American Jobs Creation Act of 2004

Dear Clients,

Here are some of the many changes taking place this year with the American Jobs Creation Act of 2004.

Many residents of states with a sales tax but no or a limited individual income tax just received a tax cut as a result of the recently passed American Jobs Creation Act of 2004. That's because, under the new law, taxpayers may choose between taking state sales taxes and state income taxes as an itemized deduction on their federal tax return for 2004 and 2005. Although the law applies nationwide, its primary beneficiaries will be citizens in the states that have sales tax but no or a limited individual income tax. Here are the details.

Sales tax not deductible under prior law. Under prior law, federal income tax filers who itemized could deduct state and local income and property taxes when computing federal taxable income, but could not deduct state and local sales taxes. Taxpayers in non-income tax states argued that this differing tax treatment was unfair.

Deductibility of sales tax under the new law. The new law addresses this inequity by allowing taxpayers to choose an itemized deduction for state and local general sales taxes in lieu of the itemized deduction for state and local income taxes. Although the measure allows taxpayers in all states to choose between deducting state and local sales taxes or state and local income taxes on their federal tax returns, a person typically pays more in income taxes than in sales taxes. Therefore, taxpayers in states without individual income taxes are primarily the ones who will benefit under the provision. These states are Alaska, Florida, Nevada, South Dakota, Texas, Washington and Wyoming. Taxpayers in states with a limited individual income tax may also benefit. (New Hampshire imposes an income tax only on interest and dividends; Tennessee on income from stocks and bonds.)

As noted above, the tax break can be used only by those who itemize their tax deductions. Taxpayers who take the standard deduction instead of itemizing receive no benefit from this provision. The deduction is in effect for 2004 and 2005, but extension to future years is possible.

So that families won't need to keep a shoe box of sales receipts, the new law gives taxpayers the option of using IRS sales tax tables and adding actual sales taxes paid for cars, boats and such other major items as the IRS may decide.

New rules affecting charitable contributions in the American Jobs Creation Act of 2004

Three important measures in the recently passed American Jobs Creation Act of 2004 that will have a major impact on charitable giving. The new provisions include a curtailment of abusive vehicle gift donations, requirements for increased charitable reporting for noncash gifts, and a crackdown on gifts of patents.

Abusive vehicle gift deductions curtailed. Under pre-Act law, when an individual gives a car, boat, RV, or aircraft to charity, the amount of the charitable deduction is usually the fair market value of the property. This rule has led to abuse, with certain charities promising charitable deductions of full Blue Book value for vehicles in poor condition.

Under the new law, the rules on vehicle donations will change radically. Beginning in 2005, the charitable deduction for contribution of a vehicle (including automobiles, boats, and airplanes for which the claimed value exceeds $500 and excluding inventory property) that is resold by the charity is limited to the gross proceeds received by the charity upon resale. Since charities often sell vehicles at auctions or in bulk sales where the prices are below Blue Book, donor deductions for gifts of vehicles will be greatly reduced.

The new law also imposes new substantiation requirements for contributions of vehicles for which the claimed value exceeds $500 (excluding inventory). A deduction is not allowed unless the taxpayer substantiates the contribution by means of a "contemporaneous written acknowledgment" by the charity stating the name and Social Security number of the donor, the vehicle identification number, and a statement that the vehicle was sold by the charity in an arm's length transaction between unrelated parties. It must also show the gross proceeds from the sale and state that the donor's deduction cannot exceed that amount. The charity must provide the acknowledgment to the donor within 30 days of sale of the vehicle. Different rules apply if the charity uses the vehicle rather than selling it or materially improves the vehicle before sale. Penalties apply to charities that knowingly furnish a false or fraudulent acknowledgment.

Increased reporting for noncash charitable contributions. Under pre-Act law, if the total charitable deduction claimed by an individual for noncash property exceeds $500, the individual must file IRS Form 8283 (Noncash Charitable Contributions) with the IRS. If the gift is more than $5,000, the taxpayer is required to obtain a qualified appraisal. The appraisal needn't be attached to the return except in the case of gifts of art valued at more than $20,000. C corporations (other than a closely-held corporation, a personal service corporation, or an S corporation) were not required to obtain a qualified appraisal.

The new law brings two major changes to this area. First, it makes the qualified appraisal rule for noncash gifts over $5,000 applicable to corporations. Second, if the amount of the contribution of property other than cash, inventory, or publicly traded securities exceeds $500,000, then the donor (whether an individual, partnership, or corporation) must attach the qualified appraisal to the donor's tax return. The new rules take effect for contributions made after June 3, 2004.

New restrictions on the deductibility of patents and other intellectual property. Under pre-Act law, charitable contributions of patents and other intellectual property were deductible at fair market value. This rule was subject to abuse, as patents and other intellectual property were often donated using excessive valuations, resulting in inflated tax deductions for donors.

The new law puts an end to this practice by providing that the donor's initial charitable deduction is limited to the lesser of the donor's basis or the fair market value of the property. Since creators usually have a low basis in their patents, the deduction in most cases will be relatively small. However, if the charity actually goes on to receive income from the patent or other intellectual property (referred to as "qualified donee income," or QDI), the donor may then take additional charitable deductions for QDI generated in the ten-year period starting on the date of the gift. The deduction begins at 100% of the QDI received in the year of the contribution and declines to 10% of the QDI by the end of the period. The charity is required to report the amount of QDI attributable to the patent or other intellectual property to the donor and the IRS. These rules also take effect for contributions made after June 3, 2004.

Attorneys' fees in certain civil rights cases made deductible under the American Jobs Creation Act of 2004

Significant provision in the recently passed American Jobs Creation Act of 2004 which is intended to ensure that plaintiffs who win awards or settlements in certain civil rights cases and other lawsuits not pay income tax on parts of the recovery they never see.

Background. Damages received (whether by suit or agreement) by individuals on account of personal physical injuries are generally not included in gross income, and expenses relating to recovering such damages are generally not deductible. Other damages, however, are generally included in gross income. The related expenses to recover the damages, including attorneys' fees, cannot simply be offset against the recovery. Instead, the expenses can only be deducted as expenses for the production of income, with the following disadvantages: (1) the expenses are classified as miscellaneous deductions and thus are deductible only to the extent the taxpayer's total miscellaneous itemized deductions exceed two percent of adjusted gross income; (2) any amount allowable as a deduction is subject to reduction under the overall limitation of itemized deductions if the taxpayer's adjusted gross income exceeds a threshold amount; and (3) for purposes of the alternative minimum tax (AMT), no deduction is allowed for any miscellaneous itemized deduction.

In some cases, claimants will engage an attorney to represent them on a contingent fee basis. That is, if the claimant recovers damages, a prearranged percentage of the damages will be paid to the attorney; if no damages are recovered, the attorney is not paid a fee. The proper tax treatment of contingent fee arrangements with attorneys has been litigated in recent years, with varying results and radically different consequences for the taxpayers involved. Some courts (specifically, the Fifth, Sixth, and Eleventh Circuits) have held that the portion of the recovery that is paid directly to the attorney is not income to the claimant, meaning that the portion of the award or settlement that is paid to the attorneys will involve no tax cost to the taxpayer. However, the majority (including the First, Second, Third, Fourth, Seventh, Tenth and Federal Circuits and the Tax Court) has held that the entire amount of damages is income, and the claimant is entitled only to a miscellaneous itemized deduction (with the disadvantages described above for the claimant) for the portion paid to the attorneys. This can result in a large amount of tax being payable by the claimant on the portion of the award or settlement that is paid directly to the attorneys and that the claimant never actually receives.

New provision. Congress believes that in certain civil rights cases it is not appropriate for individuals to be subject to tax on the portion of amounts received that are attributable to attorneys' fees and costs. Thus, the Act provides an above-the-line deduction for attorneys' fees and costs paid by, or on behalf of, the taxpayer in connection with any action involving a claim of unlawful discrimination, including age discrimination, certain claims against the Federal Government, or a private cause of action under the Medicare Secondary Payer statute. An above-the-line deduction is a deduction directly against gross income and is not subject to the rules on miscellaneous itemized deductions, the overall limitation on itemized deductions, or the disallowance of miscellaneous itemized deductions under the AMT. The effect of this provision is that the taxpayer will effectively be able to offset the legal fees against the total recovery, and will be taxed only on his net recovery.

Equity and deferred compensation changes in the American Jobs Creation Act of 2004

The recently passed American Job Creation Act of 2004 made several major changes to compensation and benefit provisions of the tax law. Specifically, the new law excludes incentive stock options and employee stock purchase plan stock options from FICA/FUTA wages and makes fundamental changes to the tax treatment of nonqualified deferred compensation. Here are the details.

Exclusion of incentive stock options and employee stock purchase plan stock options from wages

Background. Generally, when an employee exercises a compensatory option on employer stock, the difference between the option price and the fair market value of the stock (i.e., the "spread") is includible in income as compensation. In the case of an incentive stock option (ISO) or an option to purchase stock under an employee stock purchase plan (ESPP) (collectively referred to as "statutory stock options"), the spread is not included in income at the time of exercise. If the statutory holding period requirements are satisfied with respect to stock acquired through the exercise of a statutory stock option, the spread, and any additional appreciation, will be taxed as a capital gain upon disposition of such stock. Compensation income is recognized, however, if there is a disqualifying disposition (i.e., if the statutory holding period is not satisfied) of stock acquired pursuant to the exercise of a statutory stock option.

In the past, there has been uncertainty as to employer withholding obligations upon the exercise of statutory stock options. On June 25, 2002, the IRS announced that until further notice it would not assess FICA or FUTA upon the exercise by an employee of an incentive stock option or impose federal income tax withholding obligations, upon either the exercise of a stock option or the disposition of stock acquired pursuant to the exercise of a statutory stock option.

New law excludes ISOs and ESPP stock options from wages. The Act provides a specific exclusion from FICA/FUTA payroll tax withholding obligations for remuneration on account of the transfer of stock pursuant to the exercise of an incentive stock option or under an employee stock purchase plan, or any disposition of such stock.

The new law also provides that federal income tax withholding is not required on a disqualifying disposition of stock acquired from ISOs and ESPPs, nor when compensation is recognized in connection with an ESPP discount.

Treatment of nonqualified deferred compensation plans

New law tightens the rules for nonqualified deferred compensation arrangements. Prompted by corporate scandals at Enron and other companies, the Act imposes certain restrictions and limitations on the design of nonqualified deferred compensation plans. While these new rules may limit, somewhat, the flexibility that makes these plans popular with both employers and employees, the new rules do have the advantage of offering clear guidelines for employers and their advisors to follow when designing and administering plans. Until now, the only guidelines have been the expert interpretation of case law and from the IRS. The new rules add certainty to the nonqualified deferred compensation area. Here are the highlights of the new law.

Taxation. Under the new law, for deferred compensation to be excluded from gross income, the deferred compensation plan must meet distribution, acceleration of benefits, and election requirements. If a plan fails to meet the requirements, all compensation earned and deferred must be included in income for the first tax year that the nonqualified deferred compensation plan fails to meet the requirements, to the extent not subject to a "substantial risk of forfeiture" and not previously included in gross income. A 20% penalty will also be imposed on the amount required to be included in income. Interest will also be assessed on the underpayment, at the underpayment rate plus one percentage point.

Restrictions on distributions. Under the new law, a nonqualified deferred compensation plan may not permit distributions from the plan earlier than separation from service, death, disability, a specified time (or pursuant to a fixed schedule), a change in control of a corporation (to the extent allowed by the IRS), or an occurrence of unforeseeable emergency. Additionally, key employees at public corporations generally may not receive their distributions earlier than six months after separation. Calling down benefits with a "haircut" (i.e., forfeiture of a portion of the account balance in exchange for access to the plan account) is not a distribution option.

Acceleration of benefits. The Act does not permit a plan to allow for the acceleration of benefits.
Requirements relating to the timing of deferral elections. Under the new law, deferral elections generally must be made in the tax year preceding the year in which the services are performed, or within 30 days of becoming eligible for plan participation. If the award is performance-based (i.e., an incentive bonus), the election must be made not later than six months before the end of the performance period.

Delay of distributions or changes to form of distribution. Under the new rules, any subsequent election for an award generally must be made at least 12 months after the election and must defer receipt for at least five years in the future.

Prohibition on offshore funding. Although the use of rabbi trusts (trusts that are subject to the claims of general creditors) will still be available to employers in connection with nonqualified deferred compensation, the new rules generally prohibit the use of offshore rabbi trusts. Also, rabbi trusts that are convertible into secular trusts (protecting the assets from general creditors) are prohibited.

Trigger upon financial health. A deferred compensation plan may not provide that a deterioration in the financial status of the employer will trigger payment of the deferred compensation. Also, rabbi trusts that are convertible into secular trusts (protecting the assets from general creditors) are prohibited.

Effective date of new rules. The new rules, which contain transitional and anti-abuse rules, generally apply to amounts deferred after Dec. 31, 2004.

To obtain additional information on any issue mentioned above either schedule an appointment at your convenience or e-mail me at carol@4yourcpa.com.
Sincerely,

Carol W. Barsness, CPA
A Professional Corporation

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*This artilce is presented for information and educational purposes only and is not intended to constitute legal, tax or accounting advice. The article profices only a very general summary of complex rules. For advice on how these rules may apply to your specific situation, contact a professional advisor.

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