Congress Approves New Tax Cuts Geared Toward Businesses and Individuals

A yearlong effort to repeal the U.S. tax code's foreign sales corporation/extraterritorial income (FSC/ETI) tax regime has culminated in congressional passage of major tax legislation that will give ordinary taxpayers, as well as businesses of all sizes, plenty to think about as well.

The Senate on October 11, 2004, approved the conference report to the American Jobs Creation Act of 2004 (HR 4520) by a vote of 69 to 17, clearing the way for President George W. Bush's signature. This followed action by the House of Representatives late on Thursday, October 7, voting 280 to 141.

The tax measure, at first designed to eliminate what the World Trade Organization (WTO) had declared to be an illegal tax subsidy for American goods sold abroad, also would give individual taxpayers the option of deducting state and local sales taxes on their federal returns, extend favorable treatment for purchases of business equipment, allow many companies an additional deduction on their corporate returns, and provide a cornucopia of smaller tax benefits to everyone from traditional whaling captains in Alaska to the manufacturers of fish-finding sonar.

At its core, the bill would repeal an exclusion for extraterritorial income that had upset European trading partners and that, in the wake of the WTO decision, led to escalating tariffs on U.S. goods sold in Europe. The repeal would phase in over the next three years. As compensation for the lost exclusion, companies would be given a deduction based on their income attributable to domestic manufacturing. This deduction, phasing in between 2005 and 2010, would effectively lower the tax rate on income attributable to domestic manufacturing. The Act also contains an incentive to repatriate foreign earnings.

President Bush supports the bill and is expected to sign it into law.

Basic Plan Ballooned Into Complex Bill

"The basic plan to replace the exemption was simple, but the bill became more expansive, and pretty complex and convoluted in the legislative process," noted Mark Luscombe, JD, CPA, principal federal tax analyst for CCH.

"To gain support for the bill, all sorts of things were tacked on to appeal to specific groups, such as farmers, the film industry, residents of states that don't have an income tax and so on."

For example, while the legislation is supposed to benefit domestic manufacturing, "manufacturing" was expansively defined to include filmmaking, construction, engineering, architectural services and utilities such as natural gas and electricity. Dozens of other "incentives," "reforms" and "simplifications" relating to businesses and agriculture were added. One entire section of the bill is devoted to an industry-financed buyout of tobacco farmers.

However, the bill's cost of $136.2 billion would be completely offset by 61 different revenue-raisers mainly aimed at perceived abuses and tax shelters, including provisions that define the two types of corporate inversions (U.S. companies relocating overseas for tax reasons) and establish different consequences for each type; revise the tax rules for individual expatriates; set penalties for failing to disclose reportable transactions; and extend custom user fees.

In terms of volume, at 650 pages, the bill will be the biggest single piece of tax legislation passed by Congress since 1997's Taxpayer Relief Act. Some 274 Code sections are affected—either amended, added, repealed or stricken, including 34 brand new sections.

Many provisions in the new law require immediate action to maximize benefits. Effective dates, however, are all over the map.

"Tax lawyers will be working overtime, studying every comma in the Act to make sure that their companies and clients qualify to get the maximum benefits from the new law," Luscombe said.

Small Businesses Benefit

While the original impetus for the legislation came from the tax treatment of multinationals, small businesses and individuals will also be affected when it becomes law.

Businesses will be able to directly write off, or "expense," rather than depreciate, up to $100,000 a year (adjusted for inflation since 2003) in equipment purchases during 2006 and 2007 under what is known as Section 179 of the tax code. This level of Section 179 expensing was due to shrink to $25,000 at the end of 2005.

"The difference in these expensing amounts may be insignificant to a large corporation, but could have a real impact on the bottom line of a small, struggling company," said Paul Gada, JD, senior small business tax analyst for CCH. "By making things more affordable from an after-tax perspective, it would also encourage small business to purchase equipment and improve their productivity."

The legislation would narrow a loophole in the expensing rules that allowed the complete write-off of many large SUVs, however. Unlike normal cars, which must be depreciated over several years, SUVs with gross weights of more than 6,000 pounds were eligible for expensing under Section 179. The legislation would provide that only $25,000 of the cost of an SUV may be expensed.

The SUV provision will become effective the day the new bill becomes law.

"There may be a stampede to dealers of heavyweight SUVs, like the Hummer and the Cadillac Escalade," noted Gada. "But even with the new limit, a substantial portion of a new vehicle's cost can be written off through the combination of expensing and depreciation," Gada added.

Other business provisions include reducing the depreciation period for restaurants and leasehold improvements from 39 years to 15 years; reducing foreign tax credit baskets from nine to two and extending the carry forward period to ten years, while limiting the carryback period to one year; and taxing repatriated foreign profits at a 5.25 percent rate.

Individuals Reap Rewards Too

Congress did not forget a number of classes of individuals in forging the American Jobs Creation Act. For example, rural mail carriers would be able to deduct more of the expenses related to the vehicles they use on their routes. People who win employment discrimination suits would be able to deduct their attorney's fees as an above-the-line deduction, avoiding problems with the alternative minimum tax that have arisen under the current rule, which requires the fees to be taken as a miscellaneous itemized deduction. Native Alaskans who incur certain expenses in outfitting subsistence whale hunts would be able to take a charitable deduction of up to $10,000.

But it is generally taxpayers in states with no income tax--or high sales taxes--who make up the biggest group of individuals to benefit from the legislation. Beginning with this year's return and continuing through the 2006 tax year, they would have the option of deducting the state sales and use tax they pay in lieu of the deduction for state income tax.

Taxpayers would have a choice of methods in claiming the sales tax deduction. One method would be to use their actual outlays for state and local sales tax--supported by sales receipts if the IRS were to question the amount in an audit. The other method would be to use tables supplied by the IRS that will assign a deduction amount based on the taxpayer's adjusted gross income, dependents, filing status and state of residence. Taxpayers could add the sales or use tax they paid for a car, boat and "other items" specified by the Secretary of the Treasury to the table amounts.

Congress realized that it was imposing a burden by ordering the creation of these tables so close to the end of the year and the beginning of filing season.

"The conference committee report indicates that they don't expect the Secretary to have the tables ready before the 2005 filing season," Luscombe observed. "Just how people will manage 2004 is anyone's guess at this point."

The sales tax provision will be of greatest interest to residents of states with no income tax, but those living in states with low income taxes might also benefit with passage of the legislation.

"It's conceivable that people who buy a car in a location with a high sales tax and moderate state income tax would do better by foregoing their normal income tax deduction, but until there's a little more clarity on just how the deduction will work, it's hard to know for certain," Luscombe said.

Related items:

Congress Extends Individual and Business Tax Cuts; Adds New Tax Relief

Congress Moves To Make Some Tax Cuts Permanent

Prepare Now for Next Year's Tax Season

Posted September 27, 2004.