Recent Federal Income Tax Incentives

Targeted at Small Businesses

Business Law Institute

May 2012

Presented by:

Kevin W. Kaiser

Lindquist & Vennum PLLP

Kevin D. Whitaker

Moquist Thorvilson Kaufmann &

Pieper LLC

Recent Federal Income Tax Incentives Targeted

at Small Businesses

ANY TAX ADVICE CONTAINED IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN TO BE USED, AND CANNOT BE USED FOR THE PURPOSE OF (i) AVOIDING PENALTIES THAT MAY BE IMPOSED ON ANY TAXPAYER OR (ii) PROMOTING, MARKETING OR RECOMMENDING TO ANOTHER PARTY ANY MATTERS ADDRESSED HEREIN.

The information contained herein is general in nature and based on authorities that are subject to change. Applicability to specific situations is to be determined through consultation with your tax adviser.

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Small Business Tax

Policy Considerations

Policy considerations

Reward for investment in research and innovation

o Small Businesses regarded as engines of innovation

Financial markets deny small businesses adequate credit

o Small businesses are at the mercy of bankers and non-bank lenders

Small business bear disproportionate compliance burdens

o Simplification

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Small Business

Choice of Entity

Pass-through entities (generally suited for closely held businesses)

− Sole proprietorship

− Partnership/LLC

− S-corporation

o Self-employment tax considerations

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Small Business

Choice of Entity

Sole proprietorship

Administrative convenience

o No formation, license or registration fees

o No federal tax identification number (TIN) required unless the business hires employees or other special circumstances

o Business activity reported on individual tax return

o Income taxed at individual rates, plus self-employment taxes

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Small Business

Choice of Entity

Partnership/LLC

Partnerships are generally treated as pass-through entities, not subject to tax at the entity level

Partnerships provide partners with a significant amount of flexibility to vary their respective shares of partnership income

o Allocations are permitted to the extent the partner to which the allocation is made received the economic benefit or bears the economic burden of such allocation, and the allocation substantially affects the dollar amounts to be received by the partners from the partnership independent of tax consequences

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Small Business

Choice of Entity

Partnership/LLC

Many partnerships are organized as limited liability companies (LLCs)

o “Check-the-Box” rules govern the classification of legal entities

o Generally, LLC with two or more members is classified as partnerships for federal income tax purposes

Tax rules – default: two or more LLC members will be a partnership

o “Check the Box” default rules for tax:

1-member LLC = Sole proprietorship (LLC disregarded)

2 or more members = Partnership

=> Check-the-box option for LLC to be classified as a corporation

=> S-corporation election available to LLC/Corporation

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Small Business

Choice of Entity

S-Corporation

Generally, organized as a state law corporation (or, LLC)

Corporate law filings and administrative requirements, including:

o Tax identification number

o Secretary of state filings

o Separate bank account

Limitations on the number and type of shareholders

o 100 shareholder limit (family members treated as 1 shareholder)

o Only individual shareholders and selected trusts

Self Employment Tax

o Earnings from salary subject to self employment tax

o Pass-through share of income, after deduction for shareholder salary not subject to self-employment tax

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Small Business

Choice of Entity

Taxable Entities

C-corporation

o Subject to entity level tax

o Corporate law filings and administrative requirements

o Dividends payable to shareholders are taxable to recipients and not deductible to the corporation. (Corporate double tax)

o Generally, C-corporate form of business required to access public capital markets. Best suited if entity will be publicly traded.

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Small Business

Choice of Entity

Taxable entities

C-corporation

− Founders’ stock tax incentives

o Qualified small business stock (section 1202)

o Small business stock (section 1244)

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Small Business

Choice of Entity

Qualified small business stock (QSBS) gain exclusion (section 1202)

The tax rules provide a special tax incentive to encourage investments in C-corporations that qualify as “small business corporations.”

Noncorporate taxpayers can exclude from gross income 100 percent of the gain on the sale or exchange of QSBS acquired after September 27, 2010 and before January 1, 2012, and held more than 5 years. Generally, the gain on the sale or exchange of QSBS before September 27, 2010 and after January 1, 2012 is eligible for a 50 percent exclusion.

QSBS defined:

o Issuer must be a C corporation

o Aggregate gross assets must not exceed $50 million immediately before the QSBS issued

o Corporation must engaged in an active trade or business

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Small Business

Choice of Entity

Ordinary Loss Treatment for Section 1244 Small Business Stock

An individual may take an ordinary loss deduction for a loss sustained on the sale, exchange, or worthlessness of certain “small business stock” (referred to as Section 1244 stock), rather than recognize a capital loss

Section 1244 Deduction Limits

o Unmarried individuals:

Up to $50,000 of the loss on Section 1244 stock may be claimed by unmarried individuals as an ordinary loss

Any excess loss over $50,000 is treated as a capital loss and must comply with the rules for capital losses

o Married individuals:

Up to $100,000 of the loss on Section 1244 stock may be claimed as an ordinary loss by married individuals filing a joint return even if only one spouse owns the stock

Any excess loss over $100,000 is treated as a capital loss and must comply with the rules for capital losses

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Small Business

Choice of Entity

Ordinary Loss Treatment for Section 1244 Small Business Stock

Section 1244 Defined

o The corporation can have equity (total assets minus total liabilities) up to $1 million at the time the stock is issued

o The stock must be issued for cash or property not stock and securities

o More than half the corporation's income for the preceding five years before the loss must have come from business operations, not from passive income (rents, royalties, dividends, interest. annuities, or gains from the sale of stocks or securities)

o If the corporation was not in existence for five years before your loss, then the years it was in existence will be considered for the gross receipts test

o Stock must be acquired by purchase (not by-gift, inheritance, or by purchasing the stock from someone else)

o Taxpayer claiming the Section 1244 loss must be the original purchaser of the stock

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Employment Related Tax Incentives

Federal Unemployment Tax (FUTA)

− Employers pay tax on first $7,000 of each employee’s wages

− 6.2% tax rate through June 30, 2011

− Reduced to 6.0% tax rate starting July 1, 2011

− Credit for state unemployment taxes against federal limited to 5.4% of wages, producing effective FUTA tax rate of 0.6% in 2011

− The wage base remains at $7,000 for 2012. Effective tax rate for 2012 will be 0.6%

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Employment Related Tax Incentives

Deduction for Health Insurance

Self-employment tax rate reduced by 2% to 13.3% in 2011, and continued to 2012

Self-employed may continue to deduct health insurance costs from business income when determining their income tax liability

Deduction is allowed for business owner, spouse and dependents (children under 27 in certain circumstances)

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Employment Related Tax Incentives

Returning Heroes Tax Credit, and Wounded Warriors Tax Credit

Component of Work Opportunity Credit

Hired after 11/11/2011 and before 1/1/2013

Up to $5,600 for hiring a long-term unemployed veteran

Up to $2.400 for hiring a short-term unemployed veteran

Up to $9,600 for hiring an unemployed veteran with a service related disability

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Equipment Expensing Provisions

Section 179 Deduction (Immediate write-offs)

Expensing provision for certain business property

Maximum first-year write-off in 2011 is $500,000; $139,000 in 2012

Most tangible personal property eligible

Includes qualified restaurant, leasehold and retail properties in 2011

Section 179 was expanded to also cover 15-year qualified real estate/leasehold improvements in 2011

Phase out begins at $2.0 million in 2011; $560,000 in 2012

Limits and exceptions

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Equipment Expensing Provisions

Section 179D Deduction for Energy Efficient Commercial Building

Taxpayers may deduct all or a part of the cost of energy efficient commercial building property place in service after December 31, 2005, and before January 1, 2014

"Energy efficient commercial building property" is defined as property:

o For which depreciation or amortization is allowable

o Which is installed on or in a building located in the U.S.

o Within the scope of Standard 90.1-2001 of the American Society of Heating, Refrigerating, and Air Conditioning Engineers and the Illuminating Engineering Society of North America

o Installed as part of the interior lighting systems, heating and cooling ventilation

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Equipment Expensing Provisions

Bonus Depreciation (More immediate write-offs)

First-year bonus depreciation allowance for eligible property

100% deduction for property placed in service in 2011; 50% in 2012

Property eligibility requirements

Benefits of using bonus depreciation:

o Immediate tax relief

o Improved cash flow

o Additional reinvestment capital

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Equipment Expensing Provisions

Qualified Leasehold Improvements

Qualified leasehold improvement property is generally any improvement to a building that meets all of the following requirements:

o The building is non-residential real property

o The improvement is to an interior portion of the building

o The improvement was made pursuant to a lease by the tenant or sub-tenant

o The improvement was placed in service more than three years after the date the building was first placed in service by any taxpayer

For 2011 Section 179 was available for qualified leasehold improvements but not for 2012

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Start-up and Organizational Costs

Expensing

Start-up Costs

Deduction in year business starts/succeeding years

Can include full range of business investigatory costs

First $5,000 in expenses deducted; the remaining is amortized over 180 months (15 years)

$5,000 first year maximum

$50,000+ dollar-for-dollar phase-out

Organizational Costs

Deduction for certain costs in creating C or S corporation or partnership

Certain legal and accounting fees

First $5,000 in expenses deducted; the remaining is amortized over 180 months (15 years)

$5,000 first year maximum

$50,000+ dollar-for-dollar phase-out

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Research and Experimentation

Tax Credit

Federal Research and Experimentation Tax Credit

Section 41 governs the calculation and definition of credit eligible research expenses

Credit Eligible Expenses 4-Part Test

Permitted Purpose

Technological in Nature

Process of Experimentation

Elimination of Uncertainty

Creditable Expenses

Wages

Supplies

Contract labor

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Research and Experimentation

Tax Credit

Minnesota Research and Experimentation Tax Credit

Minnesota generally follows the federal rules for determining qualified R&D activities with the exception that the qualifying activity must be done in Minnesota

In 2010 the law was changed to make the Minnesota credit refundable

For those early stage/loss companies this new law creates a significant benefit and positive cash-flow impact

The credit also applies and is passed through to owners of S-corporations, partnerships/LLC’s as well as sole proprietors

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Minnesota Angel

Tax Credit

Minnesota Angel Tax Credit

Minnesota's Angel Tax Credit provides incentives to investors or investment funds that put money into startup and emerging companies focused on high technology or new proprietary technology. The Angel Tax Credit :

o Provides a 25-percent individual income tax credit for qualified investors

o Is refundable. Non-Minnesota residents, including residents of foreign countries, are eligible for the credit

o Allows a maximum credit of $125,000 per year per individual

o Allows a maximum credit of $250,000 for those married and filing jointly

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Minnesota Angel

Tax Credit

Minnesota Angel Tax Credit

The Minnesota's Angel Tax Credit has numerous requirements and requires an application process and state regulatory approval by Department of Employment and Economic Development ("DEED"). Key definitions:

o Qualified Investment – Generally, only equity investments (convertible debt in limited circumstances)

o Qualified Investor or Angel – Must be certified by DEED. Must be individual or Qualified Fund with natural persons as owners

o Qualified Small Business – Must be certified by DEED. Generally, QSB must be involved in innovation or research or technological activity

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Cash vs. Accrual Method of Accounting

Cash vs Accrual Method of Accounting

Under the cash method income is reported when constructive receipt occurs (money is available without restriction). Expenses are deducted when actual payment occurs. In general, the cash method cannot be used to account for inventory purchases and sales. However an exception applies to taxpayers with average annual gross receipts of $1 million or less. Also taxpayers with average annual gross receipts of $10 million or less can continue to use the cash method if the business is primarily a service-type business.

Generally cash basis allows the taxpayer more flexibility in controlling taxable income in a given year

One exception however, is for taxpayers who receive advance payments in which there may be income deferral opportunities if using the accrual method

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Financially Distressed Businesses

Partnership Debt for Equity Rules

The IRS released final regulations on partnership debt for equity exchanges

Generally, extinguishing debt with equity is a taxable exchange

When a debtor partnership issues a capital or profits interest to a creditor in satisfaction of a debt, the partnership is treated as having satisfied the debt for an amount of money equal to the FMV of the partnership interest being issues to the creditor

To the extent the principal amount of the debt exceeds the FMV of the equity being issued, the partnership recognizes cancellation of debt (COD) income

Such COD income must be included in the distributive shares of the partners (subject to any exclusions at the partner level)

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Financially Distressed Businesses

Net Operating Losses

Planning for Net Operating Losses (NOLs)

NOL deduction available when current year’s income is less than current year’s deductions

NOLs can be carried back 2 years and forward 20

Planning required to maximize deduction

NOL versus Section 179 deduction

NOL versus bonus depreciation

Many businesses have large NOLs generated during economic downturn

Proper planning will insure best tax result so that NOL benefits are not allowed to expire

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Tax Planning Considerations

Tax myths and recent audit results

Tax avoidance vs. tax evasion

Aggressive tax planning to avoid

o Independent contractor vs. Employee

Taxes cannot be saved by treating (true) employees as independent contractors

o Convoluted entity structuring

o Claiming tax losses that do not correspond to a true economic loss (e.g., abusive tax shelters)

o Mixing personal and business expenses

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Tax Planning Considerations

Business tax planning adds value

Every major corporation has tax professionals employed on a full time basis to do tax planning and to comply with the tax rules, regulations, and deadlines

Maximizing deductions will lower a businesses taxable income and taxes paid, and increase cash-flow

Strict adherence to tax rules, with appropriate documentation, is required to ensure that the expenses are legitimate deductions that can be supported in the event of an IRS exam

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Q&A

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Contact Information

Kevin W. Kaiser

Lindquist & Vennum PLLP

Phone: (612) 371-2467

E-mail: kkaiser@lindquist.com

Kevin D. Whitaker

Moquist Thorvilson Kaufmann & Pieper LLC

Phone: (763) 557-2583

E-mail: Kevin.Whitaker@mtkcpa.com

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