A holiday tax surprise
By Mark E. Battersby

Just as the Memorial Day holiday was about to begin, lawmakers agreed on how to fund the war in Iraq. That funding bill also raised the minimum wage.

Not a big deal, you might say, because half the states already require minimum wages in excess of the federal level.

However, H.R. 1591, “U.S. Troop Readiness, Veterans’ Health, and Iraq Accountability Act, 2007,” tacked on a lot of other tax breaks — more than $5 billion worth — that are important to know about. Those breaks are included in part of H.R. 1591 known as the “Small Business and Work Opportunity Tax Act of 2007.”

The small business tax incentives were designed to help businesses absorb the cost of a higher minimum wage that increases from $5.15 an hour to $7.25 an hour  in three steps over two years.

THE WORK OPPORTUNITY TAX CREDIT

Those who employ large numbers of workers have long been aware of the Work Opportunity Tax Credit (WOTC), which was created in 1996 to provide employers a unique tax incentive to hire individuals from among groups with particularly high unemployment rates or other special employment needs.

If your practice is located in a rural area, you may now be able to take advantage of the WOTC. The new law expands the high-risk youth target groups to include individuals from rural renewal counties. These are counties outside metropolitan areas that experienced population losses in the 1990s.

Combined with the Welfare-to-Work tax incentives for 2007, the WOTC enlists state employment security agencies to find and certify individuals who are members of a targeted group. Set to expire for employees hired after Dec. 31, 2007, the WOTC was extended through Aug. 31, 2011.

SMALL BUSINESS EXPENSING

In lieu of depreciation deductions, you can choose to deduct (expense) the cost of equipment and business property under Tax Code Section 179. The new law extends and expands Section 179, enhancing 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 investment limitation for property placed in service in tax years beginning in 2007 was formerly $450,000, as indexed for inflation. The new law retroactively raises the investment limitation 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, such as chiropractic practices.

Naturally, no first-year expensing allowance is allowed if the chiropractic practice did not have taxable income during the year in which the property was placed in service. However, the amount of the deduction disallowed for this reason may be carried forward to a nonloss year.

And, do not forget, off-the-shelf computer software placed in service in taxable years beginning before 2010 is treated as property qualifying for Section 179 write-offs.

GO ZONE BUSINESSES

The 2007 Small Business Tax Act extends and expands some of the tax incentives in the Gulf Opportunity (GO) Zone Act of 2005 and Katrina Emergency Tax Relief Act of 2005.

These include the extension of special expensing for qualified property, an enhanced low-income housing credit, and flexible tax-exempt bond financing rules.

FAMILY BUSINESS TAX SIMPLIFICATION

Although relatively rare among chiropractic professionals, married couples jointly operating an unincorporated practice or business usually attribute all of their operation’s income to one spouse.

If you are one of those married couples who did this, you need to carefully consider the new tax provisions, particularly as they relate to Social Security. The new law aims to ensure that when a married couple jointly owns and participates in a small business or practice, they both get credit for paying Social Security and Medicare taxes.

Under the new law, a married couple who jointly operate an unincorporated chiropractic practice or 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 Dec. 31, 2006.

THE S-CORPORATION BUSINESS ENTITY

Several modifications to the S-corporation rules will help small practices retain the benefits of being an S-corporation.

Two new rules — Electing Small Business Trust (ESBT) interest and Earnings and Profits (E&P) reduction — encourage the use of the S-corporation business entity by effectively reducing taxes owed by S-corporation shareholders.

Among the S-corporation reforms are those involving passive investment income.

The passive investment income test has long been a trap for many S-corporations that have converted from regular (C-corporation) status. An S-corporation is not subject to corporate level income tax on its income, but usually through income (and losses) to its shareholders — except when it comes to passive investment income.

The new tax 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.

Ordinarily, if your practice is an S-corporation, it has to pay corporate-level tax at the highest rate on its excess net passive income, if the corporation has accumulated earnings and profits from its C-corporation years and has gross receipts that are more than 25 percent passive investment income.

Worse yet, if more than 25 percent of your S-corporation’s gross receipts are passive investment income for three consecutive years, you lose your S-corporation status.

Gross receipts from more regular income streams (those derived from royalties, rents, dividends, interest, and annuities), remain subject to passive investment income limitations.

A qualified subchapter (Q-Sub) is a wholly-owned subsidiary that an S-corporation has chosen to treat as a Q-Sub. These entities are frequently employed by chiropractors in joint ventures and expansions, as well as for liability protection when spinning off a new venture.

Unfortunately, once the Q-Sub is no longer wholly-owned by the S-corporation, it ceases to qualify as a Q-Sub, and is treated as a new corporation that acquired all of its assets from the parent S-corporation in exchange for stock.

The new law favorably alters the treatment of a sale of Q-Sub stock that terminates the Q-Sub election. Under the new rules, the sale will be treated as a sale of an undivided interest in the assets of the Q-Sub.

This provision eliminates the danger of an avalanche of gain being recognized — and taxed — on the sale of only a partial, but substantial (more than 20 percent), interest in the subsidiary. Now, for example, if an S-corporation sells 25 percent of its Q-Sub stock, it would recognize only 25 percent of the gain.

Obviously, this would save your practice operating as an S-corporation substantial tax on the deemed sale.

PAYBACKS

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 all children younger than age 19 (previously younger than age 18) and students younger than age 24.

Both changes are effective for tax years beginning after May 25, 2007, which means the change should not be noticed by the average, calendar-year taxpayer.

Many of the $4.84 billion in business-related tax cuts designed to ease the pain of the increased minimum wage included in that bill are retroactive to Jan. 1, 2007. Now is the time for you and your accountants to plan to take advantage of these breaks.

Mark E. Battersby is a tax and financial advisor, freelance writer, lecturer, and author with offices in suburban Philadelphia. He can be contacted at 610-789-2480.

DISCLAIMER: The author is not engaged in rendering tax, legal, or accounting advice. Please consult your professional advisor about issues related to your practice.