Small Business and Work Opportunity Tax Act of 2007
Community Bank Advisor, 2007 Fall

In May of this year, President Bush signed into law an emergency war supplemental spending bill that includes $4.8 billion in small business tax breaks.

Some provisions of the act are summarized below.

Capital Gain of S Corporation Not Treated as Passive Investment Income

The act eliminates gains from sales or exchanges of stock or securities from the definition of “passive investment income” for S Corporation purposes.

Prior and current law provide that an S Corporation is subject to corporate level tax at the highest corporate rate on its “excess net passive income” if the corporation has accumulated earnings and profits at the close of the taxable year and has gross receipts, of which more than 25 percent are passive investment income. “Passive investment income” means gross receipts from royalties, rents, dividends, interest, and annuities.

“Excess net passive income” is the “net passive income” for a taxable year multiplied by a fraction, the numerator of which is the amount of passive investment income in excess of 25 percent of gross receipts and the denominator of which is the passive investment income for the year. Net passive income is passive investment income reduced by allowable deductions directly connected to production of the income.

Also under prior and current law, an S election terminates if the S Corporation has accumulated earnings and profits at the close of each of three consecutive taxable years and has gross receipts for each of those years of which more than 25 percent are passive investment income.

Before the amendment made by the act, passive investment income also included sales or exchanges of stock or securities, to the extent of gains.

Treatment of Bank Director Shares

The act provides that “restricted bank director stock” is not taken into account as outstanding stock; i.e., such stock is not treated as a second class of stock, a director is not treated as a shareholder of an S Corporation by reason of the stock, the stock is disregarded in the allocation of items among shareholders, and the stock is not treated as outstanding for purposes of determining if an S Corporation holds 100 percent of the stock of a QSub).

The provision is added in response to agreements between bank directors and banks (whether national or state chartered) requiring a bank or holding company to reacquire a director’s stock if the director ceases to hold the office of director.

The act defines “restricted bank director stock” as stock in a bank or a depository institution holding company that must be held by an individual under federal or state law to permit that individual to serve as a director of the bank or holding company and that is subject to an agreement with the bank or holding company requiring the director to sell the stock back upon ceasing to be a director, at the same price at which the individual acquired the stock.

The act also provides that a distribution (other than a payment in exchange for the stock) with respect to restricted bank director stock is includible in the director’s gross income and is deductible by the S Corporation for the taxable year that includes the last day of the director’s taxable year in which the distribution is included in income.

Effective for taxable years beginning after December 31, 2006; restricted bank director stock is not treated as a second class of stock for taxable years beginning after December 31, 1996.

Special Rule for Bank Required to Change From the Reserve Method of Accounting on Becoming S Corporation

The act allows a bank, which changes from the reserve method of accounting for bad debts for its first taxable year for which it is an S Corporation to elect, to take into account all adjustments under §481 by reason of the change in the last taxable year it was a C Corporation. This is effective for taxable years beginning after December 31, 2006.