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Finance: The Memorial Day 2007 Tax Surprise
By Mark E. Battersby
Posted: April 14, 2008, from the December 2007 issue of Skin Inc. magazine.
Just before the Memorial Day holiday in 2007, Congress raised the minimum wage from the old $5.15 per hour level to $7.25 per hour
within the next two years. To help small businesses cope with this increase, lawmakers added $4.84 billion in tax breaks—the Small Business and Work Opportunity Tax Act of 2007. The bill also includes incentives to help taxpayers recovering from Hurricane Katrina, as well as an important package of S corporation reforms. Many spas constitute an S corporation, as it is defined as a company that generally pays no corporate income taxes on its profits. Instead, its shareholders pay income taxes on their shares of the company’s profits.
Unlike tax bills in the past, the so-called “revenue-raisers” that typically meant more taxes for certain taxpayers, these were unusually limited. This means almost every skin care facility and business—as well as the spa business owner or manager—will benefit from the new tax law’s many retroactive provisions on 2007 tax returns.
The Work Opportunity Tax Credit (WOTC)
Those businesses that employ large numbers of workers have long been aware of the Work Opportunity Tax Credit. The WOTC was created in 1996 to provide businesses and employers such as spas with a unique tax incentive to hire individuals from among groups that traditionally have had a particularly high unemployment rate or other special employment needs.
Previously, the credit—which is a percentage of qualified wages paid during each of the first two years of employment—targeted individuals receiving public assistance, high-risk youth, ex-felons, veterans and others who were similarly situated. This year’s changes expand the targeted veterans’ community. It now includes veterans with service-connected disabilities who have been unemployed for six months or more during a one-year period ending on the hire date, with the six months not having to be consecutive. They also have to be hired within one year after being discharged from the military or released from active duty. Additionally, the new law raises the qualified wage threshold for the expanded veterans’ groups from $6,000 to $12,000.
What’s more, many employers in rural areas 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, which are defined as counties outside of 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 now has been extended through Aug. 31, 2011.
Small business expensing
In lieu of depreciation deductions, a spa with sufficiently small investments in equipment or other business property can choose to deduct—or expense—such costs 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 also retroactively raising 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, also indexed for inflation. 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 generally be confined to relatively small skin care businesses.
Naturally, no first-year expensing allowance is allowed if the spa did not have taxable income in 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 non-loss year. And what’s more, the cost of off-the-shelf computer software placed in service in taxable years beginning before 2010 is treated as property qualifying for Section 179 write-offs.
Gulf Opportunity Zone businesses
The 2007 Small Business Tax Act also extended and expanded 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 simplicfication
Although few multinational or large businesses operate as sole proprietorships, these types of business arrangements remain popular with spas and skin care professionals. Married couples who, in the past, attributed all of their spa business’ income to one spouse need to carefully consider the new provisions, particularly as it relates to Social Security. The new law aims to ensure that, when a married couple jointly owns and participates in a small business, each gets credit for paying Social Security and Medicare taxes.
Under the new law, a married couple that jointly operates an unincorporated spa or skin care business and who files 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 of the modifications to the S corporation rules also will help spas retain the benefits of being an S corporation. In fact, the new S corporation provisions were designed specifically to make it easier for small businesses to retain their status as an S corporation, a status often inadvertently jeopardized thanks to the complexity of the rules in this area.
The 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 the taxes owed by S corporation shareholders.
So-called ESBTs were created to permit interests in family-owned corporations to be transferred to a trust in which the trustee has the discretion to accumulate income rather than distribute it, as a Qualified Subchapter S Trust (QSST) is required to do. Unlike a QSST, where income from the S corporation stock is generally taxed at the highest individual tax rate—35% for 2007—the S corporation stock held by an ESBT is treated as held in a separate trust. This means the spa retains its status as an S corporation.
The new law allows an ESBT to deduct the interest paid on money borrowed to acquireS corporation stock. Thus, leveraging
S corporation ownership in an ESBT just got less expensive, given its newly allowed deductibility of interest against income otherwise taxed at the 35% rate.
Among the other 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—or C—corporation status. An
S corporation is not subject to corporate-level income tax on its income, usually passing income and losses through to 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, a spa operating as an S corporation 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% passive investment income. Worse yet, if more than 25% of the S corporation’s gross receipts are passive investment income for three consecutive years, it loses its S corporation status. Gross receipts from more regular income streams—such as those derived from royalties, rents, dividends, interest and annuities—remain subject to the passive investment income limitations.
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 under age 19—previously the law was under age 18—and students under the age of 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.
While the Memorial Day tax law raised the minimum wage, many spa owners would say that portion of the bill is not that big of a deal. After all, half of the states already require minimum wages in excess of the federal level. However, all of those tax breaks—almost $5 billion worth—tacked onto the bill warrant attention. With many of the provisions retroactive to Jan. 1, 2007, will your spa or skin care business now plan to take advantage of these tax breaks? The smart business answer is yes.