Business Income Tax Provisions and Planning Under the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010
EisnerAmper LLP continues coverage of the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (“the Act”) signed into law by President Obama on December 17, 2010.
This Alert, the fifth in our series covering the Act, provides highlights and observations regarding business income tax provisions.
The hallmark of the Act’s business income tax provisions is expanded deductions to stimulate business spending on capital assets.
Section 179 Business Equipment Deductions
The earlier Small Business Jobs Act of 2010 increased the dollar amount of expenditures on certain tangible personal property, computer software and real estate which can be deducted under Internal Revenue Code (“IRC”) Section 179 to $500,000, but provided that this dollar limitation is reduced by the amount by which the investment in such property placed in service during the year exceeds $2 million, for tax years beginning in 2010 and 2011. The new Act provides for a $125,000 dollar limit (indexed for inflation) and a $500,000 investment limit (indexed for inflation) for tax years beginning in 2012, but does not extend such expensing to qualified real estate. After the one-year decrease for 2012, businesses will only be able to utilize Section 179 expensing at pre-2001 levels of $25,000 with a $200,000 investment limit. The Act also extends the treatment of off-the-shelf computer software as qualifying property, if placed in service before 2013.
The Section 179 deduction is limited to the taxpayer's taxable income derived from the active conduct of any trade or business during the tax year, computed without taking into account any Section 179 deduction, a deduction for self-employment taxes, net operating loss carrybacks or carryovers, or suspended deductions. Any amount disallowed by the investment limitation may be carried forward and deducted in future tax years, subject to the maximum dollar and investment limitations or, if lower, the taxable income limitation in effect for the carryover year.
Observation: A Section 179 deduction for qualified real property that is disallowed by reason of the taxable income limitation may not be carried forward to a tax year that begins after 2011. Any amount that cannot be carried forward is recovered through later depreciation deductions.
The ability of a taxpayer to make, change or revoke a Section 179 election on a timely filed amended return is extended for one year, to apply to elections for tax years beginning after 2002 and before 2013.
100% Bonus Depreciation Deductions
The earlier Small Business Jobs Act of 2010 allowed 100% bonus depreciation deductions for qualified property acquired and placed in service between September 9, 2010 and December 31, 2010. The new Act extends 100% bonus depreciation for one year through 2011. Therefore, 100% bonus depreciation now applies to qualified property acquired (i) after September 8, 2010 and before January 1, 2012 and (ii) placed in service before January 1, 2012 (or before January 1, 2013 for longer-period production property and certain noncommercial aircraft). The new Act also provides for 50% bonus depreciation through 2012.
Observation: Property acquired on or before September 8, 2010, although placed in service after that date, does not qualify for the 100% rate.
Property Acquired under a Binding Contract
Bonus depreciation, at either the 100% rate or the 50% rate, may not be claimed on property acquired pursuant to a written binding contract that was in effect before January 1, 2008. Thus, property acquired after September 8, 2010, under a written binding contract entered into on or before that date, will qualify for the 100% rate as long as the contract (i) was entered into after 2007 and (ii) acquisition (delivery) under the contract takes place after September 8, 2010 and before January 1, 2012.
If a taxpayer manufactures, constructs or produces property for the taxpayer's own use, the acquisition date for bonus depreciation is satisfied if the taxpayer begins manufacturing, constructing or producing the property before 2012 (in the case of 100% bonus depreciation) or before 2013 (in the case of 50% depreciation).
Observation: For 100% bonus depreciation, however, there are two opinions on whether the manufacturing, construction or production must begin after September 8, 2010. One requires that all activity must start after that date. The opposing position argues that all acquisition requirements under IRC Section 168(k)(5) are met if the taxpayer begins manufacturing after 2007. Internal Revenue Service guidance may be needed here.
Refundable Credits in lieu of Bonus Depreciation
The new Act also includes an election to accelerate Alternative Minimum Tax (“AMT”) credits in lieu of bonus depreciation for "Round 2 extension property." Round 2 extension property is property that is qualified property solely by reason of the two-year extension of bonus depreciation by the Act.
Increase of First-Year Depreciation on Qualified Autos
Depreciation deductions can be claimed on passenger autos used in business subject to certain limitations. The first-year depreciation amount for automobiles placed in service in 2010 was increased to $11,060. To qualify, autos must be new, acquired and placed in service during 2010. The first-year depreciation amount continues to apply to vehicles placed in service post-September 8, 2010 and in 2011 even though bonus depreciation has expanded to 100%.
Observation: This $11,060 cap not only limits bonus depreciation but also may limit it so sufficiently, that electing out of bonus depreciation for that class of asset (five-year) may make sense.
Section 179 Business Deductions vs. 100% Bonus Depreciation
The bonus depreciation allowance is only available for new property, the original use of which begins with the taxpayer. Section 179 expensing is not so limited.
However, no limit exists on the total amount of bonus depreciation that may be claimed in any given tax year. Section 179 expensing in practice is limited to use by small businesses because of its dollar cap on qualifying property.
Unlike bonus depreciation, the Section 179 deduction is not restricted by calendar dates. While 100% bonus depreciation is applicable to property acquired after Sept. 8, 2010, and placed in service before Jan. 1, 2012, Section 179 expensing is dependent upon the taxpayer's tax year.
Observation: As the Section 179 deduction and investment limits are $500,000 and $2 million, respectively, for tax years beginning in 2010 and 2011, a business with a December 1 to November 30 fiscal year may expense qualifying property up to the $500,000 amount with respect to property acquired and placed in service by November 30, 2012. The increased 2012 cap of $200,000 likewise would apply to qualifying property acquired and place in service by November 30, 2013. In contrast, 100% bonus depreciation for the full cost of most new depreciable property applies to property acquired after September 8, 2010 and placed in service before January 1, 2012.
Observation: It appears that bonus depreciation generally should be elected if the property and the taxpayer are eligible. Section 179 expensing should serve as the default – rather than primary – provision, and specifically where used property is acquired (and thus may be expensed).
Other Business Provisions
• The research credit is retroactively extended to apply to research and development expenses incurred between January 1, 2010 and December 31, 2011.
• Enhanced charitable contribution rules are retroactively extended for qualified computer, food inventory, and book inventory donations made by corporations after January 1, 2010.
• The expensing rules for qualified film and television productions are retroactively extended to productions commencing between January 1, 2010 and December 31, 2011.
Qualified Small Business Stock
The 100% exclusion of gain from the sale or exchange of qualified small business stock by a noncorporate taxpayer under IRC Section 1202 now applies to all qualified small business stock (i) acquired after September 27, 2010 and before January 1, 2012 and (ii) held for more than five years.
Observation: A 75% exclusion of gain applies for qualified small business stock acquired after February 17, 2009 and before September 28, 2010 and held for more than five years. For prior acquisitions held for more than five years, a 50% exclusion generally applies.
For Section 1202 stock subject to the 100% exclusion, no AMT will be imposed on gain from the sale or exchange after the five-year holding period.
Observation: Prior legislation of 2003 provided that 7% of the gain excluded from gross income on the sale or exchange of Section 1202 small business stock acquired after 2000 is treated as an AMT tax preference item. The new Act extended this treatment through 2012. Thus, for dispositions before January 1, 2013, that are eligible for the Section 1202 exclusion, 7% of the excluded gain will be a tax preference item. For Section 1202 stock disposed of after December 31, 2012, however, 28% of the gain will be treated as a tax preference item if the stock's holding period began after 2000 (42% if pre-2001).
Since stock eligible for the 75% exclusion can be sold no earlier than (i) February 20, 2014 (if acquired on February 18, 2009) and stock acquired by September 27, 2010 (the latest acquisition date for the 75% exclusion) can be sold no earlier than (ii) September 28, 2015, such stock will be subject to 28% tax preference treatment under the new Act. That additional AMT liability should be considered in comparing an alternative disposition of the shares before the required holding period for Section 1202 treatment. For example, paying the regular long-term capital gains tax effective in 2011 and 2012 will incur only a 15% federal tax cost.
Additional Planning Opportunities
Net Operating Loss Carrybacks
Under 2009 legislation, net operating losses generated in a taxable year ending after 2007 and beginning before 2010 are subject to an election to carryback such losses for up to five years. Net operating losses generated after 2009 are only allowed the normal two-year carryback period.
Deferral of Cancellation of Indebtedness Income
General rules for cancellation of indebtedness (“COD”) income provide that, if a loan is settled for less than the original amount owed – such as where a debt is forgiven, significantly modified, exchanged for new debt or repurchased by the debtor – taxable income is generated to the extent of the debt reduction. The debtor can exclude this income in certain situations to the extent of insolvency or to the extent of debt discharged in bankruptcy, but is required to reduce certain tax attributes to the extent of the debt excluded from income. The tax attributes reduced include net operating losses, general business credits, basis for depreciable and non-depreciable assets, as well as unused foreign tax credits. However, a 2009 provision gives a debtor the ability to elect to recognize COD income ratably over a five-year period.
Observation: Under the 2009 rules, a debtor can elect to recognize and report COD income from a “reacquisition” of an “applicable debt instrument” that occurs after 2008 and before 2011. For reacquisitions occurring in 2010, the COD income is reported ratably over five-tax years starting in 2014. A “reacquisition” is defined as an acquisition of the debt instrument by the debtor (or related party) that issued the debt. An acquisition includes cash purchase of the debt, exchange of new debt for old debt, exchange of debt for corporate stock or a partnership interest, contribution of the debt to capital, or forgiveness of the total debt. An “applicable debt instrument” is defined as a debt instrument issued by a C corporation or any other person in connection with a trade or business.
Note that personal debt or debt incurred to acquire personal investments does not qualify. The election is made on a debt-by-debt basis and is irrevocable once made. This election should be considered where the debtor does not qualify for COD income exclusions. If the election is made to recognize COD income over the five-year period, the normal COD income exclusions for insolvency or bankruptcy will not apply, nor will the tax attributes reduction rules. The election can only be made by the partnership or S corporation where the debt is at the pass-through entity level.
Business Interest Deductions
If a taxpayer has debt incurred in connection with (traced to) business expenditures, including debt used to finance the capital requirements of a partnership, S corporation or LLC pass-through entity involved in a trade or business in which the taxpayer materially participates, the interest can be deducted as business interest, rather than as an itemized deduction. The interest is a direct reduction of the income from the business. This treatment allows the taxpayer to deduct all his or her business interest, even if a resident of a state that limits or disallows itemized deductions. Business interest also includes finance charges on items that are purchased for a business (as an owner) using credit cards; these purchases are treated as additional loans to the business, subject to tracing rules that allow a taxpayer to deduct the portion of the finance charges that relate to the business items purchased.
Utilizing Business Losses or Tax-Free Distributions
Where taxpayers have an interest in a partnership, S corporation, or LLC pass-through entity, they can deduct losses from the entity only to the extent (i) of tax basis and (ii) where they are “at risk” for the losses. A taxpayer with a loss from a pass-through entity that will be limited by these rules may want to make a capital contribution (or loan) before year-end 2011, thus enabling the taxpayer an allowable tax deduction for the loss. However, such losses may still be limited by the passive activity loss rules.
Conversely, taxpayers can take tax-free distributions from a partnership, S corporation or LLC pass-through entity if they have tax basis in the entity and have already been taxed on the income that is distributed. Since taxpayers are generally taxed on their share of income from these entities, regardless of whether distributions have been made, a taxpayer may have paid tax in a prior year, or will pay tax in the current year, on income that has not been received. Such a taxpayer may now take a distribution without paying additional tax, if funds are available and the entity permits such distributions.
Observation: Generally distributions from a pass-through entity are not taxable to the extent of the taxpayer’s tax basis and at-risk amount in the entity. However, there are special considerations for distributions from S corporations.
For further information on these provisions and planning opportunities, please contact Timothy Speiss or Jon Zefi or another EisnerAmper tax professional.
This publication is intended to provide general information to our friends. It does not constitute accounting, tax, or legal advice; nor is it intended to convey a thorough treatment of the subject matter.