Tax Changes in the American Jobs Creation Act of 2004

By Mark H. Levin

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Repeal of the ETI Provisions

The AJCA repealed the ETI provisions [including subpart E of Part III of subchapter N and IRC sections 54(g)(4)(B)(i), 275(a), 864(e), 903, and 999(c)(1)], and replaced them with a percentage deduction available to manufacturing activities [IRC section 199(a)].

The repeal is phased out over three years. For transactions that occurred in 2004, taxpayers retained 100% of their ETI benefits. For transactions occurring in 2005, taxpayers will retain 80% of their ETI benefits. For transactions occurring in 2006, taxpayers retain 60% of their ETI benefits. For transactions occurring after 2006, taxpayers cannot take any of their previously permitted ETI benefits.

The AJCA provides that the ETI exclusion provisions remain in effect for transactions in the ordinary course of a trade or business if such transactions are pursuant to a binding contract between the taxpayer and an unrelated party, provided that such a contract was in effect on September 17, 2003, and thereafter.

Manufacturing Deduction

THE AJCA enacted an income deduction based on a percentage of the lesser of “qualified production activities income” (QPAI, defined below) or taxable income (modified AGI for individuals) to be phased in over five years (see IRC section 199) as follows:

The deduction is effective for taxable years beginning after December 31, 2004. The deduction is limited to 50% of the W-2 wages of the employer for the taxable year.

The deduction is available to all business entities: C corporations, S corporations, partnerships, sole proprietorships, cooperatives, estates, and trusts. All members of an expanded affiliated group will be treated as a single taxpayer for the computation of this deduction. An expanded affiliated group is an affiliated group, as defined in IRC section 1504(a), except that 50% is substituted for 80% and without regard to IRC section 1504(b) [see also IRC sections 199, 54(g)(4)(B)(i), and 864(e)].

In the case of S corporations, partnerships, sole proprietorships, cooperatives, estates and trusts, or any other pass-through entity, this deduction shall be applied at the shareholder, partner, or similar level [IRC section 199 (d)(1)].

The deduction will be allowed for the purposes of computing the alternative minimum taxable income (including adjusted current income). According to IRC section 56 (g)(4)(C)(v), the deduction is determined by reference to the lesser of the qualified production activities income (QPAI) (defined below), as determined for the regular tax, or the alternative minimum taxable income (in the case of an individual, adjusted gross income is determined for the regular tax) without regard to this deduction.

Qualified Production Activities Income

QPAI is an amount equal to the excess, if any, of the taxpayer’s domestic production gross receipts for the taxable year, under IRC section 199(c)(1), over the sum of:

• the cost of goods sold that are allocable to such receipts;
• other deductions, expenses, and losses that are directly allocable to such receipts; and
• a ratable portion of other deductions, expenses, and losses that are not directly allocable to such receipts.

Domestic production gross receipts are defined as the gross receipts of the taxpayer that are derived from the following:

• any sale, exchange, or other disposition, or any lease, rental, or license, of qualifying production property that was manufactured, produced, grown, or extracted by the taxpayer in whole or in significant part within the United States;
• any sale or other disposition, or any lease, rental, or license, of a qualified film produced by the taxpayer;
• any sale, exchange, or other disposition of electricity, natural gas, or potable water produced by the taxpayer in the United States;
• construction activities performed in the United States; and
• engineering or architectural services performed in the United States for construction projects located in the United States.

The definition of “manufactured” property in the legislation is not clear and has caused considerable confusion among commentators.

A film is qualified, as described in IRC section 168(f)(3), if not less than 50% of the total compensation relating to the production is for services performed in the United States by actors, production personnel, directors, and producers [IRC section 199(c)(6)]. Films of a sexually explicit nature generally do not qualify.

Under IRC section 199(c)(5), qualifying production property is defined as tangible personal property, any computer software, and any sound recordings described in IRC section 168(f)(4).

Depreciation.The AJCA extended the $100,000 maximum deduction allowed under IRC section 179 through 2007 (it was scheduled to lapse after 2005). The AJCA also extended the $400,000 phase-out provisions of IRC section 179 through 2007 (also formerly scheduled to lapse after 2005). The section 179 deduction for sport utility vehicles rated at not more than 14,000 pounds gross vehicle weight is limited to $25,000, effective for vehicles placed in service after October 22, 2004.

The AJCA provides that qualified leasehold improvements, as defined in IRC section 168(k), placed in service before January 1, 2006, are entitled to be depreciated under a 15-year recovery period [under IRC section 168(e)(3)(E)], and continue to be eligible for the “bonus” first-year depreciation under IRC section168(k).

The AJCA provides that qualified restaurant property placed in service before January 1, 2006, may be depreciated under a 15-year recovery period [IRC section 168(e)(7)]. The allowance of a 15-year recovery period also permits qualified restaurant property to utilize “bonus” first-year depreciation under IRC section 168(k).

S Corporation Changes

The AJCA included three provisions that make it more difficult for an S corporation to be disqualified by exceeding the maximum number of eligible shareholders (see IRC section 1361).

First, for taxable years beginning after December 31, 2004, S corporations may have as many as 100 eligible shareholders (formerly limited to 75).

Second, for taxable years beginning after December 31, 2004, family members that are shareholders of an S corporation may elect to be treated as one shareholder. Family members are defined as those with a common ancestor, lineal descendants of a common ancestor, and the spouses (or former spouses) of such lineal descendants or common ancestors. A family may not consist of more than six contiguous generations.

Third, for taxable years beginning after December 31, 2004, powers of appointment are disregarded, to the extent they are unexercised, in determining the potential current beneficiaries of an electing small business trust (ESBT). In addition, also for taxable years beginning after December 31, 2004, the AJCA increases the period during which an ESBT can dispose of S corporation shares after an ineligible shareholder becomes a potential current beneficiary to one year.

The AJCA provides that, for transfers occurring after December 31, 2004, if a shareholder’s S corporation stock is transferred to a spouse (or former spouse, incident to a divorce), any suspended losses due to insufficient basis [under IRC section 1366(d)(1)] are also transferred to the spouse (or former spouse). While the AJCA addresses suspended losses due to lack of basis, it does not address losses suspended under the at-risk or passive-loss rules when transferred incident to a divorce.

For transfers made after December 2004, when a qualified subchapter S corporation trust (QSST) disposes of its shares in an S corporation, it is treated as a disposition by such income beneficiaries, allowing the beneficiaries to deduct losses suspended under the passive-loss or at-risk rules (see IRC section 1361).

In addition, the AJCA permits the IRS to waive inadvertent qualified subchapter S elections and terminations starting in taxable years beginning after December 31, 2004.

Other Provisions

Deduction of state and local sales taxes. For taxable years 2004 and 2005, taxpayers that itemize deductions may elect to deduct state and local general sales taxes instead of state and local income taxes [IRC section 164(b)(5)]. Taxpayers electing to deduct state and local general sales taxes can either save all of their receipts and deduct the exact amount paid, or use a table (based on adjusted gross income, provided by the IRS) plus the actual tax on certain “big-ticket” items.

Foreign tax credits. Starting in taxable years beginning after December 31, 2006, the number of foreign tax credit baskets will be reduced to two (currently nine). The two baskets will be passive category income and general category income (see IRC section 904).

Passive category income is defined as passive income as well as the following:

• Dividends from a DISC or former DISC [as defined in IRC section 992(a)] to the extent that such dividends are treated as income from sources not including the United States;
• Taxable income attributable to foreign trade income [within the meaning of IRC section 923 (b)]; and
• Distributions from an FSC or former FSC out of earnings and profits attributable to foreign trade income or interest, or carrying charges [as defined in IRC section 927 (d)(1)] derived from a transaction which results in foreign trade income.

General category income is defined as income other than passive category income and includes financial services income.

Effective for excess credits that can be carried to years ending after October 22, 2004, any excess foreign tax credit may be carried forward for 10 years (formerly five) [IRC section 904 (c)]. The carryback period is reduced from two years to one.

The AJCA repealed the 90% limitation on the foreign tax credit in computing the alternative minimum tax for taxable years beginning after December 31, 2004, thus allowing 100% of the foreign tax credit against the alternative minimum tax (IRC section 59).