New tax provisions enacted

by Roger McEowen, Leonard Dolezal Professor in Agricultural Law, and Director of the ISU Center for Agricultural Law and Taxation, (515) 294-4076, mceowen@iastate.edu

On May 25, 2007, the President signed into law H.R. 2226, the war on terror funding bill known as the U.S. Troop Readiness, Veterans’ Care, Katrina Recovery, and Iraq Accountability Appropriations Act, 2007 (Act). Title VIII of the bill contains numerous tax provisions that are designed, at least in part, to offset the impact on businesses and lower-skilled workers of the increase in the minimum wage which is also included in the bill.
Here is a short summary of the major tax provisions of the H.R. 2206:

• Expense method depreciation.  Under current law, for tangible depreciable personal property used in the taxpayer’s business, part or all of the income tax basis can be deducted currently in the year in which the property is placed in service, regardless of the time of year the asset was placed in service. The bill increases the aggregate basis amount eligible for the deduction from $112,000 to $125,000 for 2007. The amount eligible to be expensed is reduced (but not below zero) by the amount by which the cost of qualifying property placed in service during the taxable year exceeds $500,000 (up from $450,000 for 2007). The amount eligible to be expensed for any tax year may not exceed the taxable income for a tax year that is derived from the active conduct of the taxpayer’s trade or business.  Any amount that is not allowed as a deduction because of the taxable income limitation may be carried forward to succeeding taxable years (subject to similar limitations). The increased expense method amount is indexed for inflation beginning in 2008, and is effective through 2010. After that, without further legislation, the expense method amount will drop back to $25,000 with that amount reduced (but not below zero) for tax years in which the cost of qualifying property placed in service during the taxable year exceeds $ 200,000 (with those amounts not indexed for inflation). The Act also includes modifications of the expense method depreciation rules for Gulf Opportunity Zone property (basically, property in areas impacted by Hurricanes Katrina, Rita and Wilma). Act, Secs. 8212 and 8221, amending I.R.C. §§179 and 1400N(e).
• Work Opportunity Tax Credit (WOTC).  The legislation extends the WOTC through for qualified workers who begin employment through August of 2011. The WOTC had been scheduled to expire at the end of 2007. The bill makes other technical amendments that expand the definition of certain qualified workers and qualified wages.  Act, Sec. 8211, amending I.R.C. §51.
• Subchapter S corporations.  The Act makes numerous changes applicable to S corporations. Some of the more important changes include the following:
  • An S corporation may have no more than 100 shareholders and may have only one outstanding class of stock. An S corporation has one class of stock if all outstanding shares of stock confer identical rights to distribution and liquidation proceeds. Differences in voting rights are disregarded. National banking law requires that a director of a national bank own stock in the bank and that a bank have at least five directors.  Several states have similar requirements for state-chartered banks.  In some cases, a bank director enters into an agreement under which the bank (or a holding company) will reacquire the stock upon the director's ceasing to hold the office of director, at the price paid by the director for the stock.
    Under the Act, restricted bank director stock is not taken into account as outstanding stock for S corporation purposes. Thus, the stock is not treated as a second class of stock; a director is not treated as a shareholder of the S corporation by reason of the stock; the stock is disregarded in allocating items of income, loss, etc. among the shareholders; and the stock is not treated as outstanding for purposes of determining whether an S corporation holds 100 percent of the stock of a qualified subchapter S subsidiary. Also, bank directors required to hold shares under banking laws will not have K-1 income from the bank or be required to sign S corporation elections.  Any distributions on such shares will be deductible by the bank and includible in the director’s income.
    The provision is generally effective for tax years beginning after December 31, 2006, but the provision stating that bank director stock is not a second class of stock is effective for tax years beginning after December 31, 1996.
  • Effective for tax years beginning after 2006, banks that elect S corporate status will be able to elect to include reserves in income in their last C corporation year.  Banks making an S corporation election are required to take their bad debt reserves into income.  This election will enable such banks to avoid built-in gains tax in their first S corporation year.
  • Effective for tax years beginning after May 25, 2007, capital gains from stock or securities are no longer "passive investment income" for the special corporate-level tax on S corporations that still have C corporation earnings and profits.  Act, Secs. 8231-8233, amending I.R.C. §§641, 1361 and 1362.
• “Kiddie” tax.  Special rules apply to the net unearned income of certain children. Generally, the kiddie tax applies to a child if: (1) the child has not reached the age of 18 by the close of the taxable year and either of the child's parents is alive at such time; (2) the child's unearned income exceeds $ 1,700 (for 2007); and (3) the child does not file a joint return. The kiddie tax applies regardless of whether the child may be claimed as a dependent by either or both parents, and taxes the child’s net unearned income over $1,700 (for 2007) at the parents' tax rates if the parents' tax rates are higher than the tax rates of the child.  The remainder of a child's taxable income (i.e., earned income, plus unearned income up to $ 1,700 (for 2007), less the child's standard deduction) is taxed at the child's rates, regardless of whether the kiddie tax applies to the child.
  The kiddie tax is calculated by computing the "allocable parental tax."  This involves adding the net unearned income of the child to the parent's income and then applying the parent's tax rate.  A child's "net unearned income" is the child's unearned income less the sum of (1) the minimum standard deduction allowed to dependents ($ 850 for 2007), and (2) the greater of $850 (for 2007) or the amount of allowable itemized deductions that are directly connected with the production of the unearned income.
  Effective for tax years beginning after May 25, 2007, the Act expands the kiddie tax to apply to children who are 18 years old or who are full-time students over age 18 but under age 24. The expanded provision applies only to children whose earned income does not exceed one-half of the amount of their support. Act, Sec. 8241, amending I.R.C. §1(g).
  

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