The Senate Finance Committee held hearings on small business tax issues as part of a series of hearings on tax reform.

Chairman Max Baucus (pictured), D-Mont., noted that the income of pass-through entities such as sole proprietorships, partnerships and S corporations is all taxed as individual income after it is allocated to the business owners, even though the business models vary.

"The needs of a sole proprietor may differ from those of an S corporation," he said in his opening statement. "We need to keep these differences in mind, so that all businesses have a fair shake and can benefit from reform."

Douglas A. Shackelford, a professor of taxation at the University of North Carolina at Chapel Hill, pointed out in his testimony that C corporations face double taxation of both the entity and investors, as the profits are taxed at the corporate level and then shareholders are taxed when they receive dividends.

"If dividend deductibility is not an option, I recommend taxation of all organizational forms (including the current pass-through entities) at the entity level coupled with tax exemption at the investor level, e.g., a reduction of the dividend tax rate to zero," he said. "This would shift the burden of tax compliance from investors to the entity. An administrative advantage of this approach is that there are far fewer entities than investors. A disadvantage of this approach is that there are economies of scale in tax evasion, i.e., it is easier for one entity to avoid a single large tax bill than for many investors to shelter small portions of the firm's income."

Eric Toder, a senior fellow at the Urban Institute, testified about the increasing trend toward flow-through entities. "The current income tax generally favors smaller over larger businesses and flow-through enterprises over C corporations, most notably because of the double taxation of corporate dividends," he said. "In response to these incentives and to changes in tax laws and regulations that facilitate the use of S corporations and limited liability partnerships, the share of businesses organized as flow-through enterprises has been growing."

He noted that some of the tax reforms under consideration might make tax laws more even-handed in their treatment of smaller and larger businesses and of corporate and non-corporate organizational structures. They include reducing the corporate tax rate and broadening the business tax base, eliminating the double taxation of corporate dividends, and restructuring tax benefits for health insurance. "Beyond that, if a new federal consumption tax is ever introduced, the issue of exempting small businesses to avoid imposing large compliance burdens on them will certainly merit careful consideration," he said.

PricewaterhouseCoopers partner Samuel Starr recommended eliminating this double taxation. "One goal and objective of the tax system should be to create tax parity among the various business forms so that one taxpayer is not disadvantaged over another, from a tax perspective, simply because of its choice of business form," he said.

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