Small Business Taxes & Management^TM--Copyright 2010, A/N Group, Inc.

Introduction

The new law makes several changes to the tax law that should help small businesses. Unfortunately, many are temporary in nature. There are some offsets too. They include Form 1099 reporting for rental property owners and increased penalties for failure to properly file 1099s. There are a number of non-tax provisions in the law, intended to encourage investment and lending, level the playing field for government contractors, etc.

Provisions to Provide Access to Capital

100% Exclusion of Small Business Capital Gains. Generally, non-corporate taxpayers may exclude 50 percent (60 percent for certain empowerment zone businesses) of the gain from the sale of certain small business stock acquired at original issue and held for more than five years. For stock acquired after February 17, 2009 and before January 1, 2011, the exclusion is increased to 75 percent. Qualifying small business stock is from a C corporation whose gross assets do not exceed $50 million (including the proceeds received from the issuance of the stock) and who meets specific active business requirements. The amount of gain eligible for the exclusion is limited to the greater of ten times the taxpayer's basis in the stock or $10 million of gain from stock in that corporation. The new law temporarily increases the amount of the exclusion to 100 percent of the gain from the sale of qualifying small business stock that is acquired after the date of enactment in 2010 and before January 1, 2011 and held for more than five years. The new law also eliminates the AMT preference item attributable for that sale.

Tax Tip--If you were considering starting a new business, you might want to consider this provision when making your entity choice. The exclusion only applies to C corporations owned by individuals. In addition, certain fields such as health care, consulting, hotels, restaurants, etc. don't qualify. If you were considering investing in a small business you won't have much time to do your due deligence. Don't rush a decision to take advantage of a tax break. And be sure to check with your tax adviser for the fine print.

General Business Credit Not Subject to AMT. Under the Alternative Minimum Tax (AMT), taxpayers may 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 may be used to offset AMT liability, such as the credit for small business employee health insurance expense. The new law allows certain small businesses to use all types of general business credits against both their regular tax and AMT. This applies to general business credits for those sole proprietorships, partnerships and non-publicly traded corporations with $50 million or less in average annual gross receipts for the prior three years. The provision is effect for credits in a taxpayer's first taxable year beginning after December 31, 2009.

S Corp Holding Period for Built-In Gains Tax. 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 percent. (For example, Madison Inc. bought land for $10,000 in 1970. It converted from a C to an S corporation in 2006. At that time the land was worth $200,000. In 2010 Madison sells the land for $220,000. In addition to taxes on the $20,000 gain, Madison owes a built-in gains tax of 35 percent on the $190,000 gain.) This holding period is reduced where the 7th taxable year in the holding period preceded the taxable year beginning in 2009 or 2010. For taxable years beginning in 2011, the new law shortens the recognition period to 5 years beginning with the first day of the first taxable year for which the corporation was an S corporation.

Tax Tip--This is a one-year reprieve, and, while it might be extended, you might want to consider disposing of an asset that you'd probably be selling in the near future anyway where the built-in gain rules apply. In the example above, selling in 2011 could produce significant savings, especially if the shareholders have capital losses that could be offsetting. Talk to your tax advisor before taking action.

Provisions to Encourage Investment

Increase of Section 179 Expensing and Expansion to Certain Real Property. Under current law, taxpayers may elect to write-off the costs of certain tangible personal property that is purchased for use in the active conduct of a trade or business in the year of acquisition in lieu of recovering these costs over time through depreciation. For the taxable year beginning in 2010, taxpayers may write-off up to $250,000 of these capital expenditures subject to a phase-out once these capital expenditures exceed $800,000. The new law increases the thresholds to $500,000 and $2,000,000 for the taxable years beginning after 2009 and before 2012 for the amount of qualifying property placed in service in those years. (For calendar-year taxpayers, that means taxable years 2010 and 2011.) Within those thresholds, the Act temporarily would allow taxpayers to expense up to $250,000 of the cost of qualified leasehold improvement property, qualified restaurant property, and qualified retail improvement property.

In addition, Section 179 deductions attributable to qualified real property that are disallowed under the trade or business income limitation may only be carried over to taxable years in which the definition of eligible Section 179 property includes qualified real property. Thus under the provision, if a taxpayer's Section 179 deduction for 2010 with respect to qualified real property is limited by the taxpayer's active trade or business income, such disallowed amount may be carried over to 2011 in the manner under present law. Any such amounts that are not used in 2011, plus any 2011 disallowed Section 179 deductions attributable to qualified real property, are treated as property placed in service in 2011 for purposes of computing depreciation. The carryover amount from 2010 is considered placed in service on the first day of the 2011 taxable year. The provision also permits a taxpayer to elect to exclude real property from the definition of Section 179 property.

Tax Tip--The option to expense qualifying property such as vehicles, equipment, etc. not only improves cash flow by lowering taxes, it also reduces bookkeeping headaches. The higher limits may help some larger businesses, but of more importance here is the ability to write off leasehold improvements, and qualified restaurant and retail improvement property.

In addition, the limitation under Section 280F on the amount of depreciation deductions allowed with respect to certain passenger automobiles is increased in the first year by $8,000 for automobiles that qualify (and for which the taxpayer does not elect out of the additional first-year deduction).

Tax Tip--Bonus depreciation gives taxpayers another option for writing off equipment. The income and certain other restrictions don't apply to bonus depreciation, yet a taxpayer can write off over 60% of the cost of 7-year property in the year purchased. The combination of bonus depreciation and the Section 179 election can provide significant tax benefits and flexibility in tax planning. In addition, a taxpayer can elect out of bonus depreciation should that prove more advantageous because he or she is in a low bracket for that year.

Tax Tip--The higher depreciation limit for autos and small trucks suggests that if you were planning the purchase of a new vehicle for your business, it might make sense to do so before the end of 2010.

Reminder--The bonus depreciation and higher write-off limits on vehicles expires at the end of 2010; the higher Section 179 limits expire at the end of 2011.

Special Rule for Long-Term Contract Accounting. The provision provides that solely for purposes of determining the percentage of completion under Section 460(b)(1)(A), the cost of qualified property is taken into account as a cost allocated to the contract as if bonus depreciation had not been enacted. Qualified property is property otherwise eligible for bonus depreciation that has a MACRS recovery period of 7 years or less and that is placed in service after December 31, 2009, and before January 1, 2011 (January 1, 2012, in the case of property described in Section 168(k)(2)(B)).

Provisions to Promote Entrepreneurship

Increased Deduction for Start-up Expenditures. Taxpayers may deduct up to $5,000 in trade or business start-up expenditures. The amount that a business may deduct is reduced by the amount by which start-up expenditures exceed $50,000. For the taxable year beginning in 2010, the new law temporarily increases the amount of start-up expenditures that may be deducted to $10,000 subject to a $60,000 phase-out threshold.

Tax Tip--Being able to write off an extra $5,000 is unlikely to make you run out and start a new business, but if you were going to start a new venture, you might want to consider doing so before the end of the year.

Provisions to Promote Small Business Fairness

Modify Section 6707A Penalty. The bill revises Section 6707A of the IRC to make the penalty for failing to disclose a reportable transaction proportionate to the underlying tax savings. The penalty for failure to disclose reportable transactions to the IRS would be set at 75 percent of the tax benefit received. Reportable transactions are defined as investments in transactions that the IRS has identified as listed tax shelters or that have characteristics of tax shelters, including large losses or confidentiality agreements. The maximum annual penalty that a taxpayer may incur for failing to disclose a particular reportable transaction other than a listed transaction is $10,000 in the case of a natural person and $50,000 for all other persons. The maximum annual penalty that a taxpayer may incur for failing to disclose a listed transaction is $100,000 in the case of a natural person and $200,000, for all other persons. The provision also establishes a minimum penalty with respect to failure to disclose a reportable or listed transaction. That minimum penalty is $5,000 for natural persons and $10,000 for all other persons.

The following examples illustrate the operation of the maximum and minimum penalties with respect to a partnership or a corporation. First, assume that two individuals participate in a listed transaction through a partnership formed for that purpose. Both partners, as well as the partnership, are required to disclose the transaction. All fail to do so. The failure by the partnership to disclose its participation in a listed or otherwise reportable transaction is subject to the minimum penalty of $10,000, because income tax liability is not incurred at the partnership level nor reported on a partnership return. The partners in such partnership who also failed to comply with the reporting requirements of section 6011 are each subject to a penalty based on the reduction in tax reported on their respective returns.

In the second example, assume that a corporation participates in a single listed transaction over the course of three taxable years. The decrease in tax shown on the corporate returns is $1 million in the first year, $100,000 in the second year, and $10,000 in the third year. If the corporation fails to disclose the listed transaction in all three years, the corporation is subject to three separate penalties: a penalty of $200,000 in the first year (as a result of the cap on penalties), a $75,000 penalty in the second year (computed under the general rule) and a $10,000 penalty in the third year (as a result of the minimum penalty) for total penalties of $285,000.

The provision applies to all penalties assessed under Section 6707A after December 31, 2006.

Deductibility of Health Insurance for the Purposes of Calculating Self-Employment Tax. Business owners are not permitted to deduct the cost of health insurance for themselves and their family members for purposes of calculating self-employment tax. Under this provision the deduction for income tax purposes allowed to self-employed individuals for the cost of health insurance for themselves, their spouses, dependents, and children who have not attained age 27 as of the end of the taxable year is taken into account, and thus also allowed, in calculating net earnings from self-employment for purposes of SECA taxes. It is intended that earned income within the meaning of Section 401(c)(2) be computed without regard to this deduction for the cost of health insurance. Thus, earned income for purposes of the limitation applicable to the health insurance deduction is computed without regard to this deduction.

Comment--The benefit here will depend on your tax bracket and the cost of your health insurance. Assuming $10,000 annual cost of health insurance and SECA at 15.3%, the reduction in SECA would be $1,530. The actual tax break would be somewhat less since one-half of your SECA is deductible for federal (and possibly state) income tax purposes. This provision expires at the end of 2010.

Remove Cellular Phones From the Definition of Listed Property. Listed property is generally defined as any passenger automobile, other property used as transportation, any property of a type generally used for purposes of entertainment, recreation or amusement, computer, or cellular phone. Under the listed property rules you have to keep a log of business versus personal use to substantiate business use. The rules made some sense in 1987 when a cell phone cost $500 and all providers charged roaming and long distance fees.

The new law permanently removes cell phones from the definition of listed property, effective for taxable years ending after December 31, 2009.

Reducing the Tax Gap

Information Reporting for Rental Property Expense Payments. A variety of information reporting requirements (Forms 1099) apply. The primary provision governing information reporting by payors requires an information return by every person engaged in a trade or business who makes payments to any one payee aggregating $600 or more in any taxable year in the course of that payor's trade or business (Form 1099-MISC). Reportable payments include compensation for both goods and services, and may include gross proceeds. Certain enumerated types of payments that are subject to other specific reporting requirements are carved out of reporting under this general rule. The exception for corporations was repealed by the Patient Protection and Affordable Health Care Act. The requirement that businesses report certain payments is not applicable to persons engaged in a passive investment activity. Thus, a taxpayer whose rental real estate activity is a trade or business is subject to this reporting requirement, but a taxpayer whose rental real estate activity is not considered a trade or business is not subject to such requirement.

Under the new law, recipients of rental income from real estate generally are subject to the same information reporting requirements as taxpayers engaged in a trade or business. In particular, rental income recipients making payments of $600 or more to a service provider (such as a plumber, painter, carpenter or accountant) in the course of earning rental income are required to provide an information return (typically Form 1099-MISC) to the IRS and to the service provider. Exceptions to this reporting requirement are made for (i) members of the military or employees of the intelligence community who rent their principal residence on a temporary basis, (ii) individuals who receive only minimal amounts of rental income, as determined by the Secretary in accordance with regulations, and (iii) individuals for whom the requirements would cause hardship, as determined by the Secretary in accordance with regulations. The provision applies to payments made after December 31, 2010.

Increase Penalties for Failure to File Information Returns. The new law increases penalties for failure to timely file information returns to the IRS. The first-tier penalty (filed late, but on or before 30 days after the due date) is increased from $15 to $30, and the calendar year maximum is increased from $75,000 to $250,000. The second-tier penalty (correct return filed more than 30 days late, but on or before August 1) is increased from $30 to $60, and the calendar year maximum is increased from $150,000 to $500,000. The third-tier penalty (correct return filed after August 1) is increased from $50 to $100, and the calendar year maximum is increased from $250,000 to $1.5 million. For small businesses (3-year average annual gross receipts of $5 million or less), the calendar year maximum is increased from $25,000 to $75,000 for the first-tier penalty, from $50,000 to $200,000 for the second-tier penalty, and from $100,000 to $500,000 for the third-tier penalty. The minimum penalty for each failure due to intentional disregard is increased from $100 to $250. The penalty amounts are adjusted every five years for inflation.

The penalty for failure to furnish a payee statement is revised to provide tiers and caps similar to those applicable to the penalty for failure to file the information return. A first-tier penalty is $30, subject to a maximum of $250,000; a second-tier penalty is $60 per statement, up to $500,000, and the third -tier penalty is $100, up to a maximum of $1,500,000. The penalty is also amended to provide limitations on penalties for small businesses and increased penalties for intentional disregard that parallel the penalty for failure to furnish information returns.

Both the failure to file and failure to furnish penalties will be adjusted to account for inflation every five years with the first adjustment to take place after 2012, effective for each year thereafter.

The provision applies with respect to information returns required to be filed on or after January 1, 2011.

Tax Tip--For many small businesses, filing 1099s has not been much of an issue. The number of 1099s might have been small and your accountant or bookkeeper may have handled the requirements at minimal cost. With the increased reporting required in 2012 under the for businesses Patient Protection and Affordable Care Act of 2010 and the requirement that landlords report payments coupled with the higher penalties, 1099 reporting can now be a significant issue. Moreover, taxpayers who must report and have to file 250 or more forms must do so electronically. If you don't have systems in place (e.g., accounting software) to identify and report the payments, you should plan to do so soon.

Under FPLP, the IRS matches its accounts receivable records with Federal payment records maintained by the Department of the Treasury's Financial Management Service ("FMS"), such as certain Social Security benefit and Federal wage records. When the records match, the delinquent taxpayer is provided both notice of intention to levy and notice of the right to the CDP hearing 30 days before the levy is made. If the taxpayer does not respond after 30 days, the IRS can instruct FMS to levy its Federal payments. Subsequent payments are continuously levied until the tax debt is paid or IRS releases the levy.

Upon receipt of this information, however, the taxpayer may stay the levy action by requesting in writing a hearing before the IRS Appeals Office. Following the CDP hearing, a taxpayer has a right to seek, within 30 days, judicial review in the U.S. Tax Court of the determination of the CDP hearing to ascertain whether the IRS abused its discretion in reaching its determination. During this time period, the IRS may not proceed with its levy.

The new law allows the IRS to issue levies prior to a CDP hearing with respect to Federal tax liabilities of Federal contractors identified under the Federal Payment Levy Program. When a levy is issued prior to a CDP hearing under this proposal, the taxpayer has an opportunity for a CDP hearing within a reasonable time after the levy.

Promoting Retirement Preparation

Allow Participants in Governmental 457 Plans to Treat Elective Deferrals as Roth Contributions. Beginning in 2011, the new law allows retirement savings plans sponsored by state and local governments (governmental 457(b) plans) to include Roth accounts, which are currently available only in 401(k) and 403(b) plans and will be available in the federal Thrift Savings Plan in 2011. Contributions to Roth accounts are made on an after-tax basis, but distributions of both principal and earnings are generally tax-free.

Allow Rollovers from Elective Deferral Plans to Roth Designated Accounts. Under the provision, if a section 401(k) plan, section 403(b) plan, or governmental section 457(b) plan has a qualified designated Roth contribution program, a distribution to an employee (or a surviving spouse) from an account under the plan that is not a designated Roth account is permitted to be rolled over into a designated Roth account under the plan for the individual. However, a plan that does not otherwise have a designated Roth program is not permitted to establish designated Roth accounts solely to accept these rollover contributions. Thus, for example, a qualified employer plan that does not include a qualified cash or deferred arrangement with a designated Roth program cannot allow rollover contributions from accounts that are not designated Roth accounts to designated Roth accounts established solely for purposes of accepting these rollover contributions. Further, the distribution to be rolled over must be otherwise allowed under the plan. For example, an amount under a section 401(k) plan subject to distribution restrictions cannot be rolled over to a designated Roth account under this provision. However, if an employer decides to expand its distribution options beyond those currently allowed under its plan, such as by adding in-service distributions or distributions prior to normal retirement age, in order to allow employees to make the rollover contributions permitted under this provision, the plan may condition eligibility for such a new distribution option on an employee's election to have the distribution directly rolled over to the designated Roth program within that plan.

In the case of a permitted rollover contribution to a designated Roth account under this provision, the individual must include the distribution in gross income (subject to basis recovery) in the same manner as if the distribution were rolled over into a Roth IRA. Thus the special rule for distributions from eligible retirement plans (other than from designated Roth accounts) that are contributed to a Roth IRA in 2010 applies for these rollover contributions to a designated Roth account. Under this special rule, the taxpayer is allowed to include the amount in income in equal parts in 2011 and 2012. The special recapture rule for the 10-percent early distribution tax also applies if distributions are made from the designated Roth account in the relevant five year period.

This rollover contribution may be accomplished at the election of the employee (or surviving spouse) through a direct rollover (operationally through a transfer of assets from the account that is not a designated Roth account to the designated Roth account). However, such a direct rollover is only permitted if the employee (or surviving spouse) is eligible for a distribution in that amount and in that form (if property is transferred) and the distribution is an eligible rollover distribution. If the direct rollover is accomplished by a transfer of property to the designated Roth account (rather than cash), the amount of the distribution is the fair market value of the property on the date of the transfer.

A plan that includes a designated Roth program is permitted but not required to allow employees (and surviving spouses) to make the rollover contribution described in this provision to a designated Roth account. If a plan allows these rollover contributions to a designated Roth account, the plan must be amended to reflect this plan feature. It is intended that the IRS will provide employers with a remedial amendment period that allows the employers to offer this option to employees (and surviving spouses) for distributions during 2010 and then have sufficient time to amend the plan to reflect this feature.

Tax Tip--This provision can provide substantial benefits and flexibility in tax planning. However, it's also a revenue raiser for the government. Converting to a Roth requires paying tax on the conversion. More than one taxpayer has converted, paid the tax, only to see the market value of his investment decline or to find himself in a lower bracket on retirement. This is an important decision. Talk to your tax and investment adviser before taking action.

Permit Partial Annuitization of a Nonqualified Annuity Contract. The law provides for the exchange of certain insurance contracts without recognition of gain or loss. No gain or loss is recognized on the exchange of: (1) a life insurance contract for another life insurance contract or for an endowment or annuity contract or for a qualified long-term care insurance contract; or (2) an endowment contract for another endowment contract (that provides for regular payments beginning no later than under the exchanged contract) or for an annuity contract or for a qualified long-term care insurance contract; (3) an annuity contract for an annuity contract or for a qualified long-term care insurance contract; or (4) a qualified long-term care insurance contract for a qualified long-term care insurance contract. The basis of the contract received in the exchange generally is the same as the basis of the contract exchanged.

In interpreting Section 1035, case law holds that an exchange of a portion of an annuity contract for another annuity contract qualifies as a tax-free exchange. Treasury guidance provides rules for determining whether a direct transfer of a portion of the cash surrender value of an annuity contract for a second annuity contract qualifies as a Section 1035 tax-free exchange. Under the Treasury guidance, either the annuity contract received, or the contract partially exchanged, in the tax-free exchange may be annuitized without jeopardizing the tax-free exchange (or amounts withdrawn from it or received in surrender of it) after the period ending 12 months from the receipt of the premium in the exchange. The new law permits a portion of an annuity, endowment, or life insurance contract to be annuitized while the balance is not annuitized, provided that the annuitization period is for 10 years or more, or is for the lives of one or more individuals.

The provision provides that if any amount is received as an annuity for a period of 10 years or more, or for the lives of one or more individuals, under any portion of an annuity, endowment, or life insurance contract, then that portion of the contract is treated as a separate contract for purposes of Section 72.

The investment in the contract is allocated on a pro rata basis between each portion of the contract from which amounts are received as an annuity and the portion of the contract from which amounts are not received as an annuity. This allocation is made for purposes of applying the rules relating to the exclusion ratio, the determination of the investment in the contract, the expected return, the annuity starting date, and amounts not received as an annuity. A separate annuity starting date is determined with respect to each portion of the contract from which amounts are received as an annuity.

The provision is not intended to change the present-law rules with respect either to amounts received as an annuity, or to amounts not received as an annuity, in the case of plans qualified under section 401(a), plans described in section 403(a), section 403(b) tax-deferred annuities, or individual retirement plans. The provision is effective for amounts received in taxable years beginning after December 31, 2010.

--Last Update 09/30/10