American Jobs Creation Act of 2004
By Mike Czarnota, Jim Manning, Gordon Goldie, Bob Koza, Dean Rocheleau

Domestic Producer’s Deduction

The “replacement” for the repealed Extraterritorial Income, or ETI, exclusion is a new deduction based on a percentage of domestic manufacturing income (actually “qualified production activities income,” which includes a number of non-manufacturing businesses).

Qualifying taxpayers — The deduction for domestic producers will be available to taxpayers that have income from the sale, exchange, or other disposition of tangible personal property or computer software that was manufactured, produced, grown, or extracted in whole or in significant part by the taxpayer within the United States. Income from construction activities performed in the United States and from engineering and architectural services performed in the United States for domestic projects also qualifies.

Calculation of the deduction — The deduction is equal to a percentage of a taxpayer’s “qualified production activities income.” Qualified income is essentially gross receipts derived from qualified activities reduced by 1) the cost of goods sold that are allocable to such receipts, 2) other deductions, expenses, or losses that are directly allocable to such receipts, and 3) a ratable portion of other deductions, expenses, and losses that are not directly allocable to such receipts or to other nonqualified income.

For 2005, the deduction is equal to 3 percent of the qualified production activities income. The percentage increases to 6 percent for 2006 through 2009, and to 9 percent thereafter. When fully phased in, the deduction effectively reduces the federal tax on qualified activities by approximately three percentage points for corporations and individual owners of flow-through entities in the highest tax bracket.

Limitations — The deduction cannot exceed the taxpayer’s taxable income for the year determined without regard to the deduction. The deduction is further limited to 50 percent of the wages paid by the taxpayer during the calendar year that ends in such taxable year.

Miscellaneous provisions — The deduction is allowed for alternative minimum tax purposes as well as for regular tax purposes. The owners of a pass-through entity may claim this deduction by taking into account their proportionate shares of the entity’s qualified production income. Affiliated corporations that are eligible to file a consolidated federal tax return are treated as a single taxpayer when computing the deduction. In addition, the definition of an affiliated group is modified to include any corporation that is at least 50 percent owned by another corporation or affiliated group. The deduction is allocated among the members of the group in proportion to their individual shares of qualified production income.

New Limitations on Executive Compensation

Nonqualified Deferred Compensation

Recent news has highlighted a number of abuses related to executive compensation. This adverse publicity has prompted several important changes to the rules that govern the taxation of nonqualified deferred compensation plans. All plans and practices related to deferred compensation should be reviewed before the end of the year to evaluate compliance with the new requirements. The following is a brief summary of changes regarding deferral elections, funding methods, distribution timing, and other items:

• Elections to defer compensation for a tax year must generally be made before the beginning of that tax year. In the case of performance-based compensation, the election can generally be postponed until six months before the end of the service period.
• The election of a particular form of distribution (lump sum, installment payments, etc.) must generally be specified at the time of deferral.
• Distributions must be made at a specified time or pursuant to a fixed schedule that is established when the deferral election is made. The plan may also provide for distributions upon separation from service, disability (as defined in the act), unforeseeable emergencies (strict criteria apply) and, to the extent provided in future IRS guidance, changes in the ownership or control of the employer.
• Distributions cannot be accelerated, and severe restrictions apply to postponements.
• Compensation that is deferred is generally required to be reported on the participant’s Form W-2 or Form 1099, even if it is not currently taxable.
• Importantly, amounts that have been deferred (earned and vested) before Jan. 1, 2005 under existing plans are not subject to these new rules unless material modifications are made after Oct. 3, 2004. However, amounts deferred after Dec. 31, 2004 under existing plans, as well as amounts deferred under new plans, will be subject to the rules.

Exempt Plans — The requirements do not apply to qualified retirement plans. The committee reports indicate that bonuses and other annual compensation paid within 2 ½ months after the end of the year earned are not subject to the new rules. In addition, vacation, sick leave, disability, and death benefit plans are specifically exempted.

Consequences of noncompliance — The consequences of noncompliance are stiff. Unless the requirements are satisfied, previously untaxed amounts for all prior years must be currently included in income to the extent that they have become “vested.” Interest at the federal underpayment rate plus one percentage point is imposed based on the tax that would otherwise have been incurred in any earlier year. Moreover, the amount required to be included in income is subject to an additional 20 percent tax. The statute gives the Treasury Department authority to prescribe additional rules and exceptions within the spirit of the act, and directs it to issue guidance within 60 days regarding the amendment of existing plans to comply with the new rules.

Additional Revenue Raisers

Transfers of loss property to corporations — If the fair market value of property transferred to a corporation in a tax-free transaction is less than its adjusted cost basis, the corporation must generally reduce the tax basis of these contributed assets to their fair market value. Alternatively, the transferor and the corporation can elect to reduce the transferor’s basis in the company’s stock.

Transfers of loss property to partnerships — If a partner transfers property with a fair market value less than its adjusted tax basis to a partnership, the loss attributable to the property can only be taken into account by the transferor, and not by other partners.

Mandatory basis adjustment for partnerships — A mandatory downward adjustment is required to the basis of partnership assets if there is a sale or exchange of a partnership interest or a liquidating distribution when the adjusted basis of the partnership’s assets exceeds their fair market value by more than $250,000.

Charitable contributions of automobiles and other vehicles —
The charitable deduction for the contribution of a motor vehicle, boat, or airplane with a value in excess of $500 is generally limited to the amount that the charitable organization receives from the subsequent sale or other disposition of the vehicle. This rule applies to donations made after 2004. Special rules apply if the vehicle will be retained and used by the charity. Charitable organizations are required to provide a contemporaneous written acknowledgement that contains specified information to both the donor and the IRS. Significant penalties are prescribed for failures to comply.

Charitable contributions of intellectual property — The charitable contribution deduction for gifts of patents and other intellectual property is generally limited to the taxpayer’s adjusted cost basis in the property for contributions made after June 3, 2004. Taxpayers may be allowed to claim additional deductions if the charitable organization derives income from the subsequent licensing or sale of the property.

Definition of controlled corporate group — The definition of a controlled group of corporations that must share the lower corporate tax brackets and the alternative minimum tax and accumulated earnings tax exemptions is expanded. Under the new definition, which applies to tax years beginning after Oct. 22, 2004, corporations are treated as related “brother-sister” companies if five or fewer individuals, estates, or trusts own (directly or indirectly) more than 50 percent of the voting power or value of the stock of the companies, taking into account their ownership only to the extent that it is identical with respect to each corporation. Because of the indirect ownership rules, subsidiary corporations that are less than 80 percent owned may still be treated as controlled “sister” companies.

Tax Withholding on Bonuses — Once supplemental wage payments to an employee exceed $1 million during a calendar year beginning after 2004, federal tax must be withheld at the highest individual income tax rate.

Like-kind Exchange and the Sale of a Principal Residence — The gain on the sale or exchange of a principal residence may not be excluded from income if the principal residence was acquired, within five years, in a like-kind exchange in which any gain was not recognized.

Depreciation and Amortization of Business Assets

50 percent bonus depreciation — The first-year bonus depreciation rules are extended to cover certain noncommercial aircraft placed in service during 2005.

Section 179 business expensing — The rule that permits businesses to deduct up to $100,000 of depreciable personal property per year is extended through tax years beginning before 2008 and is now indexed for inflation. Previously, the increased amount was scheduled to be eliminated for years beginning after 2005. However, the act also reduces the maximum depreciation deduction for large sport utility vehicles from $100,000 to $25,000 for vehicles placed in service after Oct. 22, 2004.

Depreciation of leasehold improvements — Qualified leasehold improvements made to nonresidential real property can generally be written off over 15 years on a straight-line basis (rather than 39) if they are placed in service after Oct. 22, 2004 and before 2006. Qualified improvements must be made pursuant to the terms of a lease, be attributable to space used exclusively by the lessee, and be placed in service more than three years after the building was first placed in service.

Depreciation of restaurant improvements — Qualified improvements to restaurant buildings may now be depreciated over 15 years on a straight-line basis, rather than 39 years, if they are placed in service after Oct. 22, 2004 and before 2006. Qualified improvements will also be eligible for 50 percent bonus depreciation if they are placed in service before 2005. Improvements must be made to buildings that are used more than 50 percent (based on square footage) for the preparation, seating, and consumption of prepared meals, and which have already been in use for at least three years.

Start-up and organizational expenses — Until now, costs incurred to form a company or to start a new business venture could generally be amortized over a 60-month period. The new act permits up to $5,000 of costs incurred after Oct. 22, 2004 to start a new business, or to organize a new corporation or partnership, to be deducted in the year that business begins. The allowable deduction is phased out if the total start-up or organizational costs exceed $50,000. Costs that are not currently deductible must be amortized over 15 years (instead of 60 months).

Environmental remediation costs — Section 198 deductions for qualified environmental remediation costs are extended through Dec. 31, 2005 (by The Working Families Tax Relief Act of 2004).

S Corporation Reforms

Several rules related to S corporations have been liberalized. Except as otherwise noted, the following changes apply to tax years beginning after Dec. 31, 2004:

• The number of permissible shareholders is increased from 75 to 100.
• A new election enables up to six generations of a family (plus their spouses) to be counted as a single shareholder.
• Suspended losses may be transferred between divorcing spouses.
• The IRS is permitted to provide relief for invalid “QSUB” elections and inadvertent terminations.
• S corporation distributions made after Dec. 31, 1997 can generally be used by employee stock ownership plans to repay certain loans.
• For purposes of determining the potential current beneficiaries of a trust that elects to be treated as a small business trust, or “ESBT,” unexercised powers of appointment may be disregarded.

Individual Tax Benefits

Sales Tax Deduction — The act permits taxpayers to elect to deduct state sales taxes instead of state and local income taxes for 2004 and 2005. The sales tax deduction may be claimed for the actual amount of taxes paid during the year, or may be based on tables to be published by the IRS. Individuals who use the tables may also deduct taxes paid on purchases of automobiles, boats, and other items specified by the IRS.