October 2004 legislation lets advisors help business owners cut taxes.
With Americans' political attention focused squarely on the electoral process last fall, Washington quietly legislated a monumental tax bill. Little fanfare heralded President Bush's signing of the American Jobs Creation Act on October 22. Yet like every other tax law passed in recent memory, the new act adds complexity to the already labyrinthine Internal Revenue Code. Nevertheless, many business owners will benefit, even if their state doesn't embrace the new federal rules.
Changes Affecting 2004 Tax Returns
Several provisions took effect the day after enactment and thus impact the current tax-filing season.
Heavy-vehicle deductions. Blame this one on the press. Numerous articles decried a loophole in a 2002 law that allowed businesses to write-off pricey SUVs under IRC Section 179 (first-year expensing). Congress's response: capping the deduction at $25,000 for vehicles that weigh between 6,000 and 14,000 pounds. The limit applies to vehicles placed in service after October 22, 2004. The remaining cost is depreciable under regular rules.
There are exceptions to the $25,000 limit, however. Vehicles that seat more than nine behind the driver's seat (such as a shuttle van), those with a six-foot or longer cargo area (a pickup truck, for example), and fully-enclosed vehicles that don't have rear seats or extend more than 30 inches in front of the windshield (e.g., an electrician's van) remain eligible for first-year expensing up to $102,000 for 2004, provided their weight exceeds 6,000 pounds, says Scott Taylor, a tax manager at accounting and consulting firm Larson Allen in Minneapolis.
To qualify for either the limited or full Section 179 deduction, the vehicle must be used more than 50% for business. And of course, the taxpayer must be able to prove the business usage.
Start-up and organizational costs. Under old rules, the expense of getting into a new business had to be spread out over five or more years. Neither start-up costs-that is, expenses incurred prior to the commencement of business operations, such as pre-opening training -nor entities' expenditures on legal, accounting and other organizing costs could be deducted up front.
That has changed. For expenses incurred after October 22, up to $5,000 of the cost to organize and up to $5,000 of start-up expenses are deductible when incurred, says Mark Luscombe, federal tax analyst at business-information provider CCH Inc., of Riverwoods, Ill. Expenses above that amount are amortizable over 15 years. The $5,000 limit is reduced dollar-for-dollar if the total start-up or organizational costs exceed $50,000.
Leasehold and restaurant improvements. Leasehold improvements, along with other nonresidential real property, have traditionally been depreciable over 39 years, the longest recovery period in the tax code. The recent legislation allows 15-year straight-line depreciation for improvements put into service between October 23, 2004, and December 31, 2005. Qualifying improvements are those made to the interior of a leased commercial building that has been used for three or more years, other than structural components (elevators, staircases) or building enlargements.
Restaurateurs who own their buildings can also adopt the 15-year depreciable life on upgrades they make. It's not restricted to improvements on leased restaurant premises. To qualify, more than half of the building's square footage must be used for preparing meals consumed on site and seating diners. Like the rule for leasehold improvements, the building must be at least three years old. Restaurant improvements placed in service by owners between October 23 and December 31, 2004, are eligible for 50% bonus depreciation.
Changes For 2005
Modified S corporation rules. Two changes permit S corps to beef up their shareholder rosters. First, these businesses can now have as many as 100 stockholders, versus 75 previously. Further, a family can count as just one owner. For this purpose, family includes the common ancestor and spouse plus six generations of lineal descendants and their spouses. That's a lot of great-greats. This special election applies even to family who own the stock through a trust. Pass-through taxation is not impacted by the new aggregation rule. "It only affects the head count," says attorney Paul Carman, a partner in the tax department at Chapman and Cutler in Chicago.
What are the planning opportunities? For starters, says Carman, C corporations may wish to consider converting to S-corp status, although the tax cost to convert is sometimes prohibitive and must be fully explored before acting. Current S corporation owners likely to benefit from the changes include those with gifting plans. It's now easier to gift shares to all the children, grandchildren, great-grandchildren, etc. "Historically, one branch of the family was often forced out," Carman says.
Multi-family enterprises benefit for a similar reason, he adds. The old limitations on shareholders frequently prevented passing the entity to all owners' descendants. "Yet the more successful the business, the more likely that family members want equity, even if they're not interested in working in the business," says Carman.
Other uses: Bringing in outside investors and motivating key personnel. "I have about a dozen S corporation clients who give minority stock positions to employees as an incentive for them to work as owners," says Lindy Karns, a partner in the Lexington, Ky., CPA firm Dulworth Breeding & Karns, LLP. "The new rules allow you to broaden the ownership," she says.
Divorce planning may be impacted by another change. Divorcing spouses now have a reason to bargain for their spouses' S-corporation shares if the business has been a loser but has bright prospects. Under prior law, losses that S-corp owners could not deduct on their personal returns because of limits imposed by their basis in the stock were forfeited upon transfer of the shares to another individual. Now such losses, termed "suspended losses," go with the stock if the transfer is to a spouse or former spouse as part of a divorce decree, according to Grover Rutter, a certified public accountant and owner of Grover Rutter Business Brokerage, Valuation & Consulting in Findlay, Ohio. The recipient of the shares may begin using the suspended losses the year after the transfer.
Suppose the husband in a divorcing couple owns 40% of the stock of an S corporation with total suspended losses of $250,000. If he surrenders half of his interest to his wife in 2005 as part of the divorce settlement, she gets $50,000 of suspended losses (her 20% ownership times $250,000 total suspended losses of the corporation) that she may use starting in 2006 to offset any taxable income passed through to her by the business, says Rutter. That makes the shares more valuable to her than they would have been under the old rules.
Deduction for domestic manufacturing. For 2005, businesses may deduct 3% of the profits they realize on production activities, a figure that will rise to 9% by 2010. A wide range of activities qualify, including construction, film and videotape production, software development and engineering and architectural services. All entity types, as well as sole proprietorships, are allowed the deduction, even if subject to alternative minimum tax. The deduction is limited to 50% of W-2 wages paid by the business during the year. Another limitation: the business's income from qualifying production activities, or total taxable income, if lower.
Experts say that many small businesses will be challenged to retool their accounting systems to capture the data necessary for computing the new deduction. Although the Internal Revenue Service had yet to issue guidance on this provision as of this writing, businesses should reconfigure their accounting as soon as practicable and not wait until next spring when preparing their '05 returns. Says Karns: "Accounting is one of those things that is better, and cheaper, to do correctly from the start rather than after the fact."
Charitable vehicle contributions. Beginning this year, stricter rules apply when a business donates a vehicle that it wants off its books, says Randall Smith, a CPA and partner at Samet & Company PC, in Chestnut Hill, Mass. Now when a charity sells an automobile, boat or aircraft that it received from a donor, the sales price is what the donor deducts-no more simply deducting the blue book value, which in the past frequently exceeded the true market value of donated heaps. Deductions greater than $500 require attaching to the return a statement from the charity that shows the sale date, proceeds and vehicle identification number. The charity must also provide that information to the IRS. These rules are applicable to contributions by individuals, too.
Other Items Of Note
The Working Families Tax Relief Act of 2004 aids business owners by extending a variety of expiring, albeit highly specialized, credits. Several that had already expired were revived retroactive to January 1, 2004, says Smith, including the welfare-to-work credit for taking on employees from disadvantaged backgrounds.
With Social Security benefits looking like they could be cut in the future, prepare clients to fund retirement plans to the limit this year. For 401(k) plans, that's $14,000 ($42,000 for owner-only plans) plus an additional $4,000 for participants born in 1955 or earlier. For individual retirement accounts, the 2005 maximum contribution is $4,000, plus $500 for those 50 or older.
Finally, tell clients that the IRS is back in the audit business, advises attorney Joseph Darby III, a shareholder and head of the corporate tax practice in the Boston office of Greenberg Traurig LLP. "In the 1990s, Congress let the air out of all four tires in the IRS enforcement vehicle by placing a lot of restrictions on the Service. For a while, IRS basically stopped enforcing the law-and everybody knew it," Darby says. But that's no longer the case. You really do have to play by the rules these days, or expect the IRS to come a-knockin'.
Eric L. Reiner, M.B.A., is a tax accountant and business writer who teaches finance at the University of Colorado at Denver.