

Higher level extended. The child tax credit was scheduled to decrease to $700. The new law increases the child credit to $1,000 for taxable years 2005-2009. Therefore, the maximum child tax credit is $1,000 per child for taxable years 2005-2010.

Refundability. For 2004, the child credit was scheduled to be refundable to the extent of 10 percent of the taxpayer's taxable earned income (which is taken into account in determining taxable income) in excess of $10,750. The percentage is increased to 15 percent for taxable years 2005 and thereafter. Families with three or more children are allowed a refundable credit for the amount by which the taxpayer's social security taxes exceed the taxpayer's earned income credit, if that amount is greater than the refundable credit based on the taxpayer's taxable earned income in excess of $10,750 (for 2004). The new law accelerates to 2004 the increase in refundability of the child credit to 15 percent of the taxpayer's earned income in excess of $10,750 (with indexing).

Credit against AMT. The child credit is allowed against the individual's regular income tax and alternative minimum tax.

Combat pay treated as earned income. Any taxpayer may elect to treat combat pay that is otherwise excluded from gross income under Section 112 as earned income for purposes of the earned income credit. This election is available with respect to any taxable year ending after the date of enactment and before January 1, 2006.

Marriage Penalty

The new law increases the basic standard deduction amount for joint returns to twice the basic standard deduction amount for single returns effective for 2005-2008. Therefore, the basic standard deduction for joint returns is twice the basic standard deduction for single returns for taxable years 2005-2010.

The law also increases the size of the 15-percent rate bracket for joint returns to twice the size of the corresponding rate bracket for single returns effective for 2005-2007. Therefore, the size of the 15-percent rate bracket for joint returns is twice the size of the corresponding rate bracket for single returns for taxable years 2005-2010.

Extend Size of 10% Bracket

The new law extends the size of the 10-percent rate bracket through 2010. Specifically, the size of the 10-percent rate bracket for 2005 through 2010 is set at the 2003 level ($7,000 for single individuals, $10,000 for heads of households and $14,000 for married individuals) with annual indexing from 2003.

Alternative Minimum Tax

The conference agreement extends the increased alternative minimum tax exemption amounts ($40,250 unmarried individuals; $58,000 for married individuals filing jointly and surviving spouses) to taxable years beginning in 2005.

Uniform Definition of Qualifying Child

The new law establishes a uniform definition of qualifying child for purposes of the dependency exemption, the child credit, the earned income credit, the dependent care credit, and head of household filing status. A taxpayer generally may claim an individual who does not meet the uniform definition of qualifying child (with respect to any taxpayer) as a dependent if the present-law dependency requirements are satisfied. The law generally does not modify other parameters of each tax benefit (e.g., the earned income requirements of the earned income credit) or the rules for determining whether individuals other than children of the taxpayer qualify for each tax benefit.

Under the uniform definition, in general, a child is a qualifying child of a taxpayer if the child satisfies each of three tests: (1) the child has the same principal place of abode as the taxpayer for more than one half the taxable year; (2) the child has a specified relationship to the taxpayer; and (3) the child has not yet attained a specified age. A tie-breaking rule applies if more than one taxpayer claims a child as a qualifying child.

The present-law support and gross income tests for determining whether an individual is a dependent generally do not apply to a child who meets the requirements of the uniform definition of qualifying child.

Residency test. Under the uniform definition's residency test, a child must have the same principal place of abode as the taxpayer for more than one half of the taxable year. It is intended that, as is the case under present law, temporary absences due to special circumstances, including absences due to illness, education, business, vacation, or military service, are not treated as absences.

Relationship test. In order to be a qualifying child the child must be the taxpayer's son, daughter, stepson, stepdaughter, brother, sister, stepbrother, stepsister, or a descendant of any such individual. An individual legally adopted by the taxpayer, or an individual who is placed with the taxpayer by an authorized placement agency for adoption by the taxpayer, is treated as a child of such taxpayer by blood. A foster child who is placed with the taxpayer by an authorized placement agency or by judgment, decree, or other order of any court of competent jurisdiction is treated as the taxpayer's child.

Age test. The age test varies depending upon the tax benefit involved. In general, a child must be under age 19 (or under age 24 in the case of a full-time student) in order to be a qualifying child. In general, no age limit applies with respect to individuals who are totally and permanently disabled within the meaning of Section 22(e)(3) at any time during the calendar year. The law retains the present-law requirements that a child must be under age 13 (if he or she is not disabled) for purposes of the dependent care credit, and under age 17 (whether or not disabled) for purposes of the child credit.

Children who support themselves. A child who provides over one half of his or her own support generally is not considered a qualifying child of another taxpayer. The new law retains the prior-law rule, however, that a child who provides over one half of his or her own support may constitute a qualifying child of another taxpayer for purposes of the earned income credit.

Tie-breaking rules. If a child would be a qualifying child with respect to more than one individual (e.g., a child lives with his or her mother and grandmother in the same residence) and more than one person claims a benefit with respect to that child, then the following "tie-breaking" rules apply. First, if only one of the individuals claiming the child as a qualifying child is the child's parent, the child is deemed the qualifying child of the parent. Second, if both parents claim the child and the parents do not file a joint return, then the child is deemed a qualifying child first with respect to the parent with whom the child resides for the longest period of time, and second with respect to the parent with the highest adjusted gross income. Third, if the child's parents do not claim the child, then the child is deemed a qualifying child with respect to the claimant with the highest adjusted gross income.

Interaction with prior-law rules. Taxpayers generally may claim an individual who does not meet the uniform definition of qualifying child with respect to any taxpayer as a dependent if the previous-law dependency requirements (including the gross income and support tests) are satisfied. Thus, for example, as under prior law, a taxpayer may claim a parent as a dependent if the taxpayer provides more than one half of the support of the parent and the parent's gross income is less than the exemption amount. As another example, a grandparent may claim a dependency exemption with respect to a grandson who does not reside with any taxpayer for over one half the year, if the grandparent provides more than one half of the support of the grandson and the grandson's gross income is less than the exemption amount.

Citizenship and residency. Children who are U.S. citizens living abroad or non-U.S. citizens living in Canada or Mexico may qualify as a qualifying child, as is the case under the present-law dependency tests. A legally adopted child who does not satisfy the residency or citizenship requirement may nevertheless qualify as a qualifying child (provided other applicable requirements are met) if (1) the child's principal place of abode is the taxpayer's home and (2) the taxpayer is a citizen or national of the United States.

Children of divorced or legally separated parents. The new law retains the prior-law rule that allows a custodial parent to release the claim to a dependency exemption (and, therefore, the child credit) to a noncustodial parent. Thus, custodial waivers that are in place and effective on the date of enactment will continue to be effective after the date of enactment if they continue to satisfy the waiver rule. In addition, the custodial waiver rule for purposes of the dependency exemption (and, therefore, the child credit) for decrees of divorce or separate maintenance or written separation agreements that become effective after the date of enactment. Under the new law, as under prior law, the custodial waiver rules do not affect eligibility with respect to children of divorced or legally separated parents for purposes of the earned income credit, the dependent care credit, and head of household filing status.

While retaining the substantive effect of the prior-law waiver provisions, the new law modifies the mechanical structure of the rules. Under prior law, a waiver may be made with respect to the dependency exemption. The waiver then automatically carries over to the child credit, because in order to claim the child credit, the taxpayer must be allowed the dependency exemption with respect to the child. Thus, if the dependency exemption is waived, the child credit applies to the taxpayer who is allowed the dependency exemption under the waiver.

The new law obtains the same result, but through a slightly modified statutory structure. Under the new law, if a waiver is made, the waiver applies for purposes of determining whether a child meets the definition of a qualifying child or a qualifying relative under Section 152(c) or 152(d) as amended by the provision. While the definition of qualifying child is generally uniform, for purposes of the earned income credit, head of household status, and the dependent care credit, the definition of qualifying child is made without regard to the waiver provision. Thus, as under prior law, a waiver that applies for the dependency exemption will also apply for the child credit, and the waiver will not apply for purposes of the other provisions.

Effect of Change in Definition of Qualifying Child on Particular Tax Benefits

Dependency exemption. For purposes of the dependency exemption, the new law defines a dependent as a qualifying child or a qualifying relative. The qualifying child test eliminates the support test (other than in the case of a child who provides more than one half of his or her own support), and replaces it with the residency requirement described above. Further, the prior-law gross income test does not apply to a qualifying child. The rules relating to multiple support agreements do not apply with respect to qualifying children because the support test does not apply to them. Special tie-breaking rules (described above) apply if more than one taxpayer claims a qualifying child. These tie-breaking rules do not apply if a child constitutes a qualifying child with respect to multiple taxpayers, but only one eligible taxpayer actually claims the qualifying child.

The new law generally permits taxpayers to continue to apply the prior-law dependency exemption rules to claim a dependency exemption for a qualifying relative who does not satisfy the qualifying child definition. In such cases, the present-law gross income and support tests, including the special rules for multiple support agreements, the special rules relating to income of handicapped dependents, and the special support test in case of students, continue to apply for purposes of the dependency exemption.

As is the case under prior law, a child who provides over half of his or her own support is not considered a dependent of another taxpayer. Further, an individual is not treated as a dependent of any taxpayer if such individual has filed a joint return with the individual's spouse for the taxable year.

Earned income credit. In general, the new law adopts a definition of qualifying child that is similar to the prior-law definition under the earned income credit. The prior-law requirement that a foster child and certain other children be cared for as the taxpayer's own child is eliminated. The prior-law tie-breaker rule applicable to the earned income credit is used for purposes of the uniform definition of qualifying child. The new law retains the prior-law requirement that the taxpayer's principal place of abode must be in the United States.

Child credit. The prior-law child credit generally uses the same relationships to define an eligible child as the uniform definition. The prior-law requirement that a foster child and certain other children be cared for as the taxpayer's own child is eliminated. The age limitation under the new law retains the prior-law requirement that the child must be under age 17, regardless of whether the child is disabled.

Dependent care credit. The prior-law requirement that a taxpayer maintain a household in order to claim the dependent care credit is eliminated. Thus, if other applicable requirements are satisfied, a taxpayer may claim the dependent care credit with respect to a child who lives with the taxpayer for more than one half the year, even if the taxpayer does not provide more than one half of the cost of maintaining the household.

The rules for determining eligibility for the credit with respect to an individual who is physically or mentally incapable of caring for himself or herself are amended to include a requirement that the taxpayer and the dependent have the same principal place of abode for more than one half the taxable year.

Head of household filing status. Under the new law, a taxpayer is eligible for head of household filing status only with respect to a qualifying child or an individual for whom the taxpayer is entitled to a dependency exemption. Under the new law a taxpayer may claim head of household filing status if the taxpayer is unmarried (and not a surviving spouse) and pays more than one half of the cost of maintaining as his or her home a household which is the principal place of abode for more than one half the year of (1) a qualifying child, or (2) an individual for whom the taxpayer may claim a dependency exemption. As under present law, a taxpayer may claim head of household status with respect to a parent for whom the taxpayer may claim a dependency exemption and who does not live with the taxpayer, if certain requirements are satisfied.

The provision is effective for taxable years beginning after December 31, 2004.

Provisions Extending Prior Law

Research credit. The new law extends the research credit to qualified amounts paid or incurred before January 1, 2006.

Work opportunity tax credit. The law extends the work opportunity tax credit for two years (through December 31, 2005). The extension of the work opportunity tax credit is effective for wages paid or incurred for individuals beginning work after December 31, 2003.

Welfare-to-work credit. The new law extends the welfare-to-work tax credit for two years (through December 31, 2005). The extension of the welfare-to-work tax credit is effective for wages paid or incurred for individuals beginning work after December 31, 2003.

Qualified zone academy bonds. The law extends the authority to issue qualified zone academy bonds through 2005. The authority to issue qualified zone academy bonds is effective for obligations issued after December 31, 2003.

Charitable contributions of computer and technology equipment. The new law extends the enhanced deduction for qualified computer contributions to contributions made during any taxable year beginning before January 1, 2006. Effective for taxable years beginning after December 31, 2003.

Certain expenses of elementary and secondary school teachers. The law allows an above-the-line deduction for up to $250 annually of expenses paid or incurred by an eligible educator for books, supplies (other than nonathletic supplies for courses of instruction in health or physical education), computer equipment (including related software and services) and other equipment, and supplementary materials used by the eligible educator in the classroom. The new law extends the above-the-line deduction for two years, i.e., for taxable years beginning in 2004 and 2005.

Expensing of environmental remediation costs. Taxpayers can elect to treat certain environmental remediation expenditures that would otherwise be chargeable to capital account as deductible in the year paid or incurred (Sec. 198). The deduction applies for both regular and alternative minimum tax purposes. The expenditure must be incurred in connection with the abatement or control of hazardous substances at a qualified contaminated site. The new law extends the present law expensing provision for two years (through December 31, 2005).

Tax incentives for investment in the District of Columbia. The new law extends the D.C. Zone designation and related tax incentives for two years and extends the first-time homebuyer credit for two years. The extension of the D.C. Zone designation and related tax incentives is generally effective on January 1, 2004, except that the provision relating to tax-exempt financing incentives applies to obligations issued after the date of enactment.

Nonrefundable personal credits allowed against the AMT. The new law extends the provision allowing the nonrefundable personal credits to the full extent of the regular tax and the alternative minimum tax for taxable years beginning in 2004 and 2005.

Extension of credit for electricity produced from certain renewable resources. The new law extends the placed in service date for wind energy facilities, "closed-loop" biomass facilities, and poultry waste facilities to include facilities placed in service prior to January 1, 2006, effective for facilities placed in service after December 31, 2003.

Suspension of 100% of net income limitation on percentage depletion for oil and gas marginal wells. The new law extends the suspension of the net-income limitation for marginal wells for taxable years beginning before January 1, 2006. The provision is effective for taxable years beginning after December 31, 2003.

Deduction for qualified clean-fuel vehicle property. The law repeals the phase down of the allowable deduction for clean-fuel vehicles in 2004 and 2005. Thus, a taxpayer who purchases a qualifying vehicle may claim 100 percent of the otherwise allowable deduction for vehicles purchased in 2004 and 2005. For vehicles purchased in 2006 the deduction remains at 25 percent of the otherwise allowable amount as under prior law. Effective for vehicles placed in service after December 31, 2003.

Extension of Archer Medical Savings Accounts (MSAs). The new law extends Archer MSAs through December 31, 2005. The law also provides that the reports required by MSA trustees for 2004 are treated as timely if made within 90 days after the date of enactment. In addition, the determination of whether 2004 is a cut-off year and the publication of such determination is to be made within 120 days of the date of enactment. If 2004 is a cut-off year, the cut-off date will be the last day of such 120-day period. The provision is generally effective on January 1, 2004.

Mental health parity. The new law extends the ERISA and PHSA provisions relating to mental health parity to benefits for services furnished before January 1, 2006. It also extends the Code provisions relating to mental health parity to benefits for services furnished on or after the date of enactment and before January 1, 2006. Thus, the excise tax on failures to meet the requirements imposed by the Code provisions does not apply after December 31, 2003, and before the date of enactment.

Technical Corrections

The new law makes a number of technical corrections to tax laws enacted in 2003, 2002, 2001, 2000, 1997, and 1996. We've only included what we believe are the most important provisions.

Dividends taxed at capital gain rates. The Jobs and Growth Tax Relief Reconciliation Act of 2003 ("JGTRRA") generally provides that qualified dividend income of taxpayers other than corporations is taxed at the same tax rates as the net capital gain. The new law makes several amendments to the provisions adopted by that section.

The provision clarifies that the determination of net capital gain, for purposes of determining the amount taxed at the 25-percent rate (section 1(h)(1)(D)(i)), is made without regard to qualified dividend income.

Under prior law, the deduction for estate taxes paid on gain that is income in respect of a decedent reduces the amount of gain otherwise taken into account in computing the amount eligible for the lower tax rates on net capital gain (Sec. 691(c)(4)). Since it is not entirely clear under present law whether this provision also applies to qualified dividends eligible for the lower tax rates on net capital gain, the new law clarifies that the provision does so apply.

The provision clarifies that the extraordinary dividend rule applies to trusts and estates as well as individuals.

The provision rewrites portions of the provisions relating to the treatment of dividends received from a regulated investment company ("RIC") or a real estate investment trust ("REIT") to set forth the rules directly rather than be reference to rules applicable to dividends received by corporate shareholders.

The provision provides that all distributions by a RIC or REIT of the earnings and profits from C corporation years can be treated as qualifying dividends eligible for the lower rate.

The provision extends the 60-day period for notifying shareholders of the amount of the qualified dividend income distributed by a RIC or REIT for taxable years ending on or before November 30, 2003, to the date the 1099-DIV for 2003 is required.

The provision provides that, in the case of partnerships, S corporations, common trust funds, trusts, and estates, Section 302 of JGTRRA applies to taxable years ending after December 31, 2002, except that dividends received by the entity prior to January 1, 2003, are not treated as qualified dividend income. JGTRRA provided a similar rule in the case of RICs and REITs.

Satisfaction of certain holding period requirements if stock is acquired on the day before ex-dividend date. Under several similar holding period requirements relating to the tax consequences of receiving dividends, a taxpayer who acquires stock the day before the ex-dividend date cannot satisfy these holding period requirements with respect to the dividend. The new law modifies the stock holding period requirements to permit taxpayers to satisfy the requirements when they acquire stock on the day before the ex-dividend date of the stock. Specifically, the law modifies the holding period requirement for the dividends-received deduction under Section 246(c) by changing from 90 days to 91 days (and from 180 days to 181 days in the case of certain dividends on preferred stock) the period within which a taxpayer may satisfy the requirement. In addition, the new law modifies the holding period requirement for foreign tax credits with respect to dividends under Section 901(k) by changing from 30 days to 31 days (and from 90 days to 91 days in the case of certain dividends on preferred stock) the period within which a taxpayer may satisfy the requirement. The conference agreement modifies the holding period requirement for dividends to be taxed at the tax rates applicable to net capital gain under section 1(h)(11) by changing from 120 days to 121 days (and from 180 days to 181 days in the case of certain dividends on preferred stock) the period within which a taxpayer may satisfy the requirement.

Bonus depreciation. The Job Creation and Worker Assistance Act of 2002 ("JCWA") provides generally for 30-percent additional first-year depreciation for qualifying property. The new law clarifies that qualifying property includes property that is subject to the capitalization rules of Section 263A and is described in the provisions requiring an estimated production period exceeding 2 years or an estimated production period exceeding 1 year and a cost exceeding $1 million. The new law also clarifies the rules with respect to property subject to a binding contract, certain leased property, property acquired from a related party and property put in service by a lessor and sold within three months of the date placed in service.

Five-year carryback of net operating losses ("NOLs"). The new law clarifies certain rules with respect to the temporary extension of the NOL carryback period to five years under section 102 of JCWA for NOLs arising in taxable years ending in 2001 and 2002. The Act was enacted in March 2002, after some taxpayers had filed returns for 2001. The provision (1) clarifies that only the NOLs arising in taxable years ending in 2001 and 2002 qualify for the 5-year period, and (2) provides that any election to forego any carrybacks of NOLs arising in 2001 or 2002 can be revoked prior to November 1, 2002. The provision also makes several clerical changes to the NOL provisions relating to the alternative minimum tax.

New York Liberty Zone. The new law makes a number of clarifications to bonus depreciation, expensing of asset acquisitions under Sec. 179, and five-year depreciation for leasehold improvements to assets in the New York Liberty Zone.

SIMPLE plan contributions for domestic or similar workers. The Economic Growth and Tax Relief Reconciliation Act of 2001 provides an exception to the application of the excise tax on nondeductible retirement plan contributions in the case of contributions to a SIMPLE IRA or SIMPLE Section 401(k) plan that are nondeductible solely because they are not made in connection with a trade or business of the employer (e.g., contributions on behalf of a domestic worker). Section 637 of EGTRRA did not specifically modify the present-law requirement that compensation for purposes of determining contributions to a SIMPLE plan must be wages subject to income tax withholding, even though wages paid to domestic workers are not subject to income tax withholding. The provision revises the definition of compensation for purposes of determining contributions to a SIMPLE plan to include wages paid to domestic workers, even though such amounts are not subject to income tax withholding.

Constructive sale exception. Section 1001(a) of the Taxpayer Relief Act of 1997 provides an exception from constructive sale treatment for any transaction that is closed before the end of the thirtieth day after the close of the taxable year in which the transaction was entered into, provided certain requirements are met after closing the transaction (section 1259(c)(3)). In the case of positions that are reestablished following a closed transaction but prior to satisfying the requirements for the exception from constructive sale treatment, the exception applies in a similar manner if the reestablished position itself is closed and similar requirements are met after closing the reestablished position. The provision clarifies that the exception applies in the same manner to all closed transactions, including reestablished positions that are closed.

Capital gains and AMT. The provision provides that the maximum amount of adjusted net capital gain eligible for the five-percent rate under the alternative minimum tax is the excess of the maximum amount of taxable income that may be taxed at a rate of less than 25 percent under the regular tax (for example, $56,800 for a joint return in 2003) over the taxable income reduced by the adjusted net capital gain.

S corporation post-termination transition period. Shareholders of an S corporation whose status as an S corporation terminates are allowed a period of time after the termination (the post-termination transition period ("PTTP")) to utilize certain of the benefits of S corporation status. The shareholders may claim losses and deductions previously suspended due to lack of stock or debt basis up to the amount of the stock basis as of the last day of the PTTP (Sec. 1366(d)). Also, shareholders may receive cash distributions from the corporation during the PTTP that are treated as returns of capital to the extent of any balance in the S corporation's accumulated adjustments account ("AAA") (Sec. 1371(e)).

The PTTP generally begins on the day after the last day of the corporation's last tax year as an S corporation and ends on the later of the day which is one year after such last day or the due date for filing the return for such last year as an S corporation (including extensions). Section 1307 of the Small Business Job Protection Act of 1996 added a new 120-day PTTP following an audit of the corporation that adjusts an S corporation item of income, loss, or deduction arising during the most recent period while the corporation was an S corporation. This provision was enacted to allow the tax-free distribution of any additional income determined in the audit.

As a result of the 1996 legislation, an S corporation shareholder might take the position that an audit adjustment allows the shareholder to utilize suspended losses and deductions in excess of the amount of the audit deficiency. For example, assume that, at the end of the one-year PTTP following the termination of a corporation's S corporation status, a shareholder has $1 million of suspended losses in the corporation. Later, the shareholder purchases additional stock in the corporation for $1 million. The corporation's audit determines a $25,000 increase in the S corporation's income. Although the $25,000 increase in income would allow $25,000 of suspended losses to be allowed, the shareholder might take the position that the entire $1,000,000 of suspended losses could be utilized during the 120-day PTTP following the end of the audit. Similarly, an S corporation that had failed to distribute the entire amount in its AAA during the one-year PTTP following the loss of S corporation status might argue that it could distribute that amount, in addition to the amount determined in the audit, during the 120-day period following the audit.

The provision provides that the 120-day PTTP added by the 1996 Act does not apply for purposes of allowing suspended losses to be deducted (since the increased income determined in the audit can be offset with the losses), and allows tax-free distributions of money by the corporation during the 120-day period only to the extent of any increase in the AAA by reason of adjustments from the audit.

--Last Update 09/28/04