Worcester Business Journal – December 13, 2004
A taxing year
Tax law for ’04 has plenty of ‘sleepers.’
Prepare now to keep them from becoming nightmares.
CHRISTINA P. O’NEILL
The federal government giveth, and the federal government taketh away. While the Bush administration is most known for its propensity for tax cuts, Congress, in a post-Enron era, has been busy this year passing tax laws meant to clamp down on past abuses at the same time it gives out much-welcomed tax breaks for small businesses and manufacturers.
Some of the new provisions are what Bill Philbrick calls “sleepers” – the stealth-mode rules that seem to be hiding in plain sight. We spoke to about a half dozen CPAs and a tax attorney in the Central Mass. finance community to get their input on the tax changes and what they’ll mean to you for tax year 2004. Their message – enjoy the breaks, but look out for some tightened provisions that have real teeth.
William Philbrick, partner at Greenberg, Rosenblatt, Kull & Bitsoli LLP in Worcester, is one of many tax professionals who warn that the federal tax law that goes into effect for 2004 will have significant consequences for the unwary.
The American Jobs Creation Act of 2004, signed into law just this past Oct. 22, is effective for the 2004 tax year. It contains many goodies – a new tax deduction on income earned from manufacturing; a tax break that favors domestic over offshore production; and more generous (and more realistic) depreciation schedules for equipment purchase, particularly software. Additionally, S Corporations are now allowed 100 eligible shareholders, up from 75 – and family members of a business can count as one shareholders’ unit.
The rules that have been tightened up – Philbrick’s “sleepers” – can be taxpayer nightmares for the unprepared. Congress put teeth into the American Jobs Creation Act of 2004 in two key areas – deferred- compensation plans and so-called “listed transactions” which have far-ranging consequences for the non-compliant.
In addition, says Joy Child of Westboro and Worcester-based Alexander, Aaronson & Finning & Co., PC, the law imposes other restrictions, including the following:
• Shutting down “abusive” tax shelters
• Tightening rules for charitable contributions of patents, motor vehicles, boats and airplanes
• Limiting the deduction for SUVs to $25,000 a year, down from $100,000 a year ago.
Here, in compact form, and with “carrot” and “stick” symbols, is our checklist of the tax changes most likely to impact businesses for the tax year that’s about to end – and what our experts say about them.
“Stick” Non-qualified deferred-compensation plans
What they are: In these plans, which are not available to rank-and-file employees, key executives can defer bonuses or other compensation into later tax years.
What changed and why: The American Jobs Creation Act of 2004 contains stricter legislation to deal with non-qualified deferred-compensation plans. Congress got tough on these plans as a result of the abuses at Enron Corp. Executives at that company were able to cash out of their deferred compensation plans just before the firm filed for bankruptcy, getting millions of dollars in non-qualified benefits, observes Robin Lazarow, a tax attorney at Worcester-based Mirick O’Connell. The 2004 law imposes severe penalties for failure to follow Internal Revenue Code Section 409A. Those who fail to do so will owe current income tax on all amounts deferred, plus a 20 percent tax penalty on the amount that’s included in income, and interest assessed on the underpayment at the underpayment rate plus 1 percent. Additionally, as of 2005, all amounts deferred must be reported on W-2 forms, even though that money isn’t taxable, to provide the IRS a way to track the amount of deferred compensation.
Before 2005, says Lazarow, executives who, say, were still working at their previously agreed upon retirement date were allowed to postpone receipt of deferred-compensation amounts, which they often did in order to receive the distribution in a later year in which they would be in a lower tax bracket. Conversely, they could take early distribution with a penalty, or receive accelerated benefits. Not any more.
Under the new rule, according to a newsletter from Worcester-based Alexander, Aaronson & Finning, executives are going to have to elect up front when they want to receive their distribution, and only six specific events will trigger a distribution in which the recipient does not have to pay a penalty. Some of these events have yet to be officially defined. In short, they are:
• Separation from service
• A specified distribution time or distribution schedule
• Change in control of the corporation
• Unforeseeable emergency
Meanwhile, executives taking deferred compensation need to make an election in 2004 for their 2005 deferrals. As this issue went to press, lawyers and accountants were waiting for guidance by the U.S. Treasury to help taxpayers through the transition period.
Consequences: Employers must be aware of the consequences of early distribution. “You cannot violate the provisions later on, otherwise you disqualify the plan altogether,” warns Philbrick, who warns businesses, “you may end up losing an employee over it.”
What to do about it: “Deferred compensation isn’t something that many employers have necessarily paid attention to over the years,” Lazarow says. “They could have been promising deferred compensation in an employment agreement, for instance, and not realize that, because they don’t keep track, necessarily, of all of their promises to pay deferred compensation. So now, employers will really need to take an inventory of those arrangements.”
“Stick” Listed transactions
What they are: Listed transactions are a subset of so-called “reportable” transactions under IRS code. Reportable transactions include membership in hedge funds, for example. Under existing tax rules, there are currently 30 different scenarios dealing primarily with some type of tax shelter, for which the IRS requires a special disclosure on a person’s tax return. Additionally, taxpayers and their accountants who take a contrary position in reporting the nature of income must also file a disclosure of that position, regardless of whether the tax consequences would change. These provisions have been in place for years.
What changed and why: While members of investment partnerships have been required to report the relationship to other partners and to the IRS for years, the law never had any teeth. But in 2004, the law regarding disclosure of these transactions has been tightened. The intent is to crack down on abusive tax shelters.
Consequences: Taxpayers who fail to report a listed transaction face a $100,000 fine under Code Section 6662A with no “reasonable cause” exception, warns Philbrick. Penalty for deliberately omitting such disclosure is $200,000.
What to do about it: Taxpayers need to obtain confirmation from whatever investment partnership of which they’re members, documenting whether or not the partnership has been engaged in any reportable, listed transactions. Those who have investment relationships which they believe do not count as listed transactions need to file disclosure statements with their return documenting how they are treating the transaction to justify why they do not believe it’s a listed transaction.
“It really is going to behoove people who have made these investments, even though they think they’re innocuous, to make sure that they confirm that there were no reportable listed transactions for which they must be liable,” Philbrick says. “This goes to show that this whole idea of dealing with shelters, [demonstrates] how seriously Congress is taking this.”
“Carrot” Deduction for U.S. production activities; repeal of ETI exclusion
What it is: Cited by many as the most significant part of the AJ CA, this is a tax break on a percentage of business income earned from manufacturing and certain other production activities in the U.S. Originally the impetus behind the AJCA, it’s meant to encourage companies that do business internationally to do more of that business in the U.S. It’s available to regular C Corporations, S Corporations, partnerships, sole proprietorships, cooperatives and estates and trusts. The deduction is expected to generate about $77 billion in benefits over 10 years.
What changed and why: The new rule repeals the extra territorial income exclusion, or ETI, a law that formerly excluded from a company’s gross income certain offshore income. The deduction is currently a percentage of the net income from U.S. manufacturing activities. Set at 3 percent for tax years 2005 and 2006, it rises to 6 percent in 2007-2009, and then to 10 percent for 2010 and later. It measures domestic production gross receipts less certain reductions, such as factoring in the cost of goods sold. According to Newkirk, domestic production gross receipts include the sale or lease of qualified production property manufactured, produced, grown, or extracted by the taxpayer in the U.S. It also includes sale or lease of a qualified film produced by the taxpayer; the sale or lease of electricity, natural gas or drinking water; construction performed in the U.S.; and engineering or architectural services.
Consequences: “The definition of manufacturing is going to get a lot broader,” notes Philbrick. However, he says, for companies which are newly defined as manufacturers may find it’s more expensive than it’s worth it to implement a complex accounting system to actually account for the costs now defined as manufacturing. Such systems can cost in the vicinity of $25,000 and up, he says.
There are other consequences as well, says Katherine Caron, tax partner for Worcester-based Shepherd & Goldstein LLP. She notes that manufacturers who haven’t been exporting to date will benefit the most, because those who had been exporting are losing the ETI, which has been repealed.
“Congress was really backed into a corner where they had to find a way to encourage U.S. employment and U.S. manufacturing, without directly subsidizing exporting,” Caron says.
This break subsidizes companies which manufacture in the US. and export if they want. At a disadvantage, she says, are reseller exporters. They won’t get the break, and they’ll have to push for price reductions from their suppliers and manufacturers who do get it.
“Presumably, manufacturers are going to have to give a little bit of the price break up, but reseller exporters aren’t going to qualify for this any more. That’s the flip side to [the provision that] all U.S. manufacturers will qualify,” she says.
The Financial Accounting Standards Board is set to issue guidance by yearend on how companies should account for the change — whether it’s estimated as a rate change or whether it’s going to be a special deduction phased in over time. Companies with calendar fiscal years could take a considerable hit on their balance sheets if they have to make the change all at once.
“The other way to do it will be to treat it as a special deduction, which then the effect would come in over time,” Caron says.
“Stick & Carrot” Section 179 expensing
Al Bisceglia, partner at Worcester-based Bisceglia, Steiman & Fudeman, LLP says the Section 179 depreciation expense election has been a significant sales tool this year. It’s been reinstated for 2005 at $100,000 in annual allowable deductions. An additional $50,000 bonus depreciation, which expires Dec. 31, has been a sales tool for vendors this year.
What it is: The AJCA extends existing tax law under Code Section 179, allowing businesses to immediately expense more than $100,000 of new investments through 2007, rather than writing off the cost of the equipment over its depreciable life.
What changed and why: A 2003 law expanded the election, raising the dollar limit from $25,000 to $100,000 for 2003-2005. For 2004 and 2005, inflation-adjusted expensing limits are $102,000 and an estimated $105,000 respectively, according to Newkirk, Albany, NY-based provider of marketing communications for financial and health-care companies.
The Section 179 expensing limit is reduced dollar for dollar when total assets placed in service during the year exceed a certain dollar amount, Newkirk says. The 2003 law doubled the limit to $400,000 for tax years 2003-2005, adjusted for inflation. The AJCA extends the higher dollar amount through 2007.
However, the new law has an exception from the depreciation and expensing caps on so-called “luxury cars,” as that applies to sport utility vehicles. Liberal caps had encouraged many businesses to buy large SUVs for their executives, taking advantage of the expensing election of up to $100,000 to write off the full cost in the first year. AJCA caps the deduction for SUVs to $25,000, effective for vehicles put into service after Oct. 22, when the AJCA was signed.
“A lot of people were buying the Yukons and the Tahoes and all those big vehicles,” says Dede Labonte, a tax partner at Worcester-based Bollus Lynch LLP. Now, she says, SUVs weighing between 6,000 pounds and 14,000 pounds can take only a $25,000 deduction with the remainder getting written off over a longer period of time. “I don’t know if that will change business people’s minds about buying or leasing but we’ll see going forward,” she says.
Consequences: Clients are calling their accountants before they take the plunge on equipment because of the retained expense level of $100,000 capital acquisition. The elimination of the so-called bonus depreciation of another potential $50,000 asof yearend 2004 may have an impact on some companies, some concur. Al Bisceglia, partner at Worcester-based Bisceglia, Steiman & Fudeman, LLP, says vendors use the depreciation cap as a sales tool and are urging their customers to make purchases by yearend.
“Carrot” Ease of qualifying as an S Corporation
What it is: The AJCA contains 10 provisions to make it easier for businesses to qualify and operate as S Corporations. In an S Corp., income, losses, deductions and credits are passed through to shareholders, who report them on their own tax returns. Corporate income is taxed only once.
What changed and why: Increasing the number of eligible shareholders from 75 to 100 allows S Corporations to be able to issue shares to key employees. Electing to treat family members as one shareholder supports the growth of family-owned businesses. “Nobody’s giving up their voting rights,” says Philbrick. “It doesn’t mean that all of a sudden, Dad has everybody’s shares.”
And, if a shareholder’s stock is transferred to a spouse or former spouse in a divorce, any suspended loss or deduction attributable to the S Corp. goes with it, according to Newkirk.
Consequences: “It’s a friendlier, pro-business environment,” says Alexander, Aaronson & Finning’s Joy Child. Encouraging the creation of more S Corps. and making it easier to maintain status as an S Corp. encourages the growth of small business.
“Stick” Charitable donation of vehicles
What it is: The AJCA tightens restrictions on deductions taxpayers can take on vehicles donated to charity. It’s supposed to be based on fair market value on the date of the contribution.
What changed and why: Under previous law, the donor has been responsible for determining the deductible value. The IRS has been concerned that donors deduct far greater amounts than what charities could realize from selling the vehicles to third parties. “People are taking the Kelly Blue Book value. But if the car’s not running, you would never get that if you traded it in somewhere,” says Child. But unless the charity uses the vehicle in their business or agency, it usually sells it, and the taxpayer’s deduction is supposed to be limited to the sale price. “Any donation that’s non-cash that’s over $5,000 requires an appraisal, except for publicly-traded stock,” she says. “That’s always been the case but I’m sure [the IRS will] be scrutinizing their appraisals more.”
Consequences: AJCA limits the charitable-contribution deduction for donations of motor vehicles, boats and planes for which claimed value exceeds $500. If the charity sells a donated item without having used it or materially improved it, the deduction is limited to the gross proceeds from the sale. A penalty applies if the charity knowingly fails to provide a timely acknowledgement or makes a false acknowledgement.
What are you doing New Year’s?
“We’ll be busy,” says Mirick O’Connell’s Robin Lazarow. “Treasury has told us that we won’t have to sit at our desks on New Year’s Eve, that we’re going to have some relief.”
Christina P. O’Neill can be reached at firstname.lastname@example.org
For more information
o American Institute of Certified Public Accountants, www.aicpa.org/info/sarbanes_oxley
o PricewaterhouseCoopers, www.pwcglobal.com
o Tax Policy Center www.taxpolicycenter.org