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American Jobs Creation Act of 2004
Overview for Individuals and Small or Closely Held Business Owners
By David Cohen and Jack Orrick
The following is a broad overview of the recently passed tax law, the “American Jobs Creation Act of 2004,” which was signed into law by President Bush on October 22, 2004.
Although mainly directed toward large businesses, particularly multinationals, the wide-ranging law has several provisions affecting individuals and small or closely-held businesses.
On the plus side, the new law:
- creates a new deduction – with potentially wide-spread applicability – for businesses having income “attributable to domestic production activities”
- extends previously-enacted increases in the small business “expensing” allowance;
- liberalizes the rules governing S corporations;
- permits itemizers to deduct their state and local sales taxes in lieu of state and local income taxes (effective for tax years 2004 and 2004).
On the minus side, the new law:
- limits the “expensing” allowance for sport utility vehicles (SUVs) placed in service after the new law’s enactment date, to $25,000.00;
- starting January 1, 2004, imposes tighter rules on taxpayers who want to claim a deduction of more than $500.00 for motor vehicles, boats, or airplanes donated to charity;
- imposes tighter rules for documenting charitable contributions of property made after June 3, 2004;
- dramatically toughens the rules for “nonqualified” deferred compensation plans, which are used by business owners and other executives as a supplement to, or in lieu of, the “qualified” retirement plans generally available to a business’s employees.
A brief summary of the above-mentioned changes follows:
Deduction from Qualified Production Activities Income
When fully phased in, the deduction could be as much as 9% of “qualified production activities income,” which, in essence, is the net income attributable to “domestic production gross receipts.” The latter term encompasses much more than income from U.S.-based manufacturing activities. In addition to traditional manufacturers, any business might qualify if it: (1) produces, grows, or extracts, (2) “in whole or in significant part within the United States,” (3) any tangible personal property, computer software, or sound recordings; and (4) derives income from any “lease, rental, license, sale, exchange, or other disposition of” such property.
Other qualifying activities include:
- performing construction in the United States;
- performing engineering or architectural services in the United States for construction projects in the United Sates;
- producing electricity, natural gas, or potable water in the United States;
- producing films for which at least 50% of the total compensation was paid for services in the United States.
Taxpayers eligible for the deduction include individuals and passthrough entities such as S corporations, partnerships, and limited liability companies (LLCs), as well as C corporations.
More than 10% of small businesses will be affected by this provision, according to official estimates, and the Conference Committee report anticipates the need for “extensive additional regulatory guidance.” With the new rule set to go into effect in taxable years beginning after December 31, 2004, such guidance is expected to be high on the government’s priority list.
Small Business “Expensing” Increases Extended
Previous legislation increased the annual allowance for taxable years beginning after 2002 and before 2006 to $100,000 (from $25,000) and the “phaseout” threshold to $400,000 (from ($200,000), with annual inflation adjustments, and added off-the-shelf software as eligible property. For taxable years beginning after 2004, the dollar amount was scheduled to revert back to $25,000.00. The new law extends the increased annual allowance through taxable years beginning before 2008.
S Corporation Rules Liberalized
Several new rules make it easier to qualify as an S corporation or to retain that status. Among other things, the new law:
- treats certain family members as one shareholder for purposes of the limit on the number of eligible shareholders;
- increases the number of eligible shareholders to 100;
- provides relief from inadvertently invalid qualified subchapter S subsidiary (QSST) elections.
Itemized Deduction for State and Local Sales Taxes
Individuals who itemize their deductions can now elect to deduct state and local sales taxes instead of state and local income taxes. Although the principal beneficiaries are residents of states that do not have an income tax, the new deduction provides an alternative for taxpayers living in states that impose both income and sales taxes. The amount of the deduction can be based on actual taxes paid or by using IRS-prepared tables.
This provision is retroactive to January 1, 2004. Therefore, the deduction will be available for individual returns due next April.
Previously, SUVs weighing more than 6,000 pounds were not subject to the limitations imposed on so-called “luxury” automobiles because their weight put them outside the limitation-triggering definition of “passenger” automobiles. The new law creates a separate category for such SUVs (including those rated at a gross vehicle weight of not more than 14,000 pounds) and imposes a $25,000.00 limit on the deduction. This limit will be effective for property placed in service on or after October 22, 2004.
Non qualified Deferred Compensation Rules Toughened
The new law significantly changes the law applicable to non-qualified deferred compensation and imposes potentially large tax penalties for noncompliance. Unless a nonqualified deferred compensation (NQDC) plan meets the requirements of a new tax Code section, amounts deferred under the plan are includible in income back to the time of deferral or, if later, when no longer subject to a substantial risk of forfeiture, and are subject to interest at the underpayment rate plus 1% and a 20% additional tax.
The new law imposes requirements on NQDC plans with regard to participant elections, distributions, acceleration and funding that likely will necessitate amendments to most NQDC plans. A participant must make an election to defer compensation by the end of the taxable year preceding the year in which the employee will perform services for the company. Employees who are newly eligible must elect to defer within 30 days of becoming eligible. For performance-based compensation for services provided over a period of at least 12 months, the election must be made no later than six months before the end of the service period. The plan or the election must include the timing and form of a distribution.
Except as provided by regulations yet to be issued, distributions are permitted only upon the following triggers: (1) separation from service; (2) death of the participant; (3) a specified time or pursuant to a fixed schedule (but not upon a specified event); (4) change in control of the corporation; (5) an unforeseeable emergency; or (6) disability of the participant. Also except as provided by regulations, a plan may not accelerate a distribution. This provision negates such commonly used approaches as “haircuts”, which permit a participant to take a distribution at any time, but the participant must forfeit a portion of his or her account balance over the amount of the distribution.
The new law provisions apply to amounts deferred after December 31, 2004. Earnings on amounts deferred prior to that date generally are not subject to the new requirements. However, if a plan is “materially modified” after October 3, 2004, amounts deferred to a plan generally will be subject to the new law. The new law directs the Treasury to issue guidance within 60 days of the date of enactment that would provide for a limited period of time during which elections as to deferrals made after December 31, 2004, could be cancelled and plans could be amended to conform to the new requirements.
Charitable Deduction Rules Tightened
Obtaining a deduction for the charitable contribution of your car, or a boat or airplane, will be more difficult after December 31, 2004. After that date, the deduction is limited to the amount for which the charity later sells the vehicle. In addition to this limitation on the amount of the deduction, the charity must prepare, and the taxpayer must attach to his or her return, a statement identifying the vehicle and stating the amount for which it was sold. Failure to attach the statement will result in disallowance.
The legislation also includes new limitations on charitable donations of intellectual property, i.e., patents, copyrights and similar property, made after June 3, 2004. Rather than deducting the value of the intellectual property in the year of the contribution, the deduction is limited to unamortized or undepreciated cost. Finally, the new law strengthens the requirements for substantiating contributions of property (excluding contributions of cash or publicly traded stock) made after June 3, 2004. The new law codifies existing IRS rules that require that: (1) certain information be provided on the return if the deduction exceeds $500.00; and (2) the taxpayer obtain a qualified appraisal for property with a value exceeding $5,000.00. There is also a new requirement that the appraisal be attached to the tax return when the deduction exceeds $500,0000.00.
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