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CRS Reports on Federal Tax Benefits for Small Businesses

FEB. 1, 2001

RL30827

DATED FEB. 1, 2001
DOCUMENT ATTRIBUTES
Citations: RL30827

                       CRS REPORT FOR CONGRESS

 

 

                          February 1, 2001

 

 

                            Gary Guenther

 

              Analyst in Business Taxation and Finance

 

                       Government and Finance

 

 

             FEDERAL TAX BENEFITS FOR SMALL BUSINESSES:

 

                          A BRIEF OVERVIEW

 

 

SUMMARY

 

 

[1] Business income is subject to federal taxation, but in the eyes of the federal tax code, not all business income is treated equally. One of the dimensions in which the tax treatment of business income can differ is firm size. In a variety of ways, small businesses or firms receive tax benefits that are unavailable or are of lesser value to larger firms.

[2] Before identifying the principal ways in which the federal tax code bestows benefits on nonfarm small firms, it is important to understand how the code defines a small firm. This question is more complicated than it may appear because there is no consensus on what constitutes a small firm. Typically, a small firm is defined as a firm whose employment, output, or assets falls below a certain level. Regardless of which approach is taken, the distinction between small and large firms is unavoidably arbitrary. The federal tax code lacks consistency in how it extends preferential treatment to small firms. Sometimes it specifies that firms under a certain asset or receipt size are eligible for certain benefits, and in other instances the nature of the provision itself effectively limits the main beneficiaries to small firms.

[3] There are not separate federal tax codes for small and large firms. Rather, the current code contains a variety of provisions that treat small firms more favorably than large firms, and vice versa. For small firms, these provisions encompass deductions, exclusions, exemptions, credits, deferrals, and preferential tax rates. Also, some provisions aid small firms by alleviating the administrative burden of complying with federal income tax laws and regulations. A common thread running through most of the provisions is a reduction in a small firm's income tax liability relative to that of a large firm in the same line of business.

[4] The following small business tax benefits have broad impacts among sectors outside agriculture:

     o favorable tax treatment accorded passthrough entities such as

 

       sole proprietorships, partnerships, and subchapter S

 

       corporations, most of which are small in asset or employment

 

       size;

 

 

     o lower marginal tax rates for firms with relatively small

 

       profits;

 

 

     o an expensing allowance for small business investment in

 

       equipment;

 

 

     o the exemption of small corporations from the corporate

 

       alternative minimum tax;

 

 

     o the use of cash basis accounting by small firms; and

 

 

     o the 50% exclusion of gains on sales or exchanges of certain

 

       small business stock.

 

 

CONTENTS

 

 

How Small is Small Under the Federal Tax Code?

 

 

Principal Small Business Tax Benefits

 

 

Passthrough Entities: Sole Proprietorships, Partnerships, Limited

 

  Liability Companies, and Subchapter S Corporations

 

 

Graduated Corporate Income Tax Rates

 

 

Expensing Allowance for Certain Depreciable Business Assets

 

 

Exemption of Small Business Corporations from the Corporate

 

  Alternative Minimum Tax

 

 

Cash Basis Accounting

 

 

Tax Incentives for Private Investment in Small Firms

 

 

     Exclusion of Gains on Certain Small Business Stock

 

 

     Losses on Small Business Investment Company Stock Treated as

 

       Ordinary Losses

 

 

     Rollover of Gains into Specialized Small Business Investment

 

       Companies

 

 

     Losses on Small Business Stock Treated as Ordinary Losses

 

 

Uniform Capitalization of Inventory Costs

 

 

Simplified Dollar-Value LIFO Accounting Method for Small Firms

 

 

             FEDERAL TAX BENEFITS FOR SMALL BUSINESSES:

 

                          A BRIEF OVERVIEW

 

 

[5] Business income is subject to federal taxation. But in the eyes of the federal tax code, not all business income is treated equally. Its tax treatment can differ along numerous dimensions. For example, the tax treatment of business income depends in part on whether or not a firm is organized as a corporation. Corporate net income is taxed twice whereas the net income of a partnership or sole proprietorship is taxed once; or corporations that pay the alternative minimum tax may be taxed at a lower marginal rate than corporations that pay the regular corporate income tax; or the returns to corporate investments financed by debt are taxed at lower effective marginal rates than the returns to corporate investments financed by equity. 1

[6] The tax treatment of business income can also differ by firm size. Various federal income tax provisions bestow benefits on small businesses or firms that are unavailable or that are of lesser value to large firms. Some are explicitly targeted at small firms, and others are designed so that their main beneficiaries tend to be small firms. The preferential tax treatment directed at small firms underscores the considerable popularity and political influence of small business in the United States. While this influence has multiple roots, some of it stems from the view that small firms deserve such treatment because they generate most new jobs and are more innovative than and provide needed competition for large, established firms. Though it appears that many hold this view, some question its validity. 2

[7] In the interest of providing useful background information on federal support of small business, this report discusses how small business is defined in the tax code, identifies the principal ways in which the tax code subsidizes nonfarm small firms, and explains how these provisions might benefit small firms more than large firms in the same line of business. 3 It does not examine the economic arguments for and against such preferential treatment, nor does it consider legislative proposals to alter the tax treatment of small business.

HOW SMALL IS SMALL UNDER THE FEDERAL TAX CODE?

[8] Before examining the ways in which the federal income tax code favors small firms, it is important to understand how a small firm is defined. This question is somewhat complicated because there appears to be no consensus within the federal government on what constitutes a small firm. 4 Instead, federal agencies use a variety of methods to classify firms by size, and which method is used seems to depend on the purpose being served, such as economic or policy analysis, taxation, or data collection to support policy objectives. 5 One method is to define small firms in terms of some measure of output, such as sales revenue, value of shipments, or net income. Under this method, a firm is considered small if its production or revenue is below a certain level; for example, the U.S. Small Business Administration (SBA) uses business revenue to identify small firms in a range of industries in order to determine eligibility for SBA programs and certain other federal programs that assist small business. 6 A second method is to identify small firms on the basis of number of employees; this measure is often used by the SBA's Office of Advocacy and other federal agencies to collect data on and analyze trends in the small business sector. 7 And a third approach is to measure firm size on the basis of the value of accumulated assets and draw the line between small firms and all others at some arbitrarily chosen level: for example, small firms are all firms with less than $25 million in assets.

[9] How does the federal tax code define a small firm? Perhaps the best way to summarize its approach is to say that it is inconsistent. While the code comprises a multitude of provisions, relatively few confer benefits on small firms. Of these, some do not target small firms per se, but the nature of the provisions effectively limits potential beneficiaries to small firms. Other provisions restrict benefits to firms with gross receipts (which is a measure of output) below a certain level. And still other provisions apply only to firms below a certain asset size. In none of the small business tax preferences discussed in this report does the tax code use employment size as a basis for distinguishing small firms from large firms.

PRINCIPAL SMALL BUSINESS TAX BENEFITS

[10] There are no separate federal tax codes for small and large firms. Rather, the current code contains a variety of provisions that treat small firms more favorably than large firms. For the most part, these provisions encompass tax deductions, tax exclusions and exemptions, tax credits, tax deferrals, and preferential tax rates. 8 In addition, some provisions aid small firms by alleviating the administrative burden of complying with federal income tax laws and regulations. The common thread running through most of them is a reduction in a small firm's income tax liability relative to that of a large firm in the same line of business. Deductions, exclusions, and exemptions lower a firm's taxable income and thus its maximum tax liability; the degree of reduction depends, of course, on a taxpayer's marginal tax rate. Credits shrink a firm's tax liability by the amount of the credits, assuming that the firm's tax liability exceeds the value of its credits. Deferrals postpone the recognition of income for tax purposes or accelerate the deduction of business expenses; they are analogous to the federal government making an interest-free loan without collateral to a taxpayer. And preferential tax rates apply reduced marginal tax rates to part or all of a firm's taxable income.

[11] A description of the small business tax benefits with the broadest and greatest impact among sectors outside agriculture and an explanation of how they assist small firms follow: 9

Passthrough Entities: Sole Proprietorships, Partnerships, Limited Liability Companies, and Subchapter S Corporations

[12] A business enterprise has the choice of operating in a number of organizational forms. The business laws of each state determine the range of available choices. For tax purposes, the predominant forms are corporations (also known as subchapter C corporations), sole proprietorships, partnerships, limited liability companies (which are a hybrid of a corporation and a partnership), and subchapter S corporations (which also combine elements of both.)

[13] The choice of legal form has important implications for a firm's tax treatment. Corporate profits generally are taxed at two levels: once at the corporate level under the corporate income tax, and again at the personal level under the individual income tax when the earnings are distributed to shareholders as dividends or realized capital gains. By contrast, the profits earned by sole proprietorships, partnerships, limited liability companies, and S corporations generally are taxed only once: at the personal level of their owners under the individual income tax. There is no separate business-level tax on the earnings of these types of business organizations. Instead, the profits, losses, and items of income, deduction, and credit "pass through" or are attributed to their owners according to their shares of ownership -- regardless of whether the profits are distributed to them.

[14] In principle, there is no limit on how large each type of business entity can become, but in practice, passthrough firms tend to be small. In 1997, for example, the average non-farm sole proprietorship, partnership, and subchapter S corporation reported business receipts of $52,774, $634,424, and $1,183,593, respectively; by contrast, the average corporation (excluding S corporations, real estate investment trusts, and regulated investment companies) reported business receipts of $5,281,957. 10 This link between organizational form and firm size is not accidental; rather, it reflects the fact that the main characteristics of each type of passthrough entity tend to limit its size.

[15] Sole proprietorships are owned and controlled by a single individual. As a result, the owners are personally liable for business debts and claims against the business. They are required to report their business income and expenses, along with items of loss, deduction and credit, on their individual tax returns (Schedule C of form 1040.)

[16] Partnerships are syndicates, associations, joint ventures, or other unincorporated organizations with at least two members whose main purpose is to earn a profit. They generally fall into two categories: general partnerships and limited partnerships. General partners have the right to manage the firm and share in its profits, and they are personally liable for all the firm's debts and any claims against it. Limited partners, in contrast, typically do not participate in management and are not personally liable for the firm's debts and claims against it. Under the federal tax code, partnerships of all stripes are treated as passthrough entities, which means that they do not pay federal income taxes -- although partnerships are required to file an annual federal tax return (form 1065). Whatever income they earn is taxed to partners at their individual tax rates, whether it is distributed or not. The partners include their respective shares of partnership income, deductions, losses and other tax items when computing their individual tax liabilities, though a partner's share of losses that can be deducted is limited to his or her basis in the partnership interest.

[17] Limited liability companies (LLCs) are a popular type of passthrough entity that is a creation of state tax laws. They were first authorized in Wyoming in 1977, and now are legally recognized in all 50 states. 11 LLCs represent a hybrid of a partnership and a corporation in that they can be taxed as a partnership at the federal level, but their owners or members, like corporate shareholders, enjoy limited liability for the firm's debts and claims against it at the state level even if they are involved in management. As a result, a LLC's items of income and loss receive the same tax treatment as those of a partnership: they pass through to the members who include them in their individual tax returns.

[18] Subchapter S corporations also combine some of the defining traits of a corporation and a partnership. On the one hand, they are closely held firms whose income is not taxed at the corporate level but is passed through to shareholders who are taxed on it at their individual tax rates. More specifically, the S corporation's income, losses, deductions, and credits pass through to its shareholders, but the content of those items is determined at the business level. On the other hand, S corporations are organized as small business corporations, which entitles their shareholders to many of the rights held by corporate shareholders, including limited liability for a firm's debts and claims against it. To qualify as an S corporation, a firm must satisfy certain requirements, most notably that it can have no more than 75 shareholders, can issue only one class of stock, and cannot have partnerships or corporations as shareholders.

[19] Tax considerations affect the choice of business entity mainly through their impact on returns to business investments. As noted earlier, corporate profits are subject to two levels of taxation, whereas the profits of passthrough entities are taxed only once. Whether the owners of a business can earn greater after-tax returns on investment operating as a corporation or as a passthrough entity depends on a variety of factors. Five tax-related factors are thought to be important: (1) individual income tax rates, (2) corporate tax rates, (3) individual tax rates on dividends and capital gains, (4) deferral periods for the payment of dividends and the realization of capital gains on the sale of corporate stock, and (5) the length of investment horizons. 12 For example, if the maximum corporate tax rate greatly exceeds the maximum individual tax rate and all profits are distributed to owners with no deferral, then the owners of a business would probably be better off operating as a partnership or some other kind of passthrough entity. But if the maximum corporate tax rate is much lower than the maximum personal tax rate and all profits are retained, then operating as a corporation would probably generate higher after-tax returns. The current mix of relevant federal tax rates seems to favor passthrough entities by a slight margin. 13

[20] These considerations suggest that the federal tax code's rules relating to business entities currently favor small firms to the extent that small firms prefer to operate as passthrough entities and large firms as corporations. Nonetheless, it would be erroneous to infer that the tax treatment of passthrough entities in and of itself constitutes a tax benefit for small firms because large firms have the option of operating as S corporations or limited liability companies.

Graduated Corporate Income Tax Rates

[21] Under current tax law, corporations with less than $10 million in taxable income are subject to graduated income tax rates. The marginal tax rate is 15% on the first $50,000 in income, 25% on the next $25,000, and 34% on income between $75,000 and $100,000. A rate of 39% is applied to taxable income between $100,000 and $335,000, mainly to offset the benefit of the 15% and 25% rates for firms with large taxable profits. Taxable incomes between $335,000 and $10 million are taxed at a rate of 34%; a rate of 35% is levied on taxable incomes between $10 and $15 million; and a rate of 38% is applied to profits of $15 million to $18,333,333. Once again, the 38% rate is intended to offset the benefits of the lower brackets for firms with large profits. Corporations with more than $18,333,333 in taxable income are taxed at a flat rate of 35%. Most corporate profits are taxed at marginal rates of 34% or 35%. 14

[22] Corporations that are small in employment or asset size typically have small incomes and thus tend to benefit more than large corporations from the reduced rates available under this rate structure. 15 But not all small corporations are permitted to benefit from the reduced rates. Specifically, the graduated rate structure does not apply to personal service corporations, which are defined as firms that provide services in the fields of health care, law, engineering, architecture, accounting, actuarial science, the performing arts, and consulting; their taxable income is taxed at a flat rate of 35%. The reduced rates on corporate profits under $10 million encourage small business owners to operate as corporations, other things being equal.

Expensing Allowance for Certain Depreciable Business Assets

[23] Another federal tax provision that tends to confer special benefits on small firms is the expensing allowance for the purchase of certain depreciable business assets. Expensing involves treating a cost as an ordinary and necessary (and hence deductible) business expense rather than as a capital expenditure whose cost must be deducted over a longer period that ideally reflects an asset's useful life.

[24] Under section 179 of the Internal Revenue Code (IRC), firms may expense up to $20,000 of the cost of qualified business property and depreciate the remainder (if any) according to current capital cost recovery rules; this amount is scheduled to rise in increments to $25,000 in 2003 and thereafter. Qualified business property is defined as depreciable assets bought for use in a trade or business, excluding structures and air conditioning and heating equipment. The expensing allowance must be claimed in the year in which eligible property is put into service. It is phased out (ultimately to zero), dollar for dollar, once spending on qualified property surpasses $200,000; and it may not exceed a firm's taxable income from the trade or business in which the property is used. Section 179 first entered the federal tax code in 1959 as a tax deduction equal to 20% of a firm's first $10,000 in capital investment.

[25] The expensing allowance is a small business tax subsidy for investment in equipment because it has the effect of exempting from taxation the returns on investments in qualified property or lowering the required rate of return for investment in qualified property. 16 This subsidy mainly benefits small firms because of the phase-out rule: firms that spend more than $220,000 on qualified property cannot claim it, leaving them with the alternative of writing off those expenses over longer periods, as specified in current depreciation schedules.

Exemption of Small Business Corporations from the Corporate Alternative Minimum Tax

[26] Under current federal tax law, corporations must compute their liability under the regular income tax and their liability under the alternative minimum tax (AMT) and pay whichever is greater. The AMT is the excess of the latter over the former. Each tax has its own rates, allowable deductions, and rules for the measurement of income. In general, the AMT applies a lower marginal tax rate to a broader tax base. It broadens the tax base for the regular tax by including a number of regular tax preferences in taxable income. In addition, most business tax credits allowed under the regular corporate income tax (including the research and experimentation tax credit) cannot be used to reduce AMT tax liability. 17 The rate for the AMT is a flat 20%, whereas the regular corporate income tax has a graduated rate structure whose top marginal rate is 35%. The current AMT originated with the Tax Reform Act of 1986 and is intended to ensure that all profitable corporations pay some federal income tax.

[27] As a result of the Taxpayer Relief Act of 1997, small corporations have been exempt from the AMT since 1998. Nonetheless, there is some evidence that many small firms have been unaware that they are eligible for the exemption. 18 Initially, a small corporation was defined as a corporation that had average annual gross receipts of $5 million or less in the tax years 1994 to 1996 and $7.5 million or less in the tax years 1995 to 1997. Once a firm is recognized as a small corporation, it will remain exempt from the AMT as long as its average annual gross receipts for the three previous tax years do not exceed $7.5 million. Corporations formed since 1998 are exempt from the AMT in their first tax year and will remain exempt as long as their average annual gross receipts do not exceed $5 million during their first three-year tax period ending in the year before the exemption is claimed (e.g., 1998-2000 for the 2001 tax year,) and as long as their average annual gross receipts do not exceed $7.5 million in each succeeding three-year period (e.g., 1999-2001, 2000-2002, etc.). If a corporation loses its recognition as a small corporation, it becomes subject to the AMT in the first tax year in which it is disqualified and in every tax year thereafter. When this happens, a small corporation's allowable AMT credit is limited to the amount by which its regular tax liability (less other credits) in the current tax year exceeds 25% of the amount (if any) by which its regular tax liability (less other credits) exceeds $25,000.

[28] The exemption of small corporations from the AMT may or may not give them a competitive advantage over larger firms that pay the tax. This uncertainty stems largely from the uncertain impact of the AMT on a firm's incentive to invest. There is some evidence that firms temporarily subject to the AMT generally face lower investment incentives than firms permanently subject to the regular tax. But the size of the incentive gap depends on the type of asset a firm acquires, how long a firm is subject to the AMT, and how the firm finances the investment. Economist Andrew Lyon has estimated that investment in equipment and intangible assets like research and development is more adversely affected by the AMT than investment in other assets, that investment financed by debt is more adversely affected by the AMT than equity-financed investment, and that firms subject to the AMT for periods of five or more years have a higher cost of capital than firms subject to the AMT for shorter periods. 19

[29] In addition, the exemption offers small business owners another incentive to operate their firms as corporations since sole proprietors, partners, and subchapter S corporation shareholders are subject to an individual alternative minimum tax as well as the regular income tax. 20

Cash Basis Accounting

[30] Another tax benefit tied to firm size is the use of cash basis accounting rather than accrual basis accounting. A firm's taxable income must be determined in a way that meshes with its method of accounting for income and expenses. Two different accounting methods are widely used: the cash basis and the accrual basis. Under cash basis accounting, which is used by most individuals, income generally is recorded when it is received in the form of cash or its equivalent or other property, and expenses are recorded when cash is paid, regardless of when the income is earned or the expenses incurred. Under accrual basis accounting, in contrast, income and expenses generally are recorded when the transactions that created them are complete or nearly complete, regardless of when cash or its equivalent is received or paid. Each method has its advantages: the accrual method does a better job of matching expenses with income in a particular period and leads to a more accurate measurement of economic income, but the cash method is simpler to administer and thus less costly to use.

[31] Current federal tax law is quite specific about which firms may use the cash method and which must use the accrual method. In general, firms that are required to maintain inventories, subchapter C corporations with average annual gross receipts greater than $5 million in the three previous tax years, partnerships with C corporations as partners, trusts that earn unrelated business income, and authorized tax shelters must use the accrual method. 21 All other firms, including S corporations, personal service corporations, firms engaged in farming (except for certain farming corporations which must use the accrual method) or tree-raising, partnerships, and C corporations whose average annual gross receipts total $5 million or less in the three previous tax years, may use the cash method. In addition, the IRS recently ruled (Revenue Procedure 2001-10) that firms with average annual gross receipts of $1 million or less in the three previous tax years may use the cash method even if they are required to maintain inventories and have used the accrual method in the past three tax years. 22 These rules suggest that many of the firms permitted to use the cash method are likely to be small by any of the criteria used to classify firms by size.

[32] Cash basis accounting has the potential to create a small business tax benefit similar to that provided by the expensing allowance: deferral of income tax liability. In theory, a firm receives income when it is earned, which is to say when the legal obligation to be paid -- and pay whatever taxes are due on that amount -- is first established. Under the cash method of accounting, however, firms may delay the recognition of income until cash payments are received, deferring the payment of tax on that income.

[33] While the tax code effectively limits the use of cash basis accounting to small firms, it is not practical or advisable for all small firms to use it. This is because that method is regarded as inappropriate for the preparation of income statements and balance sheets used in external financial reports. 23 Cash basis accounting can distort a firm's financial position in at least two ways. First, it records only transactions involving cash, thereby ignoring transactions involving assets or liabilities. Second, the determination of net income under cash basis accounting, which is the difference between cash receipts and cash disbursements, can be manipulated by recording revenues or expenses long before or after goods and services are produced and sold.

Tax Incentives for Private Investment in Small Firms

[34] The federal tax code also contains a few provisions intended to encourage the flow of financial capital into small firms that might otherwise have great difficulty raising funds for current operations and investment. They do this largely by increasing the potential after-tax returns or reducing the potential after-tax losses on these investments. The same tax benefits are not available to individuals who purchase the stock of large established firms.

[35] EXCLUSION OF GAINS ON CERTAIN SMALL BUSINESS STOCK. In general, net gains from the sale or exchange of stock held for longer than one year are taxed at a maximum rate of 20% (10% for individuals in the 15% tax bracket). In addition, as of January 1, 2001, a special lower rate of 18% (8% for individuals in the 15% tax bracket) applies to sales or exchanges of stock held for more than five years, with slightly different holding periods for investors in the 15% tax bracket and those in higher tax brackets.

[36] However, under IRC section 1202, which was established by the Omnibus Budget Reconciliation Act of 1993, the maximum long-term capital gains tax rate applied to sales and exchanges of certain small business stock is effectively 14%. This is because 50% of the gain is excluded from taxation, provided certain conditions are met, and the remaining gain is taxed at a maximum rate of 28%. For individuals subject to the alternative minimum tax (AMT), 42% of the excluded amount is treated as an individual AMT preference item. The stock must be held more than five years, must have been issued after August 10, 1993 by a C corporation with gross assets valued at no more than $50 million when the stock was issued, and must have been acquired by individual taxpayers at its original issue in exchange for money or property, or as compensation for services provided to the corporation. In addition, the gain eligible for the exclusion is limited to the greater of $10 million or 10 times the taxpayer's cost of acquiring the stock (or his or her basis in the stock). Qualified corporations must employ at least 80% of their assets in the active conduct of a trade or business other than health care, law, engineering, architecture, farming, banking, finance, insurance, mineral extraction, lodging, and food service, a requirement known as the active-business test.

[37] Furthermore, individuals who sell qualified small business stock after August 5, 1997 may roll over any capital gain without payment of tax under certain conditions. The key conditions are that the stock must be held more than six months, and that the sellers must purchase other qualified small business stock within 60 days of the sale. Other conditions are that the replacement stock must meet the active-business test for six months following the purchase, that the holding period of the replacement stock includes the holding period of the sold stock, and that the gain is recognized only if the amount realized on the sale exceeds the cost of the replacement stock.

[38] LOSSES ON SMALL BUSINESS INVESTMENT COMPANY STOCK TREATED AS ORDINARY LOSSES. Generally, losses on stock investments are treated as capital losses. These losses may be used to offset any capital gains in the same tax year, but individuals may use capital losses to offset no more than $3,000 of ordinary income in any tax year.

[39] Under IRC section 1242, however, individuals who invest in small business investment companies (SBICs) licensed to operate under the Small Business Investment Act of 1958 are permitted to deduct from ordinary income any losses from the sale or exchange or worthlessness of stock in these companies. SBICs are regulated private investment firms that provide equity capital, long-term loans, and managerial advice to firms with less than $18 million in assets and less than $6 million in net income. In fiscal year 2000, SBICs provided $5.4 billion in financing, up 33% from the previous fiscal year. 24

[40] ROLLOVER OF GAINS INTO SPECIALIZED SMALL BUSINESS INVESTMENT COMPANIES. In general, gains or losses on the sale or exchange of stocks are recognized for tax purposes in the year when they are realized.

[41] But under IRC section 1044, which was adopted as part of the Omnibus Budget Reconciliation Act of 1993, individuals and corporations who satisfy certain conditions are allowed to roll over without payment of tax any capital gains on the sale of publicly traded securities. The proceeds from the sale must be used to purchase common stock or partnership interests in specialized small business investment companies (SSBICs) licensed under the Small Business Investment Act of 1958 within 60 days of the sale. SSBICs are similar to SBICs except that SSBICs are required to invest in small firms owned by individuals who are considered socially or economically disadvantaged -- mainly members of minority groups. If the proceeds from the sale exceed the cost of the SSBIC stock or partnership interest, the excess is recognized as a capital gain and taxed accordingly. The taxpayer's basis in the SSBIC stock or partnership interest is reduced by the amount of any gain from the sale of securities that is rolled over. The maximum gain that an individual can roll over in a single tax year is the lesser of $50,000 or $500,000 reduced by gains previously rolled over under this provision. For corporations, the maximum deferral is $250,000 or $1 million reduced by previously deferred gains.

[42] LOSSES ON SMALL BUSINESS STOCK TREATED AS ORDINARY LOSSES. IRC section 1244 permits individuals to deduct any loss from the sale or exchange or worthlessness of stock issued by a small business corporation as an ordinary rather than a capital loss. A firm must satisfy two requirements in order to qualify as a small business corporation: (1) the total amount of money and property received by the firm as a contribution to capital and paid-in surplus cannot exceed $1 million when the stock is issued, and (2) during the five most recent tax years before the loss on the stock is realized, the firm must have derived more than 50% of its gross receipts from sources other than royalties, rents, dividends, interest, annuities, and stock or security transactions. The maximum amount that can be deducted as an ordinary loss in a tax year is $50,000 ($100,000 for a couple filing jointly.)

Uniform Capitalization of Inventory Costs

[43] Firms that earn income from the production, purchase, or sale of merchandise are required to maintain inventories as a step in determining the cost of goods sold during a tax year. This cost is subtracted from gross receipts in the computation of taxable income. The cost of goods sold generally is determined by adding the value of a firm's inventory at the beginning of the year to purchases of inventory items made during the year and subtracting from that sum the value of the firm's inventory at the end of the year.

[44] IRC section 263A requires taxpayers engaged in the production of real or tangible property or in the purchase of real or tangible and intangible property for resale to "capitalize" or include in the estimated value of their inventories both the direct costs of the property and the indirect costs that can be allocated to it. This requirement is known as the uniform capitalization rule; it was added to the tax code by the Tax Reform Act of 1986. In general, direct costs are the material and labor costs associated with the production or acquisition of goods, and indirect costs are all other costs associated with the production or acquisition of goods (e.g., repair and maintenance of equipment and facilities, utilities, insurance, rental of equipment, land, or facilities, and certain administrative costs). Taxpayers have some discretion in allocating indirect costs to production or resale activities, provided the methods used lead to reasonable results for their trade or business.

[45] Some small firms are exempt from the uniform capitalization rule. Specifically, it does not apply to tangible or intangible property acquired for resale by a taxpayer with average annual gross receipts of $10 million or less in the previous three tax years. This exemption is advantageous in that eligible firms face lower administrative costs and less complexity in complying with income tax laws and have more control over the timing of business expense deductions, creating opportunities for the deferral of income tax liabilities. 25

Simplified Dollar-Value LIFO Accounting Method for Small Firms

[46] Taxpayers that are required to maintain inventories in order to determine the cost of goods sold in a tax year must measure the value of their inventories at the beginning and end of each tax year. Because it is difficult and costly to do this on an item-by- item basis, many taxpayers use methods that assume certain item or cost flows. One such method is known as "last-in-first-out" or LIFO, which assumes that the most recently acquired goods are sold first. LIFO allocates the newest unit costs to the cost of goods sold and the oldest unit costs to the ending inventory. It can be advantageous to use when the unit costs of many inventory items are rising because LIFO produces a lower taxable income and lower inventory valuation than other methods. There are various ways to apply LIFO. A widely used application is known as the dollar-value method. Under the dollar-value LIFO method, a taxpayer accounts for its inventories on the basis of a pool of dollars rather than item by item. Each pool of dollars includes the value of a number of different inventory items and is measured in terms of the equivalent dollar value of the inventory items at the time they were first added to the inventory account, or the base year. Using the dollar-value method is complicated and costly for most taxpayers. 26

[47] Under IRC section 474, which was established by the Tax Reform Act of 1986, some small firms are permitted to use a simplified dollar-value LIFO method. It differs from the regular dollar-value method in the manner in which inventory items are pooled and the technique for estimating the base-year value of the pools. A firm is eligible to use the simplified method if its average annual gross receipts were $5 million or less in the three previous tax years

 

FOOTNOTES

 

 

1 See Jane G. Gravelle, The Economic Effects of Taxing Capital Income (Cambridge, MA: MIT Press, 1994), Table 3.4, p. 59.

2 Douglas Holtz-Eakin, "Should Small Business Be Tax- Favored?", National Tax Journal, vol. 48, Sept. 1995, p. 387.

3 This report revises and updates an earlier CRS report on small business tax benefits. See U.S. Library of Congress, Congressional Research Service, Federal Taxation of Small Business: A Brief Summary, by David L. Brumbaugh, CRS Report 94-328 E (Washington: April 14, 1994).

4 Organization for Economic Cooperation and Development, Taxation and Small Business (Paris: 1994), pp. 23-24.

5 U.S. Library of Congress, Congressional Research Service, Small Business: Definitions and Demographics, by Bruce K. Mulock, CRS Report 94-327 E (Washington: April 7, 1994), pp. 1-4.

6 See U.S. Small Business Administration, "Frequently Asked Questions about NAICS and Small Business Size Standards," [http://www.sba.gov/size/NAICS-cover-page.htinl], visited Dec. 5, 2000.

7 For example, a 1998 report by the Office of Advocacy at the U.S. Small Business Administration defined small firms as those with fewer than 500 employees. See U.S. Small Business Administration, Office of Advocacy, Small Business Growth by Major Industry, 1988- 1995 (Washington: 1998). The full text of the report is available at [http://www.sba.gov/ADVO].

8 For more details on each type of tax benefit, see U.S. Congress, Senate Committee on the Budget, Tax Expenditures: Compendium of Background Material on Individual Provisions, committee print, 105th Cong., 2d sess. (Washington, GPO, 1998), pp. 566-568.

9 This means that the report does not discuss tax provisions that benefit small firms in specific industries. Some examples are the small ethanol producer tax credit under Internal Revenue Code (IRC) section 40, the special deduction for small life insurance companies under IRC section 805, and the reserve method of accounting for bad debts available to small banks under IRC section 585.

10 The contrast is even more striking when the basis of comparison shifts to assets. In 1997, the average partnership and S corporation claimed assets of $81,924 and $544,780, respectively; by contrast, the average corporation (excluding S corporations, real estate investment trusts, and regulated investment companies) reported assets of $11,732,724. Comparable data on non-farm sole proprietorships are not available. See, Alan Zempel, "Partnership Returns, 1997," U.S. Internal Revenue Service, Statistics of Income Bulletin, vol. 19, no. 2 (Washington: 1999), pp. 46-102; Susan Wittman, "S Corporation Returns, 1997," U.S. Internal Revenue Service, Statistics of Income Bulletin, vol. 19, no. 4 (Washington: 2000), pp. 42-80; George Contos and Ellen Legel, "Corporation Income Tax Returns, 1997," U.S. Internal Revenue Service, Statistics of Income Bulletin, vol. 20, no. 1 (Washington: 2000), pp. 101-121; and Michael Parist and Therese Cruciano, "Sole Proprietorship Returns, 1998," U.S. Internal Revenue Service, Statistics of Income Bulletin, vol. 20, no. 1 (Washington: 2000), pp. 8-100.

11 See Kathryn A. Pischak, "State Tax Issues Complicate the Decision to Do Business as a Limited Liability Company," Journal of Taxation, August 1995, pp.76-80.

12 Myron S. Scholes and Mark A. Wolfson, Taxes and Business Strategy: A Planning Approach (Englewood Cliffs, NJ: Prentice Hall, 1992), p. 59.

13 Under current federal tax law, the highest personal tax rate is 39.6%, most corporate profits are taxed at a rate of 35%, and the maximum long-term capital gains tax rate is 20%. If the investment horizon is one year (meaning that investors sell their ownership shares after one year,) then tax considerations would lead investors in the highest individual tax bracket to prefer the partnership form to the corporate form, since the annual pre-tax return to the former would be subject to a lower marginal tax rate: 40% versus 48%. Similarly, if the investment horizon expands to five years, all after-tax income earned during that period is reinvested in the business, and investors earn a 20% pre-tax annual rate of return on investment in both partnerships and corporations, then tax considerations still would incline wealthy investors to prefer the partnership form to the corporate form, because the former would yield a greater after-tax rate of return than the latter: 12.1% versus 10.8%. These estimates are derived from formulas given in a book on business tax planning by Myron Scholes and Mark Wolfson. See Ibid., pp. 57-59.

14 In 1997, 88% of corporate taxable income was earned by corporations with $50 million or more in business receipts. See U.S. Internal Revenue Service, Statistics of Income -- 1997 Corporation Income Tax Returns (Washington: GPO, 2000), Table 5, pp. 51-52.

15 In 1997, the average corporation filing a return with business receipts of less than $100,000 had assets valued at slightly over $183,000; by contrast, the average corporation with business receipts of $1 million to less than $5 million held $1.5 million in assets, and the average corporation with business receipts of $50 million or more held $1.2 billion in assets. See Ibid., Table 5, pp. 51-52.

16 Douglas Holtz-Eakin, "Should Small Businesses Be Tax- Favored?, "National Tax Journal, vol. 48, no. 3, September 1995, pp. 388-389.

17 Joseph J. Cordes, Robert D. Ebel, and Jane G. Gravelle, eds., The Encyclopedia of Taxation and Tax Policy (Washington: Urban Institute Press, 1999), p. 10.

18 Amy Hamilton, "Small Corporations May Have Erroneously Paid Millions in AMT," Tax Notes, vol. 89, no. 12, pp. 1511-1512.

19 Andrew B. Lyon, Cracking the Code: Making Sense of the Corporate Alternative Minimum Tax (Washington: Brookings Institution, 1997), pp. 77-97.

20 For background information on the individual AMT, see U.S. Library of Congress, Congressional Research Service, The Alternative Minimum Tax for Individuals, by Gregg A Esenwein, CRS Report RL30149 (Washington: August 10, 2000).

21 The regulations for IRC section 471 stipulate that inventories are required when income is derived from the production, purchase, or sale of merchandise. See Richard W. Harris and Robert W. Stern, "When Must a Taxpayer Keep Inventories and Use the Accrual Method of Accounting?," Taxes, vol. 72, July 1994, pp 400-402.

22 "IRS Allows More Small Businesses to Use Cash Method; Removes Conformity Requirement," CCH Federal Tax Weekly, December 14, 2000, pp. 581-582.

23 See Robert Libby, Patricia A Libby, and Daniel G Short, Financial Accounting (Chicago: Irwin, 1996), p. 111.

24 See the website for the U.S. Small Business Administration's SBIC program: [http://www.sba.gov/INV].

25 See Paul G. Schloemer, "Simplifying the Uniform Inventory Capitalization Rules," Tax Notes, vol. 53, no. 9, December 2, 1991, pp. 1065-1069.

26 For more details on this method, see U.S. Congress, Joint Committee on Taxation, Impact on Small Business of Replacing the Federal Income Tax, JCS-3-96 (Washington, April 23, 1996), pp. 18-19.

 

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