On Friday, October 22, 2004, the President signed into law the American Jobs Creation Act of 2004 (AJC Act) which contains $145 billion in business tax breaks.  Unlike the Working Families Tax Relief Act of 2004 that was signed on October 11th and basically extended tax breaks that were passed in 2001 and 2003, the AJC Act is being hailed as the most far-reaching tax cut in 20 years, but it also has revenue raising provisions that will hit individuals as well as businesses.  Indeed, the revenue raising portion of the bill is expected to equal the $145 billion needed to make the bill revenue neutral.

As we stated, this is a wide-ranging bill and in the interest of brevity, we will go right into the analysis of its impact:

The European Union (EU) currently has a 12% penalty sanction on US exports that is growing at the rate of 1% per month due to the World Trade Organization (WTO) declaring America's FSC/ETI rules  - which qualify US exporters as eligible for income exclusions for qualifying extraterritorial income - an illegal trade subsidy.   The AJC Act begins repealing the FSC/ETI rules starting in 2005.  Taxpayers will be able to claim 100% of their FSC/ETI benefits for the current year, but that drops to 80% in 2005, 60% in 2006 and is completely repealed thereafter.  The full exclusion remains in effect for companies that had entered into binding contracts in effect on September 17, 2003.

Manufacturers

In order to replace the FSC/ETI rules, the AJC Act creates a new deduction for manufacturers that reduces the corporate income tax rate for domestic manufacturing 3 percentage points from 35% to 32% in 2005.  "Manufacturers" is now a bit of a misnomer because for the purpose of this new rate, it has been defined in very broad terms as the following:

• Traditional manufacturing
• Construction
• Engineering
• Energy production
• Computer software
• Films and videotape
• Processing of agricultural products

This new deduction will remain at 3% in 2006, but will rise to 6% in 2007 through 2009 and jump to 9% in 2010 when it is fully phased in.  The deduction however, is limited 50% of the W-2 wages paid by the taxpayer during the tax year and to the lesser of:

1) qualified production activities income for the year, or

2) taxable income for the year.

The new deduction is available to corporations, S corporations, individuals, partnerships, estates, trusts and cooperatives.  The deduction is also available for alternative minimum tax (AMT) purposes. All taxpayers now identified as "manufacturers" as noted above will be eligible for the deduction regardless of whether or not they export.

As of this writing, the IRS has not released regulations describing what business activities qualify as manufacturing for purposes of this new deduction.  This is obviously going to be a critical issue for many of our clients so we will follow up with a new article as soon as we have that information.  With any luck, we may have more answers within the next few weeks and in time for year-end planning.

Small Business Expenses

The AJC Act extends through 2007, the expensing of qualifying property up to $100,000.  The special treatment is reduced when the cost of qualifying property placed in service exceeds $400,000.  However, in addition to extending the $100,000 expense option, the AJC Act also indexed the amount for inflation beginning in 2004.  For the current year, the expense amount has been increased to $102,000 with a $410,000 property cap.  The inflation index will continue to cause adjustments at least through 2007.

SUV Writeoffs

Most vehicles acquired for business use have a depreciation cap of $2,960 for the first year unless the vehicle's weight exceeds 6,000 pounds.  For the past few years, consumer advocates have complained about loopholes in the law that allowed certain taxpayers to acquire heavy SUVs and immediately take a Section 179 deduction up to the full cost of the vehicle.  Congress addressed that concern with this bill and reduced the maximum deduction to $25,000 for heavy vehicles weighing no more than 14,000 pounds.  This provision takes effect for any vehicles acquired after October 22, 2004.

Leasehold Improvements

The AJC Act sets up a new 15 year recovery period for qualified leasehold improvements made to nonresidential real property placed in service after October 22nd and before January 1, 2006.  The new 15 year recovery period uses straight-line depreciation and cannot be transferred to subsequent owners.  A qualified leasehold improvement is an improvement to the interior of a building, made by either the lessor or lessee and placed in service more than 3 years after the building is placed in service.  The 15 year recovery period replaces the prior 39 year recovery period under prior law.

Restaurant Property

The Act also establishes a 15 year recovery period and straight line depreciation for qualified restaurant property placed in service after October 22nd and before January 1, 2006 and also makes the property eligible for first-year bonus depreciation.  The restaurant must use more than half of the building's square footage and any qualified restaurant property is an improvement placed in service more than 3 years after the building is placed in service.

S Corporations

In a move intended to boost S corporations, they are now permitted to have as many as 100 shareholders instead of the previous 75 and all members of a family are now considered one shareholder.  The Act defines family members as "the common ancestor, lineal descendants of the common ancestor, and the spouses (or former spouses) of lineal descendants or common ancestor."  To qualify as a common ancestor, the person must be no more than 6 generations removed from the youngest generation of shareholders who otherwise would be members of the family.

Other AJC Act provisions affecting S corporations included:

• Permits traditional and Roth IRAs to hold shares in a bank that is an S corp;

• Allows suspended losses or deductions to be transferred in the case of transfers of stock to a spouse incident to divorce.

• Eases the rules for determining potential current beneficiaries of an electing small business trust.

• Relaxes some passive activity loss rules as they relate to qualified subchapter S trusts.

• Gives relief from inadvertent invalid subchapter S subsidiary elections and terminations.

• Provides for qualified subchapter S subsidiaries to file information returns.

• Permits distributions from an ESOP maintained by an S corp to repay certain loans.

State And Local Sales Tax Deduction

Since many states do not have an income tax, the AJC Act now allows individuals to elect to deduct state sales taxes instead of state and local income taxes for tax years beginning after 2003 and before 2006.  If you elect to deduct state and local sales taxes paid, you will either have to keep receipts for your sales taxes paid or use tabled provided by the Secretary of the Treasury based on average consumption and other factors.  

This particular provision not only helps residents of states that have no state income tax, but it can also prove to be beneficial to our clients who make large purchases during the year and find that their sales tax expenditures exceed their state and local income tax payments.  It is not anticipated that the sales tax deduction tables will be prepared in time for this year's filing season so we can only presume that the IRS will allow some type of estimate to be made for 2004.  We will obviously keep you posted on developments in this area.

Farmers

Farmers fared well under the AJC Act with several new tax breaks.  In addition to a $10 billion buyout of the tobacco price support program, the processing of agricultural products was also treated as "manufacturing" and made eligible for the tax rate deduction discussed above.  The Act also gave farmers some AMT relief since it now allows the special income averaging that farmers and fishermen are permitted to be used for comparative AMT calculations.  Under prior law, farmers often lost the benefits they were supposed to gain from income averaging because of AMT.  The Act also extends the time that farmers are allowed to reinvest the proceeds from sales of livestock due to weather-related conditions into similar livestock from 2 years to 4 years.

Vehicle Donations

The AJC Act now limits the deduction for automobiles donated to charity depending upon how the charity uses the vehicle.  In most cases of course, the charity simply sells the vehicle and it is now required to report the proceeds of that sale to the donor to be used as the donor's charitable deduction.  If the charity uses the vehicle for its own purposes, it is still required to report the value of that vehicle to the donor and the IRS.  Vehicle donation is a growing "industry" with many charitable groups and Congress is allowing the IRS to crack down on the major abuses that are occurring.

Company Aircraft

Officers, directors and owners (10% or greater) of companies will no longer be allowed to deduct the expenses for the use of a facility (such as an airplane) in connection with a nonbusiness activity to the extent that the expenses exceed the amount treated as compensation or includible income for that individual.

Donation of Intellectual Property

Contributions of patents or other intellectual property (other than certain copyrights or inventory) to charitable organizations after June 3, 2004 will be limited to a charitable deduction of the taxpayer's basis in the contributed property or its fair market value, whichever is less.  The donor is allowed to take an additional charitable deduction based on a specified percentage of the income the donee receives with respect to the donated property.  The amount of the additional deduction is calculated on a sliding scale and can be taken either in the contribution year or the subsequent tax years.

Non-Disclosure Penalties

The AJC Act increases penalties for promoters and investors who fail to disclose their participation in abusive transactions to $10,000 for individuals and $50,000 for non-individual taxpayers.  If the tax shelter is a "listed transaction," the penalty is increased to $100,000 for individuals and $200,000 for non-individual taxpayers.  In addition to the tough new penalties, the Act also creates an accuracy-related penalty for reportable and listed transactions as well as a penalty equal to 50% of the gross income derived from the abusive transaction.

Tax Shelters

The AJC Act has relaxed the confidentiality rules for communications between taxpayers and practitioners about shelters.  It also extends the statute of limitations to capture more abusive transactions and exposes promoters and others doing business with them to more strict sanctions.  "Material advisors" will be sanctioned for failing to file information returns about reportable transactions as well as not maintaining lists of investors in abusive transactions.  These tough new provision are all effective as of October 22, 2004.

Repatriation of Foreign Earnings

Certain cash dividends (with a few exceptions for non-cash) received by a US corporation from a controlled foreign corporation are eligible for an 85% dividends received deduction.  Taxpayers must elect whether to take the deduction for dividends received either during the first tax year before enactment of the new law or during the last tax year before enactment.  The new law does require taxpayers to identify how they plan to reinvest the dividends in the United States.

Expatriation

United States citizens who relinquish their citizenship for tax avoidance purposes (determined by objective rules) will be treated as citizens for federal tax purposes and taxed on their worldwide income if they return to the United States for more than 30 days.  

International Tax

The AJC Act reduces the number of foreign tax credit baskets from nine to just two consisting of passive category income and general category income.  The new law also delineates some financial services income as general category income and allows taxpayers to make a temporary election about certain creditable foreign taxes. Congress also approved changes to the interest expense allocation rules for the foreign tax credit limitation.

Other international and foreign tax credit changes include:

• Application of a re-sourcing rule to U.S. source income when a taxpayer’s foreign tax credit is reduced because of an overall domestic loss.

• Application of look-through treatment under subpart F for sales of partnership interests.

• Clarification of certain deem-paid foreign tax credits.

• Creation of new exceptions from the definition of U.S. property for certain shareholders in controlled foreign corporations.

• An election for taxpayers required to translate foreign income taxes at the average exchange rate to use exchange rates at the time the taxes are paid.

• Elimination of secondary withholding tax on dividends paid by some foreign corporations.

• Similar treatment of interest paid by foreign partnerships and foreign corporations.

• Taxpayer-friendly treatment of certain regulated investment company (RIC) income where dividends are received by foreign persons and their estates.

• Repeal of foreign personal holding company and foreign investment company rules.

• Modification of temporary exceptions from subpart F personal holding company income for banking, finance and similar business activity.

• Relaxation of the rules requiring foreign investors receiving REIT distributions to file U.S. returns.

• Reduction in the withholding tax rate on U.S. source dividends paid to a Puerto Rico corporation.

As you can see, the American Jobs Creation Act of 2004 was a fairly wide-ranging bill which addressed many issues and left some loose ends still dangling.  Over the next few months, we will try to close some of those loose ends as new information is released and as always, please do not hesitate to contact our office if you see something of concern and need further clarification.