Effects of the Small Business & Work Opportunity Tax Act
Tree Farmer Magazine: September/October 2007 - Volume 26 No. 5
The Small Business and Work Opportunity Tax Act of 207, H.R. 2206, was signed into law by the President May 25 as P.L. 110-28. Although it included no provisions specific to timber, several provisions may affect Tree Farmers.
The tax treatment of a husband and wife who jointly own a Tree Farm can be confusing. The simplest case is when (1) the timber activity is an investment, not a business; (2) all the income from the Tree Farm is capital gains; and (3) the couple files a joint tax return. On their joint Form 1040 they report their net capital gain from the sale of standing timber using Schedule D, or FOrm 4797, depending on how the timber was disposed of. The property tax is reported as an itemized deduction on Schedule A, and any other qualified management expenses are reported as miscellaneous itemized deductions, subject to the 2 percent of adjusted gross income rule. If they have qualified reforestation expenses to deduct currently, or to amortize, these deductions are reported as adjustments to their gross income. Since both short-term and long-term capital gains aren't subject to the self employment tax for social security purposes, they don't need to file Schedule SE, Self-Employment Tax.
But what if the spouses' jointly owned Tree Farm is a business? In tax jargon, such a Tree Farm is a "joint venture." If the spouses didn't incorporate or for a limited liability company for the Tree Farm business, the Internal Revenue Code requires that they file as a partnership, even if they file jointly. The partnership tax return, Form 1065, is an information return only. Specific tax items such as net income, capital gains, and dividends are allocated to each partner on Schedule K-1. Each partner then enters these amounts on the designated line of his or her Form 1040. If the partners are spouses who file jointly, the amounts from each K-1 are added back together to be entered on the joint Form 1040.
This is the case even if all their income from the Tree Farm is capital gains and therefore there is no self-employment tax to report.
Any ordinary income reported on a spouse's K-1 is also reported on their individual Schedule SE, Self-employment Tax. Note that as owners of a joint venture, one spouse can't employ the other. The partnership can make guaranteed payments to specified partners, but this is not earned income from employment. Thus, the partnership does not pay employment taxes on the partners.
The act included a "Family business tax simplification provision" (Section 8215, amending Section 761 of the Internal Revenue Code). It provides that in the case of a qualified spousal "joint venture," the spouses can elect not to be treated as a partnership for federal tax purposes. Rather, each spouse reports his or her share of all items of ordinary income, capital gains, and other items otherwise reported on Schedule K-1, on an individual business form, usually Schedule C, Sole Proprietorship of Form 1040. A Schedule F, Farm, could also be used if the spouses have been treating their Tree Farm as a farm business. This means that the spouses won't have to file a Form 1065, but they still have to make the allocations to their individual Schedule C's or F's.
A qualified joint venture is any joint venture involving the conduct of a trade or business if: (1) the only members are a husband and wife; (2) both spouses materially participate according to the criteria of the passive loss rules without regard to the rule that treats participation by one spouse as participation by the other; and (3) both spouses elect for this rule to apply. This means that each spouse must have materially participated in the Tree Farm business. The passive loss rules otherwise say that the work of both spouses can be added together to determine material participation, and they can jointly qualify.
Guidance has not yet been provided on how the election is to be made. This change is effective for tax years beginning after Dec. 31, 2006.
If you and your spouse conduct a Tree Farm business with no other partners, you should discuss with your tax preparer the possibility of making this election.
Increase and Extension of Expensing for Small Business
The so-called Section 179 deduction allows a business to recover the cost of depreciable tangible personal property, for example, a tractor, as a current deduction instead of by depreciation. The property has to be purchased for use in the active conduct of a trade or business. The base amount of the maximum expenditure that qualifies is $100,000, and this maximum deduction is reduced by the amount by which the cost of qualifying property placed in service during the year exceeds $400,000. Because of indexing for inflation, these amounts are actually $112,000 and $450,000 in 2007. Section 179 expensing was going to expire for tax years after 2009.
Section 1812 of the act increases these limits to $125,000 and $500,000 for tax years beginning in 2007 and ending before 2011. These new base amounts will be indexed for inflation in 2008 through 2010.
Kiddie Tax Age Limit Raised
A standard tax planning technique for families is to use a gifting program to place income-producing assets in the hands of family members taxed at a rate lower than their parents. This usually means minor children. The so-called "kiddie tax" took away most of the benefits of this strategy by taxing the unearned income of minors at the highest marginal tax rate of their parents. The act increases the age limit for this tax from 16 to 18, and in the case of full-time students to age 24.
This technique has been of limited use to Tree Farmers because the kiddie tax applies to net capital gains, and because of the legal issues involved in making a minor an owner of real property. Placing the interests of children under 18 years of age, or 24 for students, in a trust also doesn't usually help because trust income distributed to minor beneficiaries is subject to the kiddie tax.
Since earned income isn't subject to the kiddie tax, a visible strategy is to employ the children in the Tree Farm business. The Tree Farm business deducts the children's labor cost, and the children pay tax at their lower rate. However, they must do meaningful work. You should have in your records a job description, time cards, and all the other attributes associated with hiring and supervising an employee. Of course, the Tree Farm business has to pay the employment taxes and follow the tax-withholding rules for payments to the children. Before using this strategy, discuss it with your legal counsel or tax preparer.