Just as the Memorial Day holiday was about to begin, lawmakers preparing to flee Washington, D.C., for vacation, reached agreement on continuing to fund the war in Iraq. That funding bill also raised the minimum wage. Not a big deal, many business owners would say, because half the states already require minimum wages in excess of the federal level.
The bigger deal is all those tax breaks - over $5 billion worth - tacked onto the bill to ease the impact on small businesses.
The Small Business and Work Opportunity Tax Act of 2007, part of the much larger and more controversial, H.R. 1591 (U.S. Troops Readiness, Veteransâ€™ Health and Iraq Accountability Act of 2007), targets nearly $5 billion in tax incentives for small business. The bill also includes tax incentives to help taxpayers recovering from Hurricane Katrina, as well as an important package of S corporation reforms.
Unlike tax bills in the past, the so-called "revenue raisers" (read: more taxes for certain taxpayers) are unusually limited. The small business tax incentives, on the other hand, are designed to help businesses absorb the cost of a higher minimum wage that will rise to $7.25 an hour from $5.15 in three steps over two years.
The FICA tip credit
Area developers within the food service industry have a unique - and somewhat confusing - relief provision. Under current tax rules, an employer may claim a credit for FICA tax paid on tips received by employees for serving or delivering food or beverages consumed on the employerâ€™s premises if tipping is customary.
Employers may claim the Code Sec. 45B credit even if employees do not report the tips. Now, the new law allows employers to receive full tip credit despite increases in the Federal minimum wage.
Under the new tax rules, the FICA tip credit (also known as the Sec. 45B credit) is, in effect, frozen at the old minimum wage level so that the scheduled increase in the hourly minimum wage will not lower the credit amount. In other words, the FICA tip credit will continue to be based on the old minimum wage of $5.15 per hour, rather than the new minimum wage, which will reach $7.25 over the next two years. Even though the minimum wage has increased, the amount of the tip credit will not be reduced. The provision applies to tips received for services performed after December 31, 2006.
The Work Opportunity Tax Credit (WOTC)
Those who employ large numbers of workers have long been aware of the Work Opportunity Tax Credit. The WOTC was created in 1996 to provide employers with a unique tax incentive to hire individuals from among groups that have a particularly high unemployment rate or other special employment needs. Combined with the Welfare-to-Work tax incentives for 2007, the WOTC enlisted state employment security agencies to find and certify individuals who are members of a targeted group.
Set to expire for employees hired after December 31, 2007, the WOTC has been extended through August 31, 2011. The new law also broadens the scope of this under-utilized tax credit, with the new rules taking effect May 26, 2007.
The WOTC is available for employers hiring individuals from one or more of nine targeted groups. The credit equals 40 percent of up to $6,000 of the targeted employeeâ€™s first-year wages ($3,000 for qualified summer youth employees), provided the employee completes a minimum of 400 hours of service. In other words, the maximum credit per targeted employee is $2,400 ($1,200 for qualified summer youth employees).
The credit is reduced to 25 percent for employees who complete fewer than 400 hours of service with no credit allowed for employees who complete fewer than 120 hours of service. Naturally, the business expense deduction for wages is reduced by the amount of the WOTC claimed.
Small business expensing
In lieu of depreciation deductions, an area developer with sufficiently small investments in equipment or other business property can choose to deduct (or "expense") rather than capitalize those costs under Tax Code Sec. 179. The new law extends and expands the Sec. 179 enhanced first-year expensing provisions through 2010. It provides for an immediate 2007 increase in the expensing limit from $112,000 to $125,000, while the new law retroactively raises the investment limitation from $450,000 to $500,000 for tax years beginning in 2007 through 2010. The $500,000 amount is indexed for inflation in tax years beginning after 2007 and before 2011.
If Congress had not acted, the dollar limitation would have plummeted to $25,000 and the investment limitation to $200,000 after 2009. Because the deduction is completely phased out under the new levels for qualifying purchases above $625,000, the deduction continues to be confined generally to relatively small businesses.
And, do not forget, off-the-shelf computer software placed in service in taxable years beginning before 2010 is treated as property qualifying for Sec. 179 write-offs.
Go zone businesses
The Memorial Day legislation also extends and expands some of the tax incentives in the Gulf Opportunity Zone Act of 2005 and Katrina Emergency Tax Relief Act of 2005. These include extension of special expensing for qualified property, an enhanced low-income housing credit, and flexible tax-exempt bond financing rules.
Family business tax simplification
Married couples jointly operating an unincorporated business usually attributed all of their operationâ€™s income to one spouse. The new law aims to ensure that when a married couple jointly own and participate in a small business they both get credit for paying Social Security and Medicare taxes.
Under the new law, a married couple who jointly operate an unincorporated business and who file a joint return can elect not to be treated as a partnership for federal tax purposes. This treatment is available for tax years beginning after December 31, 2006.
The S corporation business entity
Several modifications to the S corporation rules will help small businesses retain the benefits of being an S corporation. In fact, the new S corporation provisions were designed specifically to make it easier for small businesses to retain their status as an S corporation, a status often inadvertently jeopardized thanks to the complexity of the rules in this area.
Among the restrictions that have been eased are those involving passive investment income. The passive investment income test has long been a trap for many S corporations. An S corporation is not subject to corporate-level income tax on its income, usually passing through income (and losses) to its shareholders - except when it comes to passive investment income. Fortunately, the new law eliminates some of that worry by switching treatments and no longer characterizing capital gain from the sale of stock or securities as passive investment income.
The new law also favorably alters the treatment of a deemed sale of a qualified Subchapter S subsidiary (QSub). (A qualified Subchapter S corporation is a wholly owned subsidiary that an S corporation has chosen to treat as a "QSub.") Once the QSub is no longer wholly owned by the S corporation, it ceases to be a QSub and is treated as a new corporation that acquired all of its assets from the parent S corporation in exchange for stock.
Under the new rules, a sale of QSub stock that terminates the QSub election and creates a deemed new corporation will be treated as a sale of an undivided interest in the assets of the QSub. The new treatment takes effect for tax years beginning on or after December 31, 2006.
This provision eliminates the danger of an avalanche of gain being recognized by a sale of only a partial, but substantial (that is, 20 percent) interest in the subsidiary. Now, if an S corporation sells 25 percent of its QSub stock, for example, it would recognize only a maximum 25 percent of the gain, saving the S corporation substantial tax on the deemed sale.
As with most recent tax legislation, not all of the provisions contained in the new tax law are pro-taxpayer. Some were inserted to offset the cost of pro-taxpayer provisions, pursuant to Congressional rules. One of the most significant offsets extends the reach of the so-called "kiddie tax" by raising the age limit to include (1) all children under age 19 (previously under age 18) and (2) students under the age of 24. Both changes are effective for tax years beginning after May 25, 2007, which means the change should not be noticed immediately by the average, calendar-year taxpayer.
Mark E. Battersby is a freelance writer, author, columnist, lecturer, and consultant specializing in taxes and finance for more than 30 years.
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