Another new tax law; 2007 Small Business & Work Opportunities Tax Act: good and bad news.

The following are selected highlights of the 2007 Small Business and Work Opportunity Tax Act (P.L. 110-28), signed into law May 25, 2007.

Preparer Penalties Expanded and Increased

Old Law: An income tax return preparer was defined as any person who prepared for compensation, or who employs other people to prepare for compensation, all or a substantial portion of an income tax return or refund claim. Therefore, this definition excluded non-income tax return preparers, such as gift, estate, excise or employment tax return preparers.

An income tax return preparer who prepared a return or refund claim, with respect to which there was an income tax understatement that was due to an undisclosed position for which there was not a realistic possibility of being sustained on its merits, or was a frivolous position (even if adequately disclosed), was liable for a $250 first-tier penalty--if the preparer knew, or reasonably should have known, of the position.

A preparer who prepared an income tax return or refund claim and engaged in specified willful or reckless conduct in preparing that return or claim was liable for $1,000 second-tier penalty.

Under Regs. Sec. 1.6694-2(b)(1), a position was considered to have a realistic possibility of being sustained on its merits if a reasonable and well-informed analysis by a person knowledgeable in the tax law would lead such a person to conclude that the position had approximately a one in three, or greater, likelihood of being sustained on its merits (realistic possibility standard).

A frivolous position "was one that was patently improper" [Regs. Sec. 1.6694-2(c)(2)].

New Law: The definition of "preparer" is broadened to include preparers of gift, estate, employment, excise and exempt organization returns.

The new law also alters the standards of conduct that must be met to avoid penalties for preparing a return which has a tax understatement. The realistic possibility standard for undisclosed positions is replaced with a requirement that there be a "reasonable belief" that the tax treatment of the position was more likely than not the proper treatment.

Note: Existing Regs. Sec. 1.6662-4(g)(4), pertaining to tax shelter items of noncorporate taxpayers, states that a taxpayer is considered reasonably to believe that an item's tax treatment is more likely than not the proper treatment if:

* The taxpayer analyzes the pertinent facts and authorities in the manner described in Regs. Sec. 1.6662-4(d)(3)(ii), regarding the nature of analysis for determining whether substantial authority is present, and in reliance upon that analysis, reasonably concludes in good faith that there is a greater than 50 percent likelihood that the item's tax treatment will be upheld if challenged by the IRS, or

* The taxpayer reasonably relies in good faith on a professional tax adviser's opinion--if that opinion is based on the adviser's analysis of the pertinent facts and authorities in the manner described in the preceding "bullet" and unambiguously states that the adviser concludes that there is a greater than 50 percent likelihood that the item's tax treatment will be upheld if challenged by the IRS.

The "not-frivolous" standard, accompanied by disclosure, is replaced with the requirement that there must be a "reasonable basis" for the position's tax treatment accompanied by disclosure.

Note: Existing Regs. Sec. 1.6662-3(b)(3), concerning negligence or disregard of rules or regulations, states that reasonable basis is a relatively high standard of tax reporting, that is significantly higher than "not frivolous" or "not patently improper." The reasonable basis standard is not satisfied by a return position that is merely arguable or that is merely a colorable claim. If a return position is reasonably based on one or more of the authorities set forth in Regs. Sec. 1.6662-4(d)(3)(iii) (taking into account the relevance and persuasiveness of the authorities and subsequent developments), the return position will generally satisfy the reasonable basis standard even though it may not satisfy the substantial authority standard as defined in Regs. Sec. 1.6662-4(d)(2).

In addition, the first-tier penalty is increased from $250 to the greater of $1,000 or 50 percent of the income derived, or to be derived, by the preparer from preparing the return or claim with respect to which the penalty is imposed.

The second-tier penalty also is increased from $1,000 to the greater of $5,000 or 50 percent of the income derived, or to be derived, by the preparer.

Effective Date: Under the 2007 Act's Section 8246(c), these new rules are effective for tax returns prepared after May 25, 2007.

Transitional Relief: IRS Notice 2007-54 (IRB-27, 7/2/07) relaxes this effective date for:

(1) All returns, amended returns, and refund claims due (with extensions) before 2008;

(2) 2007 estimated tax returns (vouchers) due by Jan. 15, 2008; and

(3) 2007 employment and excise tax returns due by Jan. 31, 2008.

Notice 2007-54 states:

* For income tax returns, amended returns, and refund claims, the standards set forth under the previous law and current regulations under IRC Sec. 6694 will be applied in determining whether the IRS will impose a penalty under Sec. 6694(a). Generally, in applying transitional relief for income tax returns, amended returns or refund claims, disclosure would be adequate if made on Form 8275, Disclosure Statement, or Form 8275-R, Regulation Disclosure Statement, attached to the return, amended return or refund claim, or pursuant to the annual revenue procedure authorized in Regs. Secs. 1.6694-2(c)(3) and 1.6662-4(f)(2).

* For all other returns, amended returns and refund claims, including gift, estate and generation-skipping transfer tax returns and employment and excise tax returns, the reasonable basis standard set forth in the Sec. 6662 regulations, without regard to the disclosure requirements contained therein, will be applied in determining whether the IRS will impose a penalty under Sec. 6694(a).

* No transitional relief is available under Sec. 6694(b) as transitional relief is not appropriate for return preparers who exhibit willful or reckless conduct, regardless of the type of return prepared.

Erroneous Refund Claims

Old Law: There was no separate penalty for filing refund claims that had no basis in fact or law. If a taxpayer erroneously claimed a refund, there could be no penalty if there was no additional tax attributable to that claim.

New Law: A new penalty is imposed on any taxpayer filing an erroneous claim for refund or credit. This penalty is 20 percent of the disallowed portion of the claim if there is no reasonable basis for the claimed tax treatment.

The penalty does not apply to the earned income credit (which has its own compliance rules). It also does not apply to any part of the disallowed portion of the claim that is subject to accuracy related or fraud penalties.

Effective Date: Claims filed after May 25, 2007.

Kiddie Tax 

Old Law: Special rules (known as the "kiddie tax") applied to the net unearned income (i.e., investment income) of certain children.

Generally, the kiddie tax applied to a child if:

(1) The child had not reached age 18 by the close of the tax year and either parent was alive at that time;

(2) The child's unearned income exceeded $1,700 (for 2007); and

(3) The child didn't file a joint return.

The kiddie tax applied regardless of whether the child may be claimed as a dependent by either or both parents.

New Law: The kiddie tax is expanded 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.

Effective Date: Tax years beginning after May 25, 2007 (e.g., calendar year 2008).

Increased and Extended Sec. 179 Deduction for Small Business

Old Law: Generally, the maximum amount that a taxpayer may elect to expense for tax years 2003-2009 was $100,000 of the cost of qualifying property placed in service during the tax year.

Qualifying property was generally defined as new or used depreciable tangible personal property purchased for use in the active conduct of a trade or business. Off-the-shelf computer software placed in service in tax years beginning before 2010 was treated as qualifying property.

The $100,000 amount was reduced (but not below zero) by the amount by which the cost of qualifying property placed in service during the tax year exceeded $400,000.

The $100,000 and $400,000 amounts were indexed for inflation for tax years beginning after 2003 and before 2010. For tax years beginning in 2007, the inflation adjusted amounts were $112,000 and $450,000, respectively.

Taxpayers could make or revoke Sec. 179 expense deduction elections on amended returns without IRS consent for tax years beginning after 2002 and before 2010. Any such revocation was irrevocable.

New Law: The $100,000 and $400,000 amounts are increased to $125,000 and $500,000, respectively, for tax years 2007-2010. These amounts will be indexed for inflation in tax years beginning after 2007 and before 2011.

In addition, the new law extends for one year the increased amount that a taxpayer may deduct and the other Sec. 179 rules applicable in tax years beginning before 2010. Thus, these rules continue in effect for tax years beginning after 2009 and before 2011.

Effective Date: Tax years beginning after 2006.

Partner-Spouses May Elect Non-Partnership Treatment

Old Law: A partnership was defined to include a syndicate, group, pool, joint venture or other unincorporated organization through or by means of which any business, financial operation or venture was carried on--and which was not a trust, estate or corporation. The income of a partnership and its partners was determined under Subchapter K of the Internal Revenue Code.

An election not to be subject to Subchapter K was provided for certain partnerships meeting specified criteria. Otherwise, Subchapter K applied to a venture treated as a partnership for federal tax purposes.

If an individual was a partner in a partnership, net earnings from self-employment, which was subject to the self-employment tax, generally included his or her distributive share (whether or not distributed) of income or loss from any trade or business carried on by the partnership.

New Law: A "Qualified Joint Venture" (QJV), whose only members are a husband and wife filing a joint return, is permitted not to be treated as a partnership for federal tax purposes.

A QJV is a joint venture involving the conduct of a trade or business if:

(1) The joint venture's only members are a husband and wife;

(2) Both spouses materially participate in the trade or business; and

(3) Both spouses elect to have new Sec. 761(f) apply.

Pursuant to this election, a QJV conducted by a husband and wife who file a joint return is not treated as a partnership for federal tax purposes. All items of income, gain, loss, deduction and credit are divided between the spouses according to their respective interests in the venture. Each spouse takes into account his or her share of these items as a sole proprietor. Thus, it is anticipated that each spouse would account for his or her respective share on the appropriate form, such as Schedule C.

This new provision is not intended to change the determination under the old (and continuing) law of whether an entity is a partnership for federal tax purposes (without regard to this new election).

For determining net earnings from self-employment, each spouse's share of income or loss from a QJV also is taken into account according to their respective interests in the venture.

The new law is not intended to prevent allocations or reallocations, to the extent permitted under existing law, by the courts or by the Social Security Administration of net earnings from self-employment for purposes of determining an individual's Social Security benefits.

Effective Date: Tax years beginning after 2006.

S Corporation's Capital Gains No Longer Passive Investment Income

Old Law: An S corporation was subject to corporate level tax, at the highest corporate tax rate, on its excess net passive income if the corporation had:

* Accumulated earnings and profits (AE & P) at the end of the tax year; and

* Gross receipts more than 25 percent of which were passive investment income.

Also, an S election was terminated if the corporation had AE & P at the close of each of three consecutive tax years and had gross receipts for each of those years, more than 25 percent of which were passive investment income.

Excess net passive income was the net passive income for a tax year multiplied by the following fraction: Passive investment income exceeding 25 percent of gross receipts divided by total passive investment income for the year.

Net passive income was passive investment income reduced by allowable deductions directly connected with producing that income.

Passive investment income generally included gains from sales or exchanges of stock or securities.

New Law: Gains from sales or exchanges of stock or securities are eliminated as items of passive investment income.

Effective Date: Tax years beginning after May 25, 2007.

Partial Sale of QSub

Old Law: An S corp that owned all the stock of another corporation may elect to treat that subsidiary as a "Qualified Subchapter S Subsidiary" (QSub), which was disregarded as a separate entity for federal tax purposes. Its items of income, deductions, losses and credits were treated as the S corp's items.

If the subsidiary ceased to be a QSub (e.g., failed to meet the wholly-owned requirement), it was treated as a new corporation acquiring all its assets and assuming all its liabilities immediately before such cessation from the parent S corp in exchange for its stock.

Under Regs. Sec. 1.1361-5(b), the tax treatment of the termination of the QSub election was determined under general tax law principles--including the step transaction doctrine.

In Regs. Sec. 1.1361-5(b)(3), Example (1), an S corp sold 21 percent of its QSub stock to an unrelated party. This example treated the deemed transfer of all the QSub's assets as a taxable sale because the S corp was not in control of the QSub immediately after the transfer by reason of the sale. Thus, the transfer did not qualify for nonrecognition treatment under Sec. 351.

New Law: If the sale of QSub stock results in termination of the QSub election, the sale is treated as a sale of an undivided interest in the QSub's assets (based on the percentage of stock sold) followed by a deemed transfer to the QSub in a Sec. 351 transaction.

Thus, in the above example, the S corp will be treated as selling a 21 percent interest in the QSub's assets to the unrelated party, followed by a transfer of all its assets to a new corporation in a Sec. 351 transaction. Consequently, the S corp will recognize only 21 percent of the gain or loss on the QSub's assets.

This new law is not intended to change the current law treatment of the disposition of QSub stock by an S corporation in connection with an otherwise nontaxable transaction. For instance, the transfer of QSub stock by an S corp pro rata to its shareholders can qualify as a distribution to which Secs. 368(a)(1)(D) and 355 apply if that transaction otherwise satisfies the requirements of those sections. [See Regs. Sec. 1.1361-5(b)(3), Example (4).]

Effective Date: Tax years beginning after 2006.

ESBT's Deduction for Interest on Debt Incurred to Acquire S Corporation Stock

Old Law: An Electing Small Business Trust (ESBT) was subject to tax at the highest individual income tax rate (currently 35 percent) on the portion of the trust which consisted of stock in one or more S corps (the S portion). The S portion's income was not included in the beneficiaries income.

The only items of income, loss or deduction taken into account in computing the S portion's taxable income were:

(1) The items of income, loss or deduction allocated to the ESBT as an S corp shareholder;

(2) Gain or loss from the sale of the S corp stock; and

(3) To the extent provided in regulations, any state or local income taxes or administrative expenses of the ESBT allocable to the S corp stock.

Under Regs. Sec. 1.641(c)-1(d)(4)(ii), interest paid by an ESBT to purchase S corp stock was allocated to the S portion but was not a deductible administrative expense in computing the S portion's taxable income.

In determining the tax liability of the remaining portion of the trust, the items taken into account by the S portion were disregarded.

New Law: A deduction for interest paid or accrued on debt to acquire S corp stock can be taken into account in computing the S portion's taxable income.

Effective Date: Tax years beginning after 2006.

S Corporations with Earnings and Profits

Old Law: The 1996 Small Business Jobs Protection Act provided that if a corporation was an S corp for its first tax year beginning after 1996, the corporation's AE & P at the beginning of that year were reduced by the earnings and profits (if any) accumulated in a tax year beginning before 1983, for which the corporation was an S corp.

New Law: In the case of any corporation which was not an S corp for its first tax year beginning after 1996, the corporation's AE & P as of the beginning of the first tax year beginning after May 25, 2007, is reduced by the earnings and profits (if any) accumulated in a tax year beginning before 1983, for which the corporation was an S corp.

Effective Date: Tax years beginning after May 25, 2007.

Suspension of Interest and Penalties

Old Law: Generally, interest and penalties accrued on unpaid taxes even though the taxpayer was unaware that there was tax due. However, if an individual filed an income tax return for a tax year by its due date (including extensions), the accrual of interest and penalties was suspended unless the IRS provided the taxpayer a notice specifically stating the taxpayer's liability and the basis for that liability within 18 months following the later of:

(1) The return's original due date (without extensions); or

(2) The date on which a timely return was filed.

The suspension period began on the day after the close of this 18-month period and ended on the day that was 21 days after the date on which the required notice was provided by the IRS.

This treatment was applied separately with respect to each item or adjustment. It did not apply to:

* Penalties imposed under Sec. 6651 (for failures to timely file returns or pay tax);

* Any interest or penalties in a case involving fraud;

* Any interest or penalties with respect to any tax liability shown on the return;

* Any criminal penalty; and

* Any interest or penalty with respect to a gross misstatement which is any substantial omission of items to which the six-year statute of limitations applies [Sec. 6501(e)]; gross valuation misstatement [Sec. 6662(h)]; or similar provision.

This treatment also did not apply, generally, to interest or penalties accruing on underpayments resulting from listed transactions or undisclosed reportable transactions.

Note: Under Rev. Rul. 2005-4, if an individual filed an amended income tax return reporting additional tax more than 18 months after the later of (1) the original return's due date (without extensions) or (2) the date the original return was timely filed, the suspension rules applied to interest on that additional tax. The suspension period began on the day after the close of this 18-month period and ended:

* On the date the amended return was filed if the additional tax was paid with this return; or

* 21 days after the date the amended return was filed if the additional tax was not paid with the return.

New Law: The 18-month period is increased to 36 months. Consequently, the accrual of interest and certain penalties will be suspended starting 36 months after an income tax return is filed if the IRS has not sent the taxpayer a notice specifically stating the taxpayer's liability and the basis for that liability.

Effective Date: IRS notices issued after Nov. 25, 2007.

Employment Tax Levies

Old Law: The IRS was required, generally, to notify taxpayers that they had a right to a fair and impartial Collection Due Process (CDP) hearing before a levy may be made on any property or right to property. Similar rules applied for tax liens notices, although the right to a hearing arose only on the filing of the notice.

The CDP hearing was held by an impartial IRS Appeals officer, who was required to issue a determination with respect to the issues raised by the taxpayer at the hearing. The taxpayer could appeal that determination to a court.

Taxpayers were not entitled to a pre-levy CDP hearing if a levy was issued to collect a federal tax liability from a state tax refund or if collection of the federal tax was in jeopardy. However, levies related to state tax refunds or jeopardy determinations were subject to post-levy review through the CDP hearing process.

New Law: A levy issued to collect federal employment taxes will be excepted from the pre-levy CDP hearing requirement if the taxpayer, subject to the levy, requested a CDP hearing with respect to unpaid employment taxes arising in the two-year period before the beginning of the taxable period with respect to which the employment tax levy is served.

However, the taxpayer will be provided an opportunity for a hearing within a reasonable period of time after the levy.

As the IRC provides for state tax refunds or jeopardy determinations, collection by levy of employment tax liabilities will be permitted to continue during the CDP proceedings.

Effective Date: Levies issued after Sep. 21, 2007.

Increased Penalty for Bad Checks or Money Orders

Old Law: Sec. 6657 imposed a penalty on persons tendering bad checks or money orders, equal to 2 percent of the amount of the bad check or money order. For checks or money orders that were less than $750, the minimum penalty was $15 (or, if less, the amount of the check or money order).

This penalty did not apply if the person tendered the check (or money order) in good faith and with reasonable cause to believe that it would be duly paid.

New Law: The minimum penalty is increased to $25 (or, if less, the amount of the check or money), applicable to checks or money orders that are less than $1,250.

Effective Date: Checks or money orders received after May 25, 2007.

Stuart R. Josephs, CPA has a San Diego-based Tax Assistance Practice (TAP) that specializes in assisting practitioners in resolving their clients' tax questions and problems. Josephs, chair of the Federal Subcommittee of CalCPA's Committee on Taxation, can be reached at [phone] or [e-mail].

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By Stuart R. Josephs, CPA