Tax Increase Prevention and Reconciliation Act

On May 17, 2006, President Bush signed the "Tax Increase Prevention and Reconciliation Act" or TIPRA, into law. TIPRA began life in 2005 as a tax reconciliation bill designed primarily to retroactively extend a number of popular tax breaks that expired at the end of 2005, and extend a number of tax breaks due to expire in future years. After months of discussion, the result was a short list of extended provisions, several new tax breaks, and a long list of revenue raisers.

Following is a summary of the key provisions in the Act that may affect you:

•  Extension of Lower Tax Rates: In 2003, Congress passed a measure to lower the tax rate on most dividends to 15 percent from as high as 38.6 percent, and to lower the rate on most capital gains from 20 percent to 15 percent. That measure was due to expire at the end of 2008, but the new law extends the favorable tax rates through 2010.

•  Extension of AMT Relief: The AMT is a parallel tax system which does not permit several of the deductions permissible under the regular tax system, such as state, local and property taxes. Taxpayers who may be subject to the AMT must calculate their tax liability under the regular federal tax system and under the AMT system. If their liability is found to be greater under the AMT system, this increased amount is what they owe the federal government.

Although the AMT was originally enacted to make sure wealthy Americans did not escape paying taxes, the AMT has started to ensnare more middle-income taxpayers. Congress has attempted to prevent this unintended result using temporary measures to increase the AMT exemption amount; however, those provisions expired at the end of last year, meaning that an estimated 15 million additional taxpayers would have faced paying the tax on their 2006 returns without the new relief. The new Act once again increases the AMT exemption amounts, but the increase is effective for only for one year and will expire at the end of 2006. For 2006, the AMT exemption amount for married taxpayers increases to $62,550 and for unmarried individuals to $42,500 (instead of dropping to $45,000 and $33,750 respectively).

The new Act also extends provisions allowing nonrefundable personal tax credits to be claimed to the full extent of an individual's regular tax and alternative minimum tax (instead of being limited to the excess of regular tax liability over tentative minimum tax and previously required). This provision previously expired at the end of 2005.

•  Extension of Increased Expensing for Small Businesses: A taxpayer, other than an estate, trust, and certain noncorporate lessors, may elect under Code Sec. 179 to deduct as an expense, rather than to depreciate, up to a specified amount of the cost of new or used tangible personal property placed in service during the tax year in his trade or business. The maximum dollar amount that may be deducted annually is $100,000 ($108,000 for 2006, as adjusted for inflation). Under pre-Act law, this amount was to drop to $25,000 for property placed in service in tax years beginning after 2007. The new law extends the $100,000 expense election limit and the $400,000 phaseout ceiling (as inflation adjusted) to tax years beginning before 2010.

The Act also extends two other provisions of pre-Act law. The provisions allowing the inclusion of off-the-shelf computer software in eligible “section 179 property,” and the right to amend or revoke an expense election without the IRS's consent for two years, has been extended to tax years beginning before 2010 (instead of through the end of 2007).

•  Kiddie Tax Age Limit Raised: To curtail the use income shifting, taking income out of the parents' higher tax bracket and placing it in the lower tax brackets of their children, Congress enacted the “kiddie tax” rules, which said that children under 14 who had more than a small amount of unearned income had to pay tax at their parents' marginal tax rate.

Under the new law, for tax years beginning after 2005, the age at which the kiddie tax applies is changed from under 14 to under 18 years of age. An exception to the tax would apply for a child who is married and files a joint return for the tax year, and for distributions from certain qualified disability trusts.

•  Tax Exempt Interest Information Reporting: Under pre-Act law, interest paid on tax-exempt bonds was exempt from interest reporting requirements. Thus, payors of tax-exempt interest did not have to file annual information returns.

The new Act eliminates this exception from information reporting by payors of tax-exempt interest. Thus, interest paid on tax-exempt bonds is subject to information reporting in the same manner as interest paid on taxable obligations.

Other provisions in the Act include:

•  Extension of Subpart F Exceptions: Under Subpart F, U.S. persons who are 10% shareholders of a controlled foreign corporation (CFC) are required to include in income their pro rata share of the CFC's insurance income and adjusted net foreign base company income (FBCI) whether or not this income is distributed to the shareholders.

Under pre-Tax Increase Prevention Act law, certain income from the active conduct of a banking, financing or similar business, or from the conduct of an insurance business (collectively referred to as “active financing income”) was temporarily excluded from the definition of Subpart F income, but only for tax years of foreign corporations beginning before January 1, 2007, and for tax years of U.S. shareholders with or within which any such tax year of the foreign corporation ended.

Under the new law, the exception under subpart F for active financing and insurance income is extended for two years, to tax years of foreign corporations beginning before January 1, 2009, and for any tax year of a U.S. shareholder with or within which the tax year of the foreign corporation ends.

In addition, until 2009, there is a new temporary exception from subpart F for dividends, interest, rents and royalties received by one CFC from a related CFC to the extent attributable to non-subpart F income of the payor.

•  Capital Gain Treatment: Code Sec. 1221(a)(3) provides that copyrights, literary, musical, or artistic compositions are not capital assets and receive ordinary gain/loss treatment if sold by the taxpayer. Under the new Act, a taxpayer may elect to treat the sale or exchange of musical compositions or copyrights in musical works created by his personal efforts as the sale or exchange of a capital asset if the transaction occurs before January 1, 2011.

•  Active Conduct of a Trade or Business Redefined: One of the requirements for a Code Sec. 355 tax-free corporate division (e.g., a spin-off) is that the distributing corporation (D) and any controlled corporation (C) that it distributes must be engaged in the active conduct of a trade or business. This requires either that: (1) immediately after the distribution, D and C are engaged in the active conduct of a trade or business, or (2) immediately before the distribution, D had no assets other than stock or securities of controlled corporations and, immediately after the distribution, each of the controlled corporations is engaged in the active conduct of a trade or business.

Under pre-Act law, a corporation satisfied the above active conduct of a trade or business test, if: (A) it was engaged in the active conduct of a trade or business, or (B) substantially all of its assets consisted of stock and securities of a corporation it controlled immediately after the distribution and the controlled corporations were engaged in the active conduct of a trade or business.

Under pre-Act law, a corporate group often had to undergo elaborate restructuring to satisfy the active trade or business requirement, particularly if the distributing corporation was a holding company that did not directly engage in a trade or business.

Under the new Act, the active business test for tax-free corporate spin-offs is simplified by looking at all corporations in the distributing corporation's and the spun-off subsidiary's respective affiliated group to determine if the active business test is satisfied. This new rule applies for distributions after the enactment date and before January 1, 2011.

•  Elimination of Income Limitation on Roth IRA Conversions: In a regular IRA, a taxpayer receives a deduction for dollars contributed to the IRA, and then the earnings grow tax free. However, the taxpayer must pay ordinary income tax on every dollar taken out, and withdrawals are subject to significant restrictions. In a Roth IRA, a taxpayer receives no tax deduction for contributions, but the money grows tax free and there is no tax, and few restrictions, on withdrawals.

Under pre-Act law, only taxpayers with $100,000 or less in modified adjusted gross income can convert a regular IRA into a Roth IRA. A taxpayer making the conversion generally must pay tax on money he takes out of his regular IRA, but once it is in his Roth IRA, he will not pay tax on that money or the money it earns.

Under the new Act, the $100,000 modified AGI limit on conversions of traditional IRAs to Roth IRAs is eliminated for tax years beginning after Dec. 31, 2009. For 2010 conversions, unless a taxpayer elects otherwise, the amount includible in gross income because of the conversion is included ratably in 2011 and 2012. Special rules apply if converted amounts are distributed before 2012.

•  Modified W-2 Wage Limit for the Domestic Production Deduction: Under present law, the domestic production deduction is limited to 50% of the W-2 wages paid by the taxpayer. Under the new Act, the W-2 wages taken into account for purposes of this limitation must be properly allocable to domestic production gross receipts—that is, the gross receipts from the activities that give rise to the deduction. In addition, the Act repeals the special limitation on the amount of W-2 wages that may be taken into account by partners and S corporation shareholders. The changes are effective for tax years beginning after May 17, 2006.

The above is only a summary of the highlights of the new law. Please contact us at your earliest convenience to discuss specific details of the Act, or address provisions specific to your personal or business situation.