On May 17, President Bush signed into law the Tax Increase Prevention and Reconciliation Act of 2005 (Act), a $70 billion tax package. The short title refers primarily to provisions that extend reduced tax rates on capital gains and dividends, enacted part of the American Jobs Creation Act of 2004, and to provisions designed to reduce the reach of the alternative minimum tax (AMT) by indexing the AMT exemption amounts. Of course, the Act contains numerous other tax provisions, including multiple “revenue offset provisions,” i.e. provisions that attempt to offset revenue losses from the extension of reduced capital gain and dividend rates and AMT relief.
Individual Provisions
Extension of Reduced Capital Gain and Dividend Rates
The preferential tax rates enjoyed by individuals on adjusted net capital gains and qualified dividends is extended through tax years ending on or before December 31, 2010. The preferential rates were set to expire after tax years ending on or before December 31, 2008.
AMT
To prevent more middle income taxpayers from falling into the alternative minimum tax, the Act contained modest adjustments to the thresholds for the application of the individual AMT exemption amounts.
AGI Ceiling on IRA to Roth IRA Conversions Removed after 2009
For tax years beginning after December 31, 2009, a taxpayer can convert an IRA to a Roth IRA regardless of the taxpayer’s modified adjusted gross income. Current law allows a taxpayer to effect the conversion only if modified adjusted gross income does not exceed $100,000. The advantage of a Roth IRA over a traditional IRA is that qualified distributions are not taxed. Additionally, Roth IRAs are not subject to the minimum distribution requirements of Section 409(a)(9)(A). However, taxpayers who elect to convert a traditional IRA to a Roth IRA will be taxed on the full balance of the IRA being converted in the year of the conversion, except for a conversion in 2010, in which case half of the income is includable in gross income in 2011 and the other half in 2012.
Required Payment with Offer-in-Compromise
Effective for offers-in-compromise submitted on or after July 16, 2006, taxpayers must submit partial payment (up to 20%) to the IRS while their submission is under consideration. The wording in the legislation seems to suggest that the mandatory deposit would not be returned if the offer is refused.
Because taxpayers might lose this deposit if the offer is allowed, the new law may discourage many taxpayers from entering into the program and getting a fresh start.
Business Provisions - Domestic
New Estimated Tax Payment Schedule for Certain Corporations
Corporations with assets of at least $1 billion will face a modified schedule of estimated tax payments starting with estimates due in July, 2006. Payments due in July, August and September of 2006 are increased to 105% of the payment otherwise due, and the next required payment is reduced accordingly. Payments due in July, August and September of 2012 are increased to 106.25% of the payment otherwise due, and the next required payment is reduced accordingly. Finally, payments due in July, August and September of 2013, are increased to 100.75% of the payment otherwise due, and the next required payment is reduced accordingly.
Modification of Section 199
An important limitation to the new production activities deduction is the amount of W-2 wages incurred by the taxpayer. That is, the amount of the deduction is capped at 50% of a taxpayer’s W-2 wages. The Act modified the definition of W-2 wages to not include any amount that is not properly allocable to domestic production gross receipts. The Act also repeals the two times 3 percent QPAI limitation for pass-through entities. The new definition is effective for taxable years after May 17, 2006.
This new modification may have an effect on taxpayers engaged in industries that are heavily dependant on independent contractors (whose wages do not qualify for the limitation) and were depending on the W-2 wages of individuals (i.e. management) whose activities are not properly allocable to domestic production gross receipts.
Withholding on Certain Government Payments
The Act has imposed a 3 percent withholding on certain payments made by the federal government and every state government to persons providing property or services, regardless of whether the government entity making the payment is the recipient of the property or services. The provision applies to payments made after December 31, 2010.
This will have a major cash flow impact on government contractors. The question that arises is whether governmental entities will be ready to impose the new withholding tax by 2010.
Active Trade or Business Test for Corporate Spin-Offs
The Active Trade or Business test has been amended to provide that “all members of such corporation’s separate affiliated group shall be treated as one corporation.” The second sentence of Section 355(b)(3)(B) explains that “a corporation’s separate affiliated group is the affiliated group which would be determined under section 1504(a) if such corporation were the common parent and section 1504(b) did not apply.” Taxpayers have long requested this rule in order to avoid the somewhat artificial movement of assets around a group prior to a distribution.
The transition rules provide that the new test can be used for distributions pursuant to a transaction that is entered into or announced in an SEC filing after the date of enactment, and before December 31, 2010. By its terms it does not apply if a request is pending with the IRS to rule on a proposed transaction. However, the IRS may consider applying the new rule, if the taxpayer requests.
Cash Rich Split Off
A new provision has been added to Section 355 that states that Section 355 does not apply to distributions of “disqualified investment companies.” In order for the provision to apply, the split-off must be to a person that holds a “non-historic” 50 percent or great interest in the “disqualified investment company.”
For purposes of this new provision, a corporation is a “disqualified investment company” if 2/3 or more of the fair market value of all the assets of the corporation are investment assets (cash, marketable securities, partnership interests held for investment, debt instruments and other investment assets). There are transition rules for distributions prior to December 31, 2006 (generally changing 2/3 to 3/4). In addition, exceptions are available for companies whose business involves buying and selling investment assets. Also, if the company owns 20 percent or more of a subsidiary, then a look through to the underlying assets is undertaken to determine whether or not the entity is a “disqualified investment company.”
There is broad regulatory authority to carry out this new provision.
Business Provisions - International
Look Through Rules for FPHCI for Section 951 Inclusions - A Three-Year Window
In a stunning development, for tax years that begin after December 31, 2005 and end before January 1, 2009, dividends, interest, rents and royalties received by one controlled foreign corporation (CFC) from a another commonly controlled CFC will NOT be foreign personal holding company income (FPHCI), even if the CFCs are not in the same country, to the extent the income is allocable to non-subpart F income of the paying CFC. For this purpose, interest includes income from factoring of receivables.
Active Finance Exception to FPHCI is Extended
The active finance exception to FPHCI income is extended through 2008. This extension is important to the financial-services industry.
Earning Stripping Rules
The earnings stripping rules limit the ability of a U.S. corporation to deduct interest paid to a related foreign person. The limitation is based in part on the debt to equity ratio of the U.S. Corporation. The Act confirms that the liabilities of a U.S. corporation include liabilities of a partnership in which a U.S. corporation is a partner, effectively codifying existing proposed regulations. The effective date is for tax years that begin after May 17, 2006
Repeal of FSC/ETI Binding Contract Relief
The general transition rules remain in effect for the repeal of extra terrestrial income regime (ETI). The Act repeals, however, the transition rules that allowed the use of a foreign sales corporation (FSC) and/or the ETI benefits on a going forward basis if: (i) the transactions were in the ordinary course of business; (ii) were pursuant to a binding contract between the taxpayer and an unrelated person; and (iii) the contract was in effect on September 17, 2003 at all times thereafter. A similar rule allowed for the long-term continuation of FSC benefits when the FSC rules were repealed in 2000. The FSC binding contract rules was also repealed by the Act.
Modifications for Individuals Living Abroad - Impacts the 2006 Tax Year
The amount of base compensation that can be excluded from U.S. taxable income under Section 911 of the Code is now indexed for inflation starting in 2006, a year ahead of schedule, which increases the exclusion for 2006 to $82,400 from $80,000. However, income in excess of that amount is now taxed at the rates that would apply if the $82,400 were not excluded, for both income and AMT purposes. In addition, excludable foreign housing expenses are now limited to 30% of the maximum amount of a taxpayer’s foreign earned income exclusion. Assuming an employee is present outside the US for the entire year, the maximum amount of the foreign housing cost exclusion for 2006 is $11,536. These changes will not only have an effect on a US citizen working abroad; it will have a major impact on the costs corporations typically incur in sending executives abroad.
Pepper Perspective
Although the focus of the Act was to extend popular tax breaks afforded individuals, Congress enacted several revenue raising provisions that affect corporations including the current acceleration of corporate estimated tax payments. Congress has also chosen some provisions to ease taxpayer burden and what was thought to be unnecessary restructuring in simplifying the active trade or business test of Section 355. With careful review, there may be some tax planning and restructuring opportunities from the new international look through rules that are effective for taxable years 2006-2008.
Joan C. Arnold, Annette M. Ahlers, Todd B. Reinstein and Michiel Muizelaar
