Mario J. Fazio
The recently passed 2010 Small Business Jobs Act (“2010 Act”) contains several important tax incentives for businesses that are considering investments in capital assets prior to December 31, 2010, or, in some cases, during 2011. The tax incentives come in the form of larger First Year tax deductions for capital purchases and more liberal allowances for business tax credits.
Increased First Year Tax Deduction for Investment in Capital Assets. Congress has continued the trend of increasing first year tax deductions to encourage businesses to invest in capital assets. The “Section 179 Deduction” has been increased to an annual amount of up to $500,000 (increased from $250,000) for the cost of qualifying property placed in service (first used in the business) during tax years beginning in 2010 or 2011. Property that qualifies for the Section 179 Deduction includes tangible personal property (for example, equipment and machinery), “off-the-shelf” computer software, and certain improvements to real property. Businesses may want to make capital purchases prior to December 31, 2010 to take advantage of the deduction for 2010. If a business has already purchased more than $500,000 of qualified property during 2010, it may be tax advantageous to wait until 2011 to acquire additional capital assets. To make sure the Section 179 Deduction is limited to small business, the deduction is phased-out for businesses that have more than $2 Million annually of qualified capital expense. After 2011, the Section 179 Deduction is scheduled to revert back to $25,000 per year. The Section 179 Deduction represents a significant tax break since the cost of most equipment and other tangible business property must be depreciated over a specified number of years depending on the type of property.
Certain Interior Building Improvements Qualify for Section 179 Deduction. In addition to tangible personal property and off-the-shelf computer software, the following types of improvements to building may qualify for an annual Section 179 Deduction up to $250,000, provided that they are placed in service in tax years beginning in 2010 and 2011:
Leasehold Improvements. To qualify, the improvement must be to the interior of a nonresidential building, pursuant to the terms of a lease, by the lessor or the lessee, and the building must be at least three (3) years old at the time the improvements are made. However, expansions of buildings, and the purchase and installation of elevators, escalators and certain structural improvements, do not qualify.
Restaurant Property. The cost of a restaurant building or an improvement to such building qualifies provided that at least 50% of the square footage of the building is used as a restaurant. An election to take the Section 179 Deduction precludes the use of Bonus Depreciation (discussed below) for the remainder of the cost.
Retail Improvement Property. To qualify, the improvement must be to the interior portion of a nonresidential building that is used as retail space for the sale of tangible personal property to the general public, and the building must be at least three (3) years old at the time the improvements are made. However, expansions of buildings, and the purchase and installation of elevators, escalators and certain structural improvements, do not qualify. An election to take the Section 179 Deduction precludes the use of Bonus Depreciation (discussed below) for the remainder of the cost.
One important limitation on an election to expense Qualifying Real Property costs is that the expense deduction can only be claimed in 2010 or 2011 under current law. Thus, to take advantage of this provision, the taxpayer would need to otherwise have taxable income in either 2010 or 2011 against which the Section 179 Deduction may be claimed.
Extension of “Bonus” Depreciation Allowance until December 31, 2010. The 2010 Act extends “Bonus Depreciation” for new property (most machinery, equipment, other tangible personal property, computer software and leasehold improvements) placed in service on or prior to December 31, 2010. Bonus Depreciation allows 50% of the cost of qualifying property to be deducted in the year it is first placed in service (first used) by the business. The Section 179 Deduction, together with Bonus Depreciation, can permit a substantial portion of the total investment by a business in capital assets to be tax deductible in 2010 if it is placed in service prior to December 31, 2010.
Automobiles. The 2010 Act allows an increased deduction for 2010 up to $11,060 for new passenger automobiles predominantly used in business if acquired and first used on or prior to December 31, 2010. Under current law, for passenger automobiles placed in service after December 31, 2010, the first year deduction will be limited to $3,060. If the vehicle is used for both business and personal purposes, the deduction is proportionately reduced based on the percentage of personal use during the year.
Business Tax Credit Relief for 2010. To increase the monetary value of business tax credits arising in 2010, the 2010 Act permits the credits to offset Alternative Minimum Tax (AMT) for 2010, and for unused tax credits to be carried back for a five (5) year period. There are numerous business tax credits, such as investment tax credits (ITC) to encourage businesses to invest in certain types of assets (such as renewable energy property or low-income housing). One problem with tax credits is that they may not create immediate value if the business does not have current taxable income to use the tax credit. By increasing the carry-back period to five (5) years and by allowing the credit to offset AMT in 2010, there is a greater likelihood that a business can immediately use the credit by reducing its AMT and/or by carrying the unused tax credits back to one or more of the preceding five (5) years.
Start-Up Expenses. Prior to the 2010 Act, the costs incurred to start a new business (including investigating business opportunities) prior to the date that the business begins were subject to a first-year deduction limitation of $5,000, with excess start-up costs amortized ratably over 15 years. Under the 2010 Act, the first year deduction is increased to $10,000 for 2010 only. This provision is intended to provide some additional tax break for entrepreneurs currently seeking new business opportunities.
Small Business Stock. Another apparent attempt to encourage investment in start-up companies is the prospect of paying no tax on the sale of Qualified Small Business Stock (“QSB Stock”) that is acquired after September 27, 2010 and before January 1, 2011. This is an incredibly short window (65 days) to close on the purchase of the stock. To qualify, the QSB stock must be held for at least five (5) years. While the stock is held, the corporation must be a C corporation (does not make an S election), engage in an active business and meet certain other tests. The corporation cannot have more than $50 million in assets at the time the QSB stock is issued. Professional service firms and certain other businesses, such as banking, farming, restaurants and hotels cannot qualify as a QSB. When the QSB stock is eventually sold (presumably after it has appreciated substantially in value) the gain on the sale, up to the greater of $10 million or ten (10) times the original investment, may be excluded from tax. QSB stock acquired after December 31, 2010 entitles the holder to exclude 50% of the eventual gain on sale from tax and AMT may also come into play since there is not a full 50% exclusion for AMT purposes.
Sale of Assets by S Corporations (that were formally C Corporations). An S corporation that was formally a C corporation may be subject to the so-called “Built-in-Gain” tax (“BIG tax”) upon sale of assets that were held by the corporation when the S election was made. The BIG tax potentially applies to a sale of assets occurring any time during the ten (10) year period following the S corporation election. The BIG tax imposes an additional income tax on the sale of such assets with respect to the unrealized gain in the assets that existed at the time the S election was made. Since many sales of companies are structured as asset sales at the insistence of buyers, the BIG tax is a significant tax burden to the sellers of businesses when it applies. The 2009 Recovery Act shorted the BIG tax period to seven (7) years for sales occurring in 2009 or 2010. The 2010 Act further reduces the BIG tax period to five (5) years for sales occurring in 2011. For asset sales after 2011, the BIG tax period will revert back to ten (10) years. Thus, this provision should be considered by owners of S corporation that were formally operated as C corporations who are considering a sale of the business in the next few years. There may be a substantial tax savings opportunity to close the sale in 2011.
Record keeping Relief for Cell Phones. Starting in 2010, reduced record keeping requirements will apply to the business use of cell phones. Prior to the change, cell phones were considered so-called “listed property” under the Internal Revenue Code and subject to burdensome record keeping requirements in order for an employer to deduct the cost of cell phones and to exclude the value of the use of cell phones from the employees’ W-2 income.
Roth Roll-Overs. There has been a lot of discussion this year about whether clients should convert IRA assets to a Roth IRA, because this election is now open to all taxpayers regardless of their level of income. Prior to 2010, only taxpayers with $100,000 or less of AGI were eligible to make the Roth conversion. To facilitate conversions to Roth accounts, the 2010 Act now permits qualified retirement plans to be amended to allow participants to convert their retirement plan account to a Roth account within the plan. Although amounts converted to a Roth account are taxable to the participant, the 10% early withdrawal tax does not apply. Moreover, the great advantage of a Roth account is that future distributions, including all earnings on converted amounts, may be distributed tax-free after a five-tax-year holding period and once the participant reaches 59-1/2. The amount converted to the Roth account in 2010 is taxable one-half in each of 2011 and 2012, unless the participants elect to have the entire amount taxable in 2010.
Partial Annuitization of Existing Contracts. The 2010 Act permits owners of life insurance, annuities or endowment contracts to annuitize a portion of the contract on a tax-favored basis provided that the annuitization period is 10 years or more, or for the lives of one or more individuals. The annuity payments received are entitled to tax-favored annuity treatment, while the balance of the contract can continue to grow tax-deferred. This provision applies to tax years starting in 2011.
Health Insurance Cost for Self-Employed. For 2010 only, the cost of health insurance is generally deductible against self-employment income.
Rental Income Property Owners Subject to New Reporting. Subject to limited exceptions, owners of rental property will be required to complete a Form 1099 with respect to payments of $600 or more to service providers during the year. This rule applies to payments starting in 2011.
The information in this Client Alert is a summary of complex legal and tax issues and may not address all of the issues relating to a specific situation. Accordingly, this Client Alert is not intended to be legal advice.
If you would like to discuss how these tax benefits may affect you or your business, or for a fuller description of the tax provisions of the 2010 Act please contact:
Meyers, Roman, Friedberg & Lewis
28601 Chagrin Blvd., Ste. 500
Cleveland, Ohio 44122
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