Tax Law Changes : Tax-Year 2005 Businesses

Pick a topic from the list below to learn about the tax changes:

Section 1202 Exclusion Increased for Gain from Empowerment Zone Business Stock

A taxpayer other than a corporation generally can exclude up to 50% of a gain on the sale or trade of qualified small business stock held more than 5 years. This is called the section 1202 exclusion. Beginning in 2005, the exclusion is increased to as much as 60% of your gain if you meet the following additional requirements.

  1. You sell or trade stock in a corporation that qualifies as an empowerment zone business during substantially all of the time you held the stock.
  2. You acquired the stock after December 21, 2000.

Item (1) will still be met if the corporation ceased to qualify after the 5-year period that begins on the date you acquired the stock. However, the gain that qualifies for the 60% exclusion cannot be more than the gain you would have had if you had sold the stock on the date the corporation ceased to qualify.

The part of the gain that is included in income is 28% rate gain. See Capital Gain Tax Rates in chapter 4 of Publication 550, Investment Income and Expenses.

For more information about the section 1202 exclusion, see Section 1202 Exclusion in chapter 4 of Publication 550. For more information about empowerment zone businesses, see Publication 954, Tax Incentives for Distressed Communities.

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Capital Gain Treatment Applies to Outright Sales of Timber

Outright sales of timber by landowners after December 31, 2004, will qualify for capital gains treatment if the timber was held for more than 1 year before the date of disposal. The new rules extending capital gains treatment for outright sales of timber are similar to certain disposals of timber under a contract with a retained economic interest. However, for outright sales, the date of disposal is not deemed to be the date timber is cut; the owner may elect to treat the payment date as the date of disposal. For more information on dispositions of timber, see Publication 544, Sales and Other Dispositions of Assets.

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Deduction for Domestic Production Activities

For tax years beginning in 2005, you can deduct 3% of the smaller of:

  1. Your taxable income (adjusted gross income if you are an individual) determined without regard to this deduction, or
  2. Your qualified production activities income (defined later) from the following trade or business activities.

    1. Construction performed in the United States.
    2. Engineering or architectural services performed in the United States for construction projects in the United States.
    3. Any lease, rental, license, sale, exchange, or other disposition of:

      1. Tangible personal property, computer software, and sound recordings that you manufactured, produced, grew, or extracted in whole or in significant part within the United States.
      2. Any qualified film (defined later) you produced.
      3. Electricity, natural gas, or potable water you produced in the United States.

The deduction does not apply to income derived from the sale of food and beverages you prepare at a retail establishment; property you leased, licensed, or rented for use by any related person; or the transmission or distribution of electricity, natural gas, or potable water.

Qualified production activities income. Qualified production activities income is the excess, if any, of your gross receipts from the activities described above over the sum of:

  1. The cost of goods sold that are allocable to such receipts,
  2. Other deductions, expenses, or losses directly allocable to such receipts, and
  3. A ratable portion of other deductions, expenses, and losses that are not directly allocable to such receipts or another class of income.

When determining the cost of goods sold allocable to or the adjusted basis of leased or rented property that gives rise to your gross receipts from the activities described above, the cost or adjusted basis of any item or service brought into the United States cannot be less than its value immediately after it entered the United States. If you exported the property for further manufacture, the increase in cost or adjusted basis cannot be more than the difference between the value of the property when it was exported and the value of the property when it was brought back into the United States after the further manufacture.

Qualified film. A qualified film is any motion picture film or video tape if 50% or more of the total compensation relating to its production is compensation for services performed in the United States by actors, production personnel, directors, and producers. A qualified film does not include any property that requires records to be kept under the United States Code, title 18, section 2257, because it contains a visual depiction of sexually explicit conduct.

Limits on the deduction. The deduction cannot be more than 50% of the amount of wages (including certain elective deferrals and deferred compensation) you reported to your employees on Forms W-2. This deduction is allowed for alternative minimum tax purposes, but is not allowed in determining net earnings from self-employment.

Special rules apply to patrons of agricultural and horticultural cooperatives and members of expanded affiliated groups.

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Electing S Corporation Status

For tax years beginning after December 31, 2004, the number of shareholders that an S corporation may have increases from 75 to 100.

For purposes of the 100 shareholder limit, members of a family may elect to be treated as one shareholder. The election may be made by any family member. A family is defined as the common ancestor, the lineal descendants of the common ancestor, and the spouses (or former spouses) of the lineal descendants or the common ancestor.

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Increase to Withholding on Supplemental Wage Payments Exceeding $1,000,000

For payments made after 2004, the flat withholding rate on supplemental wage payments that exceed $1,000,000 during the year is increased to to 35%. See section 7 of Publication 15 (Circular E), Employer's Tax Guide, for more information.

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Employment Taxes on Employee Stock Options

Wages for social security, Medicare, and federal unemployment tax purposes do not include remuneration from exercising an incentive stock option or an employee stock purchase plan option after October 22, 2004, or from any disposition of stock acquired by exercising such an option. Federal income tax withholding is not required on income from a disqualifying disposition of stock acquired by exercising an incentive stock option or an employee stock purchase plan option after October 22, 2004, or on income from any disposition of stock acquired by exercising an employee stock purchase plan option after October 22, 2004, equal to the discount portion of stock acquired by exercising the option. See section 2 of Publication 15-B, Employer's Tax Guide to Fringe Benefits, for more information.

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Self-Employment Tax

The self-employment tax rate on net earnings remains the same for 2005. This rate, 15.3%, is a total of 12.4% for social security (old-age, survivors, and disability insurance) and 2.9% for Medicare (hospital insurance).

The maximum amount subject to the social security part for tax years beginning in 2005 has increased to $90,000. All net earnings of at least $400 are subject to the Medicare part.

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Increase to FUTA Tax Deposit Requirement

The deposit threshold for FUTA tax has been increased from $100 to $500. The $500 threshold applies to FUTA tax deposits required for taxes reported on Form 940, 940-EZ, and 940-PR, Employer's Annual Federal Unemployment (FUTA) Tax Return, for tax periods beginning after December 31, 2004.

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