Small Business and Work Opportunity Tax Act of 2007 On May 26, 2007, the President signed into law the Small Business and Work Opportunity Tax Act of 2007. This Act is to provide small business owners with tax relief to help offset scheduled increases in the federal minimum wage. However, the Act also includes “revenue raisers” (better known as tax increases). This letter briefly summarizes the most important tax changes. Unfavorable New Kiddie Tax Rules If the Kiddie Tax applies to your child, part of his or her unearned income (typically from investments) will be taxed at your higher marginal federal rate rather than at your child’s lower rate. For 2008 and beyond, the Kiddie Tax can potentially come into play until the year during which a child turns 24. It finally cuts out for that year and for all subsequent years. More specifically, for 2008 and later years, the Kiddie Tax applies only when all of the following four requirements are met. The first three requirements are the same as before the new law. The fourth requirement (the one having to do with the child’s age) was changed. 1. Living Parent Requirement. One or both of the child’s parents are alive at year-end and in a higher marginal federal income tax bracket than the child. (Since you are reading this letter, this first requirement is probably met.) 2. Filing Requirement. Your child doesn’t file a joint return for the year. 3. Unearned Income Requirement. Your child’s unearned income for the year exceeds the annual threshold. For both 2006 and 2007, the threshold is $1,700. For 2008, it may be higher due to an inflation adjustment. If your child’s unearned income doesn’t exceed the threshold, the Kiddie Tax doesn’t apply. If your child’s unearned income exceeds the threshold, only the amount in excess of the threshold is hit with the Kiddie Tax. That means the excess income gets taxed at your higher marginal rate. 4. Age Requirement. Your child is— • • • under age 18 at the end of the year, age 18 at the end of the year and doesn’t have earned income in excess of 50% of his or her support, or age 19–23 at the end of the year, is a student, and doesn’t have earned income that exceeds half of his or her support.
The Kiddie Tax will apply if all four of these requirements are met for the year. It makes no difference if the child is, or is not, claimed as a dependent on your return (or anyone else’s return). Example 1: Melissa will be age 20 on 12/31/08. Her earned income for 2008 doesn’t exceed half of her support, and she is a student for the year. Melissa falls under the third age rule. Therefore, she will be subject to the Kiddie Tax if all of the other three requirements are also met for 2008. Example 2: Now assume Melissa is not a student in 2008. In this case, she is exempt from the Kiddie Tax because none of the age rules apply to her. However, it could be a different story in 2009–2011 if she goes to school. Liberalized Section 179 Instant Deduction Rules Under the Section 179 rules, many small businesses can immediately write off the entire cost of equipment and software additions in the year of acquisition. The Act extends the current very favorable Section 179 deduction rules for one more year—through tax years beginning in 2010. In
addition, the Act makes the rules even more generous starting with tax years beginning in 2007 (this year) by increasing the maximum Section 179 deduction to $125,000 (up from $112,000). For 2008–2010, the $125,000 amount will be indexed for inflation. Note: Unless Congress takes further action, the maximum Section 179 deduction will revert back to only $25,000 after 2010. Tax Simplification for Husband-wife Partnerships A husband-wife joint venture that is treated as a partnership for federal tax purposes generally must file an annual Form 1065 and issue each spouse a separate Schedule K-1 each year. Of course, this is a tax compliance hardship. The Act allows some husband-wife ventures to “elect out” of the partnership rules for federal tax purposes. To be eligible, the spouses must file jointly, and the husband-wife operation must be a qualified joint venture, which means a trade or business operation where: (1) the husband and wife are the only members of the venture, (2) both spouses materially participate in the venture’s trade or business, and (3) both spouses agree to elect out of the partnership tax rules. After electing out, each spouse must report his or her share of the federal income tax items from the venture on the appropriate IRS form (such as a separate Schedule C for each spouse). The new elect out option is available for tax years beginning after 12/31/06. Note: While electing out won’t change a married couple’s total federal income tax liability or total self-employment tax liability, it will eliminate the need to file Form 1065 and the related Schedules K-1. Liberalized Rules for S Corporations The Act makes the following favorable changes (among others) to the S corporation tax rules. • S Corp Stock and Securities Gains Not Treated as Passive Income. When an S corporation has earnings and profits (E&P) from prior C corporation years, it can be exposed to a corporatelevel tax on excess net passive income. In addition, the corporation’s S status can be revoked if more than 25% of gross receipts are from passive investment income for three consecutive years. Effective for tax years beginning after 5/25/07, gains from an S corporation’s sales of stock and securities won’t count as passive investment income for purposes of these unfavorable rules. Pre-1983 E&P Eliminated for Certain S Corps. If a corporation was an S corporation for any tax year that began before 1/1/83 and was not an S corporation for its first tax year that began after 12/31/96, any earnings and profits (E&P) accumulated during pre-1983 S corporation years are eliminated from the corporation’s accumulated E&P balance. For an affected S corporation, this favorable provision can reduce the amount of distributions that will be treated as taxable dividends. The change takes effect at the start of the first S corporation tax year that begins after 5/25/07. Extension and Modification of Work Opportunity Tax Credit (WOTC) The work opportunity tax credit (WOTC) provides employers with a federal income tax incentive to hire members of certain targeted groups. The credit is based on a limited amount of wages paid to a qualified employee over either a one-year or two-year period. The Act extends the WOTC for an extra 44 months to cover wages paid to qualified employees who begin work before 9/1/11. In addition, the Act expands the list of targeted groups and makes other favorable changes for wages paid to affected employees who begin work after 5/25/07.
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Employer Tip Credit (for FICA Taxes on Employee Tips) An employer is entitled to a business tax credit for the employer’s portion of Social Security and Medicare taxes paid on employee cash tips in excess of the amount treated as wages for purposes of meeting federal minimum wage requirements. The Act ensures that the employer tip credit won’t be reduced when the federal minimum wage goes up (as it is scheduled to do in stages over the next two years). This provision is effective for tips received for services after 12/31/06. WOTC and Employer Tip Credit Can Reduce Alternative Minimum Tax Bills The Act provides that both the WOTC and the employer tip credit can be used to reduce individual and corporate alternative minimum tax (AMT) liabilities. This favorable change applies to credits for tax years beginning after 2006. Other Revenue Raisers (Tax Increases) In addition to the unfavorable Kiddie Tax changes, the Act includes (among others) the following additional revenue raisers (otherwise known as tax increases). • New Taxpayer Penalty. A new taxpayer penalty on erroneous claims for refunds or credits generally equals 20% of the disallowed portion of the claim for which there is no “reasonable basis.” This change is effective for claims filed after 5/25/07. Suspension of Interest and Penalties When IRS Fails to Issue Deficiency Notice. Pretty soon the IRS will be able to accrue interest and penalties for 36 months after the date a problematic tax return is filed without bothering to issue any specific deficiency notice to the taxpayer. After 36 months, the accrual of additional interest and penalties is suspended (finally) until the IRS gets around to issuing such a notice. Previously, the IRS could only accrue interest and penalties for 18 months without issuing a specific notice. This super-unfavorable change is effective for IRS notices issued after 11/25/07. Hearings Before Employment Tax Levies. In certain circumstances, an employer can lose the right to have a hearing before the IRS issues a levy for unpaid employment taxes. This scary new rule is effective for levies issued on or after 9/22/07. IRS User Fees. The IRS charges so-called user fees for various “services” such as issuing private letter rulings and approving accounting method changes. The Act permanently extends the IRS’s legal authority to charge user fees. Minimum Bad Check Penalty. The new law increases the minimum penalty on taxpayers who issue bad checks (or money orders) to the government to $25 or the amount of the check (or money order), whichever is less. This change only applies to bad checks (or money orders) for less than $1,250 that are received after 5/25/07.
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