The Summer 2004 Tax Client Newsletter brings you up-to-date on a number of important tax law changes for 2004. As a result of tax legislation over the past few years, there are a number of significant tax law changes affecting you this year and right now.

You may be aware through media attention that many of the important tax law changes are scheduled to “sunset” (go away) at various dates – some sooner rather than later. While the House of Representatives has been very busy voting to extend a number of tax benefits (child tax credit, marriage penalty relief, lower tax brackets, etc.), the United States Senate has taken a “slow down” approach in considering 2004 tax bills. Only time will tell what, if any, tax law changes will be enacted in 2004. In July, Congress left for its summer recess with much work waiting for the post Labor Day session.  You should think of the “sunset” issue as a future concern and take advantage of the opportunities that you have today.

If you have any questions concerning any of the information being reported on in the Tax Client Newsletter, please contact my office to schedule an appointment.

 2004 Tax Law Changes

With the stroke of his pen, President George Bush signed (May 28) into law the Jobs and Growth Tax Relief Reconciliation Act of 2003. The new law contains $330 billion worth of tax cuts and many of the benefits are in place this year.

As you will read below, the 2003 Tax Act offered something for many, but not all, taxpayers.

 Tax Brackets Reduced

One of the most significant features of the recent tax law changes was the lowering of income tax brackets. The 2001 Economic Growth and Tax Relief Reconciliation Act provided that individual marginal tax rates gradually decline over several years. The 2003 legislation accelerated the reductions. The new tax rates/brackets are:

Now                           Was

35%                            38.6%

33%                            35%

28%                            30%

25%                            27%

15%                            15% (no change)

10%                            10% (no change)

Note: Rates were retroactive to January 1, 2003.

 10% Bracket Expanded

Single taxpayers with taxable income over $6,000, or a married couple with taxable income over $12,000 (head-of-household remains at $10,000), benefited from the acceleration of the expansion of the 10% bracket in 2003. Under the 2001 legislation, the 10% bracket was scheduled to increase to $7,000 for singles and $14,000 for joint filers in 2008.

The 2003 legislation expanded the 10% tax bracket and the expansion is effective for tax years 2003 and 2004. In 2005, the thresholds revert back to $6,000 and $12,000 respectively and remain there until they are bumped up again in 2008.

The 10% tax bracket amounts are adjusted for inflation in 2004 and then again in tax years beginning after 2008.

 Marriage Penalty Relief

The 2003 tax law changed the so-called “marriage penalty” rules of the tax code. The marriage penalty is a feature of the tax code that, in some cases, leaves two working spouses worse off tax wise than they would be as singles. The marriage penalty comes about because some features of the tax laws don’t always double for married couples.

For 2003 and 2004, the new law makes the standard deduction for married taxpayers filing jointly twice that of singles: $9,500 for the married couple filing jointly and $4,750 for single taxpayers.

The new law expands the 15% tax bracket for married couples filing jointly to double that of single taxpayers. The expansion of the 15% bracket to eliminate potential marriage penalties benefits all joint filers with income over $47,450, though some marriage penalty kicks in again for married couples starting above $114,650 in income.

After 2004, both the standard deduction and the 15% rate bracket expansion provisions “sunset,” meaning that the rules go back to the 2001 standards unless Congress decides to extend the changes.

 Investors Win: Lower Capital Gains Rates

Investors came out a very big winner under the 2003 tax bill. The top capital gains rate was lowered from 20% to 15%. The lowest capital gains rate decreased to 5% from 10%. Note that the lower rates are effective for transaction after May 5, 2003. The lower rates are scheduled to expire after 2008.

The paperwork on capital gains for 2003 proved to be a nightmare as taxpayers struggled with timing issues. Long-term gains on sales made through May 5, 2003 were taxed at up to 20% or 10% while sales made after May 5, 2003 are taxed at 15% or 5%. There was no increase in the $3,000 annual limitation on deducting excess capital losses. For 2004, the rates are 15% or 5% respectively.

Taxpayers in the lowest two brackets (10% and 15%) will get a one-year bonus in 2008 when they will pay no federal taxes on capital gains. The tax is reinstated after 2008.

Investors Win: Dividends Taxed at 15%

Historically, dividend income was taxed as ordinary income. Under the 2003 tax legislation, the top dividend rate was lowered to 15%. Taxpayers in the lowest two tax brackets pay 5%. This is a very significant change when you consider the fact that the top rate for dividends was 38.6%.  The new lower rates are effective for qualified dividends received after December 31, 2002. That’s right – all “qualifying dividends” received in 2003 were taxed at the lower rates of 15% and 5% respectively.

The IRS has reported that there was significant confusion on the part of companies and brokers in reporting whether the dividends were “qualified” for the lower rates. The problem resulted from a special holding period that Congress created. According to the IRS, at least 9.5% of dividend forms (1099-Div) sent to taxpayers in 2004 contained errors. The tax professional community anticipated this problem and warned the IRS that the rules were far too complicated for the average taxpayer to deal with. The IRS has recently taken steps to clarify the “qualifying dividends” rules – the changes are pro-taxpayer.

Taxpayers in the lowest two brackets will get a one-year bonus in 2008 when they will pay no tax on dividend income. The tax is reinstated after 2008.

Families Win: Child Tax Credit Increased

For 2003 and 2004, the child tax credit was increased from the current $600 to $1,000. As a result some 24.4 million families were eligible to receive a $400 rebate check in the summer of 2003. The Treasury Department and the IRS relied on data in the system from 2002 tax returns. Taxpayers and their tax professionals were not required to take any additional steps to receive the checks. Since the immediate increase in the child tax credit was in 2003, the government will not be issuing any advance rebate checks in 2004.

Parents, who give birth or adopted a child in 2003, had to wait until they filed their 2003 tax return to claim the full $1,000 credit.

The child tax credit phases out for married couples that earn more than $110,000 in AGI and single parents whose AGI exceeds $75,000.

Unless this increase in the child tax credit is extended by Congress, the credit will drop back to $700 in 2005 and $500 in 2011. After 2005, the credit will slowly build back up to $1,000 before falling to $500 in 2011. Talk about confusion.

 Additional Comments on 2004 Tax Law Changes for Individuals

One of the most significant tax law changes for 2004 is the introduction of Health Savings Accounts (HSAs). The HSAs were created in the Medicare Prescription Drug Improvement and Modernization Act of 2003. Effective January 1, 2004, HSAs allow deductible contributions to be set aside to cover medical expenses that are not covered by a high-deductible medical plan in which the taxpayer-employee participates.

The contributor to the HSA – either the employee of the employer – gets a tax deduction for the contributions going into the HSA, and then the employee is allowed to withdraw the funds tax-free in the same year or in a future year to cover their unreimbursed medical expenses. Contributions that are not used in any tax year may be rolled over for future use. Upon reaching the age of 65, accumulated funds in an HSA can be withdrawn tax-free to cover medical expenses or they can be withdrawn penalty-free (but not tax-free) for any purpose.

The above-the-line deduction (maximum of $250) for teachers for their out-of-pocket classroom expenditures expired on December 31, 2003. While it is likely that Congress will vote to reinstate this tax benefit for 2004 – it has not done so yet. Educators are advised to save receipts and hope that Congress acts before the end of the year.

The above-the-line deduction for higher education expenses increases this year based on the 2001 Tax Act. The maximum deduction increases to $4,000 for 2004 and 2005 (was $3,000). In addition, some taxpayers who were not eligible for the deduction based on their adjusted gross income are now eligible for a maximum $2,000 deduction. Unless Congress acts, the popular deduction for higher education expenses will expire at the end of 2005.

One of the tax law adjustments for 2004 relates to a schedule that Congress created in the Taxpayer Relief Act of 1997. The income eligibility limits for a deductible IRA contribution increase to a range of $45,000to $55,000 (was $40,000 to $50,000) for single taxpayers and $65,000 to $75,000 (was $60,000 to $70,000) for a married couple filing jointly.

The dependent standard deduction adjustment increases in 2004 (for the first time since 2001) to $800 (was $750).

Changes in the area of estate taxation have produced an increase in the lifetime exclusion from $1 million to $1.5 million for 2004. The maximum tax rate for estate and gift tax is now 48%. The gift tax lifetime exclusion remains at $1 million as does the annual $11,000 per recipient (donee) tax-free gifts rule. The $11,000 is $22,000 in the case of joint gifts from a married couple.

Tax Breaks for Business

Continuing with the theme that the Jobs and Growth Tax Relief Reconciliation Act of 2003 offers something for almost everyone, the law increases the amount that business can “expense” or immediately write off, from $25,000 to $100,000. For 2003 through 2005, firms that put less than $400,000 of assets in use in a year can expense up to $100,000 of the cost in lieu of depreciation. The trigger point of the investment limitation phase-out increases from $200,000 to $400,000.  The dollar limitations will be indexed for inflation during 2004 ($102,000) & 2005 (?).

The increase in the so-called expensing deduction has the potential to assist businesses while also serving to stimulate the economy. The business community can be expected to leverage the available tax incentive.

Bonus depreciation is increased from 30% to 50% for post-May 5, 2003 acquisitions. The type of property that qualifies for this special allowance is unchanged from existing law. For the 50% allowance to apply, the property must be acquired after May 5, 2003, and before January 1, 2005. Note that if a binding contract to acquire the property was in effect before May 6, 2003, the property does not qualify for the 50% bonus depreciation (30% may be available). Taxpayers may elect out of bonus depreciation.

The standard mileage rate allowance for business use has increased to 37.5 cents for 2004 (up from 36 cents); the mileage rate related to medical and moving expenses increased from 12 cents to 14 cents per mile.

Conclusion

The 2003 Tax Act is a bumpy series of starts and stops – in some cases accelerating for brief periods some provisions of the 2001 Tax Act, providing short-term business investment incentives, and dramatically reducing income tax rates on capital gains and dividends for a short period of time. The difficult work in Congress is far from over and the issue of expanding the tax benefits remains on the front burner.

As always your individual focus should be on how the tax law changes affect you and how the tax law changes may benefit you.

Thank you for reviewing the Summer 2004 Tax Client Newsletter and for the opportunity to serve as your tax professional.

Enjoy the Summer!

2002 Fall     2002 Summer         2000 Spring/Summer     1999 Summer