Consideration of any tax reform for small business must take into account the difficulties small-business owners face when deciding how to structure their business and comply with the Tax Code’s complex requirements, said Dewey Martin, a Hampden, Maine-based CPA.Martin, who testified at the recent hearings before the Senate Finance Committee on business entities and small-business tax reform, is a small-business owner himself, as well as an advisor to 200-plus small-business owners and chair of the Accounting Department at Husson College in Bangor, Maine.
“It’s important for lawmakers to understand that for tax purposes you cannot separate the business owner from the business,” said Martin. “The majority of small businesses are organized as pass-through entities, meaning that most small- business owners will pay their taxes at the individual level, rather than the corporate level. From a tax perspective, the pass-through model makes sense for a typical small firm. A small business has fewer financial resources than a typical larger corporation, so to pay a double tax — first at the corporate level and then on wages — would be onerous. This is why changes to the individual tax rates are so important to small firms.”
Nearly 75 percent of small businesses choose a pass-through business structure for their company, according to a poll by the National Federation of Independent Business Research Foundation.
“Martin’s testimony comes at a good time, as this week marks the anniversary of the 2001 and 2003 tax bills,” said Dan Danner, executive vice president of the NFIB.
“These bills [the Bush tax cuts] were extremely important to small business,” he explained. “By lowering individual rates, increasing small-business expensing, cutting capital gains and dividend rates, and reducing or eliminating the Death Tax, small-business owners were able to use business profits to re-invest in their companies, instead of using their hard-earned profits to pay the federal government in taxes.”
“My perception is that the committee was trying to learn from various perspectives,” said Martin. “That’s why the other presenters included an economist, a tax partner at a big firm, and a tax professor.”
SMALL BUSINESS, BIG PLAYER
Eric Toder, an economist at the Urban Institute and Urban-Brookings Tax Policy Center, noted that the small-business sector accounts for 25 percent of GDP.
“While the activities of small and large businesses are in many ways complementary — each group is both a customer and supplier to the other — the way in which businesses are organized matters for productivity,” he said.
“Large organizations have advantages of economies of scale, broader reach and ability to diversify risks, while small businesses have advantages of greater flexibility and less need for bureaucratic controls. No one business form is best for all activities,” he said. “Ideally, the tax system would be neutral among different forms of business organizations so that market forces — rather than tax considerations — will drive firm behavior and allow the optimal forms to emerge.”
Toder noted that the advantage of limited liability for corporations has been made more available to smaller businesses as S corporations and limited liability companies have become easier to organize.
“Flow-through enterprises are the predominant organizational form for smaller companies, although C corporations still account for the majority of business receipts of large companies,” he said.
One of the means to achieve neutrality among the various business entities would be the elimination of double taxation of corporate dividends, noted Toder.
“Virtually all proposals for double-tax relief would produce a net efficiency gain by taxing capital income from C corporations and flow-through enterprises in a much more neutral fashion,” he said. “Eliminating the double taxation of dividends would remove the incentive for businesses to organize as flow-through enterprises, reduce the tax bias favoring sectors in which flow-through businesses predominate, and eliminate the bias for corporations to finance themselves with debt instead of equity and to retain earnings instead of paying dividends.”
Samuel Starr, a partner at PricewaterhouseCoopers LLP and an adjunct professor at the Georgetown University Law Center, observed that the code does not reflect any specific guidance regarding limited liability companies.
“This is appropriate, as LLCs are state-law entities that can be classified for tax purposes as partnerships, associations or disregarded entities under the check-the-box regulations,” he said. “With that said, there are a number of areas in the code where the status of a general partner or limited partner is important in determining tax consequences.”
One area of significant importance is the treatment of general and limited partners under the self-employment tax rules. General partners are subject to self-employment tax on their earnings, whereas limited partners are only subject to self-employment tax to the extent of guaranteed payments for services rendered.
Although the Internal Revenue Service has released proposed regulations in this area, Starr urged Congress to address the issue: “We are seeing an increasing number of LLCs classified as partnerships, and there is a lack of clarity around whether the LLC members should be subject to the SE tax, and, if so, to what extent.”
The lack of dividend deductibility for C corporations is their cost for using the public capital markets, noted Douglas Shackelford, tax professor at the University of North Carolina.
“Since there is no justification for taxing private and public businesses differently, I recommend that C corporations be treated the same as pass-through entities for tax purposes,” he said.
Barbara Kasoff, the president of Women Impacting Public Policy, a Washington, D.C.-based advocacy group for women and minorities in business, agreed.
“Our members feel that the Tax Code must ensure that no matter how a business is organized, the deductions and credits apply equally,” she said. “If C corporations can deduct health care premiums, S corporations, LLCs and sole proprietors should have the same privilege.”
The latest census data shows that 48 percent of all small-business owners are women, according to Kasoff. “And small-business owners employ one in every seven Americans — more than the Fortune 500 combined,” she noted.
While the double taxation of corporate dividends may favor smaller over larger businesses, the complexity of health care options puts small business at a disadvantage, noted Maine CPA Martin.
“The code is complicated, and small businesses don’t generally have enough staff to deal with it,” he said. The different health insurance vehicles are way too complex for my small- business clients.”
“It’s getting harder for small-business owners to provide health benefits to their employees,” said Kasoff. “Premium costs are rising from 10 to 25 percent annually. The fact that we can’t negotiate rates as easily as large businesses, along with rising premiums, means we can’t provide 100 percent of benefits, so any kind of deduction or credit is helpful to us — and we want to make sure that we can take advantage of it no matter how we are organized.”
“Most of the working uninsured are employees of small businesses,” she observed. “We want to make sure that small business is on an equal footing with large business.”
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