By Jerry Kissell and Ryan Hermunslie, Minneapolis office of McGladrey
The recently enacted the Small Business Jobs Act of 2010 (the Act) contains significant tax provisions including changes to the built-in gains tax for Subchapter S corporations and increased deductions for investments in fixed assets.
Built-in Gains Tax. The Act contains a significant change to the built-in gains tax for S corporations. As you may recall, S corporations that were previously C corporations have historically been subject to a corporate level tax on recognized built-in gains for 10 years following the S corporation election. Last year, the American Recovery and Reinvestment Act of 2009 relaxed the rules by amending the law so that the built-in gains tax is no longer imposed on S corporations beginning with its eighth S corporation year. This amendment was only effective for 2009 and 2010 and potentially benefited banks that made S corporation elections effective after Jan. 1, 1999 through 2003.
The Act added a special provision that reduces the built-in gains period to five years for taxable years beginning in 2011. On the surface, the plain language of the statute seems to indicate that the corporation must be an S corporation for five full years before the beginning of 2011 in order for the five year period to apply. Therefore, if a corporation made an S election prior to Jan. 1, 2006, there will clearly be no built-in gain tax imposed during 2011.
However, there are two additional interpretations that are more likely to capture Congress's intent: 1) either the built-in gains tax will not apply to gains recognized more than five years after the S election, or 2) the built-in gains tax will not apply if the fifth taxable year of the S corporation precedes the taxable year beginning in 2011. These distinctions are subtle, but would have a profound effect on the application of the five-year built-in gain period to corporations that made an S election during 2006.
Under the first interpretation, if a corporation made an S election on July 1, 2006, built-in gains tax would not apply to any assets sold on or after July 1, 2011. Under the second interpretation, if a fiscal year corporation made an S election any time prior to Dec. 31, 2006, and had an initial short-period income tax return to put the S corporation on a calendar year filing, the built-in gains tax would not apply to any asset dispositions made in 2011.
The Committee Report for the new law indicates that Congress intended for the first interpretation to apply, meaning that for 2011 the built-in gains tax will only apply to gains recognized within five years from the first day that the corporation was an S corporation. If an S election was made during 2006, the taxpayer should be aware of the potential interpretations of the new law when planning the disposition of built-in gain assets.
If you have completed your fifth year as an S corporation, or will complete it in 2011, this provision could provide significant federal tax savings since built-in gains are taxed at the highest federal tax rate of 35 percent. Remember that under current law, the built-in gains period will return to 10 years for taxable years beginning in 2012, so it may be important to plan the timing of disposition for built-in gain assets.
Fixed Asset Provisions. The Act also contains two provisions relating to fixed assets: It extends bonus depreciation through 2010 and enhances the small business expensing rules of Section 179.
Bonus Depreciation. Previously, Congress allowed businesses to recover the costs of capital expenditures made in 2008 and 2009 faster than under ordinary depreciation provisions by permitting these businesses to immediately deduct 50 percent of the cost of new depreciable property acquired in 2008 and 2009. The new law extends this temporary benefit for qualifying property purchased and placed into service in 2010. The law is retroactive to the beginning of the year, meaning that all qualified property purchased during 2010 will be eligible for bonus depreciation. Under current law, bonus depreciation is set to expire at Dec. 31, 2010.
While bonus depreciation is an excellent opportunity to accelerate tax deductions, you should consider the effect on your shareholders before accelerating deductions. Bonus depreciation may have a considerable impact on the level of the S corporation's Accumulated Adjustments Account (AAA). Taxable income increases AAA and tax deductions decrease AAA, so utilizing bonus depreciation will reduce the S corporation's AAA balance in the year the asset is acquired and the difference from what the AAA balance would be using a regular depreciation schedule will reverse over the life of the asset.
If the S corporation has accumulated earnings and profits from when it was a C corporation, distributions to shareholders are only tax-free to the extent that an S corporation has a positive AAA balance. If distributions exceed the AAA balance, they will most likely be treated as taxable dividend income to the shareholders. Therefore, if your corporation has a relatively small or negative AAA balance, but still needs to make distributions to shareholders, additional depreciation deductions may create or increase taxable dividends to the shareholders. With the favorable tax rates on dividends that exist through the end of 2010, a corporation may or may not choose to avoid paying taxable dividends to its shareholders.
Generally, bonus depreciation is required. However, if an S corporation determines that it would better to defer depreciation deductions, an election to not have bonus depreciation apply can be made. Additionally, this election is made for each separate property class; therefore there is some flexibility in the election depending on which types of assets were acquired in 2010.
The election could be made for all property acquired in 2010, which would mean that no bonus depreciation would be taken in 2010. However, assume a corporation acquired five-year and seven-year property in 2010 and wanted to accelerate depreciation on some of its assets, but not all of them. The corporation could choose to only elect out of bonus depreciation for five-year property. In this scenario, the corporation would calculate bonus depreciation on the seven-year property, but not the five-year property. The taxpayer could conversely make the election for seven-year property, in which case they would calculate bonus depreciation on the five-year property, but not the seven-year property.
Section 179 Deduction. In addition to the bonus depreciation extension, the Act enhanced the small business expensing rules of Section 179. In order to help small businesses quickly recover the cost of certain capital expenses, small business taxpayers may elect to deduct the cost of these expenditures in the year of acquisition, in lieu of recovering these costs over time through depreciation. Previously, Congress increased the amount that small businesses could deduct for capital expenditures incurred in 2008 and 2009 to $250,000 and increased the phase-out threshold for 2008 to $800,000.
The new law increases the maximum deduction under Section 179 to $500,000 for capital expenditures incurred in 2010. Also, the phase-out of the deduction does not begin until qualifying fixed asset additions exceed $2 million. Under current law, in 2011 the Section 179 deduction limitation is set to revert to $25,000 and the phase-out threshold will revert to $200,000.
While this new law can greatly reduce your taxable income, you should also consider the impact of Section 179 deductions on your shareholders before electing to expense items using Section 179. The first area to consider is the active income limitation. In order to take a deduction under Section 179, the taxpayer must have active trade or business net income. This limitation is first applied at the corporate level, meaning that S corporations that have a taxable loss are not eligible to expense fixed assets under Section 179.
However, the limitation is also applied at the shareholder level. This means that the S corporation's shareholders must either 1) be active in the operations of the business and therefore they would be able to treat the pass-through income of the corporation as active trade or business income, or 2) they must have other active income at the individual level that could be used to offset the Section 179 deduction. Examples of active trade or business income include wages, Schedule C income, or income from other pass-through entities in which the taxpayer actively participates.
In addition, estates and certain trusts are generally unable to deduct Section 179 expense. The limitations of deductibility at the shareholder level may reduce or eliminate the benefit of making the Section 179 deduction on the S corporation tax return.
As discussed above, you should consider the effect on your shareholders prior to utilizing the bonus depreciation and Section 179 expense provisions. However, if you determine that it is beneficial to utilize the provisions, your bank may want to consider making fixed asset acquisitions prior to the end of the year because bonus depreciation is set to expire and the Section 179 deduction limitations are set to decrease substantially beginning in 2011.