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July/August 2006 — Vol. 84 , No. 6

SMALL BUSINESS

How the new federal tax law
affects your business

Tax Increase Prevention and Reconciliation Act of 2005 became law this May

By Laura A. Carrubba, C.P.A., and Bill Fleming

Carrubba is a tax partner and Fleming is the tax managing director for PricewaterhouseCoopers LLP
in Hartford

President Bush signed into law the Tax Increase Preven-tion and Reconcilia-tion Act of 2005 on May 17, 2006. The key components of the act focus on individual income taxes. However, the act also includes several important business tax changes.

Changes affecting small business

Extension of $100,000 small-business expensing election through 2010. Under current law, a small business may deduct up to $100,000 of investments in qualifying depreciable assets through 2007. The deduction, though, is reduced dollar-for-dollar to the extent the taxpayer’s annual investments exceed $400,000 (subject to inflation adjustments). The inflation-adjusted deduction limit for 2006 is $108,000 with an investment limitation of $430,000. Without the extension made by the new law, for taxable years beginning after 2007, small businesses would have been able to deduct only $25,000 of investments in qualifying depreciable assets placed in service in the taxable year, including a dollar-for dollar phase-out to the extent the annual investments exceeded $200,000.

Wage limitation on manufacturing deduction. The manufacturing deduction allows qualified taxpayers to deduct an amount equal to a phased-in percentage of either taxable income or qualified production activities income, whichever is less. Under current law, the domestic manufacturing deduction is also limited to 50% of a taxpayer’s total W-2 wages. The new law modifies the wage limitation so that taxpayers may only include W-2 wages that are deducted in arriving at qualified production activities income. This provision is effective for taxable years beginning after the date of enactment (May 17, 2006).

Advice:

  • This is a revenue-raising provision and is of special interest to industries that rely on contract labor (independent contractors) who are not employees.
  • Separating the wage component and categorizing wages between qualified production activity and other activity could be a time-consuming task.

Changes affecting individuals

Extension of 15% rate on capital gains and dividends. The act extends through 2010 the lower tax rates applicable to long-term capital gains and qualified dividend income. A 2003 tax law had lowered these tax rates for most taxpayers to 15% through 2008 and created a 5% tax rate for taxpayers who would otherwise be taxed at 10% or 15% on ordinary income. The 5% tax rate changes to zero for 2008.

Advice:

  • Business owners can continue to consider dividend payments at the lower rate.
  • This provision presents a planning opportunity to make gifts of appreciated property to lower-bracket family members and maximize the benefit of the zero capital gains tax opportunity for 2008, 2009 and 2010.

Increased AMT exemption. The act increases the Alternative Minimum Tax (AMT) exemption amount for 2006. As scheduled, the exemption for 2006 was $45,000 for married couples filing a joint return and $33,750 for single taxpayers. The new law increases the exemption for 2006 to $62,550 (joint) and $42,500 (single). The act also extends the ability to reduce the AMT in 2006 with additional credits that formerly were not available as a reduction to the AMT.

Advice:

  • Owners of pass-through business entities need to consider AMT preferences when choosing among depreciation methods. Although depreciation is supposed to be a timing preference, the AMT tax and credit calculations may lead to near permanent tax differences.

“Kiddie tax” goes older. Currently children under the age of 14 are taxed at their parents’ marginal tax rate on their unearned income, such as dividends and interest, in excess of $1,700. This provision is often referred to as the “kiddie tax.” The act raises the age at which children are taxed at their parents’ higher tax rate from 14 to 18, effective for taxable years beginning after Dec. 31, 2005.

Advice:

  • This provision is designed to increase tax revenues. The potential benefit of the extension of the no capital gains tax on lower-bracket taxpayers in 2008 through 2010 (discussed above) will be severely restricted for taxpayers with children under age 18.
  • Higher-income taxpayers may minimize the “kiddie tax” by putting their money into college savings programs, such as Connecticut’s CHET, rather than directing it to their children’s bank accounts.

New 2010 Roth IRA conversion opportunity. Roth IRAs come with significant tax advantages — distributions are income-tax-free after age 59 1/2 and after the account has been open five years, and there are no minimum distributions required during the taxpayer’s lifetime. Conversion of traditional IRAs to Roth IRAs has been limited to taxpayers with less than $100,000 of modified adjusted gross income (AGI). The act repeals the income limitation after 2009, making Roth IRA conversions available without regard to the taxpayer’s AGI. In addition, any taxpayer who converts an IRA to a Roth IRA in 2010 will be able to include one-half of the income attributable to the conversion with the 2011 tax returns and the other half with the 2012 return.

Advice:

  • This provision is designed as a revenue raiser. The repeal of the AGI limitation is likely to result in a large number of taxpayers with significant IRA balances choosing to convert to Roth IRAs. This will create significant revenue for the government in the short run, but will have an offsetting reduction in future years when this income would have been drawn down from traditional IRAs.
  • Higher-income taxpayers will have four years to contemplate whether to take advantage of the Roth IRA conversion opportunity. Many factors must be considered before converting to a Roth IRA, including the amount of taxes that will be triggered upon conversion versus expected future tax rates on traditional IRA distributions.

Other business tax changes

The act contains several other important business tax changes affecting multinational businesses and various targeted industries. These changes include:

  • a temporary controlled foreign corporation provision that will provide U.S. multinationals with additional flexibility to move active foreign income without triggering U.S. tax consequences;
  • extension of the subpart F exception for active financing and insurance income;
  • simplification of the active trade or business requirement for tax-free spin-off transactions; and
  • tax relief relating to environmental cleanup funds, certain tax-exempt bonds, the U.S. shipping industry, music publishers and songwriters.

Some tax increases

Key business tax increases in the new law include limiting the foreign earned income exclusion for housing expenses; repealing the foreign sales corporation and extraterritorial income exclusion benefits for certain “grandfathered” contracts; denying tax-free treatment to certain “cash-rich” spin-off transactions; and requiring withholding after 2010 on government contract payments.

The act also modifies certain corporate estimated tax payment requirements for large corporations (those with at least $1 billion of assets), requires reporting of interest on tax-exempt bonds, and applies the earnings-stripping rules to corporate partners. Other business revenue-raisers affect foreign investors in U.S. real estate, major integrated oil companies and pooled financing bonds.

 

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