2004 Tax Update: Federal, New York, New Jersey, and Connecticut

By Stewart Berger and Ben J. Bogdanowicz

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Working Families Tax Relief Act

“Marriage penalty” relief. The act extends earlier legislation by increasing both the standard deduction and the amount taxed at the 15% rate to twice the comparable amounts for single taxpayers.

Child tax credit. The child tax credit for 2004 is $1,000 per qualifying child. The credit was scheduled to decrease to $700 in 2005 and gradually increase to $1,000 in 2010. The new law retains the $1,000 credit until 2010.

Uniform definition of a child. The new law defines a child for purposes of the dependency exemption, child credit, dependent care credit, and head of household credit as a natural or adopted child, a stepchild, or an eligible foster child. An eligible foster child is a child placed with a taxpayer by an authorized placement agency or an appropriate court order.

Dependency exemption. In general, a child is a qualifying child of a taxpayer if the child has the same principal residence as the taxpayer for more than one half the tax year, has a specified relationship to the taxpayer, and has not reached a specified age. The new law retains the special rule that—in certain cases in which the parents are divorced or separated—the custodial parent can release the claim to the exemption in favor of the noncustodial parent.

The new law also provides tiebreaker rules in which an individual could be a qualifying child with respect to two or more taxpayers and those taxpayers can each claim benefits based on this status. A parent is preferred over other claimants under tiebreaker rules. Preference between parents is given to the parent with whom the child resided for the longest period of time. If the child resided with each parent for an equal period of time, the parent with the higher adjusted gross income receives the exemption. If none of the claimants is a parent, the taxpayer with the highest adjusted gross income is entitled to the exemption.

Dependent care credit. Although it generally follows current rules for determining the dependent care credit, the new law—

• eliminates the requirement that a taxpayer provide more than one-half of the cost of maintaining a household in order to claim the credit; and
• adds a requirement that—to be considered a qualifying individual—a spouse or dependent (other than a child under age 13) who is physically or mentally incapable of caring for herself must have the same “principal place of abode” as the taxpayer for more than one-half of the taxable year.

Child credit. The new law generally retains the current law’s rules for determining the child credit. The child tax credit is available only if the child is under age 17 (regardless of any disability).

American Jobs Creation Act of 2004

Extraterritorial income (ETI) repeal. As opposed to most European taxpayers that are taxed only on income earned in the country imposing the tax, U.S. taxpayers are taxed on their worldwide taxable income regardless of the source. Prior to repeal by the American Jobs Creation Act of 2004, the ETI rules—which replaced the Foreign Sales Corporation rules—excluded ETI from a U.S. exporter’s gross income. In theory, the exclusion applied to all foreign trade income and therefore did not favor goods produced in the United States.

The ETI regime is repealed under the new law, and becomes fully effective in 2007. For transactions in 2004, taxpayers retain 100% of their ETI benefits. For transactions in 2005, taxpayers retain 80% of the benefits they would be entitled to under the ETI provisions. For transactions in 2006, taxpayers retain 60% of the benefits they would be entitled to under the ETI provisions.

The ETI phaseout will be accompanied by a phase-in of the domestic production deduction. The domestic production deduction is not available to exporters or other dealers that do not engage in manufacturing production or extraction activities. Taxpayers will receive a deduction equal to the lesser of a phased-in percentage of taxable income or qualified production activities income. The maximum deduction of 9% is phased in over a five-year period.

Qualified production activities income is equal to the taxpayer’s domestic production gross receipts, less the following:

• The cost of goods sold that is allocable to those receipts;
• Other deductions, expenses, and losses that are directly allocable to those receipts; and
• A proper share of other deductions, expenses, and losses that are not directly allocable to those receipts or another class of income.

For 2005 and 2006, the deduction is equal to 3% of the lesser of the taxpayer’s taxable income or qualified production activities income. For 2007 through 2009, the deduction is 6% of the taxpayer’s taxable income or qualified production activities income. The deduction is 9% for tax year 2010 and thereafter.

Any lease, rental, license, sale or exchange, or other disposition of qualifying production property that was manufactured, produced, grown, or extracted by the taxpayer in whole or in significant part within the United States qualifies as domestic production gross receipts. The production deduction does not apply to taxpayers that engage solely in sales activities.

The deduction will be applied by looking through flow-through entities and applying the rules and limitations at the owner level. The deduction is limited to 50% of W-2 wages paid during the year.

Small-business expensing depreciation. The new law extends the IRC section 179 maximum expense. The section 179 limitation is $100,000 (indexed for inflation) and the investment limitation is $400,000. For 2004, the section 179 deduction is $102,000 with a $410,000 acquisition cap.

Depreciation changes. The new law limits the cost of a sports utility vehicle weighing not more than 14,000 pounds that may be expensed under IRC section 179 to $25,000 if acquired after October 22, 2004, and it does not subject such vehicle to IRC section 280F depreciation limitations. Most pickup trucks, passenger vans, and small buses that weigh at least 6,000 pounds are not subject to the annual deduction limits that apply to passenger vehicles, but they will be limited to an IRC section 179 deduction of $25,000.

Qualified leasehold improvements made to nonresidential property after October 22, 2004, and before January 1, 2006, have a 15-year recovery period. A qualified leasehold improvement is any improvement to an interior portion of nonresidential real property meeting the following requirements:

• The improvement is made pursuant to a lease by the lessee, any sublessee, or lessor.
• The lease is not between related persons.
• The building or portion of the improvement is occupied by the lessee or sublessee.
• The improvement is placed in service more than three years after the date that the building was first placed in service.

Amortization of start-up and organization expenses. For expenditures incurred after October 22, 2004, the new law allows taxpayers to deduct up to $5,000 of start-up costs and organization expenses in the tax year in which the trade or business begins. The $5,000 amount must be reduced (but not below zero) by the amount by which the costs exceed $50,000. The remaining costs that are not deductible in the year in which the trade or business begins must be amortized over 180 months using the straight-line method, beginning with the month the trade or business begins.

S corporations and partnerships. The new law has increased the number of eligible shareholders from 75 to 100. Family members from up to six generations can elect to be treated as one shareholder for purposes of counting the number of shareholders. The law also permits grandfathered IRAs to hold shares in an S corporation bank and allows suspended S corporation losses or deductions due to lack of basis to be transferred to a spouse incident to divorce.

Partnerships are required in certain cases to adjust the basis of partnership property following a transfer of a partnership interest to reflect differences in the transferee partner’s basis and its proportionate share of the adjusted basis of the property. This occurs when a partnership has a built-in loss after the transfer. The IRC section 743 adjustment is now mandatory when a partnership interest is transferred and the partnership’s basis in its property exceeds the fair market value by more than $250,000.

Election to deduct state and local general sales tax. For 2004 and 2005, individual taxpayers may elect to deduct either state and local income taxes or state and local general sales tax as an itemized deduction on their federal income tax returns. The amount of sales tax to be deducted is determined by the actual amount of sales tax paid or by IRS general tables plus the amount of any sales tax paid for motor vehicles, boats, or other IRS-specified items.

Deferred compensation. The new law imposes new requirements for nonqualified deferred compensation plans after December 31, 2004. Some of the requirements restrict acceleration of benefits and the timing of distributions, limit the use of offshore rabbi trusts, limit the available types of permitted investment alternatives, and require the election of a deferral before the services being compensated for occur. Plans in effect prior to October 3, 2004, that are not materially modified may still be operated in accordance with their existing terms with respect to amounts deferred before January 1, 2005.

Exclusion of gain on sale of principal residence. When an individual acquires a principal residence in a like-kind exchange, the new law requires that the individual own the property for at least five years prior to its sale or exchange in order for the $250,000 or $500,000 principal residence exclusion to apply.

Donations of motor vehicles, boats, and airplanes. The new law limits the deduction available for charitable contributions made after 2004 of used motor vehicles, boats, and airplanes. Charitable deductions are generally limited to the amount the charity receives when it sells the vehicles. The charity must estimate market value at the time of the donation when it has made significant use of the vehicles or has made improvements. Donors, including C corporations, that make contributions other than cash, inventory, or publicly traded securities must obtain an appraisal when claiming a deduction exceeding $5,000. If the deduction exceeds $500,000, the appraisal must be attached to the tax return.

Other provisions. Effective for cancellation of indebtedness on or after October 22, 2004, the new law provides that a partnership which satisfies an indebtedness by transferring a capital or profits interest in itself can recognize cancellation of indebtedness income from such a transfer to a creditor.

The act creates a new tax penalty for any person who fails to include on any return or statement any information regarding a reportable transaction. A reportable transaction is any transaction in which information is required to be included with a tax return or statement, because the IRS has determined that this type of transaction has the potential for tax avoidance or evasion under the tax rules.

Pension increases for 2004. Due to cost-of-living adjustments, the IRS has announced the following pension plan limits for 2005:

• The maximum annual benefit in a defined benefit plan has increased from $165,000 to $170,000.
• The limit of contributions to defined contribution plans has increased from $41,000 to $42,000.
• Catch-up contributions for those age 50 or over have increased from $3,000 to $4,000.

New York State Tax Update

On August 20, 2004, New York State enacted the 2004 Budget Act, which amended New York State law as well as the New York City Administrative Code.

Corporate taxes. An MTA surcharge on all corporations other than S corporations was extended to taxable years ending on or before December 31, 2009. The MTA surcharge is calculated on the franchise tax rates in effect on June 30, 1998.

The New York State minimum fixed-dollar tax, which includes S corporations, has been increased. The fixed-dollar minimum tax shall be computed, based on gross payroll, as follows:

• Gross payroll of $500,000 or less: $100.
• Gross payroll $1 million or less but more than $500,000: $325.
• Gross payroll $6,250,000 or less but more than $1 million: $425.
• Gross payroll less than $25 million but more than $6,250,000: $5,000 (formerly $1,500).
• Gross payroll $25 million or more: $10,000 (formerly $1,500).

The $800 fixed-dollar minimum tax remains in effect for corporations with gross payroll, total receipts, and average gross assets each totaling less than $1,000.

Revocation of hearing rights upon notice of demand. The act eliminated a taxpayer’s right to a prepayment hearing if the taxpayer disagrees with a notice of demand or a notice of additional tax due because of a mathematical or clerical error. A taxpayer who wants to contest the notice issued must first pay the tax due plus all interest and penalties.

Estate tax. Effective for estates of decedents dying on or after January 1, 2002, the credit for tax paid to other states is not limited to tax actually paid. The credit will be calculated by multiplying the federal credit for state death taxes by the ratio of non–New York property to total property.

Real property taxes. Effective August 20, 2004, New York City may require the payment of real property taxes by electronic funds transfer where the annual real property tax liability is equal to or greater than $300,000.

New Jersey Tax Update

In June 2004, New Jersey enacted the Fair and Immediate Relief Act. The highlights of this tax legislation follow.

Increase in gross income tax. The act increases the top gross income tax rate from 6.37% to 8.97% on taxable income in excess of $500,000, retroactive to January 1, 2004.

Net operating loss carryover. Corporation tax law prohibited the use of net operating losses in 2002 and 2003. For the years 2004 and 2005, corporations can offset up to 50% of their entire net income with net operating loss carryovers.

Depreciation decoupling. For assets placed in service on or after January 1, 2004, all taxpayers must decouple from federal bonus depreciation. The IRC section 179 limit for expensing fixed asset purchases is $25,000. New Jersey no longer allows 50% bonus depreciation.

Electronic funds transfer. The act lowers the threshold for mandatory use of electronic transfer as a means of filing state taxes. Electronic transfers of taxes must be used by taxpayers whose prior-year liability was $10,000 or more.

Sale of New Jersey real property. Effective August 1, 2004, estimated tax payment will be required on the sale of New Jersey real estate by nonresident individuals, estates, or trusts. The estimated tax will be based on the gain on the sale and will be at the highest personal income tax rate.

Connecticut Tax Update

New 2004 composite payment tax requirements for S corporations and partnerships. An S corporation is now required to file Form CT-1065/CT-1120SI (Connecticut Composite Income Tax Return) and make a composite Connecticut income tax payment on behalf of each nonresident shareholder where: 1) the shareholder’s pro rata share of the S corporation’s income derived from or connected with Connecticut sources is $1,000 or more; and 2) an election to be included on Form CT-G (Connecticut Group Income Tax Return) has not been made by such nonresident shareholder.

Previously, an S corporation was not required to make a composite Connecticut income tax payment on behalf of any nonresident shareholder who elected to pay Connecticut income tax by filing Form CT-1NA (Nonresident Income Tax Agreement) with the S corporation. The new law precludes this election and, if the election was previously made, nullifies this election for taxable years of S corporations beginning on or after January 1, 2004.

To determine the composite payment due from each nonresident shareholder, the S corporation must multiply each nonresident shareholder’s pro rata share of the S corporation’s separately and nonseparately computed income derived from or connected with Connecticut sources, whose expected tax liability is expected to equal or exceed $1,000, by 5%. Form CT-1065/CT-1120SI is due on or before the 15th day of the fourth month following the end of the S corporation’s taxable year (April 15th for calendar-year filers.) Similar rules apply to partnerships.

Withholding tax. Under prior law, employers had to remit withholding tax at the same time as required by federal law. The statute was amended to break from federal withholding due dates and establish state withholding due dates beginning January 1, 2005. The state of Connecticut determines that the tax be deducted and withheld using the look-back method, based on the prior year’s liability.

Weekly remittances are required if the tax withheld in the prior year was $10,000. The tax must be remitted on or before the Wednesday next succeeding the weekly period, which runs from Saturday to Friday. Monthly remittances are required if the tax withheld in the prior year was more than $2,000 but less than $10,000. The tax must be remitted by the 15th of the following month. Quarterly remittances are required if the tax withheld in the prior year was $2,000 or less. The tax must be remitted by the last day of the month of the month succeeding the end of the quarter. Household employers must pay the tax withheld on or before April 15th next succeeding the calendar year.

The business entity tax for taxable years beginning January 1, 2004, is $250. The business entity tax applies to S corporations, limited liability partnerships, limited liability companies, and limited partnerships if they are required to file an annual report with the Connecticut Secretary of State.

The tax is required to be filed on Form OP-424 and paid by the 15th day of the fourth month following the close of the entity’s tax year.