Alerts and Updates
Highlights of the Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA)
December 19, 2006
The U.S. House of Representatives passed the Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA) on May 10, 2006. The U.S. Senate followed suit on May 11, and President Bush signed it into law on May 17.
Getting past the unusual facts that (1) the first two words of the Act are "Tax Increase," and (2) although it was passed in 2006 it has the year 2005 in its title, the main features of TIPRA are alternative minimum tax relief for individuals for 2006, two more years of low-tax treatment for capital gains and qualified dividends, and two more years of generous Section 179 expensing provisions for businesses.
On the flip side, to offset a portion of the reduction in revenue that will result from those provisions, the Act contains a number of provisions for raising revenue. For example, it removes the Adjusted Gross Income (AGI) ceiling for IRA-to-Roth-IRA conversions (but only after 2009) and changes the age at which the kiddie tax applies (from under age 14 to under age 18).
The following discussion is intended to highlight some of the key provisions of TIPRA.
Tax Reduction Provisions
Alternative Minimum Tax (AMT) Relief for Individuals
TIPRA does away with the scheduled decrease in the 2006 AMT exemption amounts for individuals and provides for exemption amounts that are higher than they were for 2005.
For 2005, the maximum AMT exemption amount was $58,000 for married individuals filing jointly and surviving spouses, $40,250 for unmarried individuals, and $29,000 for married taxpayers filing separately. Without the TIPRA fix, the 2006 exemption amounts would have been $45,000, $33,750 and $22,500, respectively. Under the Act, for tax years beginning in 2006, the exemption amounts for individuals increase to the following amounts: $62,550 for married individuals filing jointly and surviving spouses, $42,500 for unmarried individuals, and $31,275 for married individuals filing separately.
For example, for married individuals filing jointly who are subject to an AMT tax rate of 26%, the increase in the 2006 exemption from $45,000 to $62,550 results in a reduction in the AMT of approximately $4,500, assuming their AMT tax liability exceeds their regular income tax liability by at least that amount.
Furthermore, in 2005 several personal credits could be used against AMT. Under pre-TIPRA law, for 2006, personal credits, other than the child credit, the adoption credit and the low-income saver's credit, could not exceed the excess of regular tax liability over tentative minimum tax. In other words, if your AMT liability exceeded your regular tax liability, most personal credits were not allowed.
Under the Act, the maximum that may be claimed for personal credits for 2006 will remain the same as in 2005. Thus, for tax years beginning in 2006, personal credits (including the dependent care credit, the credit for the elderly and permanently and totally disabled, the mortgage credit, the child tax credit, the Hope and Lifetime Learning credits, the adoption credit, the lower income saver's credit, the DC homebuyer credit and the new for 2006 residential and nonbusiness energy property credits) are allowed against the AMT.
Lower Capital Gain Rates Extended for Two Years Through 2010
A noncorporate taxpayer's adjusted net long-term capital gain is taxed at a maximum rate of 15%, or, to the extent a taxpayer is in the 10% or 15% ordinary income tax bracket, at a maximum rate of 5% (0% for tax years beginning after 2007). Adjusted net capital gain is net capital gain for the tax year (i.e., the excess of net long-term capital gains (held more than one year) over net short-term capital losses for a tax year) plus qualified dividend income. However, gain on the sale of most collectibles is taxed at a maximum rate of 28%, and gain attributable to real estate depreciation deductions is taxed at a maximum rate of 25%.
Under pre-TIPRA law, the 15%, 5% (through 2007), and 0% (after 2007) rates on adjusted net long-term capital gains were due to expire at the end of 2008, and the old rates in effect before that (ranging from 8% to 20%) were due to come back into effect. TIPRA, however, extends for two years the 15% and 0% rates on adjusted net capital gain through tax years beginning before 2011.
Lower Capital Gains Rates on Noncorporate Taxpayers' Qualified Dividend Income Extended for Two Years Through 2010
Qualified dividend income, which consists of dividends received during the tax year from domestic corporations and "qualified foreign corporations," subject to holding period requirements and specified exceptions, is effectively treated as adjusted net long-term capital gain and is therefore taxed at the same rates that apply to adjusted net capital gain (e.g., 15%).
Under pre-TIPRA law, this treatment was due to expire at the end of 2008 and qualified dividend income was then to be taxed at ordinary income rates, which can be as high as 35%. The TIPRA provisions, however, extend for two years the treatment of qualified dividend income as adjusted net long-term capital gain through tax years beginning before 2011.
Enhanced Code Section 179 Expensing Election Extended Two Years Through 2009
Most taxpayers, with the exception of estates, trusts and certain noncorporate lessors, may elect under Section 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 the taxpayer's trade or business. Under pre-TIPRA law, this amount was scheduled to drop to $25,000 for property placed in service in tax years beginning after 2007.
Furthermore, the maximum annual expensing amount is reduced dollar for dollar by the amount of qualified property that is placed in service during the tax year in excess of a phase-out amount. Under pre-Act law, it was to drop to $200,000 for property placed in service in tax years beginning after 2007.
TIPRA extends the $108,000 expense election limit and the $430,000 phase-out ceiling (as adjusted for inflation) for two years, to tax years beginning before 2010. However, unless Congress changes the rules again, for property placed in service in tax years beginning after 2009, the expensing maximum will drop to $25,000 and the phase-out ceiling will drop to $200,000.
This table summarizes these four tax reduction provisions. The shaded areas reflect the TIPRA changes.
Tax Increase Provisions
To offset a portion of the decrease in tax revenues that will result from the Act's tax reduction provisions, some of which we have discussed above, the Act contains a number of provisions for raising revenue. The most important are described below.
Adjusted Gross Income (AGI) Ceiling on Traditional IRA-to-Roth-IRA Conversions Removed After 2009
Under pre-TIPRA law, amounts in traditional IRAs can be converted to Roth IRAs, provided certain requirements are met. Those requirements are that, for the year in which the amounts are withdrawn from the traditional IRA, (1) the taxpayer's modified AGI (not including the taxable amount of the conversion) does not exceed $100,000, and (2) the taxpayer is not a married individual filing a separate return (unless the taxpayer lived apart from their spouse during the entire withdrawal year). The $100,000 modified AGI limit is determined without regard to required minimum distributions from an IRA.
Although the income resulting from the conversion is included in income for the tax year in which the funds were transferred (or withdrawn) from the traditional IRA, and therefore is a revenue producer for the government, the 10% premature distribution penalty does not apply.
TIPRA changes the law by providing that, for tax years beginning after Dec. 31, 2009, (1) the $100,000 modified AGI limit on conversions of traditional IRAs to Roth IRAs is eliminated, and (2) married taxpayers filing separate returns are permitted to convert amounts in a traditional IRA into a Roth IRA. Furthermore, principal amounts contributed to a nondeductible traditional IRA and converted to a Roth IRA would not be subject to income tax, since the contributions were nondeductible and no tax benefit was received.
The result of the elimination of the $100,000 modified AGI threshold described above, which will affect many more taxpayers than the second change, is that taxpayers may make such conversions without regard to their AGI.
For 2010 only, unless a taxpayer elects otherwise (and, in general, it would not be recommended that a taxpayer elect otherwise), none of the gross income from the traditional IRA-to-Roth-IRA conversion is included in income. Rather, half of the income resulting from the conversion is includible in gross income in 2011 and the other half in 2012. For 2011 and thereafter, the income resulting from IRA-to-Roth-IRA conversions is included on the return for the tax year in which funds are transferred or withdrawn from the IRA.
Kiddie Tax Now Applies to Children Under 18
A child subject to the kiddie tax pays tax at his or her parents' highest marginal rate on the child's unearned income (for example, interest and dividend income) over $1,700 (for 2006) if that tax is higher than the tax the child would otherwise pay on it. Alternatively, the parents can elect to include on their own return the child's gross income in excess of $1,700.
Under pre-TIPRA law, a child is subject to the kiddie tax if he or she has not attained age 14 before the close of the tax year and either parent of the child is alive at the end of the tax year. Under the Act, for tax years beginning after 2005, a child is subject to the kiddie tax if he or she has not attained age 18 before the close of the tax year, either parent of the child is alive at the end of the tax year and the child does not file a joint return for the tax year. Thus, it increases the potential applicability of the kiddie tax for an additional four years and is a revenue raiser for the government.
TIPRA Includes Many Other Changes, Including the Following Four Provisions
Information Reporting of Interest Paid on Tax-Exempt Bonds
Information reporting on Forms 1099-INT will be required for interest paid on tax-exempt bonds after Dec. 31, 2005. This has implications for both federal AMT and regular tax purposes, as well as for state income tax purposes.
Payments on Offers-in-Compromise
Taxpayers will be required to make partial payments to the IRS while their offer-in-compromise is being considered by the IRS, effective for offers-in-compromise submitted on or after July 16, 2006. For lump-sum offers (which include single payments, as well as payments made in 5 or fewer installments), taxpayers would have to make a down payment of 20% of the amount of the offer with any application. If the IRS fails to process the offer within two years, the offer will be deemed to be accepted. And although user fees would be eliminated for offers submitted with the appropriate partial payment, the 20% down payment may make offers-in-compromise substantially less appealing.
Capital Gain Treatment for Sales or Exchanges of Musical Compositions or Copyrights in Musical Works
Under prior law, literary, musical, or artistic compositions, letters or memoranda, or similar property held by a taxpayer whose personal efforts created the property were not treated as capital assets. Consequently, for example, when a taxpayer sold copyrights he owned in songs he created, gain from the sale was treated as high-taxed ordinary income rather than low-taxed capital gain. Under the new law, at the election of the taxpayer, the sale or exchange of musical compositions or copyrights in musical works created by the taxpayer's personal efforts is treated as the sale or exchange of a capital asset. This change is effective for sales in tax years beginning after May 17, 2006 that occur before 2011.
Foreign Earned Income Exclusion and Housing Allowance Changes
TIPRA also makes three changes to the foreign earned income exclusion and housing allowance.
First, the income exclusion is indexed for inflation starting in 2006 (rather than 2008 under current law).
Second, the base housing amount used in calculating the foreign housing cost exclusion in a taxable year is modified (the new base amount is 16% of the amount of the foreign earned income exclusion limitation; e.g., for 2006, .16 X $82,400 = $13,184). Although reasonable foreign housing expenses in excess of the base housing amount remain excluded from gross income, the amount of the housing exclusion in excess of the base housing amount is limited to 30% of the taxpayer's foreign earned income exclusion. Thus, for 2006, a qualified individual whose entire taxable year is within the applicable period is limited to maximum housing expenses of $24,720 ($82,400 X .30). Accordingly, the maximum housing cost amount a qualified individual may exclude from income in 2006 is $11,536 ($24,720 - $13,184). The TIPRA change applies to taxable years beginning after December 31, 2005.
After lobbying by U.S. expatriate groups, U.S. Treasury officials issued "Notice 2006-87," which provides new housing cost limits for U.S. expatriates in some nations, but not all. The limitations are adjusted based on geographic differences in housing costs relative to housing costs in the United States. There are many countries on the list, such as Hong Kong and Singapore, where housing costs are steep.
The final change provides that income excluded as either foreign earned income or as a housing allowance is included for purposes of determining the marginal tax rates applicable to non-excluded income. In other words, although a portion of your income may not be subject to taxation due to the two exclusions, the remaining portion of your income is taxed as if the exclusions did not exist.
For Further Information
If you have any questions about the information in this Alert or would like to learn more about TIPRA, please contact Michael A. Gillen, CPA, CFE, Director of Tax Accounting, or the practitioner with whom you are regularly in contact.
As required by United States Treasury Regulations, you should be aware that this communication is not intended by the sender to be used, and it cannot be used, for the purpose of avoiding penalties under United States federal tax laws.
Disclaimer: This Alert has been prepared and published for informational purposes only and is not offered, nor should be construed, as legal advice. For more information, please see the firm's full disclaimer.
