The Journal of The DuPage County Bar Association

Back Issues > Vol. 23 (2010-11)

The Tax Relief Act of 2010:How the Act Affects Small Businesses and Their Owners
By Terrence J. Benshoof

The year 2010 was a potentially far-reaching one in the taxation arena. Many tax reduction provisions had been enacted during the Bush administration, and nearly all contained “sunset” provisions, with scheduled returns to Clinton-era tax rates and deductions. Tax rates had been reduced under the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA).[1] The same Act also phased out the Estate Tax, resulting in 2010 having no estate tax on any size estate for federal tax purposes. Similarly, the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA)[2] had reduced tax rates on dividends and capital gains. However, with 2010 drawing to a close, amidst constant discussion among Congress, the Obama administration, and the media, expiration loomed with no action clearly pending. Finally, in the waning hours of the 2010 lame-duck session of the 111th Congress, a compromise tax bill emerged, HB 4853, and the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 (“Tax Relief Act of 2010”)[3] was promulgated therefrom on December 17, 2010.

The Tax Relief Act of 2010 affected most taxpayers by extending the EGTRRA tax rate brackets and a number of individual deductions, as well as extending favorable dividend and capital gain rates for an additional two years.[4] These items of relief are essentially personal in nature, affecting small business owners and employees alike. Similarly, the effects of the Tax Relief Act of 2010 with respect to estate and gift taxes apply to all types of individual taxpayers. This article will examine the effect that the Tax Relief Act of 2010 will have on those taxpayers who own and operate small, non-publicly traded businesses, with a view towards planning for effective minimization of taxes, along with asset protection.

Business Income and Expenses. Among the business-favorable aspects of the Tax Relief Act of 2010 (“the Act”) is a reduction in the employee portion of FICA taxes, as well as the Social Security and Medicare taxes for self-employed persons.[5] This is a one-year reduction, and its primary effect is to allow some additional cash flow to the business owner, whether filing Schedule C or taking salary from the owner’s Subchapter S corporation.

The business-owner taxpayer has greater concern over the Alternative Minimum Tax (“AMT”)[6] if the business is doing well. Originally enacted to prevent less than 200 taxpayers from escaping income tax through the use of deductions, the AMT was never indexed. This resulted in more and more taxpayers being subject to the AMT annually if “patches” were not enacted. It has been estimated that, in the absence of the “patch” put in place in the Act for 2010 and 2011, an additional 21 million taxpayers would have been subject to the AMT – despite the recession and high unemployment rate.[7] As a result of the threshold amount for the application of the AMT, small business owners should save considerable tax dollars if they have good years in 2010 and thereafter.

Perhaps the major item affecting small business owners is the Act’s extension of the bonus depreciation allowance, stemming from the Small Business Jobs and Credit Act of 2010 through 2011,[8] which increases that bonus depreciation amount from 50 percent to 100 percent.[9] Even taking into account the credit difficulties in today’s economy, this bonus depreciation deduction will provide considerable tax incentive for those businesses with available cash to purchase additional or upgraded equipment.

Preserving the Small Business. Prior to 2001, the Estate and Gift taxes had been a unified tax, with a single lifetime credit to be applied against those taxes in excess of annual exclusions. In 2001, EGTRRA made a major change. Under the EGTRRA,[10] the estate tax was gradually reduced until, beginning in 2010, the estate tax ceased to exist completely.[11] However, this provision was “sunsetted,” so because no new law came into effect for 2011, the estate tax was reinstated and reverted to what it would have been, allowing a $1 million exemption, and a top rate of 55 percent. Therefore, the potentially devastating effect on a small business, especially if not high in liquidity, is obvious.

The Act also made major changes in the Estate and Gift Tax area. First, when the estate tax was reinstated, it allowed for a $5 million exclusion, and reunified the estate, gift, and generation skipping taxes with the exclusion amount.[12] The exclusion section adds a new provision as well, which allows the unused part of a spouse’s $5 million exclusion to be utilized in the survivor’s estate.[13] However, in the absence of regulation on the subject, it is still unclear as to how this additional exclusion will work, especially since the new law requires an irrevocable election to be made in the estate tax return of the first to die – even if the first to die did not require a return to be filed.[14] The maximum estate tax rate is currently 35 percent.[15]

How will these changes affect the small business owner? Generally, the areas of succession planning and estate planning are overlooked by the small business owner, but because of the nature of the business, e.g. a sole proprietorship or a closely held corporation, the transfer of ownership can become a very costly matter. Prior to the Act, an owner could attempt to gift ownership interests to other family members, but was only allowed an annual exclusion of $13,000 (for 2011) per done,[16] or $26,000 as a joint gift if married.[17] If the value of the business was in the range of $2 million, this route would take considerable time. Also, under the pre-2010 EGTRRA exclusions, if the owner had other accumulated wealth, the available credits might make a taxable gift a costly option.

With the $5 million Act exclusion, a transfer of ownership through gifting could be accomplished with minimal cost, while still allowing for a minimal estate tax – or no estate tax – on the owner’s remaining wealth.[18] Since the Act’s exclusion provisions “sunset” at the end of 2012,[19] without any assurance as to continuation of the favorable aspects of the exclusions, the small business owner who plans to retire, or simply transfer ownership, while avoiding the gift or estate taxes associated with that transfer, may find that the next two years constitute an ideal time frame for such plans.

Estate planning for the client of a small business owner should also take into account these same favorable exclusion and rate provisions. If the owner has acquired other assets, in addition to the business assets, which can be placed into irrevocable trusts for the benefit of family members, gifting becomes an option that maintains wealth while avoiding estate taxes in the future. Since the gift tax laws still allow an unlimited non-taxable gift to a spouse,[20] and since each spouse is entitled to a $5 million exclusion, the owner may consider transfers to a spouse to optimize the estate tax exclusions.

Essentially, the possibilities for minimizing taxes on transfer of wealth, for the small business owner, are presently very good, and counsel should make clients who are small business owners aware of these opportunities before the law undergoes its next change, in about two years.

[1] 107 P.L. 16, 115 Stat. 38 (2001).

[2] 108 P.L. 27, 117 Stat. 752 (2003).

[3] 111 P.L. 312 (2010).

[4] I.R.C. §§ 1, 162-170.

[5] I.R.C. § 1402.

[6] I.R.C. §§ 55-59.

[7] Accounting Today. December 17, 2010.

[8] 111 P.L. 240 (2010).

[9] I.R.C. §§ 167, 179.

[10] I.R.C. § 2001 et seq.

[11] I.R.C. § 2210(a).

[12] I.R.C. §§ 2001, 2010.

[13] I.R.C. § 2010(c).

[14] 111 P.L. 312, § 303; I.R.C. § 2010(c)(2)-(6).

[15] I.R.C. § 2001(c).

[16] I.R.C. § 2503(b).

[17] I.R.C. § 2513.

[18] As a cautionary note, in January, Illinois reinstituted its Estate Transfer Tax, creating a tax that equals the credit for state death taxes allowed under I.R.C. §§ 2011 or 2604, but limiting the exclusion amount to $2 million. 35 ILCS 405/2.

[19] 111 P.L. 312, § 101.

[20] I.R.C. § 2523.
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