Tax Act Spells Tax Relief For Some Family Businesses

December 17, 2004

On Oct. 22, 2004, President Bush signed into law the American Jobs Creation Act of 2004 (AJCA).  The AJCA is the fifth major tax act passed by Congress in the last four years and the second within the period of a month (President Bush signed the Working Families Tax Relief Act of 2004 into law on Oct. 4, 2004).

Passage of the AJCA was not motivated by an attempt to simplify the Internal Revenue but rather by the need to repeal the extraterritorial income exclusion provisions of the Code ( called the "ETI Regime") that the World Trade Organization (WTO), at the behest of the European Union, found to be a prohibited export subsidy.  Instead of just passing a tax relief program to replace the ETI Regime in a manner that would be WTO-compatible, Congress decided to add other revenue raising provisions, that focus on, among other things, corporate tax shelters and international tax loophole closers, which in turn allowed Congress to pass a revenue-neutral package that will provide an estimated $137 billion in tax relief to taxpayers over 10 years.  In short, the AJCA probably provides the most sweeping business tax changes since the Tax Reform Act of 1986, with 34 new sections being added to the Code and another 274 Code sections being affected.

So, which businesses, if any, are the biggest winners in receiving tax relief?  Setting aside businesses in industries for which "special interest" legislation succeeded in getting passed (of which there are numerous instances), the answer would be those businesses which are involved in "domestic manufacturing."  Of the $137 billion in tax relief, $76 billion is projected to come from a new deduction for domestic manufacturers equal to a portion of their "qualified production activities income."  The portion deductible is phased in over six years and starts at 3 percent for the years 2005-2006, increases to 6 percent for the years 2007-2009, and then hits 9 percent in 2010 and later years.

Fortunately for taxpayers, Congress chose to broadly define domestic manufacturing to include not only the production of tangible personal property in the U.S. but also the production of certain other types of property in the U.S. including computer software, certain sound recordings, qualified films, electricity, natural gas and potable water (and receipts from these items qualify whether the receipts are from their sale, exchange, lease, rental, license, or other disposition).  Domestic manufacturing also includes construction performed in the U.S. as well as engineering and architectural services performed in the U.S. for construction projects in the U.S.  Because of this very broad definition, there is already much speculation as to what all may legitimately qualify. If  an activity is eligible, the amount of the new deduction is calculated by taking the gross receipts from such activity, subtracting the costs of goods sold that are allocable to such receipts, other deductions or expenses that are directly allocable to such receipts and a proper share of other deductions and expenses which are not directly allocable to such receipts or another class of income and then multiplying the net by the applicable percentage based upon the taxable year.

The deduction as so calculated is subject to two limitations.  First, it cannot exceed the taxpayer's taxable income for the taxable year.  Second, it cannot exceed 50 percent of the W-2 wages paid by the taxpayer to its employees during the calendar year that ends in its taxable year (with addbacks to the W-2 being permitted for elective deferrals made by employees to certain retirement plans and for certain other types of deferred compensation).  This last limitation may have implications for choice of entity considerations if it looks like the limitation might apply in that self employment income is not counted as W-2 wages paid.  As such, operating a business as a corporation with salaries being paid to the owners may result in a larger deduction than if the business is operated as a partnership or limited liability company that generates self employment income for the owners.

The new deduction is available whether the domestic manufacturer operates as a C corporation or as a pass-thru entity.  If it is a pass-thru entity, however, the deduction is applied at the shareholder or partner (member) level.  Many additional rules apply to this new deduction (for example, for affiliated groups and for the alternative minimum tax) adding to its complexity.  There are many unanswered questions with respect to it as well, particularly with respect to what all qualifies as “domestic manufacturing”, which will both provide planning opportunities as well as fodder for disputes with the IRS.

The practical effect of this new deduction for those who qualify is a reduction in tax rates.  Generally speaking, if tax rates are decreasing in the future, smart tax planning would have a taxpayer defer income into later years and accelerate deductions into the current year.  One way to accelerate deductions (and another way to enjoy some of the tax relief provided in the AJCA) is to take advantage of the more generous depreciation allowed for leasehold improvements.  The AJCA provides that qualified leasehold improvement property placed in service after Oct. 22, 2004 and before Jan. 1, 2006, is 15-year MACRS property with a 15 year recovery period (rather than 39 year property) but the taxpayer must use straight line depreciation.  Note that this provision is available for all businesses and not just domestic manufacturers.

The AJCA includes a number of other provisions that may be advantageous to closely held businesses and their owners.  First, the AJCA extends for an additional two years the changes made to the Code section 179 expense allowance by the Jobs and Growth Tax Relief Reconciliation Act of 2003.  Under section 179, taxpayers may elect to deduct the cost of eligible property up to a certain dollar limit per year which limit is in turn reduced dollar-for-dollar when total assets placed in service during the year exceed an investment limit.  For tax years 2003, 2004, 2005, 2006 and 2007, the Code section 179 dollar limitation is $100,000, up from $25,000, and the investment limit is $400,000, up from $200,000 (both numbers are adjusted for inflation).  Second, if a taxpayer happens to be in the restaurant industry, AJCA gives a 15-year MACRS recovery period to "qualified restaurant property" placed in service after Oct. 22, 2004 and before Jan. 1, 2006 (shortened again from 39 years).  “Qualified restaurant property” is generally an improvement to a building if the improvement is placed in service more than three years after the date the building was first placed in service and more than 50 percent of the building's square footage is devoted to preparation of and  seating for on-premises consumption of prepared meals.

Another advantageous provision benefits those corporations which have not been eligible to make an S election (resulting in pass-thru tax treatment) because they have more than 75 shareholders.  The AJCA not only increases the permissible number to 100 but also permits members of a "family" to be counted as one shareholder.   Corporations that have not had reason to look at being an S corporation because they were ineligible may find this election to be quite attractive.

Finally, taxpayers will be well served if they take steps to avoid some of the revenue raising provisions added to the Code.  For example, the AJCA has added section 409A that tightens up the rules on nonqualified deferred compensation plans.  Failure to comply with the new requirements (which are effective for income deferred after 2004) will result in the participant being subject to accelerated taxation on the deferred amount, plus a penalty tax equal to 20 percent of the compensation that is required to be reported, plus, if the deferred compensation should have been reported in an earlier year, underpayment interest relating back to the earlier year.  Importantly, these new rules are not limited to nonqualified plans for employees but also cover deferred compensation of outside directors and independent contractors.

Another revenue raising provision to watch out for relates to the definition of a brother-sister controlled group.  Taxpayers who have taken advantage of conducting business through multiple C corporations and structured the ownership of them to achieve multiple lower tax brackets or accumulated earnings tax credits, risk losing these benefits and will thus pay more tax.  The AJCA broadens the definition of brother-sister corporations by eliminating the 80 percent test.  As a result, for tax years beginning after Oct. 22, 2004, for purposes of separate tax brackets, accumulated earnings tax credits and the minimum tax, a "brother-sister group" means two or more corporations if five or fewer persons who are individuals, trusts or entities own stock possessing more than 50 percent of the total combined voting power of all classes of stock entitled to vote, or more than 50 percent of the total value of all stock, taking into account the stock ownership of each person only to the extent the person owns stock in each corporation.

While there are many provisions that will provide tax relief for closely held family businesses in the AJCA, there is no question that the AJCA adds much complexity to the Code and burdensome paperwork for taxpayers.  Given President Bush's announced initiatives for his second term, there is hope that the next major tax act passed will provide relief  by achieving some tax simplicity for family businesses.


Reprinted with permission from The Cincinnati Business Courier, December 17, 2004