Taxes, Trouble and
Trial Balloons in 2005

Early in his second term, President George W. Bush has already signaled a willingness to spend political capital to enact changes to the federal tax system. Those changes, in whatever form they eventually take, along with a number of changes made to the tax laws during Bush’s first term, will have a significant impact on the tax bills—and penalties—faced by every metals distributor.

Among the ideas vying for the president’s support are elimination of many of the so-called “tax preferences” in the tax law, a flat tax of less than 20 percent to replace the current tax bracket system, and the creation of a national sales tax that would completely replace the income tax.

Late in 2004, panelists at a forum sponsored by the Brookings Institution, a Washington, D.C.-based think tank, predicted that an impending stock market crash or further devaluation of the dollar would force the Bush administration to act to reduce the deficit, therefore pushing tax reform to the back burner.

In addition to this fairly dim assessment of the prospects for fundamental tax reform, the American Bar Association Section of Taxation is pressing lawmakers to repeal or modify the alternative minimum tax, claiming that it no longer serves the purpose for which it was originally intended—to ensure that high-income individuals pay at least some tax.

Other experts have said that making the Bush tax cuts permanent is the key issue for lawmakers in 2005. The administration has yet to propose a way to pay for that permanence, however.

It is difficult to predict whether the president will be able to complete his ambitious program of reforms, especially given the likelihood of opposition from Democrats and even some Republicans. In view of this, what does the year 2005 hold for metal center operators?

Coming attractions
The centerpiece of last year’s major tax-cutting legislation created a 3 percent tax rate cut for “manufacturers.” Although lawmakers’ extremely broad definition of “manufacturers” included both traditional manufacturers as well as so-called “producers” in the areas of construction, engineering, energy production, computer software, films and videotapes, and agricultural processing, that tax rate reduction is unlikely to apply to many metal centers. However, the Internal Revenue Service has the final word on which “domestic producers” will actually qualify.

Far more metals distributors will benefit in 2005 from the new threshold for Section 179 write-offs, which was raised to $100,000 from $25,000. This special, first-year expensing write-off for equipment costs is reduced by the amount by which the cost of qualifying property placed in service exceeds $400,000.

Originally designed as a temporary measure to stimulate the economy, the write-off was scheduled to drop back to $25,000 in 2006. Not only have industry groups managed to influence lawmakers to extend the higher caps through 2007, the new law also indexed the threshold amounts for inflation. In 2004, it was $102,000, with a $410,000 cap. This change carries the indexing through to 2007 as well.

On the depreciation front, lawmakers created a 15-year recovery period for qualified leasehold improvements. Thus, any steel distributor that modifies, adapts or adds to the operation’s business premises in 2005 (between Oct. 22, 2004, and before Jan. 1, 2006) will qualify for a 15-year write-off period for the cost of the improvements.

The old rules required leasehold improvements or additions to be depreciated using straight-line depreciation over the same 39-year period as business property. A qualified leasehold improvement is defined as an improvement to the interior of a building, made by either the lesser or the lessee, and placed in service more than three years after the building was first placed in service.

Say yes to S
As a result of last year’s tax law changes, many steel distributors may want to change their business entity in 2005. Despite the popularity of limited liability companies and other partnership-type entities, S corporations remain the fastest growing type of business entity. A metal center operating as an S corporation passes through income and loss to shareholders. The shareholder takes into account their shares of these items on their individual tax returns.

To encourage the continued growth of the nation’s leading job-creating businesses, last year’s law changes reformed and simplified the tax treatment of S corporations. Under the old law, most family members were treated as separate shareholders, limiting a company’s ability to diversify its investors and therefore better withstand business fluctuations.

The new law allows family members to elect to be treated as one shareholder for purposes of determining the number of shareholders of an S corporation. It also increases the maximum number of S corporation shareholders from 75 to 100.

On another front, those losses and deductions disallowed because an S corporation shareholder had an insufficient basis in the stock are usually lost once the shares are transferred. Now, thanks to the new law, those suspended losses and deductions may be transferred to a spouse or former spouse as part of a divorce settlement. The suspended loss or deduction will be treated as incurred by the S corporation in the succeeding tax year for purposes of these unique transfers.

The new law will also:

• Allow employee stock ownership plans to repay exempt loans from an S corporation using the proceeds from the S corporation and accomplish it all without jeopardizing the status of the ESOP.
  
• Ease the rules for determining potential current beneficiaries of an electing small business trust.
  
• Permit distributions from an ESOP maintained by an S corporation.

Paying the piper
When it comes to the “cost” of last year’s tax cuts, it is the metals distributor and his fellow taxpayers, not the U.S. Treasury, that will be footing the bill. According to lawmakers, the cost of the tax-cut law will be offset by closing a number of tax loopholes, as well as with other revenue-raising measures.

Among the loopholes closed in 2005 is one that allowed some small-business owners to deduct up to $100,000 of the cost of luxury sport-utility vehicles on their income tax returns. Because the vehicle caps on depreciation do not apply to cars or trucks weighing more than 6,000 pounds, metals distributors could deduct up to the full cost of the SUV immediately as a Section 179 expense. Now, under the new law, the deduction for vehicles weighing not more than 14,000 pounds is capped at $25,000, effective for SUVs placed in service after Oct. 22, 2004.

Another new provision requires increased reporting for any metal center operation or business making non-cash charitable contributions. The new law extends to all incorporated businesses, requiring that a donor obtain a qualified appraisal of the donated property if the amount of the claimed deduction is more than $5,000. Similarly, if the amount of that contributed property, other than cash, inventory or publicly traded securities exceeds $500,000, the appraisal must be attached to the annual tax return.

As for tax “strategies” owners often use to keep profits and proceeds from the sale of their businesses out of the tax collector’s grasp, the new law contains 21 provisions that crack down on a variety of tax schemes and shelters.
In 2005, both individuals and businesses such as metal centers will be required to disclose to the IRS details about their participation in tax shelters. Last year’s changes also boost the penalties for failing to do so. Penalties for failing to report a tax shelter apply not only to so-called “listed” transactions, those known to the IRS, but also to what our lawmakers term “abusive transactions.”

That’s right, for returns and statements due after Oct. 22, 2004, the law has added a new penalty for failing to disclose reportable transactions regardless of whether the transaction ultimately results in an understatement of tax. The penalty is $50,000 for businesses, or $10,000 for individuals. If the shelter is a “listed transaction,” the penalty skyrockets to $200,000 for businesses or $100,000 for individuals.

For those who may be less than truthful on their business or personal tax returns, the new law also created a new accuracy-related penalty for reportable and listed transactions. Lawmakers granted the IRS discretion in applying the penalties. Fortunately, the IRS is likely to continue its “carrot and stick” approach with taxpayers suspected of participating in, or promoting, abusive shelters.

Most of last year’s revenue-raising provisions are permanent, while the majority of tax cuts have only a temporary life. This adds to the uncertainty faced by the owners and managers of metal center operations in 2005. Will these and other tax cuts enacted in President Bush’s first-term be made permanent? Will the income tax system as we know it be abandoned in favor of a national sales tax? The year 2005 should be an interesting one as metals distributors scramble to plan in the face of this uncertainty.

Mark Battersby is a freelance writer and consultant on tax and financial issues and is based in Ardmore, Pa. He can be reached at 610-789-2480.