The Third Time is a Charm
(Washington’s October Surprise Part 2)
One of the great things about our form of government is the ability to predict with some measure of certainty the cycle of changes in our tax laws and government spending. For instance, a new president was sworn into office in early 1993 and later that year, we had a major tax increase. On the other hand, 2004 is a presidential election year and it seems there are a number of provisions in the tax code reducing income taxes. Isn’t it amazing how benefits to the taxpayers, and even spending priorities, change when our elected representatives are asking for another term in office?
Ok, to be fair, there may be other reasons for adjustments in tax and spending priorities in Washington, but the fact is, no politician - be they Republican, Democrat or Independent - wants to kick you in the teeth in the same year they need your vote. So it is with this year’s "adjustments" in the Internal Revenue Code. We’ve had three fairly important changes in our tax code that gave a lot to the taxpayer-voter, gave some to the corporate taxpayer and paid for it all with increases in penalties for non-compliance with the tax code or through closing some so-called loopholes. We will focus on the law that went into effect on October 22, 2004 - The American Jobs Creation Act of 2004 or ACJA.
Several years back, our trading partners across the pond began to get a bit disenchanted with a certain corporate entity created by our tax code - the Foreign Sales Corporation. Essentially, the FSC was a mechanism to encourage exports by giving a tax break for sales to foreign companies. The savings were huge in many cases. This tax break was considered an illegal subsidy by the Europeans and, upon review, the World Trade Organization ("WTO") agreed.
After this ruling, a number of tactics were tried to keep the tax break for corporations, but none met with WTO approval. As a result, the European countries began in 2004 to slap what amounted to approximately $4 billion in tariffs on imports from the United States. Companies began losing sales and the president and congress realized they had to fix the problem. This had been known for years, but congressional negotiators couldn’t agree on the fix. Finally, in 2004, a method was devised that would pass the test with the WTO - an incentive for manufacturing within the United States and tied to some extent with wages paid to United States residents. What follows is the abbreviated explanation.
Beginning in 2005, taxpayers will be allowed a deduction starting at 3% of U.S.-based manufacturing income. This deduction will increase to 6% of qualified production activities in 2007 and 9% of qualified production activities in 2010 forward. The deduction will be limited to 50% of W-2 wages. In one stroke, the tax code increased the incentive for companies to keep jobs in the United States and also gave our trading partners a reason to lift $4 billion in punitive tariffs.
The production activities that qualify for this tax break are fairly broad and include manufacturing activities, farming activities, extraction activities, construction activities, including engineering and architectural services, and similar business activities. In other words, this new deduction will affect a large portion of U.S. business. The one entity that will not have a fighting chance at utilizing this deduction will be the small one-person business since one of the requirements is the payment of W-2 wages. The good news is that this deduction will be available regardless of the intended market for the items produced in the U.S. (i.e. foreign or domestic market) and it thus amounts to a tax break for qualifying businesses. The bad news is this just serves to make our already complex tax code even more complex.
There are numerous rules that will be involved in determining qualified U.S. production income and we won’t try to go into that now. For the time being you just need to know that this new deduction is on the horizon and, if you took advantage of the Foreign Sales Corporation or its successor, the extraterritorial income exclusion ("ETI"), you will no longer have the 100% of ETI available to shelter income from transactions after December 31, 2004. In 2005, the available ETI will drop to 80% of its 2004 level; in 2006, the available ETI will decrease to 60% of the 2004 level; thereafter, the ETI will be fully phased out.
The new law also extended enhanced expensing elections available for qualified purchases for two years. Instead of reverting to pre-2001 depreciation and Code Section 179 deduction limitations on January 1, 2006, the reversion will take place on January 1, 2008. A new 15 year depreciation category was added for qualified leasehold improvements related to restaurants instead of the old 39 year life. Not only will this shorten the period of time to depreciate leasehold improvements, but these improvements will now be subject to the 179 deduction and bonus depreciation.
If you operate your business as an S Corporation, the new law made a number of revisions to this type entity. The number of eligible owners has been increased to 100 from 75 and the definition of owner has been adjusted to allow the aggregation of certain family members. Transferability of passive losses in the case of divorce has been included in this new law and various other business friendly measures were added.
In addition to the preceding items, agriculture received some breaks in the new law and there were a few simplification measures. All-in-all, the new law provided for numerous incentives to help business and paid for these incentives by eliminating a few loopholes and increasing penalties for noncompliance with the tax code.
Thanks to the changes in tax law over the past year, and especially in October 2004, you probably need to review your tax planning to make sure you are maximizing your deductions and minimizing your taxable income. The new law is complex and even the IRS will take some time promulgating the required regulations. Give us a call today so we can review your particular circumstances to maximize your benefits from Washington’s October surprise.
Have a great November and don’t forget to vote on November 2.