FAQ Page

IRS has issued additional guidance on the 2010 payroll tax exemption for hiring unemployed workers and the tax credit for retaining such workers. These payroll tax breaks were enacted by the Hiring Incentives to Restore Employment Act (HIRE Act, P.L. 111-147) (see Federal Taxes Weekly Alert 04/22/2010). The additional guidance, in the form of frequently asked questions (FAQs), carries valuable information on subjects such as the scope of the exemption, how it interacts with other tax breaks, and when an employer must receive the employee’s certification of former unemployment status.

Background. The HIRE Act carried two valuable incentives for employers that boost payroll this year: a payroll (FICA) tax exemption for employers that hire unemployed workers; and an up-to-$1,000 tax credit for keeping such new hires on the payroll for at least one year.

Under Code Sec. 3111(d), qualified employers are exempted from paying the employer 6.2% share of Social Security (i.e., OASDI) employment taxes on wages paid in 2010 to a newly hired qualified individual. The payroll tax relief applies only for wages paid to qualified individuals from Mar. 19, 2010 (the day after the HIRE Act was signed into law by the President) and ending on Dec. 31, 2010.

A qualified employer is any employer other than the U.S., a state, or a political subdivision of a state (i.e., a local government, or an instrumentality). (Code Sec. 3111(d)(2)(A)) However, a public institution of higher education is a qualified employer even though it is a government instrumentality. (Code Sec. 3111(d)(2)(B))

A qualified individual is an individual who:

1. Begins employment with the employer after Feb. 3, 2010 and before Jan. 1, 2011;

2. Certifies by signed affidavit, under penalties of perjury, that he or she hasn’t been employed for more than 40 hours during the 60-day period ending on the date employment begins with the qualified employer;

3. Does not replace another employee of the employer (unless that other employee left voluntarily or for cause); and

4. Is not related to the qualified employer in a way that would disqualify the individual for the work opportunity tax credit (WOTC) under Code Sec. 51(i)(1). (Code Sec. 3111(d)(3))

Unless the employer elects out of the payroll tax exemption, wages paid or incurred to a qualified individual won’t qualify for the WOTC during the one-year period beginning on the date that the qualified employer hired the individual. (Code Sec. 51(c)(5)) The election can be made on an employee-by-employee basis.

In addition to the payroll tax exemption, HIRE Act Sec. 103 provides employers with an up-to-$1,000 tax credit for retaining “qualified individuals” as defined for Code Sec. 3111(d) purposes. The workers must be employed by the employer for a period of not less than 52 consecutive weeks, and their wages for such employment during the last 26 weeks of the period must equal at least 80% of the wages for the first 26 weeks of the period.

Following are highlights of IRS’s new guidance on these payroll tax breaks.

When payroll tax exemption begins and ends. Code Sec. 3111(d)(1) provides that the requirement to pay the employer share of OASDI tax “shall not apply to wages paid by a qualified employer with respect to employment during the period beginning on [March 19, 2010, the day after the enactment date] and ending on December 31, 2010 ….” if all of the payroll tax exemption requirements are met. IRS says that the payroll tax exemption is based on when wages are paid to a qualified employee, not when the wages are earned by such an employee. Thus, only wages paid from Mar. 19 2010, through Dec. 31, 2010, qualify for the exemption, regardless of when those wages were earned. (FAQ PE7)

Form W-11. IRS recently issued Form W-11, Hiring Incentives to Restore Employment (HIRE) Act Employee Affidavit, which newly hired, but formerly unemployed, workers must sign (or its equivalent) in order for their new employers to treat the workers as qualified individuals (see Federal Taxes Weekly Alert 04/15/2010). The Form W-11 need not be notarized and shouldn’t be sent to IRS; the employer should keep the form with its records. (FAQs QE14 and 15)

Form W-11 may be submitted to the employer electronically, if: the electronic transmission is signed via electronic signature by the employee whose name is on the Form W-11; the signature is made under penalties of perjury using the same language that appears on the paper Form W-11; and the electronic signature is the final entry in the employee’s Form W-11 submission. Upon IRS’s request during an examination, the employer must supply a hard copy of the electronic Form W-11, and a statement that, to the best of the employer’s knowledge, the electronic Form W-11 was made by the employee whose name is on the form. The hard copy of the electronic Form W-11 must provide exactly the same information as, but need not be a facsimile of, the paper Form W-11. (FAQ QE18)

Deadline for receipt of Form W-11. The employer must have the signed Form W-11 (or its equivalent) by the time it files an employment tax return applying the payroll tax exemption. If the signed form is obtained after wages are paid to the employee, the employer can still apply the payroll tax exemption to determine its liability on these wages; it may in some cases have to file a corrected return for a prior quarter. (FAQ QE17)

Illustration: ABX hires Anne, an otherwise qualified employee, who begins employment on Mar. 1, 2010 and is paid wages in March. Anne does not provide the signed affidavit until Apr. 15, 2010. ABX can claim the first quarter credit on the second quarter Form 941 for the amount of the exemption with respect to wages paid to Anne from Mar. 19, 2010 through Mar. 31, 2010 and can apply the exemption to wages paid to the qualified employee starting Apr. 1, 2010, despite the fact that Anne did not provide the signed affidavit until Apr. 15, 2010. By contrast, if Anne does not provide the signed affidavit until Aug. 1, 2010, ABX can’t claim the first quarter credit on the second quarter Form 941 for wages paid to the qualified employee from Mar. 19, 2010, through Mar. 31, 2010, and can’t apply the exemption to wages paid in the second quarter because ABX did not obtain the signed affidavit by the time it filed its second quarter Form 941. Instead, ABX must file a Form 941-X to correct the second quarter of 2010 if it wants to claim the first quarter credit and apply the exemption to the second quarter wages paid to Anne. (FAQ QE17)

Temporary agency employees. A temporary agency can apply the exemption with respect to wages it pays to its qualified employees. This is determined based on when the employee begins employment with the temporary agency, and not based on when the employee begins work at a client business of the temporary agency. (FAQ QE11) If a client business hires an employee who previously provided services to the business as an employee of a temporary agency the client business gets the payroll tax exemption if the worker is a qualified employee when he or she begins employment with the client as its employee. That is, the worker must not have worked as an employee for any business (including the temporary agency) for more than 40 hours in the 60 days prior to beginning employment with the client business. (FAQ QE12)

Election out. Code Sec. 3111(d)(4) provides that a qualified employer may elect, in the manner that IRS requires, not to have the payroll tax exemption apply. IRS says that no formal election out is required; the employer that chooses not to have the payroll tax exemption apply simply reports and pays its share of social security tax on wages paid to qualified employees, along with the employee share of social security tax, Medicare taxes, and withheld income tax. (FAQ PE8)

If an employer applied the payroll tax exemption for a qualified employee on Form 941 for one or more prior quarters, it can later elect out of the exemption by filing Form 941-X for each affected prior quarter to correct its original return and pay the employer’s share of social security tax for each such prior quarter. The employer is then eligible to claim the WOTC on its income tax return. (FAQ PE10)

Employer may be selective. An employer can choose to apply the exemption with respect to none, some, or all of its qualified employees. However, if the employer applies the exemption for any wages paid to a particular qualified employee, the exemption must be applied to all wages paid to that employee from Mar. 19, 2010, through Dec. 31, 2010. (FAQ PE 9)

Retention credit and WOTC. An employer may claim the retention credit for a qualified employee (if all the requirements are satisfied) even if it also has claimed the WOTC for the same employee (i.e., even if it has elected out of the payroll tax exemption). (FAQ PE11)

Restaurant employers. Certain food and beverage employers can claim a credit under Code Sec. 45B for social security and Medicare taxes paid or incurred by them on certain employee tips. An employer could be eligible for both the payroll tax exemption and the Code Sec. 45B credit on certain tips if the employer has tipped employees who are also qualified employees under the HIRE Act. The employer claims the payroll exemption on Form 941 and the Code Sec. 45B credit on its income tax return. An employer that applies the payroll tax exemption with respect to a qualified employee will be entitled to a smaller Code Sec. 45B credit because the employer will pay only Medicare tax (and not social security tax) on the employee’s wages, including reported tips. (FAQ QR8)

The tax laws enacted in the last couple of years contain important income tax and information reporting provisions that are effective for the first time in 2011. To inform you of what’s new in the tax rules, here’s a summary of the key tax changes for 2011, broken down into three categories: Personal Income Taxes, Retirement Plan Changes, and Tax Changes for Businesses and Investors. If you’d like to discuss how these changes affect your personal, business or investment situation, please give me us a call.

Personal Income Taxes

Payroll tax holiday in place. Employees will pay only 4.2% (instead of the usual 6.2%) OASDI (Social Security) tax on compensation received during 2011 up to $106,800 (the wage base for 2011). Similarly, for tax years beginning in 2011, self-employed persons will pay only 10.4% Social Security self-employment taxes on self-employment income up to $106,800. In either case, the maximum savings for 2011 will be $2,136 (2% of $106,800) per taxpayer. If both spouses earn at least as much as the wage base, the maximum savings will be $4,272.

Stricter rules apply to energy saving home improvements. You can claim a tax credit for energy saving home improvements you make this year, but stricter rules apply for 2011 than for 2010. You can only claim a 10% credit for qualified energy property placed in service in 2011 up to a $500 lifetime limit (with no more than $200 from windows and skylights). What’s more, the credit you claim for any year can’t exceed $500 less the total of the credits you claimed for all earlier tax years ending after Dec. 31, 2005. The amount you claim for windows and skylights in a year can’t exceed $200 less the total of the credits you claimed for these items in all earlier tax years ending after Dec. 31, 2005. The credit is equal to the sum of: (1) 10% of the amount you pay or incur for qualified energy efficient improvements (such as insulation, exterior windows or doors that meet certain energy efficient standards) installed during the year, and (2) the amount of the residential energy property expenses you paid or incurred during the year.

The credit for residential energy property expenses can’t exceed: (A) $50 for an advanced main circulating fan; (B) $150 for any qualified natural gas, propane, or hot water boiler; and (C) $300 for any item of energy efficient property (advanced types of energy saving equipment, such as electric heat pumps, meeting specific energy efficient standards).

Partial annuitization of annuity contracts. When you receive non-retirement-plan annuity payments from an annuity contract, part of each payment is a tax-free recovery of your basis (cost of the annuity contract for tax purposes), and part is a taxable distribution of earnings. For amounts received in tax years beginning after Dec. 31, 2010, taxpayers may partially annuitize such an annuity (or endowment, or life insurance) contract. If you receive an annuity for a period of 10 years or more, or over one or more lives, under any portion of an annuity, endowment, or life insurance contract, then that portion is treated as a separate contract for annuity taxation purposes. The net effect is that the annuitized portion is treated as a separate contract, and each annuity payment from that portion is partially a tax-free recovery of basis and partially a taxable distribution of earnings. Absent this rule, the payments might have been treated as coming out of income before recovery of any basis. The portion of the contract that is not annuitized is also treated as a separate contract and will continue to earn income on a tax-deferred basis.

Restricted definition of medicine for health plan reimbursements. Beginning this year, the cost of over-the-counter medicines can’t be reimbursed with excludible income through a health flexible spending arrangement (FSA), health reimbursement account (HRA), health savings account (HSA), or Archer MSA (medical savings account), unless the medicine is prescribed by a doctor or is insulin. This new rule applies to amounts paid after 2010. However, it does not apply to amounts paid in 2011 for medicines or drugs bought before Jan. 1, 2011. Also, for distributions after 2010, the additional tax on distributions from an HSA that are not used for qualified medical expenses increases from 10% to 20% of the disbursed amount, and the additional tax on distributions from an Archer MSA that are not used for qualified medical expenses increases from 15% to 20% of the disbursed amount.

Retirement Plan Changes

Small employers may establish “simple cafeteria plans.” For years beginning after Dec. 31, 2010, small employers (those having an average of 100 or fewer employees on business days during either of the two preceding years) may provide employees with a “simple cafeteria plan.” An employer that uses this type of plan gets a safe harbor from the nondiscrimination requirements for cafeteria plans as well as from the nondiscrimination requirements for certain types of qualified benefits offered under a cafeteria plan, including group term life insurance, benefits under a self-insured medical expense reimbursement plan, and benefits under a dependent care assistance program.

Election to treat January 2011 charitable distributions as made in 2010. If you are age 70 1/2 or older, you can make tax-free distributions to a charity from an Individual Retirement Account (IRA) of up to $100,000. This applies for charitable IRA transfers made in tax years beginning before Jan. 1, 2012. In addition, if you make such a distribution in January of 2011, you can treat it for income tax purposes as if it were made on Dec. 31, 2010. Thus, a qualified charitable distribution made in January of 2011 may be treated as made in your 2010 tax year and count against the $100,000 exclusion for 2010. It is also may be used to satisfy your IRA required minimum distribution for 2010.

Tax Changes for Businesses and Investors

Electronic filing rules now in place. Beginning Jan. 1, 2011, employers must use electronic funds transfer (EFT) to make all federal tax deposits (such as deposits of employment tax, excise tax, and corporate income tax). Forms 8109 and 8109-B, Federal Tax Deposit Coupon, cannot be used after Dec. 31, 2010.

Up-to-$1,000 credit for “retained workers” in 2011. Employers may claim a “retention credit” for retaining qualifying new employees (certain formerly unemployed workers meeting specific requirements). The amount of the credit is the lesser of $1,000 or 6.2% of wages you pay to the retained qualified employee during a 52 consecutive week period. The qualified employee’s wages for such employment during the last 26 weeks must equal at least 80% of wages for the first 26 weeks. The credit may be claimed for a retained worker for the first tax year ending after Mar. 18, 2010, for which the retained worker satisfies the 52 consecutive week requirement. However, the credit applies only for qualifying employees hired after Feb. 3, 2010, and before Jan. 1, 2011.

New basis and character reporting rules. Generally effective on Jan. 1, 2011, every broker required to file an information return reporting the gross proceeds of a “covered security” such as corporate stock must include in the return the customer’s adjusted basis in the security and whether any gain or loss with respect to the security is short-term or long-term. The reporting is generally done on Form 1099-B, “Proceeds from Broker and Barter Exchange Transactions.” A covered security includes all stock acquired beginning in 2011, except stock in certain regulated investment companies (i.e, mutual funds) and stock acquired in connection with a dividend reinvestment plan (both of which are covered securities if acquired beginning in 2012).

Corporate actions that affect stock basis must be reported. Effective Jan. 1, 2011, issuers of “specified securities” must file a return describing any organizational action (e.g., stock split, merger, or acquisition) that affects the basis of the specified security, the quantitative effect on the basis of that specified security, and any other information required by IRS. The issuer’s return (and information to nominees or certificate holders) must be filed within 45 days after the date of the organizational action or, if earlier, by January 15th of the year following the calendar year during which the action occurred. Nominees or certificate holders must (unless the IRS waives this requirement) be given a written statement showing (1) the name, address, and telephone number of the information contact of the person required to file the return, (2) the information required to be included on the return for the security, and (3) any other information required by the IRS. In general, a specified security is any share of stock in an entity organized as, or treated for federal tax purposes as, a foreign or domestic corporation.

Reporting requirement for payment card and third-party payment transactions. After 2010, banks generally must file an information return with the IRS reporting the gross amount of credit and debit card payments a merchant receives during the year, along with the merchant’s name, address, and TIN. Similar reporting is also required for third party network transactions (e.g., those facilitating online sales).

Information reporting for real estate. For payments made after Dec. 31, 2010, for information reporting purposes, a person receiving rental income from real estate is treated as engaged in the trade or business of renting property. As a result, recipients of rental income from real estate generally are subject to the same information reporting requirements as taxpayers engaged in a trade or business. In particular, rental income recipients making payments of $600 or more during the tax year to a service provider (such as a plumber, painter, or accountant) in the course of earning rental income must provide an information return (typically Form 1099-MISC) to the IRS and to the service provider.

The rental property expense payment reporting requirement doesn’t apply to: (1) an individual who receives rental income of not more than a minimal amount (to be determined by the IRS); (2) any individual (including one who is an active member of the uniformed services or an employee of the intelligence community) if substantially all of his or her rental income is derived from renting the individual’s principal residence (main home) on a temporary basis; or (3) any other individual for whom the information reporting requirement would cause hardship (to be defined by the IRS).

© 2011 Thomson Reuters/RIA. All rights reserved.

On December 17 the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (the 2010 Tax Relief Act) was signed into law. It includes many taxpayer-friendly provisions for both individuals and businesses. This letter summarizes the changes we think will affect the most taxpayers.

Changes Affecting Individuals

Lower Tax Rates Extended through 2012. The Act extends the 10%, 15%, 25%, 28%, 33%, and 35% federal income tax rates on ordinary income through 2012. Without the new law, these rates would have been replaced in 2011 and beyond by the pre-Bush rates of 15%, 28%, 31%, 36%, and 39.6%.

The Act also extends the 0% and 15% federal income tax rates on most long-term capital gains and dividends through 2012. Without the new law, most long-term capital gains would have been taxed at 10% or 20% and dividends would have been taxed at ordinary rates of up to 39.6%.

Marriage Penalty Relief Extended through 2012. As you know, getting married can cause a couple’s combined federal income tax bill to be higher than when they were single. The 2001 Bush tax cut legislation eased this marriage penalty by tweaking the lowest two tax brackets for married couples and by giving them bigger standard deductions. Without the new law, these fixes would have disappeared after 2010. The Act extends them through 2012.

Social Security Tax Reduction for 2011 Only. The Act cuts the 6.2% Social Security tax withholding rate on employee salaries from 6.2% to 4.2%. This temporary change only affects the first $106,800 of 2011 wages (i.e., wages up to the 2011 Social Security tax ceiling). The maximum savings are $2,136 for unmarried individuals and $4,272 for couples. The Social Security tax component of the self-employment tax is cut from 12.4% to 10.4% for 2011, so self-employed folks will benefit too.

Good News:Because of this change, employees should notice bigger paychecks by the end of January, if not sooner. Self-employed folks will account for the change by reducing their 2011 estimated payments.

Personal Exemption and Itemized Deduction Phase-outs Repealed through 2012. For 2010, unfavorable phase-out rules that could reduce some of your most-cherished write-offs were temporarily repealed. The phase-out rules were scheduled to come roaring back in 2011. Thankfully, the Act keeps the repeal in place through 2012.

Alternative Minimum Tax (AMT) Patch for 2010 and 2011. As you know, it has become an annual ritual for Congress to “patch” the AMT rules to prevent millions more households from getting socked with this add-on tax. The patch primarily consists of allowing bigger AMT exemptions and allowing personal tax credits to offset the AMT. The Act makes the patch for 2010 and for 2011 as well.

100% Gain Exclusion for Qualified Small Business Corporation Stock Extended to Cover Shares Issued in 2011. The Small Business Jobs Act of 2010 (enacted last September) created a temporary 100% gain exclusion (within limits) for sales of qualified small business corporation (QSBC) stock issued between 9/28/10 and 12/31/10. The Act extends the window for taking advantage of this change by one year to cover QSBC shares issued between 9/28/10 and 12/31/11.

Note: QSBC shares must be held for more than five years to be eligible for the gain exclusion break. Thus, we are only talking about sales that will occur well down the road.

IRA Qualified Charitable Contributions Extended through 2011. For 2006-2009, IRA owners who had reached age 70½ were allowed to make annual tax-free distributions of up to $100,000 paid directly out of their IRAs to charitable organization. These donations are called qualified charitable distributions (QCDs). They generally do not directly affect your federal income tax bill because no deductions are allowed. However, you do not have to itemize deductions to benefit and QCDs count as IRA required minimum distributions (RMDs). Therefore, charitably inclined seniors can get a break by arranging for tax-free QCDs to take the place of taxable RMDs and those who do not itemize can effectively get the benefit of the deduction by arranging for tax-free QCDs. The QCD break expired at the end of 2009. The Act retroactively restores it for 2010 and extends it through 2011.

Note: If you are interested, you still have time to take advantage of the QCD opportunity for the 2010 tax year. That’s because you can make an election to treat QCDs taken during January of 2011 as 2010 QCDs that count as part of the 2010 $100,000 QCD limit and 2010 RMDs (to the extent you’ve not already taken your RMDs for 2010). Any other QCDs taken in 2011 will be treated as 2011 QCDs that count as part of the 2011 $100,000 QCD limit and 2011 RMDs (up to your RMD amount for 2011). Please contact us if you are considering QCDs.

Bigger Child Credit Extended through 2012. For 2011 and beyond, the maximum credit was scheduled to drop from $1,000 to only $500. The Act extends the $1,000 credit through 2012.

American Opportunity Education Credit Extended through 2012. The American Opportunity credit can be worth up to $2,500, can be claimed for up to four years of undergraduate education, and is 40% refundable. It was scheduled to expire at the end of 2010 and be replaced by the Hope Scholarship credit which is smaller, can only be claimed for the first two years of college, is subject to phase-out at lower income levels, and is nonrefundable. The Act extends the more generous American Opportunity credit through 2012.

College Tuition Deduction Extended through 2011. This write-off, which can be as much as $4,000, or $2,000 at higher income levels, expired at the end of 2009. The Act retroactively restores the deduction for 2010 and extends it through 2011.

More Generous Student Loan Interest Deduction Rules Extended through 2012. This write-off, which can be as much as $2,500 (whether you itemize or not), was scheduled to fall under less favorable rules in 2011 and beyond. The Act extends through 2012 the more favorable rules established by the 2001 Bush tax cut legislation.

More Generous Coverdell Education Savings Account Rules Extended through 2012.For 2011, the maximum contribution to federal-income-tax-free Coverdell college savings accounts was scheduled to drop from $2,000 to only $500, and a stricter phase-out rule would have limited contributions by many married joint-filing couples. The Act extends through 2012 the more generous contribution rules established by the 2001 Bush tax cut legislation.

Employer Educational Assistance Plans Extended through 2012. Through 2010, an employer can provide up to $5,250 in annual federal-income-tax-free educational assistance to each eligible employee. Both undergraduate and graduate school costs can be covered by the plan, and the education need not be job-related. This taxpayer-friendly deal was scheduled to expire at the end of 2010. The Act extends it through 2012.

Option to Deduct State and Local Sales Taxes Extended through 2011. For the last few years, individuals who paid little or no state income taxes had the option of claiming an alternative itemized deduction for state and local general sales taxes. The sales tax deduction option expired at the end of 2009. The Act retroactively restores it for 2010 and extends it through 2011.

More Generous Earned Income Tax Credit Rules Extended through 2012The 2009 Stimulus Act increased the refundable earned income credit (EIC) percentage for families with three or more qualifying children from 40% to 45%. This change was effective for 2009 and 2010, and it resulted in larger EICs for affected families. The Stimulus Act also increased the income threshold for the phase-out rule that can reduce or eliminate EICs for married joint-filing couples. Both changes were scheduled to expire at the end of 2010. The Act extends them through 2012.

More Generous Dependent Care Tax Credit Rules Extended through 2012. For the last few years, parents could claim a credit of up to $600 for costs to care for one under-age-13 child or up to $1,200 for costs to care for two or more under-age-13 kids, so the parents can go to work. Lower-income parents can claim larger credits of up to $1,050 and $2,100, respectively. For 2011 and beyond, the maximum credits were scheduled to drop. The Act extends the more generous maximum credit amounts through 2012. Note that in some cases, the credit can also be claimed for dependents other than under-age-13 children.

Smaller Tax Credit for 2011 Energy-efficient Home Improvements. The 2009 Stimulus Act provided that 30% of 2009 and 2010 expenditures for energy-efficient insulation, windows, doors, roofs, and heating and cooling equipment in U.S. residences could qualify for a credit, up to a maximum credit amount of $1,500 over the two years combined. The new law extends the credit through 2011, but the credit percentage is scaled back to only 10% and the lifetime credit limit is only $500. The $500 credit cap is reduced by any credits claimed in 2006-2010.

$250 Deduction for K-­12 Educators Extended through 2011. For the last few years, teachers and other eligible personnel at K­-12 schools could deduct up to $250 of school-related expenses paid out of their own pockets—whether they itemized or not. This break expired at the end of 2009. The Act retroactively restores it for 2010 and extends it through 2011.

Bigger Tax-free Limit for Employer-provided Transportation Fringes Extended through 2011. The 2009 Stimulus Act increased the maximum monthly amount that an employee can receive as a tax-free fringe benefit for employer-provided transit passes and/or employer-provided transportation in a commuter highway vehicle (van pooling) to equal the maximum monthly tax-free amount for employer-provided parking benefits. As a result of the increase, the maximum monthly tax-free amount that could be received in 2010 for transit passes and/or van pooling (together or separately) was $230. However, the increased limit expired at the end of 2010. The new law extends the increased limit for transit passes and/or van pooling through 2011. The IRS just announced that the 2011 tax-free monthly limit for transit passes and/or van pooling is $230 (same as for 2010).

New Estate and Gift Tax Rules for 2010-2012

The new law includes favorable estate tax provisions for individuals who died in 2010, as well as those who die in 2011 and 2012. Here is a brief summary.

$5 Million Estate Tax Exemption and 35% Rate. For estates of individuals who die in 2010-2012, the Act establishes a $5 million federal estate tax exemption with the 2012 amount indexed for inflation. Big estates are taxed at 35% above the $5 million threshold. (We’ll have more on special rules for estates of individuals who died in 2010 later.)

Unused Estate Tax Exemption Can Be Left to Surviving Spouse. For the first time, married individuals who don’t use up their estate tax exemptions will be able to pass along unused amounts to surviving spouses. In other words, unused exemptions of individuals who die in 2011 or 2012 (but not 2010) will be “portable.” The ability to pass along unused estate tax exemptions to surviving spouses is a very favorable development. It allows both spouses’ exemptions to be utilized without having to set up a credit shelter trust or engage in other tax planning maneuvers—as long as they both die in 2011 or 2012. Unfortunately, this new portability rule sunsets after 2012, so it won’t help decedents who die after 2012. Also, the portability rules do not apply to the generation-skipping transfer tax exemption. Thus, trusts may still be needed in certain situations.

Unlimited Basis Step-ups for Inherited Assets. For heirs of decedents who die in 2011 and beyond, the familiar rule that allows the federal income tax basis of inherited capital-gain assets (such as real estate and stock) to be stepped up to reflect fair market value on the date of death is reinstated. This favorable rule is also reinstated for decedents who died in 2010 unless the estate elects to instead use the modified carryover basis rule. (We’ll have more on this election shortly.) With the restoration of the unlimited basis step-up rule, heirs won’t owe any federal capital gains taxes on appreciation that occurs through the date of death—as long as that date is after 2010 or, for decedents who died in 2010, their estate doesn’t elect to use the modified carryover basis rules.

Estate and Gift Tax Exemptions and Rates Are Equalized. The Act sets the lifetime federal gift tax exemption for 2011 and 2012 at $5 million—with the 2012 amount indexed for inflation (ditto for the generation-skipping transfer tax exemption). Thus, the gift tax and estate tax exemptions are equalized for 2011 and 2012. This is a huge improvement over the previous $1 million gift tax exemption (which continues to apply for 2010). An unmarried person can now give away up to $5 million while alive without paying any gift tax, and a married couple can give away up to $10 million. (To the extent you dip into your gift tax exemption, your estate tax exemption is reduced dollar-for-dollar.) The tax rate on 2011 and 2012 gifts in excess of the $5 million exemption is 35%, same as the estate tax rate. Again, thanks to sunset provisions, the gift tax exclusion reverts to $1 million after 2012.

Clarity for Estates of 2010 Decedents and 2010 Generation-skipping Transfers. The Act clarifies the estate tax treatment of estates of individuals who died in 2010 and the generation-skipping transfer (GST) tax treatment of generation-skipping gifts made in 2010, but it does so in a weird way. The new law reinstates both taxes for 2010 with $5 million exemptions for each. But, executors have the option of electing out of the estate tax for 2010 in accordance with the 2010 repeal.

If executors elect out of estate tax, the aforementioned modified carryover basis rules apply to heirs for income tax basis purposes. So, heirs of large estates can wind up owing capital gains taxes on appreciation that occurs through the decedent’s date of death, but there won’t be any federal estate tax. If the election out is not made for an estate, the $5 million exemption applies for 2010, and the income tax basis of inherited assets equals FMV on the date of death.

For 2010, the GST exemption is $5 million. However, the 2010 GST rate is deemed to be 0%, so there’s no actual GST liability for 2010. Therefore, large generation-skipping gifts can be made in 2010, and only the gift tax will be owed (2010 gifts in excess of the $1 million gift tax exemption for that year are taxed at a flat 35% rate). The GST tax exemption is not subject to any portability, unlike the estate tax exclusion amount.

Thus, up to $5 million of GST tax exemption may be allocated to transfers in trust in 2010 (depending on how much GST tax exemption was used by the transferor prior to 2010).

Note: The $5 million GST tax exemption is available to an estate whether the executor of an estate for a decedent who died in 2010 chooses to be subject to estate tax or elects out of the estate tax and instead applies the modified carryover basis rules.

Business Depreciation and Depletion Changes

First-year Bonus Depreciation Allowed for Assets Placed in Service through 2012. The Act generally allows 100% first-year bonus depreciation for qualifying new (not used) assets that are acquired and placed in service between 9/9/10 and 12/31/11. It also allows 50% first-year bonus depreciation for qualifying new (not used) assets that are placed in service in calendar year 2012. For a new passenger auto or light truck that’s used for business and is subject to the luxury auto depreciation limitation, the 100% and 50% bonus depreciation breaks increase the maximum first-year depreciation deduction by $8,000 for vehicles acquired and placed in service by 12/31/12.

15-year Depreciation for Leasehold Improvements, Restaurant Property, and Retail Space Improvements Extended through 2011. The 15-year straight-line depreciation privilege for qualified leasehold improvements, qualified restaurant buildings and improvements, and qualified retail space improvements is retroactively restored for property placed in service in 2010 and extended to cover property placed in service in 2011. (Without the favorable 15-year depreciation rule, leasehold improvements, restaurant building improvements, restaurant buildings, and retail space improvements generally would have to depreciated straight-line over 39 years.)

Suspension of Percentage Depletion Net Income Limitation for Marginal Properties Extended through 2011. The suspension of the 100%-of-net-income limitation on percentage depletion deductions for marginal oil and gas properties is retroactively reinstated for tax years beginning in 2010 and extended through tax years beginning in 2011.

Business Tax Credit Changes

Research Credit Extended through 2011. The Act retroactively restores the research credit for 2010 and extends it through 2011 to cover qualifying expenses paid or incurred in those years.

Work Opportunity Credit Hiring Deadline Extended by Four Months. The Act extends the general deadline for employing eligible individuals for purposes of claiming the Work Opportunity Tax Credit by four months, from 8/31/11 to 12/31/11.

Differential Pay Credit for Small Employers Extended through 2011. Legislation enacted in 2008 created a tax credit for eligible small employers that provide differential pay to employees while they serve in the military. The credit equals 20% of differential pay of up to $20,000 paid to each qualifying employee during the tax year. The credit expired at the end of 2009. The Act retroactively restores it to cover payments made in 2010 and extends it to cover payments made in 2011.

Contractor Credit for Building Energy-efficient Homes Extended through 2011. The Act retroactively reinstates the $2,000 per-home contractor tax credit for building new energy-efficient homes in the U.S. (including manufactured homes) for 2010 and extends it through 2011. The credit can also be claimed for substantially reconstructing and rehabilitating an existing home and making it more energy-efficient. Homes that don’t fully meet the energy-efficiency standards may qualify for a reduced $1,000 credit. To qualify for this credit, a home must be sold by 12/31/11 for use as a residence.

Business Charitable Contribution Changes

Enhanced Deduction for Food Donations Extended through 2011. The new law retroactively restores for 2010 and extends through 2011 the enhanced charitable contribution deduction for non-C corporation businesses that donate food (it must be apparently wholesome when donated). This provision is intended for non-C corporation businesses that have food inventories, such as restaurants.

Enhanced C Corporation Deduction for Book Donations Extended through 2011. The Act retroactively restores for 2010 and extends through 2011 the enhanced deduction for C corporations that donate books to schools. This provision is intended for C corporations that have book inventories, such as publishers and retailers.

Enhanced C Corporation Deduction for Computer Donations Extended through 2011.The new law retroactively restores for tax years beginning in 2010 and extends through tax years beginning in 2011 the enhanced deduction for C corporations that donate computer equipment and technology to qualifying educational organizations and libraries.

Favorable Rule for S Corporation Donations of Appreciated Assets Extended through 2011. The new law retroactively restores for tax years beginning in 2010 and extends through tax years beginning in 2011 the favorable shareholder basis rule for stock in S corporations that make charitable donations of appreciated assets.

Conclusion

As you can see, the new law includes lots of changes, and we did not cover them all here due to space constraints. If you have questions or want more complete information about the new law, please contact us.

To help offset the cost of a temporary increase in funding for Medicaid and state education, the recently enacted 2010 Education and Jobs Act (Act) tightens the rules on the use of foreign tax credits that multinationals use to lower their U.S. tax bill. In general, the new law’s foreign tax provisions attempt to (1) make foreign tax credits (FTCs) available only when the income to which the FTCs relate is actually taxed by the U.S., (2) prevent artificial inflation of foreign source income, and (3) modify the resourcing rules to limit FTCs. Here is a brief overview of the new foreign tax provisions. Please call our offices for details of how the new changes may affect you or your business.

Foreign tax credit “splitting”

The Act prevents splitting FTCs from income by implementing a matching rule that suspends the recognition of foreign tax until the related foreign income is taken into account for U.S. tax purposes. The provision applies to all “split” foreign taxes paid or accrued in tax years beginning after Dec. 31, 2010 and is expected to raise $4.25 billion over 10 years.

Covered asset acquisition

The new law denies a FTC for the disqualified portion of any foreign income tax paid or accrued in connection with a covered asset acquisition (e.g., acquiring interests in entities that are corporations for foreign tax purposes, but are non-corporate entities (such as partnerships) for U.S. tax purposes). The provision generally applies to covered asset acquisitions after Dec. 31 2010 and is expected to raise $3.645 billion over 10 years.

Separate application of foreign tax credit limitation to items resourced under tax treaties

The Act prevents artificially inflating foreign source income by providing a separate foreign tax credit limitation for each item of income that could be treated as U.S. source income under the Code or foreign source income under a treaty and that the U.S. taxpayer elects to treat as foreign source. The provision applies to tax years beginning after the date of the new law’s enactment and is expected to raise $250 million over 10 years.

Limit FTCs with respect to “hopscotched” dividends

Under a prior anti-abuse rule, U.S. corporations with multiple lower-tier subsidiaries could create a “deemed dividend” from a lower-tier subsidiary that may be eligible for a higher FTC than if the dividend flowed up through the full chain of ownership to the U.S. parent. The new law limits FTCs to the maximum that could be claimed if the dividend did not “hopscotch” over the intermediary subsidiaries. The provision applies to the affirmative use of the deemed dividend rule after Dec. 31, 2010 and is expected to raise $704 million over 10 years.

Redemptions by foreign subsidiaries

The Act provides a new limitation on when a foreign acquiring corporation’s earnings and profits may be reduced by a Code Sec. 304 deemed dividend. Under the Act, the foreign earnings remain subject to U.S. income tax when repatriated to a higher-tier U.S. subsidiary and subject to U.S. withholding tax when distributed to the foreign parent as a dividend. The provision applies to acquisitions after Dec. 31, 2010 and is expected to raise $250 million over 10 years.

Repeal of 80/20 rules

The Act repeals the 80/20 rules for interest and dividends paid by U.S. corporations or resident alien individuals. Thus, regardless of the amount of active foreign business income earned by the payor, dividends and interest paid by U.S. corporations or resident alien individuals to foreign persons are classified as U.S. source and subject to 30% withholding tax. The Act includes relief for existing 80/20 companies that meet specific requirements and are not abusing the 80/20 company rules. Subject to the relief for existing 80/20 companies, the provision applies to tax years beginning after Dec. 31, 2010 and is expected to raise $153 million over 10 years.

Modification of affiliation rules for allocating interest expense

The Act modifies the affiliation rules to provide that the assets and interest expense of foreign corporations, satisfying income and ownership tests, are taken into account in allocating and apportioning the interest expense of the affiliated group for purposes of computing the foreign tax credit limitation. The provision applies to tax years beginning after the date of the new law’s enactment and is expected to raise $390 million over 10 years.

Technical correction to statute of limitations provision in the HIRE Act

The Act makes a technical correction to the foreign compliance provisions of the Hiring Incentives to Restore Employment (HIRE) Act, which was enacted earlier this year, to clarify the circumstances under which the statute of limitations will be tolled for corporations that fail to provide certain information on cross-border transactions or foreign assets. Under the technical correction, the statute of limitations period will not be tolled if the failure to provide such information is shown to be due to reasonable cause and not willful neglect.

We hope this information is helpful. If you would like more details about these changes or any other aspect of the new law, please do not hesitate to call.

© 2010 Thomson Reuters/RIA. All rights reserved.

The Internal Revenue Code includes two different tax credits for energy-saving home improvements. The rules for one of the credits have changed significantly for the worse since 2010, and that credit is scheduled to expire on 12/31/11. The other credit, which covers more exotic and expensive improvements, is still generous. Here’s what you and your clients need to know for them to cash in on the credits this year.

Modest $500 Credit for Basic Energy-saving Improvements

The first credit, under IRC Sec. 25C , equals 10% of certain qualified expenditures plus 100% of certain other qualified expenditures, subject to a maximum overall credit of $500. That’s pretty skimpy, and the $500 maximum must be reduced by any Section 25C credit claimed in any earlier post-2005 year. This restriction will cause many clients to be completely ineligible for 2011. For instance, say your client claimed a $1,500 Section 25C credit in 2010 (when the rules were much more generous) for installing energy-efficient windows. That client cannot claim any Section 25C credit in 2011. Sorry about that!

The good news is the credit (when allowed) covers a broad range of energy-saving expenditures for a taxpayer’s principal U.S. residence (including a manufactured home). Plus, it’s available against Alternative Minimum Tax (AMT), and there are no income restrictions. However, expenditures for vacation homes and foreign residences are ineligible.

Here are some more details on the Section 25C credit.

Eligible Improvement Costs. For the following improvements to a U.S. principal residence, the maximum credit equals 10% of qualified 2011 expenditures up to the overall $500 credit cap, reduced by any Section 25C credit claimed in any earlier post-2005 year.

  • Exterior windows, including skylights, that meet or exceed Energy Star program requirements—subject to a separate $200 credit cap for all post-2005 years. For instance, if your client claimed a $200 or more credit for new windows installed in 2010, no credit can be claimed for windows installed in 2011.
  • Exterior doors that meet or exceed Energy Star program requirements.
  • Insulation material or systems designed to reduce heat loss or gain that meet criteria established by the 2009 IECC.
  • Metal and asphalt roofs that meet or exceed Energy Star program requirements and have pigmented coatings or cooling granules designed to reduce heat gain of the residence.

Eligible Equipment Costs. For the following items of energy-saving equipment installed in a U.S. principal residence, the maximum credit equals 100% of qualified 2011 expenditures up to the overall $500 credit cap, reduced by any Section 25C credit claimed in any earlier post-2005 year.

  • High-efficiency central air conditioners; electric heat pumps; electric heat pump water heaters; water heaters that run on natural gas, propane, or oil; and biomass fuel stoves used for heating or hot water—subject to a separate $300 credit cap for 2011 for these items.
  • Furnaces and hot water boilers that run on natural gas, propane, or oil—subject to a separate $150 credit cap for 2011 for these items.
  • Advanced main air circulating fans used in natural gas, propane, and oil furnaces—subject to a separate $50 credit cap for 2011.

Basis Adjustments. The taxpayer’s basis in the residence is increased by qualified expenditures and reduced by the amount of any allowable Section 25C credit.

Generous 30% Credit for Big Ticket Energy-saving Equipment

The second credit, under IRC Sec. 25D , equals 30% of qualified expenditures to buy and install more-exotic (and more-expensive) energy-saving equipment for a U.S. residence (manufactured homes are apparently eligible).

Qualified Expenditures. In general, 30% of the cost for the following types of equipment (including costs for site preparation, assembly, installation, piping, and wiring) count as eligible expenditures for the Section 25D credit.

  • Qualified solar water heating equipment for a U.S. residence, including a vacation home.
  • Qualified solar electricity generating equipment for a U.S. residence, including a vacation home.
  • Qualified wind energy equipment for a U.S. residence, including a vacation home.
  • Qualified geothermal heat pump equipment for a U.S. residence, including a vacation home.
  • Qualified fuel cell electricity generating equipment for a U.S. principal residence . Vacation homes are ineligible for the fuel cell credit. Also, the maximum annual fuel cell credit is limited to $500 for each .5 kilowatt hour of fuel cell capacity added during that year.

Big Expenditures Translate into Big Credits. Because expenditures for the aforementioned items can be big numbers, Section 25D credit amounts can be big too. And there are no income limits—even billionaires are eligible. Plus, it’s available against AMT. If the client’s 2011 Section 25D credit is so large that it cannot be fully utilized on this year’s return, the excess can be carried forward to 2012 and beyond.

No Hurry for This Credit. The Section 25D credit is available through 2016, so there is no need to rush to take advantage.

Basis Adjustments. The taxpayer’s basis in the residence is increased by qualified expenditures and reduced by the amount of any allowable Section 25D credit.

Manufacturers’ Certifications Are Required for Both Credits

A good place to start your search for an energy efficient product is at www.energystar.gov/taxcredits, where you’ll find requirements for various products. But, to be sure that the product purchased satisfies the required energy saving conditions for the credit, the client must obtain the manufacturer’s certification that the product in question qualifies. The certification may be on the product packaging or it may be available on the manufacturer’s website. In any case, the certification should be kept with the client’s tax record. Certifications need not be attached to the client’s tax return, but the return must include a completed Form 5695 (Residential Energy Credits).

Conclusions

The modest Section 25C credit is scheduled to expire at year-end. So, time may be of the essence to take advantage. There is no big hurry to cash in on the much-more-generous Section 25D credit. It will be available through 2016.

In addition to the two tax credits explained here, clients might also be eligible for state and local income tax benefits, subsidized state and local financing deals, and utility company rebates. These extra inducements can amount to hundreds of dollars or more. They can usually be found by conducting an Internet search. However, note that expenditures made from subsidized energy financing don’t qualify for the Section 25C credit (the $500 credit).

Read the U.S. Congress news release and the full text of their letter to IRS Commissioner Douglas Shulman here: AMT patch.pdf

The midterm elections have changed the Congressional landscape, with Republicans winning control of the House of Representatives and picking up seats in the Senate. Even so, it’s still to early to know exactly how this will affect open tax issues for 2010 and 2011.

Specifically, when the “lame-duck” Congress returns this month, it must decide whether to “patch” the alternative minimum tax (AMT) for 2010 (increase exemption amounts, and allow personal credits to offset the AMT), as it has done in past years. It also must decide whether to retroactively extend a number of tax provisions that expired at the end of 2009. These include, for example, the research credit for businesses, the election to take an itemized deduction for State and local general sales taxes in lieu of the itemized deduction permitted for State and local income taxes, and the additional standard deduction for State and local real property taxes.

In addition, Congress must decide whether to extend the Bush tax cuts for some or all taxpayers. They and other Bush-era tax rules expire at the end of this year. Without Congressional action, individuals will face higher tax rates on their income, including capital gains. Also, unless Congress changes the rules, the estate tax, which isn’t in effect this year, will return next year with a 55% top rate.

In short, year-end planning—which always involves some educated guesswork—is a bigger challenge this year than in past years.

That said, we have compiled a checklist of actions that can help you save tax dollars if you act before year-end. These moves may benefit you regardless of what the lame-duck Congress does on the major tax questions of the day. Not all actions will apply in your particular situation, but you will likely benefit from many of them. We can narrow down the specific actions that you can take once we meet with you to tailor a particular plan. In the meantime, please review the following list and contact us at your earliest convenience so that we can advise you on which tax-saving moves to make.

Year End Moves for Individuals

•Increase the amount you set aside for next year in your employer’s health flexible spending account (FSA) if you set aside too little for this year. Don’t forget that you cannot set aside amounts to get tax-free reimbursements for over-the-counter drugs, such as aspirin and antacids (2010 is the last year that FSAs can be used for nonprescription drugs).

•Realize losses on stock while substantially preserving your investment position. There are several ways this can be done. For example, you can sell the original holding, then buy back the same securities at least 31 days later. It may be advisable for us to meet to discuss year-end trades you should consider making.

•Increase your withholding if you are facing a penalty for underpayment of federal estimated tax. Doing so may reduce or eliminate the penalty.

•Take an eligible rollover distribution from a qualified retirement plan before the end of 2010 if your are facing a penalty for underpayment of estimated tax and the increased withholding option is unavailable or won’t sufficiently address the problem. Income tax will be withheld from the distribution and will be applied toward the taxes owed for 2010. You can then timely roll over the gross amount of the distribution, as increased by the amount of withheld tax, to a traditional IRA. No part of the distribution will be includible in income for 2010, but the withheld tax will be applied pro rata over the full 2010 tax year to reduce previous underpayments of estimated tax.

•Make energy saving improvements to your main home, such as putting in extra insulation or installing energy saving windows or buying and installing an energy efficient furnace, and qualify for a 30% tax credit. The total (aggregate) credit for energy efficient improvements to the home in 2009 and 2010 is $1,500. Unless Congress acts, this tax break won’t be around after this year. Additionally, substantial tax credits are available for installing energy generating equipment (such as solar electric panels or solar hot water heaters) to your home (this break stays on the books through 2016).

• Convert your traditional IRA into a Roth IRA if doing so is expected to produce better long-term tax results for you and your beneficiaries. Distributions from a Roth IRA can be tax-free but the conversion will increase your adjusted gross income for 2010. However, you will have the choice of when to pay the tax on the conversion. You can either (1) pay the tax on the conversion when you file your 2010 return in 2011, or (2) pay half the tax on the conversion when you file your 2011 return in 2012, and the other half when you file your 2012 return in 2013.

• Purchase qualified small business stock (QSBS) before the end of this year. There is no tax on gain from the sale of such stock if it is (1) purchased after September 27, 2010 and before January 1, 2011, and (2) held for more than five years. In addition, such sales won’t cause AMT preference problems. To qualify for these breaks, the stock must be issued by a regular (C) corporation with total gross assets of $50 million or less, and a number of other technical requirements must be met. Our office can fill you in on the details.

Take required minimum distributions (RMD) from your IRA or 401(k) plan (or other employer-sponsored retired plan) if you have reached age 70 1/2. Failure to take a required withdrawal can result in a penalty of 50% of the amount not withdrawn. A temporary tax law change waived the RMD requirement for 2009 only, but the usual withdrawal rules apply full force for 2010. So individuals age 70 1/2 or older generally must take the required distribution amount out of their retirement account before the end of 2010 to avoid the penalty. If you turned age 70 1/2 in 2010, you can delay the required distribution to 2011, but if you do, you will have to take a double distribution in 2011—the amount required for 2010 plus the amount required for 2011. Think twice before delaying 2010 distributions to 2011—bunching income into 2011 might push you into a higher tax bracket or have a detrimental impact on various income tax deductions that are reduced at higher income levels.

•Make annual exclusion gifts before year end to save gift tax (and estate tax if it is reinstated). You can give $13,000 in 2010 or 2011 to an unlimited number of individuals free of gift tax. However, you can’t carry over unused exclusions from one year to the next. The transfers also may same family income taxes where income-earning property is given to family members in lower income tax brackets who are not subject to the kiddie tax.

Year End Moves for Business Owners

•Hire a worker who has been unemployed for at least 60 days before year end if you are thinking of adding to payroll soon. Your business will be exempt from paying the employer’s 6.2% share of the Social Security payroll tax on the formerly unemployed new-hire for the remainder of 2010. Plus, if you keep that formerly unemployed new-hire on the payroll for a continuous 52 weeks, your business will be eligible for a nonrefundable tax credit of up-to-$1,000 after the 52-week threshold is reached. This credit will be taken on the business’s 2011 tax return. In order to be eligible, the formerly unemployed new-hire’s pay in the second 26-week period must be at least 80% of the pay in the first 26-week period.

Put new business equipment and machinery in service before year-end to qualify for 50% bonus first-year depreciation allowance. Unless Congress acts, this bonus depreciation allowance won’t be available for property placed in service after 2010.

Make expenses qualifying for the $500,000 business property expensing option. The maximum amount you can expense for a tax year beginning in 2010 is $500,000 of the cost of qualifying property placed in service for that tax year. The $500,000 amount is reduced by the amount by which the cost of qualifying property placed in service during 2010 exceeds $2 million. Also, within the overall $500,000 expensing limit, you can expense up to $250,000 of qualified real property (certain qualifying leasehold improvements, restaurant property, and retail improvements). Note that at tax return time, you can choose not to use expensing (or bonus depreciation) for 2010 assets. This is something to consider if tax rates go up for 2011 and future years, and you’d rather have more deductions after 2010 than for 2010.

•Set up a self-employed retirement plan if you are self-employed and haven’t done so yet.

•Increase your basis in a partnership or S corporation if doing so will enable you to deduct a loss from it for this year. A partner’s share of partnership losses is deductible only to the extent of his partnership basis as of the end of the partnership year in which the loss occurs. An S corporation shareholder can deduct his pro-rata share of an S corporation’s losses only to the extent of the total of his basis in (a) his S corporation stock, and (b) debt owed to him by the S corporation.

•Consider whether to defer cancellation of debt (COD) income from the reacquisition of an applicable debt instrument in 2010. The business can elect to elect to have the cancelled COD income included in gross income ratably over five tax years beginning with the fourth tax year following the tax year in which the repurchase occurs (i.e., beginning with 2014).

These are just some of the year-end steps that can be taken to save taxes. Again, by contacting us, we can tailor a particular plan that will work best for you.

The recently enacted 2010 Small Business Jobs Act includes a wide-ranging assortment of tax breaks and incentives for small business, paid for with various revenue raisers. Here’s a brief overview of the tax changes in the new law.

Tax breaks and incentives

Enhanced small business expensing (Section 179 expensing). In order to help small businesses quickly recover the cost of certain capital expenses, small business taxpayers can elect to write off the cost of these expenses in the year of acquisition in lieu of recovering these costs over time through depreciation. Under pre-2010 Small Business Jobs Act law, taxpayers could expense up to $250,000 of qualifying property—generally, machinery, equipment and certain software—placed in service in tax years beginning in 2010. This annual expensing limit was reduced (but not below zero) by the amount by which the cost of qualifying property placed in service in tax years beginning in 2010 exceeded $800,000 (the investment ceiling). Under the new law, for tax years beginning in 2010 and 2011, the $250,000 limit is increased to $500,000 and the investment ceiling to $2,000,000.

The new law also makes certain real property eligible for expensing. For property placed in service in any tax year beginning in 2010 or 2011, the up-to-$500,000 of property expensed can include up to $250,000 of qualified real property (qualified leasehold improvement property, qualified restaurant property, and qualified retail improvement property).

100% exclusion of gain from the sale of small business stock for qualifying stock acquired after date of enactment and before Jan. 1, 2011. Before the 2009 Recovery Act, individuals could exclude 50% of their gain on the sale of qualified small business stock (QSBS) held for at least five years (60% for certain empowerment zone businesses). To qualify, QSBS must meet a number of conditions (e.g., it must be stock of a corporation that has gross assets that don’t exceed $50 million, and the corporation must meet active business requirements). Under the 2009 Recovery Act, the percentage exclusion for gain on QSBS sold by an individual was increased to 75% for stock acquired after Feb. 17, 2009 and before Jan. 1, 2011. Under the new law, the amount of the exclusion is temporarily increased yet again, to 100% of the gain from the sale of qualifying small business stock that is acquired in 2010 after date of enactment and held for more than five years. In addition, the new law eliminates the alternative minimum tax (AMT) preference item attributable for that sale.

General business credits of eligible small businesses for 2010 allowed to be carried back five years. Generally, a business’s unused general business credits can be carried back to offset taxes paid in the previous year, and the remaining amount can be carried forward for 20 years to offset future tax liabilities. Under the new law, for the first tax year of the taxpayer beginning in 2010, eligible small businesses can carry back unused general business credits for five years. Eligible small businesses consist of sole proprietorships, partnerships and non-publicly traded corporations with $50 million or less in average annual gross receipts for the prior three years.

General business credits of eligible small businesses in 2010 aren’t subject to AMT. Under the AMT, taxpayers can generally only claim allowable general business credits against their regular tax liability, and only to the extent that their regular tax liability exceeds their AMT liability. A few credits, such as the credit for small business employee health insurance expenses, can be used to offset AMT liability. The new law allows eligible small businesses, as defined above, to use all types of general business credits to offset their AMT in tax years beginning in 2010.

S corporation holding period. Generally, a C corporation converting to an S corporation must hold onto any appreciated assets for 10 years following its conversion or face a business-level tax imposed on the built-in gain at the highest corporate rate of 35%. This holding period is reduced where the 7th tax year in the holding period preceded the tax year beginning in 2009 or 2010. The 2010 Small Business Jobs Act temporarily shortens the holding period of assets subject to the built-in gains tax to 5 years if the 5th tax year in the holding period precedes the tax year beginning in 2011.

Extension of 50% bonus first-year depreciation. Businesses are allowed to deduct the cost of capital expenditures over time according to depreciation schedules. In previous legislation, Congress allowed businesses to more rapidly deduct capital expenditures of most new tangible personal property, and certain other new property, placed in service in 2008 or 2009 (2010 for certain property), by permitting the first-year write-off of 50% of the cost. The new law extends the first-year 50% write-off to apply to qualifying property placed in service in 2010 (2011 for certain property).

Special rule for long-term contract accounting. The new law provides that in determining the percentage of completion under the percentage of completion method of accounting, bonus depreciation is not taken into account as a cost. This prevents the bonus depreciation from having the effect of accelerating income.

Boosted deduction for start-up expenditures. The new law allows taxpayers to deduct up to $10,000 in trade or business start-up expenditures for 2010. The amount that a business can deduct is reduced by the amount by which startup expenditures exceed $60,000. Previously, the limit of these deductions was capped at $5,000, subject to a $50,000 phase-out threshold.

Limitation on penalty for failure to disclose certain reportable transactions (including listed transactions) on a return. The new law limits the penalty to 75% of the decrease in tax resulting from the transaction. The minimum penalty is $10,000 for corporations and $5,000 for individuals (for failure to report a listed transaction, the maximum penalty is $200,000 and $100,000, respectively). These changes are retroactively effective to penalties assessed after Dec. 31, 2006.

Deductibility of health insurance for the purpose of calculating self-employment tax. The new law allows business owners to deduct the cost of health insurance incurred in 2010 for themselves and their family members in calculating their 2010 self-employment tax.

Cell phones removed from listed property category. This means that cell phones can be deducted or depreciated like other business property, without onerous recordkeeping requirements.

Offsets (revenue raisers)

Information reporting required for rental property expense payments. For payments made after Dec. 31, 2010, the new law requires persons receiving rental income from real property to file information returns with IRS and service providers reporting payments of $600 or more during the tax year for rental property expenses. Exceptions are provided for individuals renting their principal residences on a temporary basis (including active members of the military), taxpayers whose rental income doesn’t exceed an IRS-determined minimal amount, and those for whom the reporting requirement would create a hardship (under IRS regs).

Increased information return penalties (effective for information returns required to be filed after Dec. 31, 2010).

Application of continuous levy to tax liabilities of certain federal contractors. For levies issued after date of enactment, the new law allows IRS to issue levies before a collection due process (CDP) hearing on Federal tax liabilities of Federal contractors (taxpayers would have an opportunity for a CDP hearing within a reasonable time after a levy is issued).

Allow participants in governmental 457 plans to treat elective deferrals as Roth contributions. For tax years beginning after Dec. 31, 2010, the new law will allow retirement savings plans sponsored by state and local governments (governmental 457(b) plans) to include designated Roth accounts. Contributions to Roth accounts are made on an after-tax basis, but distributions of both principal and earnings are generally tax-free.

Allow rollovers from elective deferral plans to designated Roth accounts. The new law allows 401(k), 403(b), and governmental 457(b) plans to permit participants to roll their pre-tax account balances into a designated Roth account. The amount of the rollover will be includible in taxable income except to the extent it is the return of after-tax contributions. If the rollover is made in 2010, the participant can elect to pay the tax in 2011 and 2012. Plans will be able to allow these rollovers immediately as of date of enactment.

Crude tall oil (a waste by-product of the paper manufacturing process) is excluded from eligibility for the cellulosic biofuel producer credit. The new law limits eligibility for the tax credit to fuels that are not highly corrosive (i.e., with an acid number of 25 or less), effective for fuels sold or used after Dec. 31, 2009.

Nonqualified annuity contracts. The new law permits holders of nonqualified annuities (annuity contracts held outside of a qualified retirement plan or IRA) to elect to receive part of the contract in the form of a stream of annuity payments, leaving the remainder of the contract to accumulate income on a tax-deferred basis.

Guarantee fees. Amounts received directly or indirectly for guarantees of indebtedness of a U.S. payor issued after date of enactment are sourced, like interest, in the U.S. As a result, amounts paid by U.S. taxpayers to foreign persons will generally be subject to U.S.withholding tax.

Please keep in mind that I’ve described only the highlights of the most important changes in the new law. If you would like more details about any aspect of the new legislation, please do not hesitate to call.

© 2010 Thomson Reuters/RIA. All rights reserved.

As you may know, the so-called Bush tax cuts (from legislation enacted in 2001 and 2003) are scheduled to expire at the end of this year. Some may believe that only individuals in the top two federal income tax brackets will face higher rates. Unless Congress takes action and President Obama goes along, rates will automatically go up for everyone who pays taxes.

Specifically, the existing 10% bracket will go away, and the lowest “new” bracket will be 15%. The existing 25% bracket will be replaced by the “new” 28% bracket; the existing 28% bracket will be replaced by the “new” 31% bracket; the existing 33% bracket will be replaced by the “new” 36% bracket; and the existing 35% bracket will be replaced by the “new” 39.6% bracket.

The Administration has pledged to keep the three lowest brackets in place. The 28% bracket would be expanded to accommodate unmarried taxpayers with income below $200,000 and joint filers with income below $250,000. Only taxpayers with income above those levels would be affected by the new 36% and 39.6% rates. As we said, however, Congress must make changes, and the president must go along for these things to happen.

Marriage Penalty Will Get Worse

Right now, the 10% and 15% rate brackets for married joint-filing couples are 200% as wide as the 10% and 15% brackets for singles. Similarly, the standard deduction for joint-filing couples is 200% of the amount for singles. Right now, the 10% and 15% rate brackets for those who use married filing separate status are the same as the 10% and 15% brackets for singles. Similarly, the standard deduction for those who use married filing separate status is the same as the standard deduction for singles.

If the cuts expire, the new lowest bracket of 15% for Married Filing Joint (MFJ) couples will be only 167% as wide as the 15% bracket for singles—for Married Filing Separate (MFS) couples, it’ll be 83.5% as wide as the 15% bracket for singles. Similarly, the new standard deduction for joint-filers will be only 167% of the standard deduction for singles. For MFS status, it’ll be only 83.5% of the amount for singles.

Itemized Deduction Phase-out Rule Will Return with a Vengeance

Before the Bush tax cuts, a nasty phase-out rule could eliminate up to 80% of affected itemized deductions for higher-income individuals. The phase-out rule covered the big-ticket deductions for mortgage interest, state and local taxes, and charitable donations. Deductions for medical expenses, investment interest expense, casualty and theft losses, and gambling losses were not affected. Thanks to the Bush tax cuts, the phase-out rule was gradually eased and finally eliminated this year. Next year, however, it will automatically return with a vengeance, unless Congress takes action and the president goes along.

If nothing changes, clients will lose $1 of affected deductions for every $3 of AGI in excess of the applicable AGI threshold (subject to the 80% disallowance limitation), starting next year.

Personal Exemption Phase-out Rule Will Return with a Vengeance

Before the Bush tax cuts, another nasty phase-out rule could eliminate some or all of a higher-income individual’s personal exemption deductions. Thanks to the Bush tax cuts, this phase-out rule was gradually eased and finally eliminated this year. Starting next year, it will automatically return with a vengeance, unless Congress takes action and the president goes along.

If nothing changes, clients need to be ready for yet another bite out of their wallets if their 2011 AGI exceeds the applicable threshold. As shown in Appendix 1, the phase-out thresholds for 2011 are estimated to be $256,700 for MFJ; $171,100 for singles; $213,900 for heads of households; and $128,350 for MFS.

Outlook: The Administration has said it wants the phase-out rule back, but at different AGI thresholds: $250,000 for married joint-filing couples, $200,000 for unmarried individuals, and $125,000 for those who use married filing separate status. Since this is pretty close to what will happen without any making changes, it would not be surprising if Congress chooses to do nothing.

Higher Capital Gains and Dividends Taxes for All

Right now, the maximum federal rate on garden-variety long-term capital gains and qualified dividends is 15%. Starting next year, the maximum rate on garden-variety long-term capital gains will increase to 20% (or 18% on gains from assets held for over five years). Starting next year, dividends will once again be taxed at ordinary income rates. So, the maximum rate on dividends will balloon to a whopping 39.6%.

Right now, a 0% federal rate applies to garden-variety long-term capital gains and qualified dividends collected by folks in lowest two rate brackets of 10% and 15%. Starting next year, folks in the “new” lowest bracket of 15% will have to pay 10% on long-term gains (or 8% on gains from assets held for over five years) and 15% on dividends (since dividends will be taxed at ordinary income rates). Again—these things will happen automatically, unless Congress takes action and the president goes along.

The Administration has repeatedly said the current 0% and 15% rates on long-term capital gains and qualified dividends will be left in place except for married couples with income above $250,000 and unmarried individuals with income above $200,000. For this to happen, however, Congress must take action and the president must go along

Some Bush Tax Cuts Are Likely to Be Continued

Some elements of the Bush tax cuts have gained bipartisan support and become “extenders.” They will probably be continued, despite the scheduled demise of the Bush tax cuts. Examples include inflation-indexed AMT exemption amounts, the ability to use nonrefundable personal tax credits to offset individual AMT liabilities, the above-the-line deduction for qualified higher education tuition and fees, and the increased Section 179deduction. We also think the current versions of the child tax credit, earned income credit, dependent care credit, and adoption credit are also likely to be continued, despite the scheduled demise of other elements of the Bush tax cuts.

Conclusions

Despite what some people think, the Bush tax cuts don’t just help “the rich.” They help just about anyone who pays federal income taxes, including folks who only file returns to collect free money from the government thanks to refundable tax credits. The scheduled demise of the Bush tax cuts next year will hurt lots of people, unless Congress makes changes and the president jumps on board.

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