President Obama signed the 2010 Small Business Jobs Act (the “Act”) into law on Sept. 27, 2010. Despite its name, the Act provides tax incentives for both small and large businesses. This Alert focuses on four incentives:
- Increased expensing deductions for depreciable property in 2010 and 2011;
- Temporary five-year built-in gain periods for S corporations;
- Expanded use of general business credits for eligible small businesses; and
- 100 percent gain exclusions for qualified small business stock.
Incentives To Purchase Depreciable Property
The Act vastly increases the Code §179 expense deduction for eligible property. Businesses can immediately expense up to $500,000 of depreciable tangible personal property and off-the-shelf software placed in service during tax years beginning in 2010 and 2011. The ability to expense eligible property immediately begins to phase out when a business places in service more than $2 million of such property during the tax year. It is completely phased out when the business places in service more than $2.5 million of eligible property. For tax years beginning after 2011, the Code §179 expense deduction drops to $25,000, and the phase out begins at $200,000.
The Act also expands the Code §179 expense deduction to permit businesses to expense up to $250,000 of qualified real property placed in service in tax years beginning in 2010 and 2011. Thus, up to half of the $500,000 overall Code §179 expense deduction for eligible property for tax years beginning in 2010 and 2011 can be qualified real property. Qualified real property includes:
- Qualified leasehold improvement property under Code §168(e)(6);
- Qualified restaurant property under Code §168(e)(7); and
- Qualified retail improvement property under Code §168(e)(8).
The increased Code §179 expense deduction is a valuable tax incentive for small and midsize businesses. Few will place more than $2.5 million of eligible property in service during a single tax year. Furthermore, it applies retroactively to businesses that have already placed in service eligible property during a tax year beginning in 2010.
The Act also extends 50 percent first-year bonus depreciation to qualified property acquired and placed in service by Dec. 31, 2010 (and 2011 for aircraft and other property with a long production period). This bonus depreciation is another expensing option available to both small and large businesses.
For bonus depreciation purposes, qualified property is property with a recovery period of 20 years or less, tools, equipment, and other tangible personal property, most software, and many leasehold improvements. Importantly, businesses can take both bonus depreciation and regular depreciation on the same item of property in the same taxable year. Like the increased Code §179 expense deduction, the extended bonus depreciation applies retroactively to taxpayers that have already placed qualified property in service in 2010. While the increased Code §179 expense deduction applies to property placed in service during a tax year beginning in 2010 or 2011, the bonus depreciation only applies to qualified property acquired and placed in service during 2010.
Consider the benefits of the Code §179 expense deduction and the Code §168 bonus depreciation in the following example. For the purposes of illustration, the example assumes that the property would otherwise be five-year property depreciated using the straight-line method.
Cost of Assets Placed in Service $600,000
Code § 179 Expense Deduction $500,000
Balance $100,000 Code § 168 Bonus Depreciation $ 50,000
Regular Depreciation $ 10,000
Total Depreciation $560,000
Percent deductible in 2010 93.30%
Temporary Five-Year Built-in Gain Period for S Corporations
An S corporation is not taxed on its income because it passes its income through to its owners who pay tax on their share of the corporation’s income. Under an exception to this rule, an S corporation that was formerly a C corporation (or acquired property from a C corporation in a tax-free transaction) is taxed at the highest corporate tax rate on its built-in gains if it disposes of the property during a timeframe known as the “recognition period."
Historically, the recognition period was the ten-year period beginning after the S corporation elected S corporation status (or the 10-year period after the transfer of property from a C corporation). The Act reduces the recognition period to five years for tax years beginning in 2011. The American Recovery and Reinvestment Act of 2009 previously reduced the recognition period to seven years for tax years beginning in 2009 and 2010. Thus, the recognition period is seven years for 2009 and 2010, and five years for 2011.
Expanded Use of General Business Credits for Eligible Small Businesses
The Act increases the carryback of the general business credit for eligible small businesses and expands the amount of income that they can offset. Under pre-Act ordering rules, a business must first carry back its unused general business credit to offset the previous year’s taxes paid, and then the business can carry forward the remaining amount to the earliest of the next 20 years. The Act increases the carryback to five years for eligible small business credits. An eligible small business is any partnership, corporation that is not publicly traded, or sole proprietorship that has average annual gross receipts for the previous three tax years of less than $50 million.
An eligible small business can also offset more income tax, including its alternative minimum tax (“AMT”) liability, with the general business credit. Generally, under pre-Act law, a business could only offset its tax liability with general business credits to the extent that its regular tax liability exceeded its tentative minimum tax liability. An eligible small business can now offset both its regular tax and AMT liability under the Act.
100 Percent Gain Exclusions for Qualified Small Business Stock
The Act permits noncorporate taxpayers to exclude 100 percent of the gain from the sale or exchange of qualified small business stock (“QSBS”) held for more than five years. The gain exclusion applies to regular tax and AMT liability. The taxpayer must acquire the QSBS after Sept. 27, 2010 and before Jan. 1, 2011.
Prior to the Act, a noncorporate taxpayer acquiring QSBS after Feb. 12, 2009 and before Jan. 1, 2011 could exclude 75 percent of the gain from the sale of such QSBS if held for more than five years. For QSBS the taxpayer acquired outside this period, the gain exclusion was only 50 percent, or 60 percent if the QSBS was in a company engaged in an empowerment zone business. For AMT purposes, a portion of the excluded gain was a preference item, which required the taxpayer to include the gain in income when calculating AMT liability.
A majority of the tax incentives under the Act will benefit small and midsize businesses, but the first-year bonus depreciation will benefit businesses of all sizes, including large businesses. A particularly noteworthy aspect of the Act is that the Code §179 expense deduction and the bonus depreciation may retroactively apply to property that the taxpayer has already placed in service. The tax incentives for QSBS do not have retroactive effect, and the taxpayer must acquire the QSBS after Sept. 27, 2010 and before Jan. 1, 2011.