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

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.