Six Thoughts on Taxes and Small Business

By :: March 3rd, 2011

This morning I appeared at hearing of the Select Revenue Measures Subcommittee of the House Ways and Means Committee on "Small Businesses and Tax Reform.” My full testimony, “Tax Policy and Small Business,” is available here.

My opening statement:

America’s tax system is needlessly complex, economically harmful, and often unfair. Because of a plethora of temporary tax cuts, it’s increasingly unpredictable. And it fails at its most basic task, raising enough money to pay our government’s bills. For these reasons, the time has come for fundamental tax reform.

Such reform could have far-reaching effects on every participant in the economy, including small businesses. To provide a foundation for thinking about these effects, my testimony discusses basic facts about the relationship between tax policy and small business. I make six main points:

1. Today’s tax code generally favors small businesses over larger ones. Provisions such as Section 179 expensing, graduated corporate tax rates, and special, low capital gains taxes benefit businesses that are small in terms of investment, income, or assets.

2. Many small businesses also benefit from the opportunity to organize as pass-through entities. S corporations, limited liability companies, partnerships, and sole proprietorships all avoid the double taxation that applies to income earned by C corporations.

3. The benefits of organizing as a pass through are not limited to small businesses. Some large businesses adopt these forms as well. Although these large firms account for a tiny share of pass-through entities, they represent a substantial fraction of pass-through economic activity. For example, only 0.3 percent of S corporations had revenues above $50 million in 2005, but they accounted for more than a quarter of S corporation income. The situation is even more extreme with partnerships. Only 0.2 percent had revenues above $50 million, but they accounted for 57 percent of partnership income. Lawmakers should therefore take care not to assume that all pass throughs are small businesses.

4. Small businesses face disproportionately high costs in complying with the tax code; they are also more likely to understate their income and underpay their taxes. High compliance costs thus disadvantage responsible small businesses, while the greater opportunity to evade taxes can advantage less responsible ones.

5. An ideal tax system would collect enough revenue to pay for government services while minimizing distortions to economic activity. To the extent possible, economic fundamentals, not tax considerations, should drive business decisions about organizational structure. By treating pass throughs and C corporations differently, our current tax system deviates from that ideal.

6. In discussing reform proposals, it is important to distinguish between businesses—a broad category that includes pass throughs—and corporations, which generally means C corporations. Many tax reform proposals would reduce business tax preferences and use the resulting revenue to cut corporate income tax rates. Such revenue-neutral reforms could lessen the disparity in tax treatment between pass throughs and C corporations. Pass throughs would see their tax burden increase (since they would lose some tax preferences but not benefit from the rate reduction), while C corporations would, on average, see their taxes decline.

15Comments

  1. Michael Bindner  ::  4:09 pm on March 3rd, 2011:

    There should be one tax reporting system for business, regardless of ownership form or size. VAT and Business Revenue Tax proposals do that quite well. If employees or owners earn outsized profits, a separate personal income surtax is appropriate (so that owners and employees need not share all their income information with their employer or investment entity).

  2. TaxVox » Blog Archive » Six Thoughts on Taxes and Small Business « Double Taxes  ::  7:05 pm on March 3rd, 2011:

    […] this link: TaxVox » Blog Archive » Six Thoughts on Taxes and Small Business Comments […]

  3. Sid F.  ::  8:40 pm on March 3rd, 2011:

    A couple of comments on this post, sorry, some are not very complimentary. Going by numbered issue on the Post:

    1. Yes, the tax code does favor small business in some ways. The idea of Tax Neutrality is an unrealistic ideal. Taxes affect behavior; a neutral tax system is impossible. The case for the tax code favoring small business can be made because small business creates a disproportionate amount of jobs, small business has a disadvantage in competing with large businesses and helping small business imputes a concept of “fairness” to the tax system.

    2. Small business can gain advantages by organizing as pass throughs. As the next comments in the Post points out, so can large companies. The Pass Through concept is not based on size, it is primarily based on number of shareholders for S corporations and private ownership for S’s, LLC’s and Partnerships. As far as the benefits are concerned, Martin Sullivan estimates this at $140 billion (Martin A. Sullivan,Tax Analysts, Passthroughs Shrink the Corporate Tax by $140 Billion, 130 Tax Notes 987 (Feb. 28, 2011): but goes on to say that 2/3rd of this amount is recaptured by the income tax on income passed through to owners. So even if Martin is correct (he provides no documentation to his 2/3rds number) we are talking about at most about $50 billion. Significant, yes, but not going to make a big dent in the deficit. Anyway, is anyone proposing, or is the Congress going to accept a $50 billion tax increase for small business?

    Small closely held C corporations can get around the double taxation issue by paying out profits to shareholders in the form of bonuses and higher salaries. For large publically held corporations the double taxation is part of the progressive nature of the income tax.

    3. It is agreed that Pass throughs are not necessarily small businesses. Tell this to Republicans who use them as a surrogate for small business to criticize tax increases.

    4. The Post seems to make a statement that small businesses have high compliance costs. As a tax consultant I can state this is normally not the case. My CPA firm and tax consulting experience saw the about same charge and difficulty for S Corporations, LLC’s , Partnerships and C Corp tax returns. Exactly what evidence does the Author have to support the statement that small business understates income and underpays taxes? How much income is unreported and how much taxes are unpaid? Unsupported generalizations are not very useful in any discussion.

    5. The bold part of statement five seems unconnected to the rest of the discussion. An ideal tax system would have the government run large deficits in periods of economic recession. Also, other than the double taxation issue, which as noted can be eliminated for small closely held C Corps where the owners are also actively involved in the business, my experience is that tax issues do not drive the organization decision. In many cases legal issues do.

    6. Point six is a very good point, but maybe that would eliminate the differential, if it exists, in point two above.

    If everything else in the tax world were pretty much settled, the Pass Through vs C Corp discussion might be justified, but with all the other issues currently on the table, this is not one that should command much attention.

  4. Steve Roth  ::  9:09 am on March 4th, 2011:

    Perhaps this has been discussed here before, but I’m new to this blog.

    I wonder what the experts here think about the suggestion by Milton Friedman that all corporations should be treated as S corps. No corporate taxes, but shareholders pay taxes on all profits whether distributed or not.

    I can think for several arguments for the proposal, but of course the implications would be complex.

  5. Sid F.  ::  10:14 am on March 4th, 2011:

    The concept of full pass through for all business income is interesting, but in the end probably not the way to go.

    Historically, Corporations have been separately taxed in part because they are a “person” in the eyes of the law, whereas sole proprietorships and partnerships were regarded as extensions of individuals, and hence the logic of the income flowing through to the individual or the partner. The further conveyance of “personhood” on Corporations by Citizens United gives even more support to the fact that they are separate from their shareholders, and since they have some of the rights of “persons” they justifiably pay a tax.

    The concept of the S Corporation was simply to give closely held, presumably small Corporations the option of being taxed as a Partnership. This allowed the organization to obtain the benefits of limited liability that were not present in a Partnership without having to give up the benefits of Partnership taxation. This was, of course before LLC’s and the advent of LP’s.

    The math of having a revenue neutral full pass through is difficult. Stock owned by non-profits would pay no tax on the business income, and the holdings by pension plans, 401(k) plans and other retirement plans would present revenue problems in a revenue neutral proposal. The flow through of tax preference items, like accelerated depreciation and charitable contributions must be dealt with. Finally there is the issue of whether or not dividends could be paid to shareholders to offset the tax liability. Some Corporations may be earnings rich and cash poor, and if the Corporation did not pay dividends but had taxable income this could present a hardship (and a lot of irritation) to some shareholders.

    The basis issue must also be addressed. Pass through entities have outside basis adjustments and some have the ability to make inside basis adjustments. The practical issue of dealing with this with a large multi-national Corporation is huge. Section 338 elections would be interesting to deal with.

    Political considerations may trump economic issues however. In order for a tax system to be accepted by the population it must be perceived as being fair (Notice the choice of words, fairness itself is not a criteria for acceptance, since fairness is subjective and cannot be measured. It is the perception of fairness that is important). Eliminating taxes at the Corporate level would be seen by a majority of the public as a huge tax giveaway to the largest, most powerful and most financially successful of organizations. The public would not understand that the taxes are still being paid, they would see Microsoft and Exxon Mobile and AT&T and others as enjoying all the benefits of personhood without paying any of the costs. Although much demagoguery would result, given Citizens United, that position is not unreasonable.

    If a change is to be made, it should probably be in the direction of making all business income, except Schedule C type, subject to the same tax regime.

  6. ty  ::  10:56 am on March 7th, 2011:

    Pass the FairTax and solve all these issues.

  7. Sid F  ::  1:21 pm on March 7th, 2011:

    If the Fair Tax were really a fair tax then the proponents of the Fair Tax would not have to call it a Fair Tax.

  8. Around The Dial – March 8  ::  3:02 pm on March 8th, 2011:

    […] TaxVox discusses tax policy and small businesses. […]

  9. Business Valuations  ::  5:03 pm on March 11th, 2011:

    The ability of small business to be organized as a pass-through entity is enormously beneficial to owners. This is offset, though not fully, by the inability of small business to fully capture tax advantage available to businesses with more to spend on tax advisory preparation services. Great article. Thanks.

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    The bitch wasn’t worth it.

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  15. Thomas Rodgers  ::  1:07 am on November 26th, 2013:

    I find the outlook of the government entity quite consistent. Washington DC income averages led the nation through the recession. I find the treatment of entities with a 9 digit tax number disparate and unequal, be they social security numbers or entity numbers. I find the presumed and unfortunately enforced government ownership of private property and income streams to have grown far too much from the time of income tax inception in 1913. Is not 1% in 1913 to the 30% my average employee pays a growth of 3000%? I find the fiduciary responsibility of the treasury to be to the government which has post WWII behavioural patterns of a defense state not a civil entity. I understand that the only defense against this emerging form of government is to avoid the FDIC banking system. I appreciate that commodity infrastruture ownership of assets as collateral by the banking system is just the lower level of a treasury supported and therefore influenced mechanism of supply. I appreciate the parallels of company script being used to pay workers and what it couldnt buy at a company store and the deflationary processes in use with the dollar . I see posters who dont realize the taxes and fees paid on imports before they arrive through US customs and how that income stream is much preferred by government compared to domestic production. What amuses me is a government worker being told they have paid taxes when their employer simply puts the money back in his treasury resulting in no effective transfer of funds. Its worrysome that the generation currently making governing decisions is so oblivious to the view so many hold of their poor husbandry and complete inability they have to hold an asset in reserve.