How to Simplify the Tax Burden For Small Businesses
Small businesses spend more than $16 billion each year hiring tax professionals to provide advice and to handle the messy job of preparing and filing their federal tax returns. Is this out of laziness, or greed?
More likely than not, it’s because understanding and complying with the tax law isn’t nearly as simple as it should be.
Taxes are an issue every small business has to deal with. Ideally, they’re a minor inconvenience compared to trying to grow a business and create jobs.
There is a system in the tax law that is supposed to be simple for small businesses, but Congress and the IRS have managed to make it way more complicated than is necessary.
It is not news that the Internal Revenue Code is too complex for the average citizen. We have all heard the statistics about the code’s length (more than 4 million words) and all-too-frequent edits (over 4,000 since 2001).
“If tax compliance were an industry, it would be one of the largest in the United States,” according to Nina E. Olson, the IRS National Taxpayer Advocate.
As a tax accountant, allow me to express my professional gratitude to the US government. However, many of our country’s small businesses are not at all enthusiastic about the system we have, and it’s easy to understand why.
As the president of the American Apparel and Footwear Association recently put it to the US House of Representatives:
A successfully reformed code would be transparent, include clear requirements, and be geared towards allowing businesses to easily pay their fair share without being unnecessarily burdened by determining exactly what that share consists of.
Further, “small business” is something of a misnomer; small businesses account for more than half of the jobs in the United States. Depending on how you calculate and cut off the designation, they could represent as much as 98 percent of all US employers. More than that, they are generally acknowledged to be the greatest source of job creation in the country. In the aggregate, there is nothing “small” about small business.
The business owner’s task with taxes is twofold. First, income needs to be determined accurately; second, qualifying expenses need to be computed properly.
There are two methods available to so-called “mom-and-pop” shops to determine their taxable income: the accrual method, which is vastly more complicated, and the cash method, widely viewed as the lesser of two evils.
Under the accrual method, a transaction is usually considered income when something is sold or a service delivered, regardless of when money comes in the door. This can leave business owners high and dry with taxable income, even though they are dealing with bounced checks and cash- flow issues if customers are behind on payment. When it comes to expenses, the rules are even more complex.
However, qualification to use the simpler cash method is limited. For example, any business that buys or sells merchandise is required to use the accrual method of accounting. A little more than a decade ago, the IRS allowed businesses with less than $1 million in gross receipts to use the cash method; it then extended that to $10 million, unless a business was precluded specifically by the tax law from using the cash method.
Once a business qualifies to use the cash method, the owner must clear the next, bigger hurdle: actually computing the taxes.
Despite its innocuous name, the “cash method” of accounting is far from simple.
When it comes to income, this is largely due to three judicial doctrines—constructive receipt, economic benefit, and cash equivalent—that require taxpayers to recognize income (and pay taxes on it) even though they may not have received cash in the literal sense. For example, income must be recognized if the cash is made available to the taxpayer, regardless of whether the cash itself is in the taxpayer’s physical possession—such as when a customer offers to pay but the taxpayer does not stop by to pick up the cash or check.
These judicial theories can result in taxes being owed even though the taxpayer does not have any cash in hand; consequently, they can impose a severe cash flow problem on small businesses that are facing immediate and intractable expenses, such as rent, salaries, and equipment. The three theories are designed to prevent deferral of income recognition, but small businesses usually do not have the resources to engage in sophisticated tax manipulation strategies. They have expenses they have to pay with cash.
Moreover, the benefit to the federal government of applying these intricate tax theories to small businesses is likely minimal, since small businesses would regardless receive the cash at some point in the not-too-distant future.
Believe it or not, computing deductions under the cash method is far more difficult than determining income.
In general, under the cash method a deduction is permitted when payment is made. There are, however, four complicated exceptions to this seemingly straightforward rule:
- Prepayments, which are not deductible if the good or service is provided more than one year after payment is made.
- Depreciation, in which deductions must be spread over recovery periods of three to 39 years.
- Inventory, the cost of which is deducted only when the inventory is sold.
- Capitalization, meaning that certain expenses must be capitalized and deducted in the future.
The bottom line is that the current cash method is based on convoluted tax principles rather than on simplicity. A truer measure of taxation for small business would be focused on actual cash flow.
In 2007, after encouragement from the George W. Bush administration, the Treasury put forth a simplified reporting method for small businesses. The President’s Economic Recovery Advisory Board supported it. Unsurprisingly, these political and economic minds concluded that the taxpayers’ time would be better spent on more productive endeavors, such as actually running a business.
Nothing came of it; no legislation was ever introduced, and it was not put forward formally by any administration. It just languished in time and space.
We respectfully submit a proposal for a simplified cash method of accounting for small businesses. This proposal has been put forward to the House Committee on Ways and Means’ Tax Reform Working Group on Small Business and Pass-Through Entities and others engaged in the tax-legislation process.
The Kogod Tax Center proposes that taxable income be computed as follows:
Cash receipts minus expenses, including:
- Materials and supplies
- Depreciable property = Taxable income.
This means the end result would be based only on amounts actually received or paid during the tax year. It’s a more fundamental, back-to-basics approach—a “checkbook” approach to examining checks cut and deposits made. “Income” would mean only cash, property, or services received, without regard to the judicial doctrines that deter- mine imputed income.
“Expenses” would mean amounts paid to run the business, including inventory, which would be deducted in full when paid for—not when sold.
A threshold of $10 million in gross receipts for a business to be eligible for this method would mean that more than 99 percent of all small businesses would qualify.
Aside from the benefits to the small businesses themselves, we believe this approach would result in a more focused, efficient overall tax system, with little or no loss of tax revenue.
Learn more about the Kogod Tax Center.