Tax Break Extensions + New Provisions

President Bush signed a new tax law last week that contains good news for investors, as well as an assortment of other changes that spell relief for some taxpayers and financial pain for others. Here is a rundown of the provisions in the Tax Increase Prevention and Reconciliation Act.

"Kiddie Tax" Rules Now Apply to Age 18, Starting This Year     The "Kiddie Tax" has been around for a long time. It can cause a dependent child’s unearned income (most often from investments held in a custodial account or a Crummey Trust set up in the child’s name) to be taxed at the parent’s higher marginal federal income tax rate. Until this year, however, the Kiddie Tax only applied through the year before a child turned age 14. The new law changes the magic age to 18. Even worse, the change is retroactive to January 1, 2006. Therefore, the tax suddenly applies to dependent children who will be age 17 or younger as of December 31, 2006. The only bit of good news here is that for 2006, the Kiddie Tax will only affect under-age-18 dependent children with unearned income in excess of $1,700.     Observation: The retroactive change in the Kiddie Tax rules may eliminate expected tax savings from the strategy of postponing income and gains until the year the child reaches the age of 14 or later years. For example, many parents have used custodial accounts or Crummey trusts set up for their children to invest in growth stocks and U.S. Savings Bonds with the idea that gains and income from these assets could be postponed until those years and thereby taxed at their children’s lower rates. That game is now over — unless the assets are held until at least the year during which the child turns age 18.

Even More Provisions     A number of other relatively obscure provisions are part of the new tax law. For example:     It requires 3 percent federal income tax withholding after 2010 on payments made by government entities for services or property provided by taxpayers.     It changes the amounts of housing allowances that can be treated as tax-free by individuals working abroad, under the "Section 911 income exclusion."     The law repeals binding contract relief rules intended to smooth over the impact of unfavorable changes made by 2004 tax legislation affecting the treatment of foreign sale corporations and extraterritorial income. Repeal was necessary because the World Trade Organization deemed the binding contract relief provisions to be illegal government trade subsidies.     It makes changes to the taxation of Superfund settlement funds, the Veterans’ Mortgage Bond Program and the size of vessels allowed to elect into the tonnage tax. In addition, the law includes an exception from the arbitrage bond rules for certain university funds, and changes the rules for qualified small issue bonds, the application of rules under the Foreign Investment in Real Property Tax Act, and the imposition of penalties on tax-exempt entities that participate in prohibited tax shelter transactions.

What the New Law Doesn’t Include Unfortunately, the Tax Increase Prevention and Reconciliation Act didn’t get the whole job done. There are a number of popular tax breaks that expired at the end of 2005 that members of Congress are committed to reinstating. As a result, we will likely see another new tax law later this year to extend: The itemized deduction for state and local sales taxes in lieu of writing off state and local income taxes. The tax credit for expanding research and development activities. The work opportunity and welfare-to-work tax credits for employing members of certain targeted groups. The deduction for up to $250 of classroom costs paid by elementary and secondary school teachers out of their own pockets. The deduction for up to $4,000 of qualified higher education tuition and related fees. All of these tax breaks (as well as some others not listed here) are expected to be retroactively resurrected for at least 2006 by yet-to-come legislation.

Low Rates for Investors Go On

The new law extends through 2010 the favorable federal income tax rates for long-term capital gains (generally from investment assets held for more than one year). It also extends the current favorable rates for qualified dividends, which includes most of those paid by domestic corporations, as well as many foreign companies.

Specifically, the maximum individual federal income tax rate for most long-term capital gains will remain at the current level of 15 percent through 2010. The rate for individuals in the lowest two tax brackets (the 10 and 15 percent brackets) will remain at the current 5 percent level through 2007 and then drop to zero percent for 2008 through 2010. The same preferential rates will also apply to qualified dividends received through the end of 2010. Under prior law, the rates on long-term capital gains and qualified dividends were scheduled to rise after 2008.

The ultra-favorable 5 percent and zero percent rates will benefit many more people than you might think, because taxpayers can be in the 10 percent or 15 percent brackets even though they earn a healthy income. For example, let's say a married couple with two dependent children claims the standard deduction. They can have 2006 gross income of up to $84,800 and still be in the 15 percent bracket. Thanks to inflation adjustments, the couple could earn even more in 2008 through 2010 and still be eligible for the zero percent tax rate on long-term capital gains and qualified dividends collected in those years.

The 28 percent maximum federal rate on long-term capital gains from sales of collectibles is extended through 2010. The same goes for the 25 percent maximum rate on long-term real estate gains attributable to depreciation write-offs (so-called unrecaptured Section 1250 gains).

AMT Band-Aid Applied for This Year

In order to prevent millions more individuals from falling victim to the alternative minimum tax (AMT) in 2006, the new law increases the AMT exemption amounts for this year only. The updated figures are as follows:

 $62,550 for married couples filing jointly (up from $58,000 for 2005). However, the exemption is phased out between alternative minimum taxable income (AMTI) of $150,000 and $400,200. Without the new law, this year’s exemption would have fallen back to only $45,000.

 $42,500 for single taxpayers and heads of household (up from $40,250 for 2005). The exemption is phased out between AMTI of $112,500 and $282,500. Without the new law, this year’s exemption would have dropped to only $33,750.

 $31,275 for those who use married filing separate status (up from $29,000 for 2005). The exemption is phased out between AMTI of $75,000 and $200,100. Without the new law, this year’s exemption would have been only $22,500.

The new law also allows taxpayers to use various personal tax credits (such as the dependent care credit and the two college education credits) to reduce both their regular tax and AMT bills for 2006 only. This fix will prevent many middle-income individuals from being forced into paying AMT this year. The same rule applied for 2005.

Section 179 Deduction Rules for Businesses Extended

The tax law currently allows many small businesses to claim an instant first-year depreciation write-off for the full cost of most equipment and software additions (new or used). This is thanks to the "Section 179 deduction," which is a longtime favorite of small business operators.

For tax years beginning in 2006, the maximum Section 179 deduction is a generous $108,000 (the amount is adjusted annually for inflation). However, the Section 179 write-off was scheduled to decrease to a mere $25,000 for tax years beginning in 2008. The new law extends all aspects of the current favorable Section 179 deduction rules (including annual inflation adjustments) by two years — through tax years beginning in 2009. For tax years beginning in 2010, the $25,000 limitation will kick in unless Congress takes further action.

No Income Limit for Roth Conversions — But Not for Awhile

Under current law, an individual with modified adjusted gross income (MAGI) above $100,000 cannot convert a traditional IRA into a Roth IRA. The new law eliminates the MAGI limitation, but you’ll have to wait a long time to take advantage of it. The favorable change will kick in starting in 2010. For Roth conversions that occur in 2010 only, half of the taxable income triggered by the conversion generally must be reported in 2011 and the other half in 2012. For conversions in 2011 and beyond, all the income must be reported in the conversion year — as is the case under current law.

Observation: Congress could decide to change its mind in the future and eliminate this favorable provision before it ever becomes effective.

Many Other New Rules Affect Only Targeted Taxpayers

The big changes in the new law, described above, impact many taxpayers. But there are lots more. The legislation also includes a host of other provisions that affect only certain taxpayers. Here is a brief description:

 Domestic Producers Deduction – The new law clarifies how to calculate the 50-percent-of-W-2 wages limitation on the "Section 199" domestic producers deduction. The law also repeals a complicated limitation provision for W-2 wages allocated to partners and S corp. shareholders. Both changes are effective for tax years beginning after the enactment date of May 17, 2006.

 Corporate Estimated Tax Payments – Estimated tax payments are increased for corporations with assets of $1 billion or more. This only applies to payments due in: July, August, and September of 2006 (105 percent of the normal amount); and for some in tax years 2012 and 2013. The next payments due after the increased payments are reduced by offsetting amounts.

 Tax-Free Spin-offs – One requirement to qualify for a tax-free corporate spin-off transaction is that the corporation that distributes subsidiary stock and the subsidiary must both be engaged in the active conduct of a trade or business. The new law makes it easier for corporate groups that use holding company structures to satisfy the active conduct requirement. This favorable change is effective for stock distributions occurring after the enactment date and before 2011.

 Tax-Free Spin-offs Disallowed for Investment Companies – The new law disallows tax-free treatment for certain corporate distributions of subsidiary stock in so-called spin-off transactions. The unfavorable change applies to “disqualified investment companies” and is generally effective for stock distributions occurring after the May 17, 2006, enactment date.

 Foreign Income – Existing favorable treatment for taxpayers with foreign income from active financing and insurance activities is extended for two more years — generally through 2008. A favorable new rule applies when income from interest, rents, or royalties is received by one controlled foreign corporation from another related one. This second rule is effective for tax years after 2005 and before 2009.

 Certain Oil Company Costs – The new law extends the amortization period for geological and geophysical costs from the normal 2 years to 5 years for “major integrated oil companies.” This unfavorable change applies to costs paid or incurred after the date of enactment.

 "Earnings Stripping" – The new law codifies unfavorable rules for earnings stripping transactions involving C corporations that have ownership interests in partnerships with liabilities, interest income, or interest expense (in other words, certain corporate partners). The provision applies to tax years beginning on or after the enactment date.

 Loans to Continuing Care Facilities – Complicated rules can apply when individual taxpayers make loans that charge below-market interest rates. Current law grants an exception to these tricky rules for certain loans made by individuals to qualified continuing care facilities under continuing care contracts. The new law makes the exception available to more individuals by lowering the eligibility age from 65 to 62 and liberalizing the definition of what qualifies as a continuing care contract. These favorable changes apply to calendar years 2006 to 2010 (regardless of the date of affected loans).

 Self-Created Musical Works – Favorable capital gains rates can now apply to profits from selling self-created musical works. This helpful change is effective for sales in tax years beginning after the date of enactment and occurring before 2011.

 Costs to Acquire Song Rights – Taxpayers can now elect five-year amortization for certain costs paid to create or acquire song rights. The election can be made for the cost of qualified rights placed in service in tax years beginning after 2005. However, the election will no longer be available for tax years beginning after 2010.

 Partial Tax Payments Required for "Offers in Compromise" – Under offer in compromise arrangements, the IRS will sometimes agree to settle federal tax debts for less than the full amount owed. Starting with offer requests submitted on or after July 16, 2006, most requests must be accompanied by a "down payment" equal to 20 percent of the amount offered by the requesting taxpayer. However, IRS user fees will be eliminated for offers submitted with appropriate down payments.

 Information Reporting for Tax-Exempt Bond Interest – Interest paid after 2005 on tax-exempt bonds must be reported to the IRS on information returns in the same fashion as payments of taxable interest.