In response to the current state of the economy, Congress has passed some tax legislation amending the Internal Revenue Code (the “Code”). Although it is up for debate, some would say that Congress has not been busy enough. As we near the end of the year, many taxpayers and their advisers are going through their usual year-end tax planning checklist. This year, planning may be greatly impacted both by recent legislation and by items that Congress has not yet addressed, including, among others, the extension (or lapse) of the “Bush tax cuts.”
In anticipation of 2010’s year-end tax planning, the following brief discussion highlights some of Congress’s most recent changes to the Code, as provided in the Small Business Jobs Act of 2010, and summarizes some of the items that still are pending and for which we are awaiting some clarity.
SMALL BUSINESS JOBS ACT OF 2010
The Small Business Jobs Act of 2010 (the “Act”) was signed into law by the President on September 27, 2010. Note that several of these changes are particularly important for tax planning this year and next because the changes are only applicable to the 2010 and/or 2011 tax years as indicated below.
Business Investment Incentives
- Raised Deduction for Start-Up Expenditures – 2010. Taxpayers may currently deduct up to $5,000 in trade or business start-up expenditures (i.e., expenses paid or incurred in connection with investigating or creating an active trade or business, which would be deductible if paid or incurred in connection with the operation of an existing active trade or business). However, the amount of the current deduction is reduced by the amount of expenditures exceeding $50,000. Taxpayers may also deduct the remaining expenditures ratably over the 180-month period following the start-up. For 2010, the Act temporarily increases the amount of start-up expenditures that may be currently deducted to $10,000, with a phase-out beginning at $60,000.
- 100 Percent Exclusion of Gain from Sale of Small Business Stock – 2010. Non-corporate taxpayers can generally exclude up to 50 percent (and, in certain circumstances, up to 60 percent) of the gain realized on the sale of qualified small business stock that the taxpayer has held for more than five years. Qualified small business stock generally includes stock of a C corporation that: (a) has gross assets that do not exceed $50 million; (b) was engaged in an active trade or business during the taxpayer’s holding period; and (c) was acquired at its original issue. Prior to the Act, the American Recovery and Reinvestment Act of 2009 (the “Recovery Act”) increased the exclusion from 50 percent to 75 percent for stock acquired between February 17, 2009 and January 1, 2011. The Act increases the exclusion to 100 percent for qualified small business stock acquired after September 27, 2010 and before January 1, 2011.
- General Business Credits of Eligible Small Business Not Subject to AMT and Extended Carryback – 2010. Prior to the Act, only the empowerment zone employment credit, the New York Liberty Zone employment credit, and certain other specified credits could offset alternative minimum tax (“AMT”) liability. However, for 2010, eligible small businesses are permitted to use the general business credit to offset their AMT liability as well as their regular tax liability. In addition, any remaining credit may be carried back five years (as opposed to 1 year under the pre-Act law). For this purpose, “eligible small business” includes sole proprietorships, partnerships, and non-publicly traded corporations with average annual gross receipts of not more than $50 million over the last three years.
- Reductions of S Corporation Holding Period for Built-In Gains Tax – 2011. If a C corporation elects to convert to an S corporation, the S corporation will be taxed at the highest corporate rate (currently 35 percent) on the built-in gains of the corporation that existed at the time of the conversion if such gains are recognized by the S corporation during the 10-year period following the conversion. The Recovery Act reduced the 10-year recognition period to 7 years if the recognition event occurs in 2009 or 2010. The Act further reduces the 10-year recognition period to 5 years if the recognition event occurs in 2011 (i.e., if the conversion occurred prior to January 1, 2006, then the S corporation may recognize the built-in gain in 2011 without the 35 percent tax penalty).
- Increased Business Expensing – 2010 and 2011. Prior to the Act, eligible taxpayers had the option to expense (rather than depreciate) up to $250,000 of the purchase price of qualifying “Section 179” property (generally tangible personal property and certain “off-the-shelf” computer software) that is placed in service in tax years beginning in 2010, subject to reduction by the amount by which the cost of qualifying Section 179 property exceeds $800,000. Now, as a result of the Act, for 2010 and 2011, the $250,000 limitation is increased to $500,000 and the investment limit to $2 million. In addition, the definition of qualifying Section 179 property is broadened to include “qualified real property,” which includes qualified leasehold improvement (subject to certain exclusions), qualified restaurant property, and qualified retail improvement property. For “qualified real property,” up to $250,000 of the total cost of the qualified real property (note that the cap applies to the aggregate cost of “qualified real property”) may be expensed. The Act also permits a taxpayer to elect to exclude real property from the definition of qualifying Section 179 property which may be useful if a business is otherwise nearing the $2 million eligible property cap. After 2011, the $250,000 limitation is scheduled to revert to its prior level of $25,000 and the $800,000 investment limit to $200,000 (which would have occurred in 2011, but for the Act).
- First-Year Bonus Depreciation Extension – 2010 and 2011. Generally, businesses are allowed to recover the cost of capital expenditures over time. For the last two years, businesses have been allowed to recover the cost of certain capital expenditures more quickly than under ordinary depreciation schedules by permitting an immediate write-off of 50 percent of the cost of certain “qualified property” placed in service before 2010, or with respect to certain aircraft and long-production period property (e.g., a recovery period of at least 10 years) placed in service before 2011. The Act extends this first-year 50 percent depreciation for qualifying property purchased and placed in service before 2011 (or 2012 for certain aircraft and long-production period property). Qualified property includes most tangible personal property, water utility property, certain interior improvements to nonresidential buildings, and most computer software, but does not include certain retail improvement property or restaurant property.
Fringe Benefit Assistance
- Temporary Deduction for Healthcare Costs for Self-Employment Tax Purposes – 2010. A taxpayer is generally permitted to reduce his taxable income by the amount paid for health insurance for the taxpayer and the taxpayer’s (a) spouse, (b) dependants, and (c) children under the age of 27. Normally, self-employed taxpayers are not allowed to take this deduction when determining how much of their income is subject to self-employment tax. However, the Act provides that health insurance costs are deductible for self-employment tax purposes during 2010.
- Removal of Cell Phones from Listed Property – 2010 and After. Deductions and credits are disallowed for “listed property” unless the taxpayer substantiates certain items by adequate records or by sufficient evidence corroborating the taxpayer’s own statement. The Act removes cellular telephones and other similar telecommunications equipment from the listed property provisions thereby allowing deductions and depreciation of cell phones without having to comply with the strict substantiation requirements. This new approach is effective beginning with the 2010 tax year.
New Reporting and Payments
- Information Reporting for Rental Property Expense Payments – 2011 and After. All persons engaged in a trade or business that make certain payments in the course of that trade or business of $600 or more in any tax year are required to file an information report with the IRS and deliver a corresponding report (typically a 1099-Misc) to the person receiving the payment. Prior to the Act, taxpayers with rental activity that was not considered a trade or business did not have to comply with these reporting requirements. The Act provides that, beginning January 1, 2011, rental income recipients will be considered to be engaged in the trade or business of renting property, and, as a result, will now be subject to these reporting requirements. Exceptions to these reporting requirements are available for individuals who receive a minimal amount of rental income, active members of the uniformed services (if the income is derived from the rental of their primary residence on a temporary basis), and anyone for whom reporting such amounts would cause a hardship.
- Certain Corporate Estimated Taxes – 2015. Generally, corporations are required to pay estimated federal income tax for each tax year in 4 equal installments due on the 15th day of the 4th, 6th, 9th, and 12th month of the corporation’s tax year. Under the Act, in 2015, corporations with assets of $1 billion or more will face a temporary increased estimated tax. Instead of the regular installment estimated tax payment, such corporations will have to pay 159.25 percent of the estimated tax that would otherwise be due in July, August, or September of 2015. The amount of the next required installment will be reduced to reflect the amount of the increase. Important to note is that only corporations that meet the $1 billion asset value threshold and who have an estimated tax payment due in July, August, or September will be subject to this accelerated payment of corporate estimated tax.
“TO BE OR NOT TO BE?” – OUTSTANDING YEAR-END QUESTIONS
At this time, there is a certain level of uncertainty with respect to whether certain tax provisions that have expired or will expire will be extended past 2009 and 2010. What follows is a discussion highlighting some of those provisions.
Provisions that Expired at the End of 2009
- AMT Patch. For the past several years, Congress has enacted an AMT patch to prevent the AMT exemption amount from reverting to prior levels. In 2009, approximately 4 million filers were subject to the AMT. To date, Congress has not passed an AMT patch for the 2010 tax year. If Congress fails to pass a patch, it is estimated that an additional 23 million filers will be subject to the AMT in 2010.
- Additional Standard Deduction for Property Taxes. For 2008 and 2009, homeowners could increase their standard deductions by an additional $500 or $1,000 for real estate taxes paid by the homeowner. This deduction was designed for homeowners who did not itemize their deductions, but who paid real estate taxes. This additional standard deduction expired at the end of 2009. It is uncertain whether this additional standard deduction will be extended.
- Deduction of State Sales Tax. Generally, individuals that itemize their deductions choose between a deduction for state and local income taxes or state sales taxes paid during the taxable year. This deduction for state and local sales taxes expired at the end of 2009. If Congress does not extend this deduction, then those individuals in states (such as Texas) that do not have a state income tax likely will have a larger tax bill for the 2010 tax year.
- IRA Distribution to Charities. Previously, certain taxpayers could transfer up to $100,000 from an IRA directly to certain qualified charities. Amounts transferred were excluded from a taxpayer’s income and the taxpayer did not receive a deduction for the charitable contribution. This special provision expired at the end of 2009. It is uncertain whether this special provision will be extended.
- Research and Development Credit. The research and development tax credit provides taxpayers with a tax credit for certain qualified research expenses incurred in a trade or business. This credit has been extended multiple times since its creation, but was allowed to expire at the end of 2009.
Provisions Set to Expire at the End of 2010
- Change of Income Tax, Capital Gains Tax, and Dividend Tax Rate Structure. The “Bush tax cuts” are set to expire at the end of 2010. While the current administration has stated that it intends to keep the “Bush tax cuts” for those individuals earning less than $200,000 and those joint filers earning less than $250,000, no action has been taken to date. In the past few days, the Obama administration has indicated a willingness to discuss extending all of the Bush tax cuts. Absent congressional action, the following will occur:
- The two highest marginal rates will rise from 33 percent to 36 percent, and from 35 percent to 39.6 percent.
- The tax rate on qualified dividends will rise from 15 percent to as high as 39.6 percent (i.e., qualified dividends will be taxed at ordinary income tax rates).
- The maximum rate on long-term capital gains will rise from 15 percent to 20 percent.
- Limitations on itemized deductions and personal exemptions will be reinstated for high-income individuals.
- Estate and Gift Tax. The top tax rate for estates in 2009 was 45 percent with a $3.5 million exemption. If no retroactive law is passed, there will be no estate tax applicable to persons who die in 2010. Also absent congressional action, on January 1, 2011, the estate tax will be restored with a 55 percent top tax rate and a $1 million exemption.
- Marriage Penalty. In the past, married couples had to pay more taxes than they would have paid if they were single filers. When the “Bush tax cuts” were enacted, the marriage penalty was alleviated by doubling the single standard deduction and by adjusting the tax bracket for 15 percent taxpayers. Absent congressional action, these means of alleviating the marriage penalty will expire at the end of 2010.
On the Horizon
- Carried Interest. Historically, persons who have provided investment and advisory services to a real estate, private equity, or hedge fund in exchange for carried interests have been able to treat much of the income attributable to such carried interests as capital gains income, which is subject to lower rates than ordinary income. However, as part of the “tax extenders” legislation now in the form of Senate Bill 3793, as much as 75 percent of this income earned by fund managers could be treated as ordinary income and subject to the self-employment tax.
- Significant Changes to Oil and Gas Tax. President Obama’s 2011 budget proposal includes $36.5 billion of new oil and gas taxes over the next 10 years. The proposal includes, among other things, (a) repealing the percentage depletion allowance, (b) terminating the expensing of intangible drilling costs, (c) increasing independent producers’ allowed geological and geophysical amortization, and (d) repealing the domestic manufacturing tax deduction for oil and gas companies. Given the recent election and the Republican control of the House, it is unclear whether any of these budget proposal items will be successful.
- Republicans May Target Certain Tax Credits. Certain Republicans have indicated an intent to target certain tax credits that they find wasteful or unnecessary as a means of reducing the budget deficit and paying for proposed legislation. One credit that appears to be under review is the research and development credit discussed above.
- Democrats May Propose Revenue-Raisers. Democrats intend to submit proposals to raise revenues to pay for future legislation. For example, the party has proposed to raise the Oil Spill Liability Trust Fund excise tax by 8 cents per barrel. If passed, the cost of gasoline is expected to rise by a few cents per gallon. The party also intends to continue its push to raise revenue by taxing carried interest income earned by investment managers as discussed above.
- Pay-As-You-Go. It is important to keep in mind that certain future legislation is subject to the Statutory Pay-As-You-Go Act of 2010 (“PAYGO”). The PAYGO rules generally require that all new legislation that changes taxes, fees, or expenditures must not increase projected deficits.
Therefore, if Congress passes legislation that increases spending or cuts taxes, those costs must be offset by raising revenue or cutting expenditures in other programs.
Note that this alert contains a general discussion of the law and is not intended to address any particular circumstance. If you have any questions or would like to discuss these or any other tax concerns, please contact any of the attorneys listed below.