Tax and Business Alert - December 2004

New Tax Bill Saves Popular Tax Breaks

By overwhelming margins in both federal chambers, the House and Senate approved the Working Families Tax Relief Act of 2004 (the Act). The Act doesn't blaze any new trails, but, instead extends the expiration of numerous tax provisions. A host of technical corrections were thrown in for good measure. The major individual provisions of the Act are highlighted below. See the related article on page two for information on the business provisions of the Act.

Standard Deduction on a Joint Return. The standard deduction for a married couple filing a joint return in 2005 was scheduled to drop to 174% of the deduction for a single taxpayer (from 200% in 2004) before rising back to 200% in 2009. The Act raises the standard deduction on a joint return in 2005 through 2008 to twice that on a single return. Thus, the estimated standard deduction for a 2005 joint return is $10,000.

AMT Exemption. The 2004 alternative minimum tax (AMT) exemption amounts of $58,000 (joint), $40,250 (single), and $29,000 (married filing separately) were scheduled to drop to $45,000, $33,750, and $22,500, respectively, in 2005. The Act retains the higher 2004 amounts for 2005.

10% Tax Rate Bracket. For 2004, the 10% tax bracket applies to the first $7,150 of taxable income for single taxpayers and the first $14,300 of taxable income on a joint return. For 2005 through 2007, the upper end of the 10% bracket was scheduled to drop to $6,000 (single) and $12,000 (joint) before increasing to $7,000 and $14,000 in 2008 (adjusted for inflation after 2008). The Act resets the size of the 10% bracket for 2005 through 2010 at the 2003 level ($7,000 for single individuals, $10,000 for heads of households, and $14,000 for married individuals filing a joint return) with annual indexing after 2003. Thus, for 2005, the end of the 10% bracket is projected to be $7,300 for singles, $10,450 for heads of households, and $14,600 for joint returns.

15% Tax Rate Bracket. The 15% tax bracket on a joint return was scheduled to fall to 180% of that of a single taxpayer in 2005 (from 200% in 2004) before rising back to 200% in 2008. The Act increases the size of the 15% bracket to twice that on a single return for 2005 through 2007. Thus, the end of the 15% bracket in 2005 is projected to be $59,400 on a joint return and $29,700 on a single return and married filing separate return.

Child Tax Credit. For 2004, an individual may claim up to a $1,000 tax credit for each
qualifying child under age 17 at the end of the year. The maximum credit was scheduled to drop to $700 for 2005 and eventually increase back to $1,000 by 2010. The Act increases the child credit to $1,000 for 2005 through 2009. The Act also accelerates to 2004 the increase in refundability of the child credit to 15% (up from 10% now) of the taxpayer's taxable earned income in excess of $10,750 (including combat pay).

Business Provisions of the 2004 Tax Act

The Working Families Tax Relief Act of 2004 (the Act) extends the effective date for numerous tax provisions affecting businesses, but otherwise does not make any changes to them. Notable within the Act is the extension of various tax credits including the Research Credit, Work Opportunity Tax Credit, Welfare-to-work Credit, Credit for Electricity Produced from Certain Renewable Resources, Credit for Qualified Electric Vehicles, and Indian Employment Tax Credit.

Also extended were provisions related to:

Extension of parity in the application of certain limits to mental health benefits.

Qualified Zone Academy Bonds.

Payment of excise tax on distilled spirits to Puerto Rico and Virgin Islands.

Charitable contributions of computer technology and equipment used for educational purposes.

Expensing of environmental remediation costs.

New York Liberty Zone provisions.

Tax incentives for investment in the District of Columbia.

Combined employment tax reporting.

Suspension of 100%-of-net-income limitation on percentage depletion for oil and gas from marginal wells.

Accelerated depreciation for business property on Indian reservations.

Disclosure of return information relating to student loans.

Deduction for qualified clean-fuel vehicle property.

Disclosure relating to terrorist activities.

Extension of Archer Medical Savings Accounts (MSAs).

Gift Coupon is Not an Excludible Fringe Benefit

De minimis fringe benefits include goods and services that have a small (nominal) value where accounting for the item is unreasonable or administratively impractical. This type of benefit is usually tax-free to the employee. However, cash or gift certificates provided to employees generally will not qualify as de minimis (tax-free) benefits.

In a recent technical advice memorandum related to a specific taxpayer's situation, the IRS concluded an employer's $35 holiday gift coupons, redeemable at a certain grocery store, were taxable to the employees and subject to employment taxes and withholding. In the memorandum, the IRS stated "There are no facts that indicate it is administratively impractical for the taxpayer to properly account for (the coupon)... In this case, there is no difficulty in determining the value or accounting for it; each employee that received a gift coupon received a cash equivalent fringe benefit worth $35.

Deferring Income Using Annuities

The popularity of commercial annuities can be attributed to several factors including the level of income tax rates and an aging population's growing need for a retirement vehicle that will keep pace with inflation. An annuity contract with an insurance company can provide for an immediate annuity (the first annuity payment is due after the initial or single premium is paid) or a deferred annuity (the first annuity payment is due a specified number of years after the initial or single premium).

A commercial individual annuity contract may be purchased through investment advisors, insurance agents, brokerage firms, banks, or mutual fund companies or by paying premiums directly to an insurance company. Payments may be made over time or with a single premium. Earnings on the invested premium accumulate tax-free until withdrawals by the annuitant begin. The investor may choose to purchase a fixed-rate annuity, which will earn a rate of return set by the insurance company, or a variable annuity, which allows the investor to choose how premiums are invested, potentially maximizing return.

A tax-deferred accumulation of earnings within an annuity is similar to a traditional (non-Roth) individual retirement account (IRA). Individuals who (1) have made maximum contributions to their 401(k) plans through their employer, (2) are not eligible to make deductible contributions to traditional IRAs or nondeductible contributions to Roth IRAs, or (3) want to set aside amounts in excess of the annual IRA limitation may find annuities particularly attractive. In addition, most annuities allow the investor to choose among several payout options.

Variable Annuities. In reality, variable annuities are mutual funds with an insurance wrapper that shelters income from current taxation. A typical variable annuity allows the investor to put funds in stock, bond, and money market portfolios (called subaccounts by the insurance companies that sell the annuities). The investment options are limited only by the flexibility of the insurance company.

An annuity's earnings are normally not taxed at the point they are earned, but are tax deferred. Thus, the ability to defer tax makes annuities an attractive investment. Ultimately, though, the portion of any annuity payout that does not represent a return of capital is subject to tax as ordinary (rather than capital gain) income.

Variable annuity payouts (like fixed annuities, discussed below), are taxed partly as income and partly as a return of principal. The recovery of principal (the investment portion of the payout) is excluded from income. A death benefit received by a beneficiary when the annuitant dies before the annuity starting date is normally subject to income tax to the extent of gain (i.e., the death benefit minus the net premiums paid for annuities purchased after October 20, 1979).

Fixed Annuities. Fixed annuities pay a fixed amount (on the principal invested) based on the time value of money. In contrast, the value of a variable annuity can change (increase or decrease) depending on the performance of the investment portfolios linked to the annuity. Generally, fixed annuities can only lose value if the issuer becomes insolvent.

The purchaser of a fixed annuity contract obtains a tax basis (or cost) in the plan. Technically, this is the participant's investment in the contract. When distributions are made from the annuity, the portion categorized as earnings is taxed as ordinary income. Because the investor has already paid taxes on the original investment, the portion of any distributions categorized as return of principal is not subject to tax.

Selecting the Appropriate Entity for Your Business

A principal consideration for any business, whether new or existing, is choosing an appropriate legal entity. Available options in most states include C corporations, S corporations, general and limited partnerships, limited liability companies (LLCs), limited liability partnerships (LLPs) and sole proprietorships.

Each type of entity has various advantages and disadvantages. One issue to consider is tax savings. The proper entity can minimize self-employment and income taxes. Understanding the total tax situation, including income tax, payroll tax, and estate tax exposure is essential in making the choice-of-entity decision.

Personal liability protection is often and owner's main objective in choosing the appropriate entity. Operating as a proprietorships or general partnership renders the owner liable for the business debts. Limited partnerships, LLCs, LLPs, and S and C corporations provide liability protection for the owners. For sole owners, the single-member LLC is becoming the popular liability-limiting alternative to a proprietorship.

If a business is owned by more than one individual, it cannot be run as a proprietorship. If all owners provide management services, a limited partnership is not a viable option because this (providing management services) would jeopardize their status as limited partners. Other entity types do offer management by multiple individuals without limitations.

Capitalization of the business through outside sources may also be an objective. When issuing ownership interests, it is important to identify preferences regarding voting versus nonvoting status of investors as well as the method of return desired by investors - equity growth or current income distributions.

In many cases, a change in entity status is sought to accomplish a transition in ownership. Whether the objective involves moving ownership to a successor via gifts, an installment sale, a stock redemption, a bequest, or a combination of methods, it is often necessary to use a different form of entity to meet these objectives.

Each entity selection situation is unique. The business owner's objectives must be systematically matched with the various entities' attributes. All major tax and nontax issues must be considered and alternatives explored before choosing the appropriate structure for your business.