SMALL-BUSINESS TAXATION SUMMARIZED BY CRS.

FEDERAL TAXATION OF SMALL BUSINESS: A BRIEF SUMMARY

David L. Brumbaugh Specialist in Public Finance Economics Division

April 14, 1994

SUMMARY

The Federal tax code does not apply a single, uniform set of rules to small businesses but does contain numerous separate provisions that apply differently to small firms than large ones. Most of the provisions result in favorable tax treatment for small businesses compared to large ones. Those with the largest impact are probably the exemption of sole proprietorships, partnerships and certain closely-held corporations (called "S" corporations) from the corporate income tax. Other important provisions are reduced corporate tax rates on the first $100,000 of taxable income, the use of cash accounting, and the deduction of the first $17,500 of equipment purchases in the year incurred, both of which provide tax deferrals. It might be argued that large firms can economize on the compliance costs of taxation where small firms cannot. In general, however, the provisions that favor small firms likely more than offset any extra compliance burden.

Economics suggests that unless markets fail to work properly, favorable tax treatment for particular activities impairs the efficient operation of the economy. One of the principal arguments favoring government support for small business is based on such a market failure. It points out that the market by itself generally fails to allocate sufficient resources to research, and maintains that small firms are particularly innovative. Yet studies have suggested that the link between innovation and small firms is uncertain. In any case, much more direct support for research is already provided by several tax provisions, including a tax credit for research and experimentation.

Another argument holds that small business should be subsidized in order to prevent the development of monopoly power by large firms. But here too, the link between smallness and the market failure is not exact; small firms as well as large ones can develop market power. In any case, it is likely there are more direct ways to regulate monopoly power than by subsidizing small business.

Perhaps the most oft-cited argument supporting small business subsidies that small business generate a disproportionate amount of employment. Economic theory, however, suggests that employment is generally not an appropriate goal for a permanent tax subsidy; in the long run, selective tax subsidies cannot create more jobs than the economy would create through normal growth. Further, the evidence that small business is a disproportionate generator of employment is uncertain.

In terms of equity, tax benefits for small business probably do not increase the progressivity of the tax system. It is possible that economic adjustments shift a substantial part of the benefits to all owners of capital, who tend to have higher incomes than individuals that earn exclusively wage and salary income. Also, small business owners tend to be upper income individuals. Begin one-page summary three hard returns after Style, not to exceed this page. [sic]

CONTENTS

S CORPORATIONS, PARTNERSHIPS, AND SOLE PROPRIETORSHIPS

OTHER TAX PROVISIONS FAVORING SMALL BUSINESS

THE RATIONALE FOR FAVORABLE TAXATION OF SMALL BUSINESS

FEDERAL SMALL BUSINESS TAXATION: A BRIEF SUMMARY

The Federal tax code does not apply a single, uniform set of rules to small businesses but does contain numerous separate provisions that apply differently to small firms than large ones. Most of the provisions result in favorable tax treatment for small businesses compared to large ones. Those with the largest impact are probably the exemption of sole proprietorships, partnerships and certain closely-held corporations (called "S" corporations) from the corporate income tax. Other important provisions are reduced corporate tax rates on the first $100,000 of taxable income, the use of cash accounting, and the deduction of the first $17,500 of equipment purchases in the year incurred. It might be argued that large firms can economize on the compliance costs of taxation where small firms cannot. In general, however, the provisions that favor small firms likely more than offset extra compliance burdens.

S CORPORATIONS, PARTNERSHIPS, AND SOLE PROPRIETORSHIPS

Corporate income is generally subject to two levels of federal income tax. Profits are normally subject to the corporate income tax at the corporate level and are taxed again under the individual income tax when they are received by stockholders as realized capital gains or dividends. Several types of business entities, however, are exempt from the corporate income tax: sole proprietorships, partnerships, and "S" corporations. While any of these entities can in principle be quite large, they have characteristics that tend to restrain their size. Thus, there is a close correlation between a firm's smallness and its ability to avoid the double-taxation that applies in the corporate sector.

A SOLE PROPRIETORSHIP is operated exclusively by an individual taxpayer and, unlike a partnership or corporation, it has no existence apart from the taxpayer. An individual who runs his or her own business is required to report profit or loss on Schedule C of form 1040; individual income taxes apply to the income but corporate taxes do not. However, many of the rules for determining income -- for example, depreciation rules -- are generally the same for both corporations and sole proprietorships.

A PARTNERSHIP is an unincorporated syndicate, association, joint venture, or other group that carries on a business. Instead of being subject to the corporate income tax, partnership income is "passed through" to the partners, generally in the year it is earned; each partner is allocated their pro rata share of the partnership's income or loss, and individual income taxes apply. For an organization to be classified as a partnership, Internal Revenue Service regulations require a firm to have no more than two of the following corporate characteristics: continuity of life, centralization of management, limited liability, and free transferability of interest. ¹

An S CORPORATION is business that is organized as a corporation but that meets certain tax code requirements and is taxed as a partnership. To qualify as an S corporation, a corporation can have no more than 35 stockholders, can have no stockholders who are not individuals (e.g., a corporation or partnership), and must have only a single class of stock. Once a firm qualifies, its annual income or loss is passed through to its shareholders and subject to individual income taxes.

To qualify as a sole proprietorship, partnership, or S corporation, there are no explicit tax code restrictions on a firm's assets, receipts, or employees. Indeed, some non-corporate businesses can be quite large. Still, firms that are organized as corporations can raise capital more easily than non-corporate firms; and smallness is closely correlated with the three types of entities. Tax return data verifies that, on average, the three types of entities are quite a bit smaller than corporations in terms of average assets and average receipts per return. ²

OTHER TAX PROVISIONS FAVORING SMALL BUSINESS

Small businesses that are not exempt from the corporate income tax tend to benefit from the GRADUATED CORPORATE TAX RATES that the tax code applies to taxable corporate income. Under the corporate tax rate schedule, corporations that earn small incomes are taxed at lower rates. And while the connection between income and size is not perfect -- large corporations can have small profits and small firms can earn large incomes -- there is nonetheless a relationship. Relatively small firms tend to earn smaller profits than large ones.

The marginal statutory corporate tax rates are set forth in table 1, below. The 39 percent rate that applies between $100,000 and $335,000 is designed to offset the benefit of the 15 percent and 25 percent rates for firms with large incomes. A wide range of corporate income -- income earned by firms with incomes between $335,000 and $10,000,000 -- is thus taxed at an average rate of 34 percent. Similarly, the 38 percent rate is designed to ensure that firms that earn over $18,333,333 pay taxes at an average rate of 35 percent. Since most corporate income is earned by firms with large incomes, most corporate income is taxed a marginal rate of either 34 or 35 percent.

            TABLE 1. MARGINAL STATUTORY CORPORATE TAX RATES

Expensing provides a type of tax benefit known as a tax deferral. A tax deferral does not change the amount of taxes a person or firm ultimately pays, but instead postpones them. The postponement constitutes a benefit because the funds that represent the postponed taxes can -- at least in theory -- be invested and earn a return for the taxpaying person or firm until the taxes are ultimately paid. Section 179's expensing provision is a tax deferral because it permits firms to deduct the value of assets well in advance of the time the assets actually wear out. Indeed, the tax benefit from expensing is quite large; its value is the equivalent of a tax exemption for any income produced by the expensed investment.

The expensing allowance is phased out over a range of investment, hence its connection with small firms. The phase-out provisions reduce the $17,500 allowance by the excess of a firm's investment over $200,000. Again, there is no hard and fast relation between smallness and the expensing benefit; a large firm that is shrinking can invest little. Still, on average, firms that are small tend to invest less than firms that are large and the provision favors small businesses over large ones.

A tax benefit that is linked more directly to smallness is the use of CASH ACCOUNTING rather than accrual accounting. Under cash accounting, income is generally recognized for tax purposes when it is actually received; expenses are deducted when they are paid (exceptions are deductions for inventory and depreciation). Under accrual accounting, income is recognized when it is actually earned, which may be in advance of actual payment.

The tax code requires corporations to use accrual accounting unless they earned an average of less than $5 million in gross receipts over the preceding years. S corporations are also exempt from the accrual requirement, along with personal service corporations (corporations performing health, law, accounting, engineering, architectural, or certain other services). A separate, more lenient set of qualification rules applies to corporations engaged in farming.

As with the expensing allowance, cash accounting can provide a tax deferral. According to economic theory, a business gains income when the income is first earned; even if cash is not actually received, an obligation to be be paid is. Thus, when cash accounting permits taxation of a given amount of income to be delayed until cash payment is actually received, it provides a tax benefit. We should point out, however, that many small firms would likely find it difficult to use accrual accounting; a requirement for all firms to use it would likely favor large companies over small ones.

The Ominibus Budget Reconciliation Act of 1993 (OBRA93) contained a provision EXCLUDING 50 PERCENT OF CAPITAL GAINS ON QUALIFIED SMALL BUSINESS STOCK from taxable income. Ordinarily, long term capital gain -- gain on assets held for more than 1 year -- is subject to a maximum 28 percent tax rate. Under OBBA93, the taxable portion of part of the qualified gain is subject to a maximum 28 percent tax rate; the maximum tax on qualified gain is thus 14 percent (50 percent of 28 percent). The amount of gain eligible for the exclusion is the greater of 10 times the taxpayer's "basis" in the stock or $10 million. (The stock's basis is generally the stock's acquisition cost.) The general qualifying requirements for the tax- favored stock are: it must be held at least 5 years by the taxpayer, it must be acquired at the stock's original issuance, and it must be issued by a C corporation having less than $50 million in assets. ³

The tax code contains numerous other, more narrowly applicable special provisions for small business. Some provide explicit tax benefits for firms of limited size that engage in certain activities; others exempt small businesses from more stringent rules that apply to large firms. The following list contains most of the remaining provisions.

OTHER SMALL BUSINESS TAX PROVISIONS:

Small life insurance company taxable income adjustment

Special alternative tax on small property and casualty insurance companies

Less stringent requirements for small exporters under the Foreign Sales Corporation (FSC) provisions

Small ethanol producer tax credit

Tax credit for disabled access expenditures of small businesses

Small business exception from inventory cost capitalization rules

Small business exception from long-term contract rules

Simplified dollar-value LIFO accounting for inventories

Special rules for losses on small business stock

Exception for small restaurants from certain tip reporting requirements

Non-recognition of stock gain reinvested into small business investment companies

THE RATIONALE FOR FAVORABLE TAXATION OF SMALL BUSINESS

It is clear from the above discussion that much small business investment is taxed favorably compared to investment in large corporations. The chief factor in the treatment is probably the exemption of S corporation, partnership, and sole proprietorship income from the corporate income tax. As a result of their exemption from the corporate income tax alone, these entities bear tax burdens substantially less than that of taxable corporations.

Table 2, below, is from a previously published CRS report and contains estimated marginal effective tax rates for different assets owned by taxable corporations, on the one hand, and unincorporated businesses on the other. (Marginal effective tax rates are generally the percent by which taxes change an asset's pretax rate of return.) The table shows that the tax burden for corporate equipment is almost twice that of unincorporated business; the gap between tax rates is substantial for other assets also. Note, too, that the calculations only include the exemption from the corporate income tax; consideration of other provisions would further widen the differential.

Is the tax differential justified? Economic theory holds that the economy's scarce investment funds are normally allocated most efficiently when taxes do not distort the market's allocation of investment by favoring one sector or investment over another. It is only when the market fails to work properly that a tax benefit can improve the operation of the economy. ⁴ (Of course, some tax benefits are designed to support various social, political, or health values rather than economic efficiency.)

       TABLE 2. MARGINAL EFFECTIVE TAX RATES FOR EQUITY-FINANCED

Another argument holds that small business should be subsidized in order to prevent the development of monopoly power by large firms. Here the link between tax treatment, smallness, and the market failure is not exact. Small firms as well as large ones can develop market power. In any case, it might be argued that there are more direct ways to regulate monopoly power than with tax differentials favoring small business.

Perhaps the most oft-cited argument supporting small business subsidies is that small business generates a disproportionate amount of employment. In fact, using 1990 Small Business Administration data, roughly 40 percent of all U.S. jobs are in businesses of 99 or fewer employees. There are reasons, however, to question the argument as it bears on new job creation. First, economic theory suggests that employment is generally not an appropriate goal for a PERMANENT and selective tax differential; in the long run selective tax subsidies cannot create more jobs than the economy would create through normal growth. Second, the evidence that small business is a disproportionately large generator of new employment merits analysis for net effect. It has been pointed out that most jobs created by small business are created by new firms; and a large proportion of those jobs will not persist because most new firms fail within a few years. ⁶ Finally, tax benefits delivered through the income tax are normally incentives to invest capital rather than employ labor. Any incentive to use labor is thus necessarily indirect, and may even encourage firms to substitute capital for labor.

In terms of equity, tax benefits for small business probably do not increase the progressivity of the tax system. It is possible that economic adjustments shift a substantial part of the benefits to all owners of capital, who tend to have higher incomes than individuals that earn exclusively wage and salary income. But the tax benefits affect equity the same way even if it is assumed that the tax benefits are not shifted and accrue exclusively to owners of small business. A recent analysis by Brown, Hamilton, and Medoff found that families that own small businesses have incomes that are 1.8 times higher than that of the average U.S. family, and have assets that are more than 5 times as large. ⁷ Thus, though many small businesses fail in their early years and many surviving owners toil long and risk much, small business owners apparently tend to be upper income individuals.

² In 1990, S corporations averaged $472 thousand in assets per return, partnerships averaged $1,084 per return, and all corporations averaged $4,894 per return. (Asset data are not available for sole proprietorships.) Also in 1990, S corporations averaged $1,029 thousand in gross receipts per return, partnerships averaged $364 thousand in gross receipts, sole proprietorships averaged $49 thousand, and corporations averaged $3,070. Partnership and sole proprietorship data are from the U.S. Internal Revenue Service's Statistics of Income Bulletin, Summer 1992 and Fall 1992, respectively. S Corporation data are from: U.S. Internal Revenue Service. 1990 Statistics of Income. Corporation Income Tax Returns. Washington, U.S. Govt. Print. Off. 1993. p. 111.

³ For a more detailed description of the exclusion's provisions, see: U.S. Congress. Conference Committees, 1993. Omnibus Budget Reconciliation Act of 1993. Conference Report of the Committee on the Budget, House of Representatives to Accompany H.R. 2264. H. Rpt. 103-213. 103d Cong., 1st Sess. Washington, U.S. Govt. Print. Off., 1993. p. 523-8.

⁴ Many economists argue that the corporate income tax creates economic efficiency. [sic] Intuitively, it might at first seem reasonable to suppose that extending that treatment to small business would exacerbate the situation. But the supposition is unfounded; it is precisely the differential treatment of corporations and unincorporated business that is responsible for much of the inefficiency that economic theory finds in the corporate income tax.

⁵ U.S. Library of Congress. Congressional Research Service. Small Business Tax Subsidy Proposals. Report No. 93-316 S, by Jane G. Gravelle. Washington, 1993. p. 13.

⁶ See the discussion of various studies in Ibid., p. 7-9.

⁷ Brown, Charles, James Hamilton, and James Medoff. Employers Large and Small. Cambridge, Mass. Harvard University Press, 1990. p. 4.