The ink was barely dry on President George W. Bush's signature before critics and proponents of provisions in the new tax reconciliation legislation voiced their reactions, and practitioners began studying planning opportunities for their clients.What began life as bipartisan 2005 reconciliation legislation became a political football involving months of negotiations, infighting and eventual compromise before a bill was passed that includes a number of extenders, tax breaks and revenue raisers.
The extenders that didn't make it into the reconciliation bill will presumably be included in a "trailer" bill to follow. Senate leadership intends the trailer to include the college tuition tax deduction and the state and local sales tax deduction.
The chairman of the Senate Finance Committee, Chuck Grassley, R-Iowa, "made a promise to pass the trailer bill, and promises were made to him by other senators," said George Jones, managing editor of CCH's Washington office. "Reconciliation was initially delayed because of the trailer bill, and Grassley said he wouldn't pass it until these assurances were made."
Grassley struck back at Democrats who criticized the "pain" that the bill will cause for middle-class families because of the absence of the tuition deduction.
"I've said many times, on the Senate floor, in the Congressional Record, to anyone who will listen, that no one is abandoning the extension of the college tuition tax deduction," he said. "It's going in the second tax bill under development right now, for inclusion in the pension conference report or any other vehicle that'll get it done quickly and efficiently."
"This is a good midterm election tax bill," said CCH's Jones. "It took care of pressing business - most importantly the AMT patch for 2006 - while managing not to alienate any group despite the benefits being tilted arguably toward the well-off. And with midterm election predictions favoring the Democrats, this could be the last tax-cut train coming out of the station for a while."
Conversion for all!
The Roth IRA conversion provision could end up being "bigger than originally intended," according to Susan Glenn, of counsel in the New York office of Morrison Foerster. "It does not happen until 2010, but the repercussions are significant for very wealthy taxpayers," she said. "The beauty is that you don't have to decide now. You can wait and see what the landscape is in 2010."
The provision eliminates the $100,000 income limit on conversions of traditional IRAs to Roth IRAs, and, for conversions in 2010, allows the taxpayer to average the tax due over two years. "If you do the conversion in 2011, you have to pay all the tax in one year, so there will be a rush to do it in 2010," said Tom Ochsenschlager, vice president of taxation at the American Institute of CPAs. "Not everyone will do it because the average person says, 'Why pay taxes earlier than I have to?'"
"The obvious ones to do it are those with a small balance in their regular IRA, so converting to a Roth won't cost much in taxes," he explained. "And it could be used by those who anticipate very substantial appreciation later on - taxpayers who are relatively young, and expect their IRA to increase significantly by the time they retire."
The provision might also be recommended for those older taxpayers with sizeable amounts in their IRA, Ochsenschlager said. "An older taxpayer with a significant balance who doesn't need it for retirement might use this as a vehicle to pass it to his estate," he said. "There are two advantages: He doesn't have to begin distributions at age 70-1/2, as he would with a traditional IRA, and paying the tax on it up front takes cash out of the estate."
Ochsenschlager noted the disadvantage of having cash in a regular IRA because it all comes out at the ordinary income rate when distributions are made. "In some ways, a regular brokerage account is an advantage, because capital gains are taxed at a 15 percent rate," he said.
"The Roth conversion provision is an unusual situation where Congress is paying for one tax break by giving another tax break, since people making the conversion pay tax at the time of the conversion," said Bob Scharin, senior tax analyst at New York-based RIA. "It's an opportunity for higher-income people to roll over their traditional IRA to a Roth IRA and then not be subject to the required distributions after age 70-1/2. The assets can now continue to grow tax free for a longer period of time."
"Higher-income taxpayers, who under current law cannot make Roth contributions, may contribute now to a nondeductible traditional IRA, and when 2010 rolls around they can convert the balance to a Roth," Scharin noted.
They grow up so fast ...
The change in the "Kiddie Tax" age from 14 to 18 should affect what practitioners will be advising their clients in their financial planning, according to Scharin. "A long-term strategy has been to transfer assets to a child and therefore shift investment income from the parents' high tax bracket to the child's lower tax bracket. Now the window of opportunity for this has been reduced," he said. "The child would need to be at least age 18 to pay the tax at the lower rate, and, of course, once the child is out of school, he or she is earning enough to no longer be in the lower tax bracket."
The use of a child's lower bracket has become mainstream for the upper middle class to save for college, observed CCH's Jones. "Making the age raise retroactive to the first of the year strikes some as unfair, although there's a debate as to whether the mere fact that it was proposed and passed by the Senate last November was fair warning."
"Kids can work at summer jobs when they're 15 or 16 to save for college," added Mel Schwarz, principal at Grant Thornton's national tax office. "Do we want to tell them, 'You can save your money, but if you earn interest on it we'll tax you on Dad's rate and not your rate?' This is a disincentive for teenagers to save the money they've earned."
Some extensions
The two-year extension of Section 179 expensing and the extension of the alternative minimum tax patch were both praised as encouraging small business owners to grow and expand their businesses.
"Allowing small firms to immediately expense critical investments has proven to be a key component of our economic recovery and continued expansion," said Dan Danner, executive vice president of the National Federation of Independent Business. "These increases have put money back into the hands of small-business owners to hire new employees, purchase new equipment and expand their facilities - all significant factors contributing to our robust economy."
The AMT patch is also significant for small business, according to Danner, since the AMT complicates deducting interest on loans that small businesses use for purchases often made under Section 179.
Although not effective until 2011, a provision mandating government agencies to withhold 3 percent on payments for services or property provided by a taxpayer has generated some concern, according to Schwarz. "It's a burden not only to report, but to actually withhold," he said. "It will take a significant amount of work on accounting systems."
Ochsenschlager agreed. "The typical contractor doesn't make 3 percent," he said. "Their margins are very thin. For someone building, say, a bridge, he will have to increase the estimates in his proposal to account for the fact that more than his profit has to be deferred until the bridge is done."
The new law provision for the repeal of the 2004 Jobs Act transition rule was a surprise, according to Washington-based international tax attorney Martin Tittle.
"After the most recent World Trade Organization decision, the party line was that there was no sentiment in Congress to rework any part of the Jobs Act, due to the extensive balancing of competing interests that had gone into its enactment," he said. "This is especially true of the permanent transition relief provided by the binding contract extension of [foreign sales corporation/extraterritorial income] benefits."
"That relief was included because some U.S. businesses, especially lessors with long-term contracts, had to report the total FSC or ETI benefit for each contract at the inception of the contract for financial accounting purposes," he explained. "Removal of the tax asset represented by taking the entire benefit into account at the inception of the contract will cause companies to have to restate their earnings, and that could lead to lower stock prices. Those are the reasons for including it in the Jobs Act to begin with, and why it shouldn't be taken back."
In addition, said Tittle, the act exempts from Subpart F "those dividends, interest, rents and royalties received by one [controlled foreign corporation] to another CFC to the extent attributable to non-Subpart F income of the payor for tax years beginning after 2005 and before 2009. This looks to me like someone with influence wanted the advantage of not having to check the box on the payor."
