Small Business Tax Reform
What's on the table to simplify compliance and provide tax relief for small businesses?
August 28, 2008
by Annette Nellen, CPA/Esq.
Several bills and hearings of the 110th Congress addressed small business tax reform. This article reveals data on small businesses that explain reasons for the attention and summarizes key proposals.
Per the IRS, one in seven individual tax returns includes a Schedule C or Schedule C-EZ (Schedule C-EZ is used to report net profit from business). More than 21 million Schedule C forms were filed in 2006 reporting aggregate net profits exceeding $269 billion (IR 2008-63). For 2005, the mix of business returns was as follows (Joint Committee on Taxation, JCX-48-08 (PDF)):
|Sole proprietorships||67.3 percent|
|C corporations||6.2 percent|
|S corporations||11.6 percent|
Small businesses are crucial to the economy since they produce 60 percent to 80 percent of new jobs each year, noted Senator Max Baucus (D-MT) at a June 2008 Senate Finance Committee hearing on small business and tax reform. (June 2008 testimony (PDF)).
In April 2008, the House Small Business Committee held a hearing on modernizing the tax law to help small businesses stimulate the economy. The committee's report states that with the economy on the "brink of a recession … small businesses can help get us back on track, just as they have done so many times before" (Seven Ways to Stimulate the Economy by Updating the Internal Revenue Code (PDF)). Proposals of the committee and others aim to simplify compliance, modernize tax rules, provide tax relief, and make rules more equitable among different entity types. (For hearing information, see April 2008 press release, July 2008 press release and July 2008 testimony.) Key proposals of the 110th Congress are summarized below.
Expensing: S. 269 permanently increases the §179 expensing amount to $200,000 and the start of the phase-out limit to $800,000. These amounts would be indexed annually for inflation. The increased limitation would expand the number of businesses eligible for expensing. This proposal simplifies the law by eliminating the need to track depreciation on most personal tangible property and off-the-shelf software acquired by small businesses. Sponsors expect this change to "contribute to continued productivity growth" (Senator Snowe, Congr. Rec. S4592, April 2008 (PDF)).
Improved depreciation deductions: The committee (PDF) notes that depreciation limits on cars (§280F) only enable a taxpayer to take full annual depreciation on a car costing $14,460. They propose to change the limitation to enable an individual using a car over 75 percent for business to claim full depreciation over 5 years if the basis is $25,000, adjusted annually for inflation.
The committee also observed that the statutory depreciable life of some assets is longer than the business life thereby discouraging capital investment and causing cash flow problems. The following assets were identified as warranting a shorter depreciable life:
Home office simplification: The committee's report (PDF) states that despite the fact that roughly eight million of the 20 million Schedule C filers are using rooms in their homes for business, only 2.7 million claimed a home office deduction. Low use of this deduction stems from its complexity and ineffectiveness, according to the committee.
H.R. 6601 proposes a $2,000 standard deduction in lieu of actual costs with the deduction adjusted annually for inflation. The bill also allows personal use of office space to be ignored if minor, such that is it "unreasonable or administratively impracticable" to account for it.
Eased recordkeeping: Given that cell phones and PDAs have become inexpensive, crucial necessities of any business, rather than luxuries, the committee (PDF) suggests modernizing the listed property rules. The committee proposes removing computers, PDAs and cell phones from the listed property rules. Users would be allowed to prove substantial business use without the need to maintain detailed logs. H.R. 6601 and H.R. 5450 would remove cell phones from the listed property definition.
Increased M&E deduction: The committee report (PDF) states that large businesses use deductible advertising to promote their businesses while small businesses are more likely to use partially deductible meals and entertainment. H.R. 6601 would allow any business with average annual gross receipts in the prior five-year period of $5 million or less to deduct 80 percent of meals and entertainment.
Accounting simplification: S. 270 would allow start-up partnerships and S corporations to select a tax year other than their required year provided it ends in any month from April through November. That year could be used until average annual gross receipts in the prior three-year period exceed $5 million. Per Senator Snowe, this change allows more businesses to select a year appropriate for their business cycle and gives them a benefit enjoyed by large corporations.
S. 296 would allow businesses with average annual gross receipts in the prior three-year period of $10 million or less to use the cash method and to not have to account for inventories. The dollar amount would be adjusted annually for inflation.
Investment incentives: The committee (PDF) notes that today's 15 percent capital gains rate reduces the investment incentive of §1202 enacted in 1993 allowing 50 percent gain exclusion for qualified small business stock held over 5 years. The committee recommends that incentives be restored that encourage investment in small firms.
Choice of entity equity: The committee (PDF) observes that common entity forms for small businesses — sole proprietorships, partnerships and S corporations do not always get the same favorable deductions available to C corporations. They propose to fix the inequity which allows corporations to treat employee health insurance costs on a pre-tax basis thereby avoiding FICA taxes. In contrast, sole proprietors, partners, and LLC and S corporation owners pay for their insurance using income subject to FICA tax thereby paying more tax. The committee proposes allowing self-employed taxpayers the same health insurance deduction available to large firms.
Prospects for Change
Data on compliance costs for small businesses supports simplification proposals. The Small Business Administration found that tax compliance costs for businesses with less than 20 employees is about $1,304 per employee — 67 percent higher than for larger companies (Snowe)
Suggestions for modernizing the law and making it more equitable among entity types also seem supportable. However, various issues are likely to hinder change:
If major tax reform is considered in the 111th Congress, entity structures currently used by small businesses will be a focal point because many reform proposals tax all businesses the same. (For example, Treasury, Approaches to Improve the Competitiveness of the U.S. Business Tax System for the 21st Century (PDF), December 2007 and H.R. 1040.)
Small business tax reform is unlikely to ignore the tax gap for sole proprietors. The IRS estimates that in 2001, over 60 percent of sole proprietors underreported their income. (GAO-07-1014 (PDF)) Thus, we are likely to see any small business tax reform paid for with compliance measures.
Compelling arguments have been made for small business tax reform. We'll soon see how compelling they are to the next Congress and President.
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Annette Nellen, CPA, Esq., is a tax professor and Director of the MST Program at San José State University and an Irvine Fellow at the New America Foundation. Nellen is an active member of the tax sections of the ABA and AICPA. She has several reports on federal and state tax reform and a blog.