Basics and Beyond Income Tax Seminars

On Friday May 25, President Bush signed the emergency war supplemental spending bill (H.R. 2206) that includes a minimum wage increase and the Small Business and Work Opportunity Tax Act of 2007 (Title VIII B of the bill).

The new law raises the minimum wage to $7.25 an hour from $5.15 in three stages over two years. The bill also includes $4.84 billion in tax breaks for small businesses who made a case, supported by Republicans and the White House, that the minimum wage increase would be a burden for them.

Among its other provisions, the new law also includes changes to the FICA tip credit computation, revision of tax preparer penalties, and modification of unemployment tax collection procedures.

Minimum Wage Increase Summary

The new minimum wage law that was passed as part of the Iraq war funding bill is entitled The Fair Minimum Wage Act of 2007. It amends the original minimum wage law, The Fair Labor Standards Act of 1938, which also regulates overtime pay and child labor.

Workers who now make $5.15 an hour will see their paychecks go up by 70 cents per hour before the end of the summer. Another 70 cents will be added next year, and by summer 2009, all minimum-wage jobs will pay no less than $7.25 an hour. This will be the first change since the minimum wage went from $4.75 to $5.15 on Sept. 1, 1997. The effective dates for the new national minimum wage (which increases in three phases) are:

$5.85 per hour 60 days after enactment (which will be July 24, 2007),
$6.55 per hour one year after the first increase (which will be July 24, 2008), and
$7.25 per hour two years after the first increase (which will be July 24, 2009)

The changes will affect employers in different ways, depending on the state in which their employees work. We've included a few paragraphs at the end of this article that summarizes how the new Federal minimum wage increases will impact various state mimimum wage requirements.

[Click here to go to State Minimum Wage Recap]

The Small Business Work Opportunity Act

The Small Business and Work Opportunity Tax Act of 2007 goes hand-in-hand with the new minimum wage law. It provides tax relief for small businesses, to ease their burden of paying the new minimum wage and subsequent increases.

On the plus side, The Small Business and Work Opportunity Tax Act of 2007 contains a number of small business tax incentives, including a number of provisions affecting small businesses, changes to Gulf Opportunity Zone tax incentives, and some favorable changes to the rules governing S corporations. To help pay for the benefits, the legislation includes a number of revenue raisers such as new and enhanced penalties and yet another broadening of the kiddie tax. The act also extends a number of provisions that were due to expire.

Among the general business incentives are:

enhanced and extended expensing;
improvements to the FICA tip credit and the work opportunity tax credit; and
a new election for joint ventures conducted by spouses.

S corporation changes covered include:

a new opportunity for electing small business trusts to deduct interest on debt used to acquire S stock;
eased rules for QSubs that lose their qualification;
elimination of passive income treatment from gains on sales of stock and securities; and
favorable changes for banks operating as S corporations.

Gulf Opportunity Zone relief includes:

enhanced and extended expensing for property used in highly damaged GO Zone areas;
eased tax-exempt qualified mortgage bond treatment for rehabilitating GO Zone residences; and
eased low-income housing credit rules for buildings in the GO Zones.

The Act pays for the above benefits by:

Raising the kiddie tax age from under-18 to under-19 (under-24 if a student).
Modifying the rule that IRS must stop charging interest and filing related penalties if it fails to notify the taxpayer about a deficiency within 18 months after the taxpayer filed the return-the time limit is extended to 36 months.
Eliminating the requirement that IRS hold a collection due process hearing before issuing a levy on delinquent employment taxes.
Expanding preparer penalties to all types of tax returns (e.g., employment, excise, exempt orgs., estate and gift tax) and increasing the penalty amounts.
Creating a new penalty on claims for refund that are filed without any reasonable basis.
Increasing the penalty for bad checks and money orders.

General Small Business Tax Relief Overview. The tax relief provisions in the small business tax package:

Extends and liberalizes the work opportunity tax credit.The credit is extended for 3.5 years with liberalized rules for hiring disabled veterans and workers in rural renewal counties.
Extends and enhances Section 179 small business expensing. The (Code Sec. 179) expensing limit is increased to $125,000 and the investment-based expensing phaseout is increased to $500,000, effective for tax years beginning after 2006, and the enhanced expensing provision is extended for another year (through 2010).
Extends and enhances certain GO Zone tax incentives. The small business expensing rules allowed for GO Zone businesses (i.e., $100,000 higher expensing limit and $600,000 higher phaseout point) are extended for one year (through 2008) for small businesses in the hardest hit area of the GO Zone. Also, the low-income housing credit rules for buildings in the GO Zones are extended and expanded, and the bond financing rules for repairs and reconstructions of residences in the GO Zones are modified.
Enhances the tip credit for certain small businesses. The Federal minimum wage level for purposes of calculating the tip credit is frozen at $5.15 per hour, thereby allowing restaurants to continue claiming the full tip credit despite an increase in the Federal minimum wage. This income tax credit provided for under Code Section 45B is for Social Security and Medicare (FICA) taxes paid by food or beverage employers on certain employees' tips. Generally, the Section 45B credit is equal to the total FICA taxes that the employer paid on tips received by employees, less tips used to meet the minimum wage. The Act provides that, effective for tips received for services performed after Dec. 31, 2006, the FICA tip credit will not be reduced by any future federal minimum wage increases.
Simplifies family business tax. An unincorporated business that is jointly owned by a married couple in a common law state is permitted to file as a sole proprietorship (under prior law, unless the married couple was located in a community property state, both the married couple and the business were subject to penalties for failing to file as a partnership). The new law also ensures that both spouses receive credit for paying Social Security and Medicare taxes.
Waives individual and corporate AMT limitations on work opportunity tax credits and tip credits. Prior law limited a small business' ability to claim the work opportunity tax credit and the tip credit by imposing a limitation that such credits could not be used to offset taxes that would be imposed under the alternative minimum tax (AMT). The new law provides a permanent waiver of the individual and corporate AMT limitations for the work opportunity tax credit and the tip credit.

S Corporation Tax Changes Summarized. The new law contains several provisions beneficial to S corporations, including measures that:

Change Capital Gains to Non-Passive Investment Income. The act redefines “passive investment income” for purposes of S corporation revocation rules to exclude gains from the sale or exchange of stock or securities as an item of passive investment income.

Current Federal tax law penalizes S corporations if they earn too much passive investment income. Specifically, if an S corporation that previously was a C corporation has undistributed dividends, and earns 25 percent of its gross receipts as passive investment income, then two things will happen. First, the S corporation is taxed on its income at the highest corporate rate. Second, if the S corporation earns too much passive investment income for three consecutive years, then the S election is terminated altogether. Passive investment income generally means gross receipts from royalties, rents, dividends, interest, annuities, and sale or exchanges of stock or securities (to the extent of gains).

However, the corporate-level passive investment income tax is imposed so that C corporations cannot convert to S corporations and thereby avoid the personal holding company (PHC) tax that applies to C corporations. But since PHCs are no longer prohibited from generating passive investment income from gain on the sale of stock or securities, it no longer made sense to impose that restriction on S corporations. Accordingly, the new law eliminates gains from sales or exchanges of stock or securities as an item of passive investment income. The new rule applies to taxable years beginning after the date of enactment of the 2007 Small Business Act.

Change the Classification Of Bank Director Shares. Bank directors often own stock in a bank to comply with national or state banking law. Frequently, a bank director will enter into an agreement under which the bank will reacquire the stock upon the director's ceasing to hold the office of director, at the price paid by the director for the stock (“restricted bank director stock.”). However, federal tax law provides that an S corporation may have no more than 100 shareholders and may have only one outstanding class of stock. To clarify the treatment of bank director shares under the S corporation rules, the new law provides that restricted bank director stock will not be taken into account as outstanding stock in applying the S corporation rules. This means that:

the stock will not be treated as a second class of stock;
a director will not be treated as a shareholder of the S corporation by reason of the stock;
the stock will be disregarded in allocating items of income, loss, etc. among the shareholders; and
the stock will not be treated as outstanding for purposes of determining whether an S corporation holds 100 percent of the stock of a qualified subchapter S subsidiary.

The new provision generally applies to taxable years beginning after Dec 31, 2006, but the provision providing that restricted bank director stock is not treated as a second class of stock is effective for taxable years beginning after December 31, 1996.

Set forth a special accounting rule for banks that become S corporations and that change from the reserve method of accounting for bad debts.

Allow deductibility of interest expense of an electing small business trust (“ESBT”) on indebtedness incurred to acquire S corporation stock. The new law eliminates a distinction between an individual purchaser of S corporation stock and a trust purchaser, and makes the ESBT more attractive. Under prior law, the only permissible deductions against an ESBT's income were its administrative expenses, such as costs incurred in the management and preservation of the trust's assets. Interest incurred to acquire S corporation stock was not deductible. The new law permits an electing ESBT to claim an income tax deduction for any interest incurred to purchase S stock. The new rule applies to taxable years beginning after December 31, 2006.
Revise the Tax Treatment for disposition of an interest in qualified Subchapter S subsidiary (“QSub”). Under pre-Act law, an S corporation could be required to recognize 100 percent of the gain inherent in a QSub's assets if it sold more than 20 percent of the stock of the QSub. This result was counter to sound tax policy because the S corporation, in effect, was required to recognize gain on assets without making any disposition of those assets. The new law rectifies this situation by providing that the S corporation is only required to recognize gain proportionate to the percentage of stock sold. The new law applies to taxable years beginning after December 31, 2006.
Eliminate Earnings And Profits Attributable To Pre-1983 Years.
Prior to 1983, income earned by an S corporation gave rise to earnings and profits. Concluding that it was inconsistent with the modern view of S corporations to continue to view pre-1983 S corporation income as giving rise to earnings and profits, in 1996 Congress eliminated pre-1983 earnings and profits for any corporation that was an S corporation prior to 1983, but only if the corporation was an S corporation in its first taxable year beginning after December 31, 1996.

In hindsight, congress concluded that there seemed to be no policy reason why relief from pre-1983 S corporation earnings and profits should be dependent on whether the corporation continued to be an S corporation after 1996. Accordingly, the new law eliminates pre-1983 earnings and profits arising during an S corporation year, regardless of whether the corporation was an S corporation in its first taxable year beginning after December 31, 1996. This provision applies to taxable years beginning after the date of enactment of the 2007 Small Business Act.

Change Treatment of S corporation banks changing from reserve method of accounting. Under current law, banks that use the reserve method of accounting are ineligible to make the S corporation election. If a bank makes an S corporation election, the bank is automatically switched to the specific charge-off method of accounting for bad debts. This change in accounting method results in recapture of the bad debt reserve over four years. The recapture of the reserve by the bank S corporation is treated as built-in gain subject to a special corporate-level tax. Under the built-in gain provisions, tax on the built-in gain must be paid both at the corporate and shareholder level in the year of recognition. In contrast, a C corporation would pay tax on the recapture amount at the corporate level but the shareholders would not have to pay tax on that amount until the C corporation paid dividends. The new law allows banks to take the recapture of the bad debt reserves into account in the last C corporation year, rather than the first S corporation year, thereby eliminating the imposition of a second layer of tax. The new rule applies to taxable years beginning after December 31, 2006.

Overview of Extensions in the Act. The act also contains extensions for several popular tax breaks. In addition, a number of provisions, such as small business expensing and the work opportunity tax credit, were enhanced in the new legislation to provide more valuable incentives and additional tax relief. Here's an overview of the extension provisions in the new legislation the President has signed into law:

The Work Opportunity Tax Credit. The work opportunity tax credit (WOTC) allows employers tax credits for hiring individuals from one or more of nine targeted groups (such as recipients of public assistance, qualified veterans on assistance, and “high risk youth”). The credit was scheduled to expire at the end of this year, but the new law extends the credit for more than 3 years (through September 31, 2011). In addition, the new law expands and enhances the credit by:
- Expanding the qualified veterans' targeted group to include an individual who is certified as entitled to compensation for a service-connected disability and who (1) is hired by the employer within one year of being discharged or released from active duty in the Armed Forces of the United States, or (2) has been unemployed for six months or more during the one-year period preceding the date of hiring. For these individuals, the amount of first-year wages eligible for the credit is increased from $6,000 to $12,000.
- Expanding the definition of high-risk youths to include otherwise qualifying individuals age 18 but not yet age 40 on the hiring date. Also, the provision expands the definition of eligible individuals under this category to include otherwise qualifying individuals from rural renewal counties, defined as a county outside a metropolitan area which had a net population loss during the five-year periods 1990-1994 and 1995-1999.
- Modifying the definition of vocational rehabilitation referral for purposes of the credit to include certain individual work plans developed and implemented by an employment network under the Social Security Act.
  
  Generally, the extension of the credit is effective for wages paid or incurred to a qualified individual who begins work for an employer after December 31, 2007 and before September 1, 2011. The other provisions are effective for individuals who begin work for an employer after the date of enactment of the 2007 Small Business Act in taxable years ending after that date.
Extension of increased expensing for small business. A taxpayer, other than an estate, trust, and certain noncorporate lessors, may elect under Code Sec. 179 to deduct as an expense, rather than to depreciate, up to a specified amount of the cost of new or used tangible personal property placed in service during the tax year in his trade or business. Under pre-Act law, the maximum dollar amount that could be deducted annually was $100,000 ($112,000 for 2007, as adjusted for inflation). The taxpayer's maximum annual Code Sec. 179 expensing amount is reduced dollar-for-dollar by the amount of qualified expensing-eligible property that he places in service during the tax year in excess of a phaseout amount. Under pre-Act law, this amount was $400,000 ($450,000 for 2007, as adjusted for inflation). The new law increases the expensing limit to $125,000 and the phaseout level to $500,000 for 2007 (indexed for inflation) and extends the enhanced expensing provision through 2010.

GO Zone Related Tax Relief Summary. The term “GO Zone” refers to the areas along the Gulf Coast that were hardest hit by the 2005 hurricanes Katrina, Rita, and Wilma and that have been designated for tax and other forms of relief legislation designed to spur re-investment and redevelopment. Here is a summary of the GO Zone provisions in the legislation the President is expected to sign into law soon.

Extension of GO Zone small business expensing. In general, federal tax law permits businesses to elect to expense (deduct currently) up to a certain amount of the cost of machinery and equipment (and some types of software) bought for use in business. Under pre-Act law this amount was $112,000 for 2007 as adjusted for inflation. For GO Zone businesses, however, this amount was increased by $100,000 (to $212,000 for 2007).

In addition, GO Zone businesses benefited from a higher level of investment at which their benefits phased out ($1,050,000 for 2007 as adjusted for inflation, rather than the generally applicable $450,000), thus allowing more businesses to use this tax benefit in rebuilding. However, these benefits were set to expire after this year. The new law extends these benefits for one year (through 2008) for small businesses in certain specified portions of the GO Zone.

Extension and expansion of low-income housing credit rules for buildings in the GO Zones. Earlier Gulf Opportunity Zone, Rita GO Zone and Wilma GO Zone (the “GO Zones”) relief legislation provided affected Gulf states with additional low-income housing tax credits to spur the construction of housing for Gulf Coast residents in the form of affordable rental units. The earlier legislation also provided that properties financed by tax credits placed in service in the calendar years 2006, 2007, and 2008 would be treated as Difficult to Develop Areas (DDA), which provides a 30% boost in eligible basis for the properties. The earlier legislation required developments to be placed in service by the end of 2008, and the DDA designation was set to expire at the same time. As a practical matter, however, it would have been difficult if not impossible for a development receiving tax credits in 2007 or 2008 to meet the end of 2008 placed in service requirement. For that reason, the new legislation extends the placed in service deadline for GO Zones tax credits and the GO Zones' DDA designation for two years, through December 31, 2010.
Bond financing rules for repairs and reconstructions of residences in the GO Zones. The new law waives the Mortgage Revenue Bond program's 20-year and existing walls rules for qualified rehabilitation in the GO Zone, Rita GO Zone, and Wilma GO Zone for owner-financing provided after enactment of the 2007 Small Business Act and before January 1, 2011.

Other Key Tax-related Provisions.

Tax preparer penalties. The Act broadens the definition of a tax preparer to include preparers of employment tax returns. Penalty amounts are increased. A tax return preparer who prepares a return or refund claim for which any part of a tax liability understatement is due to an unreasonable position must pay a penalty equal to the greater of $1,000, or 50% of the income derived (or to be derived) by the tax return preparer in preparing the return or claim.

Unemployment tax collection procedures. In order to ensure the payment and collection of employment taxes, the IRS is authorized to take various collection actions, including issuing federal tax levies. Before a tax levy can be issued, however, the IRS must generally provide the taxpayer with notice and an opportunity for an administrative collection due process (CDP) hearing. The Act will eliminate the requirement that the IRS hold a due process hearing before issuing a levy on delinquent employment taxes for a "disqualified employment tax levy"

Effective Dates for Various Act Provisions

Most of the Act's provisions became effective with the Act's signing on May 25, 2007. Provisions with effective dates other than May 25th that now have a specific effective date as a result of the May 25 signing by the President include the following:

the provision excepting levies to collect federal employment taxes from the regular, pre-levy collection due process (CDP) hearing requirement is effective for levies on or after Sept. 22, 2007 (the date that is 120 days after the enactment date). (Act § 8243(c))
the provision giving IRS more time to notify individuals about liability before interest and penalties are suspended is effective for IRS notices provided after Nov. 25, 2007 (the date which is six months after the date of enactment). (Act § 8242(b))

Recap of Act's Impact on Various State
Minimum Wage Requirements

In general, employers in 17 states will effectively see the minimum wage they are required to pay increase in lockstep with the three increases outlined above. Those states are Alabama, Georgia, Idaho, Indiana, Kansas, Louisiana, Mississippi, Nebraska (employers covered by state, but not federal law, will not be required to pay federal minimum wage), North Dakota, Oklahoma, South Carolina, South Dakota, Tennessee, Texas, Utah (the state's minimum wage does not apply to anyone entitled to the federal minimum wage), Virginia, and Wyoming (employers covered by state, but not federal law, will not be required to pay federal minimum wage.)

However, the federal changes will have a different effect in the 34 states that had already set the state minimum wage above the old federal minimum wage ($5.15 per hour). Because the federal law covers nearly all employees, making most employers subject to both state and federal laws, employers may effectively ensure compliance with both sets of laws simply by following the one that is most beneficial to the employee.

The minimum wage change on the federal level will generally have no effect on employers in 8 states because they currently have minimum wages at or above $7.25 per hour. (California, Connecticut , Hawaii, Massachusetts, Oregon (indexed to inflation), Rhode Island, Vermont (indexed to inflation) and Washington (indexed to inflation)

Four additional states (Illinois, Iowa, Kentucky, and Michigan ) have minimum wages that are currently lower than $7.25 per hour but will rise to or above that level at a faster pace than the federal minimum wage.

In Illinois, the state minimum wage (currently $6.50) will rise to $7.50 in July 2007, $7.75 in July 2008, $8.00 in July 2009, and $8.25 in 2010.
In Iowa, the state minimum wage (currently $6.20 per hour) will rise to $7.25 per hour on January 1, 2008.
In Kentucky, the state minimum wage will increase from $5.15 per hour to $5.85 per hour beginning July 1, 2007. Beginning July 1, 2008, the minimum wage will rise to $6.55 per hour. The minimum wage will move to $7.25 beginning July 1, 2009.
In Michigan, the state minimum wage (currently $6.95) will rise to $7.15 on July 1, 2007 and to $7.40 on July 1, 2008.

In 7 states (Arkansas, Maryland, Minnesota's large employers, Missouri, Montana, Morth Carolina and Wisconsin) employers won't be affected by the federal changes until the second step (when the federal minimum wage rises to $6.55 per hour).

Employers in the remaining 10 states generally won't be affected by the federal changes until the third step (when the federal minimum wage rises to $7.25 per hour). These states are Alaska, Arizona, Colorado, Delaware, Florida, Maine, New Jersey, New York, Ohio and Pennsylvania.

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