The 2010 Small Business Jobs Act has been passed by the Senate on September 16, 2010 and the House on September 23, 2010 and is expected to be signed into law by the President shortly. The Act includes a wide-ranging assortment of tax breaks and incentives for small business, paid for with various revenue raisers. Certain of these provisions, if taken advantage of, can have a major beneficial effect on a variety of small and medium-sized businesses.
Here’s a brief overview of the most significant tax changes in the new law affecting small business and individual taxpayers.
Tax Breaks and Incentives
1) Enhanced small business expensing (Section 179 expensing). In order to help small businesses quickly recover the cost of certain capital expenses, small business taxpayers can elect to write off the cost of these expenses in the year of acquisition in lieu of recovering these costs over time through depreciation. Under pre-2010 Small Business Jobs Act law, taxpayers could expense up to $250,000 of qualifying property—generally, machinery, equipment and certain software—placed in service in tax years beginning in 2010. This annual expensing limit was reduced (but not below zero) by the amount by which the cost of qualifying property placed in service in tax years beginning in 2010 exceeded $800,000 (the investment ceiling). Under the new law, for tax years beginning in 2010 and 2011, the $250,000 limit is increased to $500,000 and the investment ceiling to $2,000,000.
Observation: Virtually all small businesses will be able to take advantage of this change, in light of the enhanced depreciation not phasing out completely until a business taxpayer places $2.5M or more of expensing-eligible property into service in its tax year. Also, prior to the Act, the Section 179 deduction was set to decrease to $25,000 for 2011. This reversion back to a $25,000 cap has now been deferred until tax years beginning in 2012.
Costs of leasehold improvements now eligible. The new law also makes certain real property eligible for expensing. For property placed in service in any tax year beginning in 2010 or 2011, the up-to-$500,000 of property expensed can include up to $250,000 of qualified real property (qualified leasehold improvement property, qualified restaurant property, and qualified retail improvement property).
Observation: This is the first time that Section 179 enhanced depreciation can be claimed for realty. Hence, small and medium-sized business taxpayers can take an immediate writeoff for the costs of various leasehold improvements and the like.
Summary: Section 179 is a powerful mechanism for small and medium-sized businesses to use to lower the after-tax costs of their current capital acquisition needs and, if you or your business is a candidate for these enhanced depreciation deductions, we urge you to plan carefully to take full advantage of this opportunity. Towards that end, we note both that there are a variety of rules, regulations and pitfalls related to the mechanics of these accelerated depreciation deductions and that we would be happy to help you navigate your way to successful exploitation of these recent changes to the Code.
2) Qualified small business stock – No Tax on Gain – 100% exclusion of gain from the sale of small business stock for qualifying stock acquired after date of enactment and before Jan. 1, 2011. Before the 2009 Recovery Act, individuals could exclude 50% of their gain on the sale of qualified small business stock (QSBS) held for at least five years (60% for certain empowerment zone businesses). To qualify, QSBS must meet a number of conditions (e.g., it must be stock of a corporation that has gross assets that don’t exceed $50 million, and the corporation must meet active business requirements). Under the 2009 Recovery Act, the percentage exclusion for gain on QSBS sold by an individual was increased to 75% for stock acquired after Feb. 17, 2009 and before Jan. 1, 2011. Under the new law, the amount of the exclusion is temporarily increased yet again, to 100% of the gain from the sale of qualifying small business stock that is acquired in 2010 after date of enactment and held for more than five years. In addition, the new law eliminates the alternative minimum tax (AMT) preference item attributable for that sale.
Observation: If you are considering investing in a small business, it behooves you to determine whether the new total exclusion for QSBS would work to your advantage. However, it should be noted that while the new provision for QSBS is ostensibly intended to encourage investment in small businesses, it may be less effective in that regard than desired, due to the restrictions on obtaining the total exclusion, specifically: (1) the narrow window within which the small business stock must be purchased (i.e., between date of enactment and the end of 2010); (2) the long holding period requirement for QSBS (the stock must he held for at least five years); and, most importantly, (3) the fact that the tax break only applies to investments in C corporations, a form of business organization that is not often used by small businesses, which, for tax purposes, are typically operated as S corporations, partnerships, limited liability companies or sole proprietorships.
3) Self-Employment Tax Break – Deductibility of health insurance for the purpose of calculating self-employment tax. Generally, business owners can’t deduct the cost of health insurance for themselves and their family members for purposes of calculating self-employment tax. The new law allows business owners to deduct health insurance costs incurred in 2010 for themselves and their family members in calculating their 2010 self-employment tax.
At issue is the 15.3% tax that self-employed individuals pay on their net earnings, commonly referred to as self-employment tax. The self-employment tax rate is the sum of 12.4% for Social Security (old age, survivors, and disability insurance) and 2.9% for Medicare (hospital insurance). The Social Security tax applies to the first $106,800 of net earnings in 2010; there is no ceiling on the Medicare tax.
Back in 2003, small-business advocates won the first battle in this area by achieving legislation allowing self-employed individuals to deduct the cost of health insurance for income tax purposes. While this change enabled small-business owners to deduct the cost of health care from their income, that income already had been exposed to self-employment tax. Thus, the self-employed effectively paid self-employment tax on income used to purchase health care.
According to a report by the Kaiser Family Foundation, employers paid an average health insurance premium of $13,770 for family coverage in 2010. The 15.3% self-employment tax on earnings used to pay this average premium would be $2,107.
Arguing that this was money that could be used to reinvest in and grow the business, small-business advocates have pushed for legislation that would allow the self-employed to deduct their health insurance premiums on their self-employment tax as well as their income tax.
The new legislation does precisely that, and that will constitute a huge benefit to the bottom line for most small business owners. For now, however, the change is limited to the 2010 tax year.
4) General business credits of eligible small businesses for 2010 allowed to be carried back five years. Generally, a business’s unused general business credits can be carried back to offset taxes paid in the previous year, and the remaining amount can be carried forward for 20 years to offset future tax liabilities. Under the new law, for the first tax year of the taxpayer beginning in 2010, eligible small businesses can carry back unused general business credits for five years. Eligible small businesses consist of sole proprietorships, partnerships and non-publicly traded corporations with $50 million or less in average annual gross receipts for the prior three years.
General business credits of eligible small businesses in 2010 aren’t subject to AMT. Under the AMT, taxpayers can generally only claim allowable general business credits against their regular tax liability, and only to the extent that their regular tax liability exceeds their AMT liability. A few credits, such as the credit for small business employee health insurance expenses, can be used to offset AMT liability. The new law allows eligible small businesses, as defined above, to use all types of general business credits to offset their AMT in tax years beginning in 2010.
5) S corporation holding period. Generally, a C corporation converting to an S corporation must hold onto any appreciated assets for 10 years following its conversion or face a business-level tax imposed on the built-in gain at the highest corporate rate of 35%. This holding period is reduced where the 7th tax year in the holding period preceded the tax year beginning in 2009 or 2010. The 2010 Small Business Jobs Act temporarily shortens the holding period of assets subject to the built-in gains tax to 5 years if the 5th tax year in the holding period precedes the tax year beginning in 2011.
6) Extension of 50% bonus first-year depreciation. Businesses are allowed to deduct the cost of capital expenditures over time according to depreciation schedules. In previous legislation, Congress allowed businesses to more rapidly deduct capital expenditures of most new tangible personal property, and certain other new property, placed in service in 2008 or 2009 (2010 for certain property), by permitting the first-year write-off of 50% of the cost. The new law extends the first-year 50% write-off to apply to qualifying property placed in service in 2010 (2011 for certain property).
7) Boosted deduction for start-up expenditures. The new law allows taxpayers to deduct up to $10,000 in trade or business start-up expenditures for 2010. The amount that a business can deduct is reduced by the amount by which startup expenditures exceed $60,000. Previously, the limit of these deductions was capped at $5,000, subject to a $50,000 phase-out threshold.
Offsets (Revenue Raisers)
1) Information reporting required for rental property expense payments. For payments made after Dec. 31, 2010, the new law requires persons receiving rental income from real property to file information returns with IRS and service providers reporting payments of $600 or more during the tax year for rental property expenses. Exceptions are provided for individuals renting their principal residences on a temporary basis (including active members of the military), taxpayers whose rental income doesn’t exceed an IRS-determined minimal amount, and those for whom the reporting requirement would create a hardship (under IRS regs).
2) Increased information return penalties (effective for information returns required to be filed after Dec. 31, 2010).
3) Allow rollovers from elective deferral plans to designated Roth accounts. The new law allows 401(k), 403(b), and governmental 457(b) plans to permit participants to roll their pre-tax account balances into a designated Roth account. The amount of the rollover will be includible in taxable income except to the extent it is the return of after-tax contributions. If the rollover is made in 2010, the participant can elect to pay the tax in 2011 and 2012. Plans will be able to allow these rollovers immediately as of date of enactment.
Please keep in mind that I’ve described only the highlights of the most important changes in the new law. However, as you can see, the benefits to small businesses stemming from the new and/or extended tax breaks and incentives will in most cases far outweigh the additional burdens stemming from the revenue raisers. If you would like more details about any aspect of the new legislation, please do not hesitate to call.