Higher Business Taxes May Follow Treasury’s Definition of Small

By Andrew Zajac

Aug. 18 (Bloomberg) -- A new definition of what constitutes a small business being considered by the Treasury Department is raising concerns among some closely held companies that it’s a step toward requiring them to pay corporate taxes.

The proposed definition, included in an Aug. 9 Treasury report, places the upper limit for a small business at $10 million in annual gross income or deductions. Currently, there is no size limit on what constitutes a small business for purposes of tax policy discussions.

The parameters could affect larger, closely held businesses, including those organized as partnerships, S corporations and limited liability companies. Such firms are called flow-through entities because profits flow directly to their owners, who pay personal income tax without first being subject to corporate tax. Large investment firms, including D.E. Shaw LP of New York and Renaissance Technologies Corp. of East Setauket, New York, and major law firms such as Los Angeles- based Latham & Watkins LLP are organized as flow-through companies.

The announcement of the proposed definition, coming as congressional lawmakers consider rewriting the U.S. tax code, heightens concerns of larger flow-through businesses that they are being targeted for a tax increase, said Brian Reardon, a lobbyist for the S Corporation Association of America, which advocates on behalf of family- and closely held businesses.

“The administration has made it clear that it’s interested in drawing an arbitrary line and taxing firms above it,” Reardon told Bloomberg Government.

Corporate Taxation

Reardon said his members were concerned earlier this year that Treasury was developing a proposal that would levy corporate taxes on flow-through businesses with more than $50 million in annual revenue as part of an effort to lower U.S. corporate tax rates by broadening the base.

“It’s obviously something that they’ve been looking at,” Reardon said.

The proposed definition is designed for tax policy discussion and has no effect on government contracting or other government agencies with their own definitions of small businesses.

A Treasury official familiar with the crafting of the definition said that it isn’t intended to lead to a tax increase and is an attempt to address a widely acknowledged information gap resulting from difficulty matching tax returns of flow- through businesses with their owners’ returns.

‘Big Step Forward’

As a result of the difficulty matching returns, taxpayers reporting flow-through income typically have been counted as small business owners, even if they are large companies.

“This is a really big step forward,” said Edward Kleinbard, a former staff director of the Joint Committee on Taxation, who is now a law professor at the University of Southern California. “Before this, you had the largest law firms in America, with revenues over $1 billion, and they were being treated as small businesses. That’s just preposterous on its face,”

More than 90 percent of businesses are structured as flow- through entities and their owners pay about 43 percent of all U.S. business taxes on their individual tax returns, according to a study by Robert Carroll, a former Treasury official, for the S Corporation trade group.

Reardon said subjecting flow-through profits to corporate taxes would amount to double taxation because owners of such companies already pay personal income tax on their earnings.

Small Business Cutoff

Using $10 million as the cutoff for a small business is arbitrary, though it does have some basis in tax administration, according to the Treasury official. For example, the Internal Revenue Service uses $10 million in assets as the administrative dividing line between large and small businesses.

Under the proposed definition, there would be significantly fewer small businesses and fewer owners of such businesses would be included in top income brackets.

Democrats could use the proposed definition to argue for tax increases, said Payson Peabody, a former tax counsel to former Republican Senator Jim Bunning.

“In the short term, this report is aimed at Republicans in Congress who say that raising top rates would impact small business,” said Peabody, who represents the Angel Capital Association, a trade group of private early-stage investors. “The White House always has said the impact on small business would be smaller, and, by narrowing the definition of small business, this report attempts to back that claim,”

Using the proposed definition, 20 million small business owners reported $376 billion in net business income for 2007, according to a Treasury analysis of returns that year.

Under a second, narrower definition in which profit or loss from a business represented at least 25 percent of a filer’s income, researchers estimated there were 9.4 million small business owners with $335 billion in reported income for 2007.

The previous methodology counted 34.7 million filers reporting $662 billion in income in 2007.

Under the new definitions, the share of small-business income subject to the top two tax rates dropped to 32 percent under the broad definition and to 29 percent under the narrower one. By comparison, under the previous methodology, 50 percent of small- business income was taxed at the top two rates.