New tax legislation extends tax cuts, adds new provisions

After months of negotiations, Congress finally passed and the president signed the $70 billion reconciliation legislation that was authorized last year.

The Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA) has tax savings for many business and individual taxpayers. It also has some tax increases, compliance provisions and accelerations. This newsletter addresses some of the key provisions. This is only a summary. If you have questions, please contact our tax department.

Alternative minimum tax relief

The alternative minimum tax (AMT) was created to ensure that all taxpayers paid their fair share of taxes. Before the AMT was enacted, some taxpayers with significant incomes were able to eliminate or reduce their tax liabilities.

When the regular tax rates were lowered in 2001 and 2003, the AMT rate was not changed. This caused a substantial increase in the number of taxpayers subject to AMT.

Part of the AMT calculation is an exemption designed to help low- and middle-income taxpayers avoid or reduce the amount of AMT.

TIPRA increases the AMT exemption from $58,000 and $40,250 for married and single taxpayers to $62,550 and $42,500 respectively. The increase is designed to keep the number of taxpayers subject to AMT constant.

The increase in the AMT exemption applies only to 2006. Unless there is further action, the AMT exemption will be reduced in 2007 to $45,000 and $33,750, the amounts established in 2001, for married and single taxpayers respectively. Taxpayers should watch for further AMT legislation.

The new tax law also extends, for 2006, the ability of taxpayers to use nonrefundable personal credits such as dependent care and Hope and Lifetime Learning against the AMT.

It is important to recognize that in both cases the provisions apply only to 2006. The estimated cost to extend the AMT fix to 2007 is more than $35 billion.

The AMT will continue to affect many taxpayers, especially those in high-tax states such as Massachusetts, New York and California. Our firm will continue to monitor future changes in this area.

Qualified dividends and capital gains rate

The special lower tax rates for qualified dividends and capital gains were scheduled to expire after 2008. The new tax law extends the lower rates through 2010.

While taxpayers in the top four tax brackets will continue to pay taxes on capital gains and qualified dividends at 15 percent, taxpayers in the bottom two tax brackets will pay no tax from 2008 through 2010. However, because of the change in the “kiddie tax” discussed below, taxpayers will have to plan carefully for capital gains and qualified dividends for minors.

The special rates for qualified dividends and capital gains are now scheduled to expire in 2010 along with the reduced rates for regular tax.

'Kiddie tax'

The kiddie tax provides that a child's net unearned income (dividends, interest, capital gains and pass-through income from partnerships and S corporations), in excess of $1,700 for 2006, is taxed at the parents' tax rate. Because the parents' tax rate is usually higher, this provision raises money for the government.

TIPRA changes the age for the kiddie tax from under 14 to under 18 effective retroactively to the beginning of 2006.

Roth IRA conversion

Many financial planners consider the Roth IRA and its cousin the Roth 401(k) the best retirement planning tools available. The Roth 401(k) is such a good deal that, even though it was authorized in 2001, it was not actually allowed until 2006.

Generally, taxpayers can convert a traditional IRA to a Roth IRA only if their adjusted gross income does not exceed $100,000. The ability to make contributions to Roth IRAs is also limited by a taxpayer's income. These limitations were put in place so high-income taxpayers could not take advantage of Roth IRAs.

As a revenue-raising procedure, TIPRA removes the income test for conversions from a traditional to a Roth IRA for years beginning after 2009. If the conversion occurs in 2010, the taxpayer will have the option of recognizing all the income in 2010 or averaging the income over the next two years.

As 2010 comes closer, we will be providing examples of when the conversion would be beneficial.

Small business expensing

Beginning in 2003, to promote business investment in tangible property, the amount and phaseout threshold for expensing of purchased tangible personal property and certain other assets was significantly increased. The increased amounts were set to expire after 2007. TIPRA extended the increased amounts through 2009.

Production deduction

In another revenue-raising provision, the wage limitation for the production deduction (IRC §199) will be changed effective for years beginning after enactment. As originally passed, the production deduction was limited to 50 percent of the entire business's wages. The deduction is now limited to 50 percent of the wages that are deducted in determining the qualified production activity income.

Withholding on government payments

Beginning in 2011, all federal, state and local governmental agencies will be required to withhold 3 percent of payments made for services or property. The government agencies will report the amount of the withholding and payments made to the IRS.

Other items

Following is a list of some of the other items included in TIPRA. If you have questions concerning these items, contact our tax department.

• Sale or exchange of self-created musical works
• Estimated tax payments for corporations with $1 billion or more in assets
• Simplification of the active trade or business test in tax free spinoffs
• Special tax treatment for settlement funds from superfund distributions
• Changes to amounts that must be paid in submitting an offer-in-compromise to the IRS
• Changes to the housing exclusion of U.S. citizens working abroad
• Risk of penalties for tax-exempt entities that are parties to tax shelters
• Codification of earnings stripping rules
• Information reporting of interest on tax-exempt bonds
• Increase in the amortization period of geological and geophysical costs
• Modification of the Foreign Investment in Real Property Tax Act
• Limitation on spinoffs of certain disqualified investment corporations
• Modification of pooled financing bond requirements
• Repeal of FSC and ETI transition rules for some contracts

Coming attractions

Congress intends to attach tax trailer legislation to the upcoming pension legislation. While it is unclear what items will be included, some items that have expired or will expire shortly may be in the legislation.

• Welfare-to-Work and Work Opportunity Credits
• Archer Medical Savings Accounts
• 15-year amortization of leasehold and restaurant improvements
• Expensing of environmental remediation costs
• Research and development credit
• Option to deduct sales taxes

Our firm will keep track of these important “extenders” for you.