Federal minimum wage hike ushers in new tax breaks

Just as the Memorial Day holiday was about to begin, as lawmakers prepared to flee Washington for vacation, agreement was reached to continue funding the war in Iraq. That funding bill also raised the minimum wage.

Not a big deal, many veterinarians would say, because half the states already require minimum wages above the federal level. However, there are numerous tax breaks – over $5 billion worth – tacked onto the bill to consider.

The Small Business and Work Opportunity Tax Act of 2007, part of the much larger and more controversial H.R. 1591, U.S. Troops Readiness, Veterans' Health and Iraq Accountability Act of 2007, targets nearly $5 billion in tax incentives for small businesses. It includes tax incentives for Hurricane Katrina victims and an important package of S-corporation reforms.

Here are some of the small-business tax incentives, which were designed to help businesses absorb the cost of a minimum wage that will rise to $7.25 an hour from $5.15 in three steps over two years:

Work-opportunity tax credit

Those who employ large numbers of workers have long been aware of the Work Opportunity Tax Credit (WOTC), created in 1996 to provide employers with a unique tax incentive to hire individuals from among groups that have a particularly high unemployment rate or other special employment needs.

Many veterinarians in rural areas now may 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. These are counties outside 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.

Previously set to expire for employees hired after Dec. 31, the WOTC was extended through Aug. 31, 2011.

Small-business expensing

In lieu of depreciation deductions, a veterinary practice can choose to deduct (or "expense") the cost of equipment and business property 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 retroactively raising the investment limitation from $450,000 to $500,000 for tax years 2007 through 2010.

The investment limitation for property placed in service in tax years beginning in 2007 had been $450,000, indexed for inflation. The new law retroactively raises the investment limitation to $500,000 for tax years 2007 through 2010. The $500,000 is indexed for inflation in tax years beginning after 2007 and before 2011.

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 be confined generally to relatively small veterinary practices and businesses.

Naturally, no first-year expensing allowance is permitted if the veterinary practice did not have taxable income in the year in which the property is placed in service. However, the amount of the deduction disallowed for this reason may be carried forward to a non-loss year.

And, do not forget, off-the-shelf computer software placed in service in taxable years beginning before 2010 is treated as property qualifying for Section 179 write-offs.

Zone businesses

The 2007 Small Business Tax Act extends and expands some of the tax incentives in the Gulf Opportunity Zone Act of 2005 and Katrina Emergency Tax Relief Act of 2005. These include extension of special expensing for qualified property, an enhanced low-income-housing credit and flexible tax-exempt bond-financing rules.

Family-business tax simplification

Although relatively rare among veterinarians, married couples jointly operating an unincorporated practice or business usually attributed all of their operation's income to one spouse.

Married couples who formerly attributed all of their veterinary practice's 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 own and participate in a small business or practice, they both get credit for paying Social Security and Medicare taxes.

Under the new law, a married couple who jointly operate an unincorporated veterinary practice or business and who file 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.

S corporations

Several modifications to the S-corporation rules will help small practices retain the benefits of being an S corporation.

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.

Among 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 earnings, usually passing through income (and losses) to its 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 veterinary practice 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 percent passive-investment income. Worse yet, if more than 25 percent 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 (those derived from royalties, rents, dividends, interest and annuities), remain subject to the passive-investment income limitations.

A qualified Subchapter S corporation (QSub) is a wholly owned subsidiary that an S corporation treats as a "QSub." These entities frequently are used by veterinarians in joint ventures, for expansion as well as for liability protection when spinning off a new venture. Unfortunately, once the QSub is no longer wholly owned by the S corporation, it ceases to qualify as a QSub and is treated as a new corporation that acquired all of its assets from the parent S corporation in exchange for stock.

The new law favorably alters the treatment of a sale of qualified Subchapter S subsidiary (QSUB) stock that terminates the QSub election. Under the new rules, the sale will be treated as a sale of an undivided interest in the assets of the QSub.

This provision eliminates the danger of an avalanche of gain being recognized – and taxed – on the sale of only a partial, but substantial (more than 20 percent) interest in the subsidiary.

Now, for example, if an S corporation sells 25 percent of its QSub stock, it would recognize only 25 percent of the gain. Obviously, this would save a veterinary practice operating as an S corporation substantial tax on the deemed sale.

Paybacks

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 (1) all children under age 19 (previously under age 18) and (2) 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 Congress recently handed a major victory to low-income workers by passing the first increase in the federal minimum wage in a decade, small businesses have not been ignored.

Many of the $4.84 billion in business-related tax cuts designed to ease the pain of the increased minimum wage included in that bill are retroactive to Jan. 1, 2007.

Will you – and your veterinary practice – plan now to take advantage of these tax breaks?

Mark E. Battersby is a financial consultant in Ardmore, Pa.