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