September 2011

In August, the Treasury Department released a report that redefines what constitutes a small business.  In the coming debate about raising taxes, you will hear about this report, albeit in only the most glossed-over and summarized way.  This new Treasury “study” is a transparent effort to reduce the identified size of the small business community, and thereby minimize the impact that raising taxes will have on them.  If the White House changes the definition of “small”, then the now-“big” businesses need not be analyzed in terms of whether new taxes will harm them or the jobs that they would otherwise create.

Previously, pass-through entities were often used as a proxy for being a small business.  While this definition was generally correct, some quite large businesses also elect pass-through tax treatment.  Under the Treasury Department’s new definition, the number of small businesses shrinks by about half and now excludes numerous businesses that are genuinely small and entrepreneurial.  The Treasury study limits the number of small businesses by:

  1. Claiming that any business with over $10 million of gross revenues or deductions is not really small, and
  2. Claiming that any business that comprises less than 25% of an owner’s adjusted gross income is not really a business.

The remaining businesses that meet the Treasury Department’s new definition earn only 17% of the income that earlier Treasury reports identified as pertaining to small businesses.  Roughly 20% of small businesses under the new definition employ others.  The employment statistic becomes important because, under the new definition, the remaining “small” businesses are not really important for job creation.  Once a business reaches $10 million in revenues, the job creation no longer comes from a “small” business.

As noted above, under the new definition of a small business, the income amounts by the remaining small businesses are indeed small.  The Treasury paper summarizes their conclusions as follows:

“This technical paper presents a revised methodology to improve the identification of small businesses and their owners for the purpose of tax policy analysis.  In the first section, we identify small businesses.  We apply two tests to separate business from non-business entities. We then further sub-divide filers we identify as business entities into small and other businesses based on a $10 million gross income and deduction test. Overall, approximately 54 percent of filers across the six tax forms and schedules we consider meet the criteria we use to define a small business. Those entities reported 18 percent of total business income

[confusingly, the word “income” in the report means gross revenues] (average of $270,000) and 16 percent of net business income (average of $21,600) for tax year 2007.  Approximately half of our small businesses reported total income less than $50,000, and almost 90 percent reported net income less than $50,000. Roughly half are in the real estate-rental, construction or professional-scientific sectors.  Based on our definition of employer (direct labor compensation exceeds $10,000), we find that slightly more than one-fifth of small businesses were also employers.”

Why Small Business Taxation is the Battle Front

Small business taxation is important because there are few other sources of increased revenues.  In the debate of who should pay higher taxes, it is generally acknowledged that the U.S. tax rate on regular or C-Corporations is higher than in most other developed countries.  Some even suggest that the corporate tax rate be decreased to improve U.S. competitiveness for international capital formation (and related jobs).  Most politicians also agree that broadening the tax base to include individuals who are currently paying no meaningful income taxes (currently around half of the population) is politically unacceptable.  Once these starting points are accepted, the most important remaining pot of money left for a tax increase are pass-through entities.

However, because pass-through entities (which are generally smaller companies) have been important for employment and economic growth, most politicians do not want to hurt these small businesses and their related job creation.  According to a study performed on behalf of accounting firm Ernst & Young using 2008 data, S corporations, partnerships, limited liability companies, and sole proprietorships:

  1. Accounted for nearly 95 percent of all business entities;
  2. Employed 54 percent of the private sector work force; and,
  3. Reported 36 percent of all business receipts.

Additionally, between 2004 and 2008 owners of flow-through business reported 54 percent of all business net income and paid 44 percent of all federal income taxes.

It is because of this success that those seeking to raise taxes will go to those successful business enterprises which are currently treated as a pass-through entity.  In February 2011, U.S. Treasury Secretary Timothy Geithner told the Senate Finance Committee that:

“Congress has to revisit this basic question about whether it makes sense for us as a country to allow certain businesses to choose whether they’re treated as corporations for tax purposes or not,”

Secretary Geithner subsequently suggested taxing pass-through entities, repeating the need to alter a business owner’s current ability to bypass taxation at the business level and to instead be taxed at the personal level.

The new Treasury report minimally addresses the significance of those in the highest tax brackets.  Over half of taxpayers in the top two tax brackets get their income from their employment in businesses currently treated as a pass-through entity for tax purposes.

“Our analysis can also identify taxpayers who own employer and small employer businesses. We find that 14 percent of taxpayers reporting flow-through income or loss and positive taxable income own at least one business that meets our definition of “employer.”  However, that figure increases to 51 percent for individuals in the two top rate brackets.”

Practically all lawyers and other professionals use a pass-through entity to avoid double taxation of their business income.  Currently, there is no size limitation in order to qualify as a partnership, S-corporation or other pass-though entity.  This pass-through tax treatment is being challenged by those seeking tax increases.


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