The relentless chatter about relieving tax burdens on small business might lead you to believe Congress is giving top priority to helping the beleaguered entrepreneur. But that inference is false.
As we enter the 2012 election season, the overarching tax issue is whether the top individual rate will stay at 35 percent, return to its pre-2001 level of 39.6 percent, or be raised higher. Small business taxation is getting prime-time attention because the best defense Republicans have for keeping the rate at its current level is to wrap high-income taxpayers in the cloak of small business. They express shock that anybody would want to raise taxes on these millions of job creators. But in fact only a small fraction -- about 10 percent -- of high-bracket income is related to small business job creation. If high-end rates weren't an issue, we wouldn't be seeing this level of compassion for small business among Republicans. (See "The Myth of Mom-and-Pop Business," Tax Notes, Sept. 12, 2011, Doc 2011-18977, or 2011 TNT 176-1.)
That's too bad. Small business taxation is a mess. On those rare occasions when Congress gets serious about reform, it gives priority to the individual income and corporate taxes. Taxation of small business and passthrough income is neither here nor there. It is a poorly thought-out byproduct of these larger efforts. The result is a patchwork that is neither simple nor fair. It is a landscape filled with potholes and traps for the ill advised.
For small businesses, whose compliance costs are disproportionately large compared with their tax size, tax reform is all about simplification. If Congress really wanted to do something for small business, it could roll up its sleeves and work out a rational and efficient system to minimize IRS interference with doing business. Real small business tax reform does not have to degenerate into a partisan battle. Is it too Pollyannaish to suggest this could be a low-profile issue on which Democrats and Republicans could work together for the genuine good of the economy?
How Bad Is It?
This unfortunate state of affairs in small business taxation is nothing new. And matters have only gotten worse, as lawmakers and the IRS keep piling on more rules. The following quotes (complete references are in the endnotes) give you a sample of expert opinion.
Instead of neutralizing the tax impact of contrasting patterns of doing business, Congress is creating an increasing number of separate tax molds, each with its particular quirks, each having certain advantages and disadvantages, and each suggesting a different haven into which confused taxpayers may find solace.
-- former IRS Commissioner Mortimer M. Caplin, 1961
It is a well-known fact that tax considerations play an important part not only in the choice of business form in which to operate, but also in almost every aspect of the business, and there is growing concern that tax consequences rather than market considerations dominate business decisions.
-- Prof. Harry J. Haynsworth, 1978
The current system for taxing business is unfair, complicated, and difficult to administer. Private enterprises are still taxed under three different regimes. . . . [The system] is badly in need of reform.
-- Prof. Jeffrey L. Kwall, 1997
The income taxation of private business should be reformed and simplified. There is simply no policy justification for allowing such firms to continue to choose among subchapters C, K, and S for their applicable tax rules, and the existence of the choice unnecessarily complicates the law.
-- Profs. George K. Yin and David J. Shakow, 2001
And there is a special place in tax hell for the partnership rules:
A large number of partnerships . . . seem to be governed by what might be called "intuitive subchapter K." Taxpayers and tax advisers who want to comply account for partnership transactions in ways that are consistent with their conceptions of the basic aims of subchapter K; others account as adventurously as they believe the IRS is likely to tolerate. IRS auditors challenge partnership accounting only if it seems to be seriously out of whack. No one has the ability, resources, and incentive to figure out exactly what the rules require.
-- Prof. Lawrence Lokken, 1999
Near Consensus on Reform
What would small business tax reform look like? The authors of the last three quotes have offered their proposals. The similarities are more striking than the differences. Based on their work, a simpler and more logical system would have four fundamental parts.
(1) Divide business into two categories. Income from businesses whose shares are traded on public exchanges would be subject to the corporate tax. Assuming there is not a major effort to integrate the individual and corporate taxes, income would continue to be subject to a second layer of tax at the shareholder level. All other business income would be subject to a single layer of tax.
(2) Eliminate subchapter C as an option for private firms. More than 1 million small businesses voluntarily subject themselves to double taxation under subchapter C. They do this out of ignorance or to take advantage of the combination of the low graduated corporate rate, low rates on dividend distributions, and the favorable treatment of fringe benefits uniquely available to active owners of subchapter C corporations. The elimination of the subchapter C option would make small business taxation fairer and simpler.
(3) Divide passthrough businesses into two subcategories. Small businesses with uncomplicated ownership arrangements would all be subject to a single simple passthrough regime. This set of rules would be similar to current subchapter S rules, with some modifications to allow for broader application.
(4) Private firms not eligible for simplified passthrough rules would be offered a system far simpler and less subject to abuse than the current subchapter K. This component of reform causes disagreement among academics. On the grounds of promoting efficiency and fairness, Yin and Shakow make the case for a single layer of tax at the individual level. Kwall and Lokken argue for entity-level taxation because they believe it would be simpler and less subject to abuse.
Although they were writing a decade ago, Kwall and Yin still support small business tax reform. But both are realistic about the possibilities. Kwall sees little chance that Congress will move on structural small business reform until the dominant issues of establishing the corporate and top individual rates are settled. He points out that if Congress shows no interest in taking the "baby step" of eliminating the graduated corporate rates, it's hard to see how it could ever undertake more sweeping small business reform.
Yin points out that reform has many natural enemies. First, there are small subchapter C corporations that would lose advantages if they did not have the subchapter C option. Second, there are the partnerships using aggressive tax planning that would not welcome any limitations on their allocation of tax attributes. Finally, there are the grandfathered publicly traded partnerships that don't want their privileged status questioned.
Moreover, Yin said: "Structural changes, such as fundamental reforms of the technical rules of subchapters C, K, or S, have greater difficulty getting on the radar screen. . . . They do not naturally come to the attention of members [of Congress], and when they do, the significance of the proposals may not be fully appreciated if the member lacks the background and time to learn about the change." Yin, a former chief of staff of the Joint Committee on Taxation, emphasizes the importance of staff work on these less political and highly technical issues.
Kwall said that integration of individual and corporate taxes may simply be too much for the legislative process. Given the vast differences between GE and a mom and pop business, it is foolish to try to get one size of business tax reform to fit everyone. As a political matter, there is far less interest in integration for big business than there is for small business. It would make sense for integration efforts to start with small business tax reform. Not only would that vastly improve current law, it would also "set the stage for the ultimate expansion of integration to publicly traded enterprises if that end becomes viable," according to Kwall.
Yin pointed out that there may be a symbiotic relationship between small and large business tax reform. "Many of the technical subchapter C rules also address problems primarily associated with closely held corporations; these rules could be greatly simplified or eliminated," he said. With a rationalized system of small business taxation, we could jettison all the code sections pertaining to personal holding companies, personal service corporations, and the accumulated earnings tax. More significantly, as Yin argued, almost all the distribution rules, which are focused on preventing ordinary dividends from being taxed as capital gains, could be eliminated because they are targeted at transactions carried out by closely held corporations.
Instead of being an afterthought, should small business be the point of departure for any corporate tax reform?
Mortimer M. Caplin, "Income Tax Pressures on the Forms of Business Organization: Is It Time for a 'Doing Business' Tax?" Virginia Law Review, 1961.
Harry J. Haynsworth, "The Need for a Unified Small Business Legal Structure," The Business Lawyer, Vol. 33, Jan. 1978.
Jeffrey L. Kwall, "Taxing Private Enterprise in the New Millennium," Tax Lawyer, Vol. 51, No. 2, 1997.
Lawrence Lokken, "Taxation of Private Business Firms: Imagining a Future Without Subchapter K," Florida Tax Review, Vol. 4, 1999.
George K. Yin, "The Future Taxation of Private Business Firms," Florida Tax Review, Vol. 4, 1999.
George K. Yin and David J. Shakow, Federal Income Tax Project: Taxation of Private Business Enterprises Reporters' Study, American Law Institute, 1999.
George K. Yin and David J. Shakow, "Reforming and Simplifying Income Taxation of Private Business Enterprises," in Joint Committee on Taxation, "Study of the Overall State of the Federal Tax System and Recommendations for Simplification," Vol. III, JCS-3-01, 2001, Doc 2001-12005, 2001 TNT 85-16.
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