Enacted in the waning days of the 111th Congress, the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (2010 Tax Relief Act, PL 111-312) was a creature of political compromise.
But the act nonetheless built upon already attractive incentives that had been passed only a few months before in the Small Business Jobs Act of 2010 (PL 111-240). The jobs act, as explained in the JofA article “2010 Small Business Jobs Act: Good for Big Business” (Dec. 2010, page 30), authorized a host of business incentives that, although designated for “small businesses,” statistically could apply to 99.9% of all U.S. businesses. The 2010 Tax Relief Act steps in where the Small Business Jobs Act ends, enhancing and extending business incentives, including IRC § 179 expensing, bonus depreciation and tax credits.
In this article, we compare the two acts’ primary incentive provisions, then analyze the enhanced benefit produced by combining them. Finally, we provide guidance on how three typical company types (a loss company with a valuation allowance; profitable company with an NOL carryforward and valuation allowance; and a profitable company without a valuation allowance) will be affected by the acts from a cash flow and accounting perspective, along with their key financial statement and tax return considerations.
STRATEGICALLY APPLYING THE ACTS’ PROVISIONS TOGETHER
The Small Business Jobs Act and the 2010 Tax Relief Act are each significant to businesses on their own merits, as shown in the chart summarizing their important business incentive provisions (see Exhibit 1).
When the provisions of the Small Business Jobs Act and the 2010 Tax Relief Act are strategically merged, the benefits to businesses may be lucrative.
Research credit and five-year carryback. Perhaps the greatest tax savings opportunity from the interplay of the two acts is that of the research credit and the general business credit five-year carryback.
The Small Business Jobs Act in IRC § 39(a)(4) authorized eligible small businesses to carry back general business credits generated during 2010 to the prior five tax years (2005 to 2009). Eligible small businesses are corporations whose stock isn’t publicly traded, partnerships or sole proprietorships that have average annual gross receipts for the three-tax-year period preceding the tax year of no more than $50 million (section 38(c)(5)(C)).
The problem was that the act did not extend one of the most popular and most used federal general business credits, the IRC § 41 credit for increasing research activities that had expired Dec. 31, 2009. Without an extension to 2010 of the research credit, the credit carryback opportunity was of little or no value to many businesses. It was only when the 2010 Tax Relief Act was passed, extending the federal research credit retroactively through 2010, that the credit carryback became meaningful to many eligible small businesses.
Research credit and AMT offset. In addition to the general business credit carryback, the Small Business Jobs Act authorized general business credits for eligible small businesses to offset alternative minimum tax (AMT) during 2010 and for the five-year carryback period. Once again, the problem faced by many businesses in using this tax savings opportunity was that the ever-popular research credit had expired. And, once again, the 2010 Tax Relief Act extension of the credit retroactively through 2010 reopened the potential for businesses generating federal research credits to offset their 2010 AMT, as well as AMT in the prior five years via the credit carryback opportunity.
Leasehold improvement and bonus depreciation. The Small Business Jobs Act extended 50% bonus depreciation for all businesses through Dec. 31, 2010. What the act did not do was broaden the definition of what constitutes qualified leasehold improvements for purposes of bonus depreciation. The provision is significant to many businesses, as leasehold improvements typically are depreciated over 39 years, resulting in lower annual depreciation deductions. The 2010 Tax Relief Act fills this gap by extending through 2011 the section 168(e)(3)(E)(iv) rule treating qualified leasehold improvement property as 15-year property. Thus, such property is once again eligible for bonus depreciation.
The 2010 Tax Relief Act also extends through 2011 the section 168(e)(3)(E)(v) rule and the section 168(e)(3)(E)(ix) rule treating qualified restaurant property and qualified retail improvement property, respectively, as 15-year property. However, under sections 168(e)(7)(B) and 168(e)(8)(D), these types of property are not treated as qualified property for purposes of the bonus depreciation rules in section 168(k) and thus aren’t eligible for bonus depreciation.
Bonus depreciation enhancement and extension. Although the two acts’ provisions do not differ in kind, they work together to lengthen the period and extent to which bonus depreciation is available. The Small Business Jobs Act extended bonus depreciation through 2010, but at 50%. The 2010 Tax Relief Act bolsters this depreciation acceleration to 100% for qualified property purchased and placed in service between Sept. 8, 2010, and Dec. 31, 2011. Although this depreciation acceleration is merely a timing difference rather than a reduction in federal taxes, when applied to fixed assets of longer class lives (such as qualifying leasehold improvements at 15 years) the time value of money becomes significant. While interest rates are currently low, the accelerated depreciation may provide enhanced net operating loss carryback opportunities or guarantee that the deduction may be used to reduce taxes if 2010 or 2011 is profitable.
Section 179 expensing enhancement and extension. The Small Business Jobs Act expanded the section 179 expensing limit and phaseout threshold to $500,000 and $2 million, respectively, along with expanding the definition of qualified real property, but only through Dec. 31, 2011. The 2010 Tax Relief Act continues through Dec. 31, 2012, higher limits than if they had reverted in 2012 to prior-law rates (maximum expensing amount of $25,000 and phaseout threshold of $200,000).
NAVIGATING THE ACTS IN COMBINATION
Theoretically, it makes sense to apply the Small Business Jobs Act and 2010 Tax Relief Act in combination. But, practically speaking, how these acts’ provisions are applied and the ensuing cash flow/accounting benefits depend greatly on the tax status of the business, as shown in Exhibit 2 (exhibit opens in new window).
Loss company with valuation allowance. Typically, loss companies with a valuation allowance will not benefit from the acts’ provisions either on a cash flow or accounting basis. To the extent these companies are not currently incurring federal regular income tax or AMT and have not done so in the past, there is no potential to currently monetize any of the acts’ benefits discussed in this article. From an accounting perspective, the depreciation-related benefits result in merely a swap of deferred tax asset (DTA) components from fixed-asset-related DTA to NOL-related DTA, and the credit opportunities are generally limited to a 2010 increase in DTA arising from a federal general business credit carryforward. No financial statement effects result from this redistribution and/or increase of DTA, due to the offsetting valuation allowance.
Profitable company with NOL carryforwards and valuation allowance. A profitable company with NOL carryforwards and a valuation allowance will record a tax benefit from the acts’ provisions. This type of company will use its NOL carryforwards to eliminate regular federal income tax and AMT, the latter down to the minimum 2% threshold (20% AMT multiplied by 10% AMT NOL utilization limitation). Therefore, to the extent front-loading depreciation deductions decreases the company’s limited AMT NOL carryforward, the company will receive a current benefit from the reduction in AMT. No corresponding deferred tax impact will arise, due to the full valuation allowance.
The acts’ credit opportunities also may be of current benefit to this company type, because now research (and other general business) credits may offset AMT, which is likely the type of tax this company is paying, due to its NOL utilization. This company type also is more likely to have pre-2006 AMT credits that it can monetize, due to its typical pattern of paying federal AMT. Likewise, the company will record a current benefit without the corresponding deferred tax expense from credit utilization.
Profitable company without valuation allowance. Profitable companies without a valuation allowance must take into consideration deferred taxes as well as current taxes; thus, the deferred tax impacts from securing the acts’ opportunities result in no net profit-and-loss impact. Under each opportunity addressed in Exhibit 2, the decrease in current tax expense is offset by a corresponding increase in deferred tax expense. From a cash flow perspective, this company type benefits most from accelerating depreciation under section 179 and bonus depreciation, resulting in an immediate 35% reduction to taxable income. Although the refundable AMT credit may be available to this company type, it is more likely the company will claim the immediate depreciation benefits rather than the in-lieu-of-bonus-depreciation AMT refundable credit, which may take some time to monetize through refund claims.
To the extent this company type does not utilize federal research (or other federal general business) credits during 2010, it likely will pursue additional cash flow by applying the 2010 federal credit to any AMT liabilities in the prior five tax years.
For all three company types described above, monetizing the 2010 federal research (and other federal general business) credit via the five-year carryback could result in an ASC 740-10 (formerly FIN 48) liability, to the extent a reserve has been established for the underlying credits.
CONSIDERATIONS BEFORE CLAIMING BENEFITS
Important considerations should be taken into account before claiming the incentive opportunities available from the acts.
Claiming a refund. Generally, businesses that are not corporations (including sole proprietorships filing Schedule C with their Form 1040) may accelerate a refund by using Form 1045, Application for Tentative Refund. Corporations may also accelerate a refund by using Form 1139, Corporation Application for Tentative Refund. The IRS will work to issue refunds generally within 45 days. Applicable amended returns also may be filed during a specific time frame allotted by the IRS. The typical three-year federal statute of limitations is generally waived during this time to allow businesses the full five-year carryback opportunity. Specific instructions related to claiming these benefits likely will be issued by the IRS in the near future.
Audit considerations/Schedule UTP. The IRS monitors research credit refund claims, so companies that claim the credit should maintain adequate documentation to support their positions. In addition, for tax years beginning in 2010, Schedule UTP will be required for C corporations (individuals and pass-through entities are currently exempt) with assets exceeding $100 million for 2010. The schedule requires detailed disclosure of a business’s uncertain tax positions related to income tax (similar to ASC 740-10 disclosures but much more detailed). Therefore, if any uncertainty exists related to the underlying research credits’ monetization via the five-year carryback, this uncertainty will be disclosed on Schedule UTP included with the 2010 federal income tax return. Although the IRS has publicly stated that it will not use the Schedule UTP as an “audit roadmap,” such information is undeniably available to the IRS for whatever purpose it deems necessary, including federal audits.
The Small Business Jobs Act and 2010 Tax Relief Act each enhanced and/or extended significant tax benefits for businesses, especially those that can combine certain provisions. These include an extension of the research credit (for 2010 and 2011), longer carryback of the general business credit arising in 2010 for eligible small businesses, and several measures for enhanced expensing and depreciation of business property.
However, how these provisions are applied and their amount of benefit depend on the tax status of the business. For example, a loss company with a valuation allowance may benefit little from bonus depreciation and higher IRC § 179 expensing limits. A profitable company with NOL carryforwards and a valuation allowance can benefit in lower regular income tax and alternative minimum tax, and a profitable company without a valuation allowance will realize the greatest cash flow benefit from accelerating depreciation under the acts’ provisions and carrying back general business credits, including the research credit.
A procedure is available to claim a refund arising from carrybacks more quickly than by filing amended returns—Application for Tentative Refund (Form 1045) and Corporation Application for Tentative Refund (Form 1139).
Companies that claim the research credit should maintain adequate documentation to support the claim. For tax years beginning in 2010, companies required to file Schedule UTP reporting uncertain tax positions (generally, C corporations with more than $100 million in assets) may be required to include in that reporting any such uncertainty associated with claiming a research credit.
Douglas M. Sayuk (firstname.lastname@example.org) and Matthew H. Fricke (email@example.com) are partners, and Shamen R. Dugger (firstname.lastname@example.org) is a director, all with Clifton Douglas LLP of San Jose, Calif.
To comment on this article or to suggest an idea for another article, contact Paul Bonner, senior editor, at email@example.com or 919-402-4434.
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