27 September 2010

The Small Business Jobs Act of 2010

The Small Business Jobs Act of 2010 (Title II of H.R. 5297) cleared Congress on September 23, 2010 and is expected to be signed any day now by the President. Many provisions are small but notable, although many will effectively only provide reduced taxes after the fact rather than incentives to take positive economic action as a result of the bill.

Most of the changes change the timing of revenue collections rather than the ultimate amount due. The bill reduces revenues from the 2010 tax year by about $55 billion and reclaims all but about $53 billion of that over the decade that follows. To the extent that interst rates stay low, that deferral of income taxation isn't worth much economically, but the idea is to provide stimulus now and pay for it when the economy recovers.

* Before the law was passed, self-employed people could generally deduct health insurance above the line for income tax purposes, but not for self-employment tax purposes (i.e. a tax in lieu of FICA) without relatively involved tax planning. For 2010, self-employed people can deduct it for both purposes, providing parity with the tax treatment of health insurance for employees. This is a major tax cut for small business owners. This one year tax break reducing revenues by $1.9 billion, provides one of the biggest pieces of permannent tax relief, as opposed to tax deferral, in the bill.

It was possible to obtain a similar result with a self-employed Section 125 plan under the health care reform bill already passed, but that involves more paperwork and fewer people were aware that it was available.

* Special record keeping requirements designed to prevent personal use of cell phones from being deducted as a business expense have been eliminated. This is a bit of uncontroversial tax simplification with only slight revenue costs.

* Business start up expenses up to $10,000 can be deducted rather than amortized over 60 months in 2010. The previous limit was $5,000.

* Up to $500,000 of purchases of capital assets that would otherwise have to be depreciated can be "expensed" in the current tax year to the extent that the assets cost under $2,000,000. The previous limit was $250,000. Expensing has also been extended to include qualified leasehold improvement property, qualified restaurant property, and qualified retail improvement property (appropriately, as leasehold improvements rarely have an economically useful life as long as the appropriate depreciation period, even if they don't become useless due to wear and tear in that time period).

Enhanced first year depreciation ("50% first year bonus depreciation") is available for investments that can't be expensed. In fact, this tax break for big businesses accounts for more than $40 billion of the $55 billion of tax breaks in the first year of the bill.

While both of these provisions should help spur capital investment, they may actually destroy jobs as well as creating them, since one common reason to make capital investments is to automate jobs, and this kind of tax break makes it sensible from a tax perspective to automate a job even when it costs more to automate the job than it would to keep the person employees on a discounted cash flows basis.

* The law excludes from income taxation and the alternative minimum tax 100% of the gain on the sale of qualifying small business stock stock purchased from C corporation with less than $50 million of assets and an active business (i.e. not more than 10% of which involves investments or real estate) that is acquired in 2010 after date of enactment (basically October, Novembver and December 2010) and held for more than five years. Various discounts of 50% or more have been available under prior law in a variety of circumstances, but not a 100% exclusion that is AMT free.

For the most part, the benefits are not attractive enough to make a C corporation more desirable than an S corporation for a start up business with owner-employees, particularly if the favorable tax rates for qualified dividends are not extended, and Democrats and the President don't want to extent those favorable dividend tax rates.

It also isn't very attractive for businesses that would own assets expected to appreciate in value, since assets held by C corporations don't receive favorable capital gains tax rates.

But, it could be attractive for angel investors and venture capitalists seeking to invest in growth companies that reinvest earnings rather than paying dividends, for companies making small NASDAQ public offerings, and for businesses where all owner-employees will be earning more than the maximum salary subject to Social Security taxation for whom selling the business is a viable exit strategy (it is pretty useless in "buy yourself a job" businesses).

This provision, combined with the start up cost and expensing provision, could make a C corporation attractive for businesses making significant, but not huge, investments in plant, equipment or leasehold improvements. For example, it makes investing a few hundred thousand dollars in a new franchised retail store look pretty attractive.

Of course, none of this matters if you can't find investors willing to put money into your business, and interest rates on loans to finance a business investment have never been lower for those who can get them.

From an economic stimulus perspective, the notion that this kind of provision increases economic growth is dubious. A three month tax holiday window offered with little advanced notice has probably delayed the closing of some C corporation stock sales, and will probably speed up other C corporation stock investments that otherwise would have closed in early 2011. But, offering more favorable tax rates on a profitable investment for which favorable tax rates were already available probably doesn't do much to change the amount of equity funding in this kind of venture over the entire year centered around the three months when the tax break is provided. It virtually guarantees a depressed venture capital environment in early 2011.

It takes too long to set up a long term, small C corporation equity investment opportunity for this to shift the amount of available investment funds from other kinds of investment opportunity (e.g. municipal bonds) to this kind of investment by very much. As stimulus, it is really pretty useless and is quite expensive from a revenue perspective.

This is the economic equivalent of the housing tax credit, or cars for clunkers, for investors. It is really little more than a transfer payment to people who were going to do what they did anyway. Unless a tax preferences turns a gain into a loss, or a loss into a gain, a change in the tax rate that applies that a gain won't change the number of situations where it makes sense to invest very much.

If there is any long term stimulus effect, it will probably start coming in around five years from now when the investors sell their investments and have more money available to invest in new venture capital projects than they would have in the absence of the tax break.

* Appreciated property in S corporations can be taxed at the owner's preferrential capital gains tax rate, rather than the C corporation ordinary income tax rate after a five year holding period from the S corporation conversion, rather than a ten year holding period.

Most taxpayers who use this provision have probably already started counting down the years until the ten year period runs and will now be able to liquidate their S corporations immediately, rather than a few years later. The theory would be that this frees up a de facto restriction on the alienation of appreciated property, mostly real estate, and strengthens the real estate market.

This does work as permanent stimulus, but the effect is probably pretty small. The change in the tax law that made it problematic for C corporations to hold appreciated property took place in 1986 when the General Utilities doctrine was repealed, so not many investments in appreciating property like real estate or investments were made after then through C corporations. There are 24 year old (or older) C corporations with appreciated assets in them kept in tact until death to erase unrealized capital gain in the stock, which are mostly medium sized businesses and professional practices that owned their own office buildings that heirs want to sell upon inheriting them because they aren't continuing the businesses, but there aren't a lot of them, and there are fewer than have recently made S elections to start the holding period running in time to benefit from the new rule.

* 401(k), 403(b), and governmental 457(b) plans can be rolled over into Roth IRAs in 2010 with the taxes due on the rollover paid over 2011 and 2012. This shifts revenues into the present from the future to make up for other short term revenue deceases, while looking like a tax break since it relaxes IRS rules to allow taxpayers to do something that they want to do.

Other than the revenue shifting effect this has no economic benefit, since the funds will probably be invested in the same things, and it probably discourages investment now by causing people to use available cash to pay rollover triggered taxes instead of making investments in productive activities or consuming it.

* Rental real estate owners must 1099 to claim expenses paid over $600 starting in 2011 and penalties for not filing information returns generally are increased starting in 2011. This should help to reduce the tax gap in the gray economy of informally operating home repair and cleaning professionals. This particularly puts the squeeze on self-employed undocumented immigrants who make up a fairly large share of employees in this part of the economy and may have a hard time producing Social Security numbers so that they can be hired by someone who knows that they will have to send 1099s to them later.

1 comment:

Andrew Oh-Willeke said...

Signed into law September 28, 2010.