TAX INCREASE PREVENTION & RECONCILIATION ACT

Congress Approves Tax Reconciliation Bill: $90 Billion in Targeted Benefits & $20 Billion in Revenue Raisers

After months of back and forth negotiations, a House-Senate conference committee released H.R. 4297, the Tax Increase Prevention and Reconciliation Act of 2005 (Tax Reconciliation Act).  The House promptly approved the bill on May 10, 206, by a vote of 244 to 185 and the Senate followed the next day by a vote of 54 to 44.  President Bush is expected to sign the bill as soon as it reaches his desk.

The Tax Reconciliation Act impacts a broad cross-section of taxpayers.  The new law extends the controversial dividend and capital gains tax rate cuts for two more years beyond 2008, gives taxpayers some immediate relief from the alternative minimum tax (AMT), extends small business expensing thresholds, and allows high-income taxpayers a Roth conversion opportunity.  Moreover, it makes over 20 other significant changes.

Conferees worked for many weeks before pressure from Congressional leaders and the White House encouraged an agreement.  While the final bill has undergone many changes since it started as last year’s 2005 reconciliation bill, it still contains $70 billion in net tax cuts.  It also contains $20 billion in revenue raisers that should get the attention of a wide variety of taxpayers.

Comment.  The compromise bill came together after prodding by the White House, which wanted a legislative victory before summer.  Congress has been bogged down with immigration and lobby reform as well as trying to respond to high energy prices.  The official name of this new law carries a “2005” designation because it is in fact a carryover from last year’s budget.  Expectations are that, given mid-term elections, there will be no further tax measures this year under the auspices of the “budget process.”

More on the Way

To reach an agreement, and keep within budget constraints, conferees removed some important provisions which will likely appear in stand-alone legislation, a “trailer” bill, or could be tacked onto the pending pension reform bill.  These additional provisions include: extending the state and local sales tax deduction, the teachers’ classroom expense deduction, R&D provisions, some employment tax credits, and other popular but temporary incentives.

AMT Relief

The Tax Reconciliation Act extends and increases-for 2006 only-the AMT exemption amount for individuals.  It also lessens the sting of the AMT for 2006 by allowing the use of certain nonrefundable personal credits.

Despite dire predictions about the AMT soon becoming the “regular” tax for millions of middle-income Americans, Congress hasn’t found the wherewithal to repeal the AMT or reform it.  The Tax Reconciliation Act, like many tax bills before it, merely provides limited AMT relief.

Higher AMT exemption amounts.

Through December 31, 2006, taxpayers will be able to take advantage of higher AMT exemption amounts.  The AMT exemption amount for married couples filing jointly is $62,550 and for single taxpayers is $42,500.

Impact.  Without this 2006-only retroactive relief, an additional 15 million taxpayers, many of them middle-class, would be subject to the AMT.  Congress will have to face similar “dire consequences” again for 2007.

Comment.  The Working Families Tax Relief Act of 2004 extended the higher AMT exemption amounts through December 31, 2005, but at lower levels ($58,000 for married couples filing jointly and $40,250 for single taxpayers).

Nonrefundable personal credits.

The Tax Reconciliation Act extends through 2006 the provision allowing taxpayers to use nonrefundable personal credits to offset AMT liability.  Nonrefundable personal credits include the dependent care credit, the credit for the elderly and disabled, the credit for interest on certain home mortgages, the Hope credit for certain college expenses and the Lifetime Learning credit.

Dividend and Capital Gains Rate Cuts

No recent tax cut has been as controversial as the dividend and capital gains tax rate cut enacted in 2003.  While the White House and Republicans credit this tax cut with spurring economic growth.  Democrats decry it as a give-away to the wealthy.

Comment.  The dividend and capital gains tax rate cut is so controversial that Republicans knew they could only get it through Congress as part of a tax reconciliation bill, which requires only a simple majority in the House and Senate to pass.  Otherwise, a stand-alone bill would require at least 60 votes in the Senate to pass and no Democrat would sign on. 

In 2003 Congress lowered the maximum dividend and capital gains tax rates – for most, but not all, dividends and capital gains – to 15 percent for qualifying taxpayers.  Taxpayers in the 10- and 15-percent tax brackets are eligible for an even lower rate of five percent.  In 2008, the rate for taxpayers in the 10- and 15-percent tax brackets falls to zero.  As originally enacted, these tax rate cuts were temporary.  They were scheduled to expire at the end of 2008.

The Tax Reconciliation Act extends these cuts for two more years through December 31, 2010.

Reminder.  Not all dividends and capital gains qualify for the lower rates.  Since 2003, the IRS has explained in published guidance which dividends and capital gains are eligible.

Impact.  Extending this tax break represents a significant tax cut for many of those affected.  Once the extension ends in 2011, capital gains will effectively be taxed at a 33.33 percent higher rate (20 percent instead of 15 percent); while those in the highest tax bracket (set to revert to 39.1 percent) will pay over 130 percent more tax on dividends.

Impact.  The extension through December 31, 2010, now aligns the dividend and capital gains tax rate cuts with the tax cuts enacted in the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), including the lower individual marginal income tax rates, marriage penalty relief and temporary repeal of the federal estate tax.  All the tax cuts in EGTRRA will sunset after December 31, 2010, and at this time, it’s anyone’s guess whether Congress will extend them.  The current White House and many Republicans in Congress want to, but many lawmakers, and not only Democrats, believe the country cannot afford them with the federal budget deficit at an all-time high.  Therefore, the possibility of higher tax rates should be considered in any long-term tax strategy.

Capital Gains

Self-created musical works.  The Tax Reconciliation Act allows taxpayers to elect to treat the sale or exchange of self-created musical compositions or copyrights as the sale or exchange of a capital asset.  This special treatment is effective for sales or exchanges in tax years beginning after the President signs the new law and before January 1, 2011.

Caution.  Despite some initial proposals to lower the capital gains tax rate on collectibles, the final bill leaves the current 28-percent tax rate on collectibles unchanged.

Amortization of song rights.  In a related music-industry development, the Act permits a taxpayer that puts any musical composition or musical copyright into service to elect to use the five-year amortization period for certain expenses paid or incurred with respect to all musical compositions and musical composition copyrights placed in service in that tax year.

Impact.  This will allow music publishers to amortize advances they make to song writers over five years.

Small Business Expensing

Since 2003, Congress has enhanced small business expensing under Code Sec. 179 several times to encourage business investment.  The Tax Reconciliation Act continues this special treatment.  The enhanced small business expensing thresholds in the American Jobs Creation Act of 2004 are extended through December 31, 2009.

Comment.  The maximum amount a taxpayer may expense is $100,000 of the cost of qualifying property, reduced by the amount by which the cost of qualifying property exceeds $400,000.  Both amounts are indexed for inflation for tax years beginning after 2003 and before 2010.  These amounts are increased for Gulf Opportunity Zone property.  For 2006, the amounts are $108,000 and $430,000, respectively.  Without the extension, the expensing limit would have dropped to $25,000 on a $200,000 cap after 2007.

Revenue Raisers

Important Changes to Roth IRA’s

The Tax Reconciliation Act eliminates the $100,000 adjusted gross income ceiling for converting a traditional individual retirement account (IRA) to a Roth IRA, for tax years after 2009.  A conversion is treated as a taxable distribution, but is not subject to the 10-percent early withdrawal penalty.  Taxpayers who convert in 2010 can elect to recognize the conversion income in 2010 or average it over the next two years.

Impact.  The elimination of the $100,000 ceiling has higher-income taxpayers and their financial advisors salivating.  High-income taxpayers with substantial amounts in traditional IRAs previously were shut out of the benefits of conversion.  Now, anyone can convert to a Roth IRA.  Many critics are calling the “revenue-raiser” classification of this Roth conversion opportunity for high-income taxpayers a “budget gimmick.”

Reminder.  Contributions to a Roth IRA are not deductible, but the earnings are permanently tax-free.  Also, Roth IRAs have no required minimum distribution at age 70 ½.

Planning strategies.  Most experts believe that such conversions will be advantageous because future tax rates are not likely to go down significantly.  While the provision would raise revenue in the short-term, estimates from the Urban Institute for Tax Policy indicate that the provision is ultimately a revenue drain.

Comment.  The make-or-break factor for many taxpayers, however, will be whether the conversion can be funded outside the converted account or whether the conversion can be funded outside the converted account or whether the individual must dip into the proceeds to pay the tax.  Such withdrawals will be subject to both income tax and early withdrawal penalties.

Impact.  This provision does not extend to 401(k) plans.  However, nothing would prevent Roth IRA conversions of traditional IRAs that have received proceeds of 401(k) balances when an individual leaves employment.  Nor does the new law prevent high-income taxpayers from contributing to nondeductible traditional IRAs now in anticipation of converting to Roth IRAs in 2010.

Impact.  2010 is the last year for the current low income tax rates before they sunset in 2011.  The rush to do Roth conversions in 2010 may be historic, especially if Congress does not extend the lower tax rates.

Offers-In-Compromise

The Tax Reconciliation Act increases the amounts that must be paid by taxpayers submitting an offer-in-compromise.  Under the new law, taxpayers are required to make partial payments of their liability in addition to any user fee now imposed by the IRS; however, the user fee will be applied to the outstanding tax liability.  For a lump sum offer, taxpayers will pay 20 percent of the amount offered.  For an installment payment offer, taxpayers will make their proposed scheduled payments while the IRS considers the offer.  If the IRS fails to process the offer within two years, the offer will be deemed to be accepted.

Impact.  The two-year deadline may provide a significant benefit to taxpayers waiting for the IRS to process their offer.

Kiddie Tax

The kiddie tax rules require a child’s unearned income such as dividends and interest, to be taxed at the parents’ tax rate, which is usually a higher rate.

Under current law, the kiddie tax applies if the child is under age 14, the child has net unearned income over $1,700, and the parent can claim the child as a dependent.  The Tax Reconciliation Act raises the age limit to under 18.

Impact.  This provision is effective immediately, for the entire 2006 tax year.  Parents who had planned to sell a child’s college stock portfolio after age 13 and before entering college have no opportunity now to accelerate that planning technique if the child is over 13.  If the family was planning to postpone a sale until 12008, when the rate for capital gains would be zero, that’s a loss of 15 percentage points on the tax otherwise not due on the sale of stock or other portfolio assets.

Withholding on Government Payments

Effective in 2011, federal, state and local government agencies must withhold three percent on payments for services or property provided by a taxpayer.  Agencies must report the payments and the amount withheld to the IRS.  The new requirement will not apply to payments determined by a needs or income test, such as food stamps or welfare payments.

Tax Shelters

Tax-exempt entities that are parties to tax shelter transactions risk penalties under the new law.  The penalties are imposed on tax-exempt entities and on any entity manager that causes the entity to be a party to the tax shelter transaction.  The tax-exempt entities are subject to disclosure requirements and the parties to a prohibited tax shelter transaction are required to disclose to tax-exempt entities the fact that it is a prohibited transaction.

Comment.  Congress has been particularly concerned about the role of tax-exempts in tax shelters, especially as promoters have been seeking new vehicles for tax shelters.  This provision could be just the first of many that crack down on exempt-organizations that willingly – or unwittingly – participate in abusive transactions.

Information provided by CCH a Wolters Kluwer business, May 11, 2006