Significant Tax Incentives in Jobs Act; Not Limited to Small Business
With an eye to the economy, Congress has enacted the
Small Business Jobs Act of 2010. Signed into law September 27, it includes $12 billion in business tax incentives and $14.5 billion in revenue provisions, many of which have retroactive impact for 2010. It’s labeled a small business bill but affects larger businesses and individuals as well.
Expanded Section 179 deduction
Prior to this legislation, the first-year Section 179 expense deduction allowed businesses to write off the first $250,000 of capital equipment purchases. This deduction phased out on a dollar-for-dollar basis as the taxpayer’s eligible purchases exceeded $800,000.
For tax years beginning in 2010 and 2011, the Section 179 amount increases to $500,000 and adjusts the asset addition phase-out threshold to $2 million. As a result, with the phase-out threshold now running from $2 million to $2.5 million, a greater number of businesses will qualify for the Section 179 write-off.
“The expansion of the Section 179 deduction is significant, and raising the current year asset purchase limit for eligibility opens this deduction to businesses previously excluded,” says Mark Joyce, tax principal with LarsonAllen.
Limited expansion of Section 179 to 15-year qualified real estate
For tax years beginning in 2010 and 2011, the legislation allows up to $250,000 of a taxpayer’s $500,000 Section 179 allowance to be applied to three categories of qualified real estate that otherwise are depreciable over a 15-year recovery period:
- Qualified leasehold improvement—This is defined as an improvement to an interior portion of a building that has been in service for more than three years and is used other than as a residential rental. The expenditure may be made by either the landlord or tenant. The building must be under a lease arrangement, but it cannot be a related-party lease. Finally, the improvements cannot include an elevator or escalator, nor be for the enlargement or internal structural framework of the building.
- Qualified restaurant property—Restaurant building improvements, as well as a restaurant building acquisition, qualify.
- Qualified retail property—This applies to buildings that have been in service more than three years and are used in selling tangible personal property to the general public. The enhancements must be to an interior portion of the building, and cannot include an elevator, escalator, building enlargement, or internal structural framework.
Example: Applying the New Section 179 Limits for 2010
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Company Q acquired $150,000 of equipment during 2010, and made $300,000 of interior improvements to a building it leases from an unrelated party. Q may claim $250,000 of Section 179 expense with respect to the $300,000 of leasehold improvements. In addition, Q claims $150,000 of Section 179 expensing in connection with its equipment purchases, for a total deduction for 2010 of $400,000.
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“Applying the Section 179 write-off to commercial building improvements is a first. Those owning restaurants, retail stores, or other commercial buildings under lease can benefit if the changes are completed in their 2010 or 2011 tax year,” Joyce says.
Retroactive extension of 50 percent bonus depreciation
During 2008 and 2009, the tax law allowed a 50 percent first-year bonus depreciation for the cost of new property. The new legislation retroactively extends this to property that is both acquired and placed in service during calendar year 2010.
The definition of qualified property for the 50 percent bonus deduction is unchanged. It must have a recovery period of 20 years or less, the original use must commence with the taxpayer (i.e., the property is new rather than used), and the asset is both acquired and placed in service within the eligible time period. Qualified leasehold improvement property is specifically eligible, but qualified restaurant and qualified retail improvement property is not. There is also an incentive to acquire new cars and light trucks for business use. An extra $8,000 of first-year depreciation is allowable, bringing the first-year maximum deduction to about $11,000.
Percentage-of-completion accounting method
Businesses with long-term construction contracts generally use the percentage-of-completion accounting method. Under the new law, they will be able to deduct any 50 percent bonus depreciation on equipment with a seven-year or less recovery period, but can ignore that write-off in calculating the costs for the percentage-of-completion of ratio.
“The effect will be to compute a lower percentage of the contract as completed during the 2010 tax year, which defers a greater amount of profit on the contract to later years,” Joyce says.
Improved deduction of pre-opening costs
Presently, a taxpayer starting a new business is allowed to deduct the first $5,000 of start-up or pre-opening expenses. Excess amounts must be capitalized and amortized over 15 years. But if total start-up costs exceed $50,000, a phase-down of the $5,000 deduction occurs on a dollar-for-dollar basis, and all costs must be capitalized and amortized. Pre-opening or start-up expenditures are defined as costs related to the investigation, acquisition, or creation of a business, or expenses incurred before the day business begins.
For the taxable year beginning in 2010, the first-year deduction for pre-opening or start-up costs increases to $10,000. Also, the threshold at which a phase-out begins increases from $50,000 to $60,000. Accordingly, as total pre-opening costs increase from $60,000 to $70,000, the $10,000 deduction decreases proportionately, and excess costs are subject to 15-year amortization.
This change is for one year only and only affects those starting a new business activity.
Temporary 100 percent gain exclusion on section 1202 stock
Individuals and other non-corporate taxpayers have been allowed to exclude 75 percent of the gain from the sale of Section 1202 small business stock acquired at original issue and held for at least five years. A Section 1202 corporation must be organized as a C corporation, and conducting an active business other than in professional services, financial services, agriculture, extractive industries, or hospitality. Further, the corporation must have gross assets of $50 million or less. A special 28 percent rate applies to the 25 percent portion of the gain that is taxable, so an effective 7 percent regular tax rate applies to Section 1202 stock gain.
A portion of the excluded gain is an alternative minimum tax (AMT) preference, so that, historically, Section 1202 stock has had a higher AMT tax rate than regular tax rate.
The new legislation allows a 100 percent gain exclusion on Section 1202 stock acquired after September 27, 2010, and before January 1, 2011, and held for at least five years. Further, gains on this stock have no AMT adjustment, so the effective AMT rate is also zero.
Section 1202 still requires that the stock be acquired originally from the C corporation and the business operate in limited industries, such as manufacturing, construction, and retailing-wholesaling. Venture capital investments in recent years have generally been in pass-through vehicles such as LLCs. The fact that a Section 1202 business activity must continue to incur the corporate income tax means this incentive likely will be used rarely.
“There may be some opportunity for issuing stock in family businesses, where we can expect a stock sale to the next generation rather than an asset sale. But this needs to be planned carefully, so that no appreciating assets are trapped inside a C corporation,” says Joyce.
Enhanced small business tax credits
Presently, business credits in excess of current tax can be applied to future years, specifically back one year and forward up to 20 years. Most business credits only offset income tax, not AMT. Business credits that pass through to individual returns frequently are not used currently, because the individual is subject to AMT—those credits go into carryover status.
The small business act makes two changes to improve the use of business credits by those eligible. For the tax year beginning in 2010 only, excess small business tax credits will carry back to the prior five years rather than just one year (the carryforward period remains at 20 years). Second, small business credits created for the tax year beginning in 2010 offset all tax, whether regular or AMT.
An eligible small business for these two privileges is defined as a corporation that is not publicly traded, or it is a partnership or a sole proprietorship, if the average annual gross receipts for the three preceding tax years do not exceed $50 million. Aggregation rules apply for related or controlled entities. In the case of credits passed through from a partnership or S corporation, the individual partner or shareholder must also meet the $50 million gross receipts test for the year the credits are allowed as current.
Several key business credits are already offsetting both regular tax and AMT:
- Small Business Health Care Tax Credit
- Low Income Housing Tax Credit
- Work Opportunity Tax Credit
- FICA Tax Tip Credit
- Federal Rehabilitation Tax Credit for old buildings and certified historic structures
Those credits are only enhanced to the extent that a new 2010 tax credit will allow recovery of taxes paid in the prior five years. There are almost 30 other business credits that in the past have not had the capability of offsetting AMT and have been limited to a one-year carryback. Many are narrow energy-related credits, but some commonly used credits that now receive improved treatment include:
- Research and Development Tax Credit
- Credit for Employer-Provided Childcare Facilities and Services
- Credits for alternative energy vehicles (hybrids) and plug-in electric vehicles used in business
Reduced period for S corporation built-in gains tax
When a C corporation subject to the corporate income tax elects S status, it is exposed to a top-rate 35 percent built-in gains tax on any corporate-level gain recognition during the first 10 years the S election is in effect. However, as part of recent economic recovery legislation, Congress shortened the reach of the built-in gains tax to the first seven years of S corporation status, effective for S tax years beginning in 2009 and 2010.
The new law further decreases the reach of the built-in gains tax. For the S corporation tax year beginning in 2011, the tax is not applicable if the corporation has been in S status for the prior five years.
For the 2010 S corporation tax year, under the seven-year rule, an S corporation must have made an S election effective January 1, 2003, or earlier to be free of the built-in gains tax. For the 2011 calendar year under the five-year rule, an S election as recently as January 1, 2006, allows the S corporation to be free of the built-in gains tax.
2010 break on self-employment tax
Self-employed proprietors and partners presently claim an income tax deduction for the cost of health insurance, including that of spouse and dependents/children not yet age 27 as of the end of the tax year. However, this health insurance deduction is not available in computing the self-employed Social Security tax.
Effective only for the tax year beginning in 2010, a self-employed taxpayer may deduct the cost of health insurance both for income taxes and the self-employed Social Security tax.
The value of this one-year deduction in computing self-employment tax will be significantly greater for those whose self-employment income is under $106,800. In this case, the taxpayer receives the full 15.3 percent benefit of the deduction. However, higher income individuals whose self-employment income is only subject to the 2.9 percent Medicare rate will receive a lesser savings.
Documentation rules eased on cell phones
Previously, cell phones have been categorized as “listed property” in the tax law. This placed extra substantiation requirements on those who depreciated cell phones and claimed monthly deductions for mobile contracts for business use.
For tax years beginning in 2010 and after, cell phones are no longer subject to the increased substantiation rules affecting “listed property.”
The Joint Committee explanation of the legislation states that this provision does not affect the ability of the IRS to determine the appropriate characterization of cell phones as a working condition fringe benefit. Effectively, the business versus personal use will be a factual matter that is reviewed in the event of an IRS examination, but without the extensive recordkeeping requirements associated with listed property.
1099 reporting by landlords
Taxpayers conducting a business activity with payments of $600 or more to a service provider are required to issue a Form 1099 report to both the IRS and the payee. However, owners of rental property, if operating in passive status, have not been subject to this rule.
Under the act, those who receive rental income from real estate are considered to be engaged in a business, and are subject to the requirement to issue 1099 information returns. For example, a landlord making payments within the year of $600 or more to individuals or partnerships providing services such as repairs, painting, or bookkeeping would be required to issue a Form 1099-MISC to both the IRS and the payee. This provision applies to payments made after 2010, with limited exceptions for those who rent their principal residence or who receive a minimal amount of rental income (amount to be prescribed by the IRS).
Increase in information return penalties
The tax law already imposes a series of penalties on those who fail to file various 1099 and other information returns with both the IRS and the payee. The penalty for failure to file the information return with the IRS is a tiered penalty based on the timeliness of the late filing. This penalty caps at $50 per return. There is also a $50 penalty for each failure to furnish a statement to the payee.
Under the act, for information returns required to be filed on or after January 1, 2011 (i.e., the 2010 Form 1099s), the late filing penalties per 1099 failure are increased as follows:
Late Filing Timeframe
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Old Law
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New Law
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Within 30 days
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$15
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$30
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By August 1
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$30
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$60
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After August 1
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$50
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$100
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This tiered system is imposed under the new law on both the failure to furnish a 1099 to the IRS and the failure to furnish the information return to the payee.
In addition to doubling the penalty for each late information return, the new law also substantially increases the cap any employer can incur from these penalties in a single year. For example, a small business with gross receipts of not more than $5 million tops out at $500,000 in information return failure to file penalties to the IRS, and also $500,000 for not furnishing information statements to payees.
“Businesses should carefully review their compliance on 1099 reporting. There are dozens of transactions requiring 1099s, and with these new penalties, we can expect increased IRS scrutiny,” Joyce says.
Provisions affecting individuals
Section 457 plans allowed to add Roth feature
Section 457 plans are salary-reduction arrangements maintained by state and local governments and agencies. But unlike 401(k) and 403(b) plans, they have not been allowed to include a Roth feature that allows participants to reduce their salary to invest in an after-tax Roth account.
Effective for tax years beginning after 2010, a 457 governmental plan can be amended to allow participants to contribute to Roth accounts.
Rollovers within elective deferral plans to Roth accounts
Under former law, elective deferral 401(k) and 403(b) plans are permitted to have a designated Roth account, allowing an employee to make an elective annual contribution to a Roth account. Further, those plans may accept a rollover from another eligible retirement plan that is not a Roth IRA into the plan’s Roth account. In that case, the rollover is subject to taxation but is not subject to the 10 percent tax on early distributions.
Effective for distributions after September 27, 2010, 401(k), 403(b), and 457(b) plans may be amended to allow a participant to transfer funds from a non-Roth account within the plan to a designated Roth account within the same plan. The amount is included in taxable income but is not subject to the 10 percent early distribution tax. Further, any amount from a pre-tax qualified plan that is converted to a Roth account during 2010 is included in income equally in 2011 and 2012, unless the taxpayer elects otherwise.
“Converting a pre-tax amount to a Roth provides employees an opportunity to absorb extra taxable income at lower rates. However, the extra tax should be paid from outside funds,” Joyce says. “If retirement plan funds are withdrawn to pay the tax, a 10 percent early distribution penalty will generally occur.”
Partial distributions from the cash value of an annuity or life insurance contract are taxable first as ordinary income, with any cost in the contract only recovered tax-free after distribution of all income. In the case of an annuity, the holder is permitted to annuitize the entire contract, recovering each lifetime payment partially as ordinary income and partially as return of basis.
Effective for amounts received in tax years beginning after 2010, a taxpayer is permitted to annuitize a portion of the investment in an annuity, endowment, or life insurance contract while not annuitizing the balance. However, the portion annuitized must be paid over a period of 10 years or more or be annuitized for the lives of one or more individuals.
This provision provides important new flexibility, particularly for retirees who might benefit from annuitization of a portion of the cash value they hold in a tax-deferred annuity or life insurance policy.
How we can help
We can assist you in determining which of these incentives and provisions affect you and your business, and how to take advantage of them. We can also review your compliance status to help you avoid penalties.
For more information, view the Joint Committee technical explanation of the act.
View our tax principals.