State and Local Tax Surprises for Your Small Business

This article is a reprint of Wise Bread's contribution to OPEN Forum from American Express -- where small business owners can get advice from experts and share tips with each other.

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Griping by business owners about federal income taxes on their hard-earned profits is common, and often appropriate. However, there may be even greater reasons for complaining about state and/or local taxes. Where your business is located can make a big difference in the amount of state and local taxes you pay.

Depreciation Rules

Usually, the cost of business equipment and machinery is depreciated over a number of years. However, for federal income taxes, there are two important tax breaks that apply for 2011 to accelerate write offs for the year in which the equipment is bought:

• A “Section 179 deduction” of up to $500,000: This deduction, also called “first-year expensing,” applies to both new and pre-owned items, such as computers, office furniture, and other equipment. It can only benefit profitable businesses.
• 100% bonus depreciation: The full cost of new items can be deducted in the year of purchase instead of spreading depreciation write-offs over a number of years. There is no dollar limit to this deduction. The deduction can be used to create or increase a net operating loss for businesses that are marginal or in the red.

These tax breaks do not necessarily apply on the state level. In seven states — Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming — there is no reason for concern because they have no income tax. New Hampshire and Tennessee tax only interest and dividends. Of the other states, some follow federal rules while others have “decoupled” their tax rules from federal law and apply their own rules when it comes to depreciation.

Not every state follows the federal rule allowing first-year expensing. Hawaii, Pennsylvania, and Wisconsin, for example, do not. California limits expensing to $25,000 (compared with the $500,000 federal limit).

New York does not allow bonus depreciation except for resurgence zone property and New York liberty zone property, which are specially-designated areas within the state. New York is not alone. Many other states (called “nonconforming states”), including California, Massachusetts, and New Jersey, do not allow bonus depreciation.

Other states have certain refinements for bonus depreciation. For example, in Connecticut, sole proprietors can use bonus depreciation but corporations cannot.

Capital Gains

For federal income taxes, capital gains are usually taxed at 15% (those in the 10% or 15% tax bracket pay no federal income tax on their gains). This rule is set to apply through 2012.

What’s more, those who acquire “qualified small business stock” after September 27, 2010, and before January 1, 2011, and hold it more than five years, will pay no federal income tax on their gain, regardless of their tax bracket at the time of sale. Qualified small business stock is stock in a C corporation engaged in technology, manufacturing, or certain other endeavors.

On the state level, however, these favorable capital gains rules do not necessarily apply. In California, for example, capital gains are taxed as if they were ordinary income. There is no preferential treatment given to capital gains; 22 other states apply the same treatment. However, there are some variations. In Minnesota, capital gains from most investments are taxed as ordinary income, but the state uses the favorable federal rule for gain on qualified small business stock.

Special Taxes

Some jurisdictions have special or unique taxes that do not apply at the federal level. For example, in the New York City metropolitan area, there is a Metropolitan Commuter Transportation Mobility Tax, referred to as the MTA tax, imposed on self-employed individuals and company payrolls. The tax rate is 0.34% of an individual’s net earnings from self-employment allocated to the Metropolitan Commuter Transportation District (the five counties in New York City and seven surrounding counties).

Bottom Line

While there is a level playing field under federal tax rules for businesses across the country, state and local tax rules can significantly alter your after-tax profits depending on where you are located. Learn more about your state taxes and how they stack up against other states from the Tax Foundation.

As always, the best course is to work closely with a tax professional who is knowledgeable about tax rules in your location. This will enable you to comply with tax filing and payment rules and avoid penalties and interest.