Chapter 8
“Tax Payments Can Be the Difference between Survival and Failure”
It’s difficult to embark on a project of this kind completely free of expectations regarding what you’re likely to hear. As we set out to ask entrepreneurs across the nation about the issues and challenges that complicate their efforts, one of our expectations was that taxes might come up as a source of frustration. After all, any business owner would naturally prefer to keep as large a portion of the business’ earnings as possible—to reinvest into the business or to simply enjoy more of the fruits of one’s labor.
And, indeed, as we expected, the subject of taxes came up frequently—but not in the way we expected. In fact, all over the country we heard entrepreneurs make comments such as: “I understand that we all have to pay taxes,” and “I’m fine paying taxes,” and even, “I didn’t get into business to avoid paying taxes.” And yet our roundtables made clear that taxes are a source of frustration and even anxiety for many of our participants.
For a while, we were puzzled by this nuanced, even seemingly contradictory feedback regarding taxes. But as we continued to listen, we began to understand.
“We literally spend thousands of dollars a month on accountants,” said Mark Casey, president and chief executive officer of CFN Services, a telecommunications networking company based in Herndon, Virginia. “Sometimes the issue is getting bills for taxes that we’re not even aware that we owe. How do you find out about these things? I’ve raised my hand and said ‘I’m doing business in your state—have someone call me.’ We’re not trying to be noncompliant. But we need a little help to make sure that we’re not missing something. Large businesses have huge accounting departments to take care of this, but for smaller firms it’s a real burden.”
“Here’s the problem with taxes,” said Bob Burns, president of RL Burns, Inc., a construction management company in Orlando, Florida. “We do the work and then we wait to get paid. So cash flow is extremely important. It’s where we’re most vulnerable. When you have a good year, you get hit hard with taxes. When you have a bad year that extra cash you paid in taxes would really be great to have. And so taxes make things difficult, especially given how volatile things have been.”
Our roundtables revealed that entrepreneurs often think about taxes the way they think about two other critical challenges—the burden and distraction of regulation, and access to capital. Tax complexity and uncertainty—like regulatory complexity and uncertainty—divert the time, attention, and energy of entrepreneurs away from the essential tasks required to successfully launch and grow their businesses. Even more important, tax payments drain new businesses of critical cash flow and operating capital.
Taxes are a business reality, and our roundtable participants are “fine” with paying them. But tax complexity and uncertainty, together with the loss of precious capital, can amount to mortal threats to new businesses, particularly in the critical early years.
“Cash flow is the lifeblood of start-ups,” Reggie Chandra, president and chief executive officer of Rhythm Engineering in Lenexa, Kansas, told us. “People around the table have talked about the importance of access to capital in the context of outside investors. But it’s also about holding onto the capital you generate internally through sales. Young businesses barely scrape by in the beginning and then the government takes a third of their profit in taxes—money that could have been invested back into to the business. That money can be the difference between survival and failure.”
Chad Gummer agreed. “Our biggest challenge that we run into is tax issues.” Gummer is president of Gummer Wholesale, Inc., a family-owned and -operated wholesale distribution company based in Heath, Ohio, that supplies convenience stores in Ohio, Kentucky, and West Virginia. “We’re in a high sales dollar, low net profit kind of business. So when they come and take the money from your net sales, it kills you.”
“My big frustration, and what I see as the big issue affecting not only women-owned businesses but small businesses in general, is that business only works when you can project,” said Laura Yamanaka, president and founder of LA-based teamCFO, and chairwoman of the National Association of Women Business Owners. “These days, it feels more like Vegas—so much unpredictability . . . the tax rules have to change so we have more predictability. So that it’s attractive to invest and so that the economy is working.”
Research supports the feedback from our participating entrepreneurs. For example, higher tax rates have been shown to reduce investment spending by entrepreneurs and to deter their hiring of additional workers.1 And, indeed, a survey of more than 900 chief executives of small businesses conducted by the Wall Street Journal in December of 2012 found that, due to anticipated tax increases associated with the “fiscal cliff” negotiations in late 2012, 32 percent of respondents indicated they planned to reduce investment spending, while another 30 percent planned to hire fewer workers.2
During the 2012 tax policy debate leading up to the year-end expiration of tax cuts passed during the Bush Administration, an analysis by Ernst & Young found that raising top individual tax rates would be associated with a loss of approximately 710,000 jobs because more than 2 million U.S. businesses organized as S corporations,3 partnerships, limited liability companies, and sole proprietorships would be affected.4 Such businesses are referred to as “pass-through” businesses because their profits are passed through to owners and investors who pay taxes on those distributions by way of their individual returns.5 Nearly 95 percent of U.S. businesses,6 85 percent of small businesses,7 and virtually all new businesses are organized as pass-throughs.
Such firms employ more than half of the private sector workforce.8 A recent analysis of the Federal Reserve’s Survey of Small Business Finances by George Haynes of Montana State University reveals that small-business owning families who earn more than $250,000 per year employ 93 percent of the people employed by small businesses.9 Because the vast majority of new and small businesses are organized as pass-throughs, raising taxes on wealthy individuals also raises taxes on millions of start-ups and other small businesses, leaving them with less money to reinvest, expand, and create jobs.10
The American Taxpayer Relief Act of 2012, signed into law by President Obama on January 3, 2013, following month-long negotiations between the Administration and Congress to avoid the so-called “fiscal cliff”11 raised tax rates on personal income above $400,000 for individuals and $450,000 for couples from 35 percent to 39.6 percent. As a result, businesses organized as pass-throughs that earn income above those levels now pay a tax rate 4.6 to 10 percentage points higher than businesses organized as corporations.12 According to Doug Elmendorf, Director of the Congressional Budget Office, the higher rates mean 750,000 fewer new jobs in 2013.13
In Chapter 7, we explained that the stifling effect of regulatory burden, complexity, and uncertainty is particularly acute for new businesses. New firms lack the resources and scale of larger firms over which to absorb and amortize the costs of compliance. Moreover, their very survival, especially during the initial years, depends on the energy, focus, and flexibility of their leaders. According to the Small Business Administration, the cost of regulatory compliance for small businesses is 36 percent higher per employee than for larger firms.14
For similar reasons, new businesses are much more vulnerable to the impact of tax complexity and uncertainty than larger businesses. According to the National Federation of Independent Business (NFIB), tax compliance costs are 67 percent higher for small businesses than for larger businesses, costing small businesses nearly 2 billion hours and more than $18 billion each year. Nearly nine out of 10 small businesses are forced to rely on outside tax professionals to ensure compliance. A recent NFIB survey of 12,500 of its member businesses found that 85 percent want Congress to “fundamentally revise” the tax code in 2013, with 78 percent supporting a simpler tax code with fewer exemptions and preferences.15
“Take some of the tax burden off!” an exasperated Brent Frei of Smartsheet in Seattle, Washington, told us. “When this state was talking about slapping a 10 percent tax on the ‘wealthy,’ what that really means is small businesses. If that had passed, I would have moved our business out of the state, because it would have paid to do so—and might have made the difference.”
Frei went on to explain another way that taxes can undermine new businesses, or even discourage them from ever launching. “I’ve started three companies and I know a lot of successful entrepreneurs. They succeeded by clawing and scratching at the dirt. A lot of hours and a lot of personal risk. They look for a longer-term payout after a lot of short-term pain. That’s the culture. And it’s fundamental. I didn’t go without a wage for the entire founding phase of my businesses and put all my personal capital into them in hopes of an eventual payout only to have that hurdle raised unexpectedly down the road. I mean, that’s crazy. Make the incentives better for people and they’ll go out and take the risk.”
An additional issue we heard is that the tax code is often irrational—punishing, or not sufficient rewarding, business activity that should be encouraged, and encouraging activity that should be minimized. For example, the research and development tax credit was created by way of the Economic Recovery and Tax Act of 1981 and is intended to incentivize technological progress and innovation by allowing businesses to deduct a portion of the cost of research and product development from their taxable earnings. Unfortunately, the original credit was temporary and, while Congress has renewed the credit 14 times, it has never made it permanent, creating year-to-year uncertainty for firms that need to plan their R&D spending coherently over time.16 Moreover, even when renewed, the formula for calculating the credit has changed many times.
“We took a third of our profits last year and invested in R&D,” said Brent Gendleman, president and chief executive officer of 5AM Solutions, a life science and healthcare software engineering company in Reston, Virginia. “This is how the tax credit worked: Take 50 percent of the money that we invested, then take 20 percent of that 50 percent. That’s the tax credit we got. Just 10 percent of what you invest. And only off the top line of your tax burden, so the actual value is minimal. Maybe a laptop. For a state to claim that’s an incentive to entrepreneurship is nonsense.”
We propose two broad reforms of the R&D tax credit in the next chapter.
Rob Lilleness, president and chief executive officer of Seattle-based Medio Systems explained how the tax code virtually requires him to invest offshore: “The U.S. rewards companies for having people and assets offshore. In a prior company we opened in Singapore—zero taxes. We opened in Hong Kong—12 percent taxes. Before long, the majority of our revenues were outside the United States, even though I might not want it that way or even believe in it. We serve our shareholders and they want the best return on their capital. We offshored, that lowered our tax base, and boosted our earnings per share. And now that the money is banked offshore, it makes more sense to buy companies and talent overseas because you can’t repatriate that capital or you’ll face a 35 percent hit.”
But the most common complaint we heard from entrepreneurs regarding taxes is that they are too complex and constantly changing, requiring far too much time, energy, and other resources, and making it virtually impossible for young businesses to effectively plan. This feedback from our roundtable participants is consistent with the results of the 2012 Small Business Taxation Survey released by the National Small Business Association. Asked what tax-related issue is the most significant challenge to their business, 56 percent of respondents said the administrative burden of the tax code. Eighty-five percent said the tax code is so complex they have to hire an external tax practitioner or accountant to handle their taxes.
Another survey conducted in January of 2013 asked senior executives at 600 start-up companies across the nation: “What piece of advice would you give to President Obama with regard to supporting the innovation economy?” The top response, offered by nearly a third of survey respondents, was to simplify the tax system. Attracting and retaining the world’s best talent was the second most common response.17
“Just give me a number!” said an exasperated Rhonda Pressgrove, founder and chief executive officer of Help Me Rhonda Cleaning Services in Southaven, Mississippi, and a participant at our Memphis, Tennessee, roundtable.
“And don’t change it!” echoed Rick Leung, vice president of development and chief technology officer at Austin, Texas–based Vyopta, Inc., a developer of applications for business video. “If we have a number we can count on, we can build a business around that. What we can’t manage is the goal posts constantly moving. We don’t have the time or the money to keep up with changes year after year that force us to rethink our business model and what our tax liability is going to be.”
“We just want [the government] to make taxes easy to handle,” said Mary McCarthy, co-founder and president of Your Management Team, a Westerville, Ohio–based management consulting firm serving entrepreneurs and small business owners. “And the employment laws and healthcare laws, too. The things that impact us. Make them as simple as possible so that we can just focus on our business.”
A number of our participants went so far as to say that they would pay higher tax rates—despite the impact on their businesses—in exchange for certainty.
Policy Recommendations
With the intention of significantly reducing tax burden, complexity, and uncertainty for new businesses, we recommend the following:
Establish a Preferential Tax Framework for New Businesses
In Chapter 7 we proposed that the Congressional Budget Office (CBO) and the Office of Management and Budget (OMB) be directed to co-develop a preferential regulatory framework to which fragile new businesses would be subject for the critical first five years after formation. The preferential framework would be comprised of only the most essential product safety, environmental, and worker protection regulations in order to minimize regulatory burden on new firms. To minimize regulatory uncertainty, the new-business regulatory framework should also protect new businesses from new regulations for the first five years after formation.
To this preferential regulatory framework, we propose adding preferential tax treatment of new businesses. Specifically, we propose that the Internal Revenue Service (IRS) be directed to establish a new entrepreneur—or “e-corp”—tax status, whereby newly launched businesses would be subject to a flat 5 percent income tax for the first five years after formation. Call it the “Five for Five” plan. Such favorable and predictable tax treatment will help cultivate new business formation, survival, and growth by allowing new businesses to retain and reinvest most of what they earn, preserving critical cash flow, and eliminating the distraction and burdens of tax complexity and uncertainty.
As we mentioned in Chapter 7, the IRS, working with CBO and OMB, should develop appropriate definitions, characteristics, and limitations regarding the meaning of “new business” to avoid abuse of the preferential regulatory and tax framework, such as business owners simply renaming or reconstituting existing companies every five years.
Allow Cash Method of Accounting for the First Five Years
Current law generally permits businesses with gross receipts of $10 million or less to use the cash method of accounting. The cash method is simpler, less costly, and easier for new businesses to understand than accrual accounting or other more complex accounting methods to which some businesses are subject. As part of the proposed framework of favorable and predictable tax treatment of new firms, we also propose that all new businesses, regardless of revenue levels, be permitted to use the cash method of accounting, if they choose to, for the first five years of their operation.
Allow 100 Percent Expensing of Business Investment for the First Five Years
The Small Business Tax Revision Act of 1958 created for the first time a special first-year depreciation allowance whereby small businesses could deduct or “expense” from their taxable earnings a portion of the total cost of capital and equipment investment, pursuant to section 179 of the Internal Revenue Code. The purpose of the provision was to reduce the tax burden on small businesses, stimulate small business investment, and simplify tax accounting for smaller firms. The original deduction was limited to $2,000 of the cost of new and used business machines and equipment.18
Expensing is the most accelerated form of depreciation, allowing businesses to write off the cost of business investment immediately rather than over time. Future deductions are not as valuable to businesses due to the time value of money and because deductions are not indexed for inflation. Expensing stimulates business investment by maximizing the tax benefit of depreciation and thereby effectively lowering the cost of the capital required to make the investment.19
Since 1958, the limits and details of the special expensing allowance have changed many times—most typically to raise the expensing limit as a means of stimulating economic growth by incentivizing business investment. Most recently, in the midst of the accelerating economic downturn in 2008, Congress raised the allowance to $250,000 as part of the Economic Stimulus Act of 2008, and then to $500,000 as part of the Small Business Jobs Act of 2010. The American Taxpayer Relief Act of 2012, signed by President Obama to avoid the “fiscal cliff,” preserved the $500,000 allowance for 2013.
As part of our proposal to provide preferential tax treatment for new businesses over the critical first five years after their formation, we also propose that new firms be allowed 100 percent first-year expensing of the total cost of business-related capital, equipment, off-the-shelf software, and real estate investment. According to an analysis by the Treasury Department, 100 percent expensing lowers the average cost of capital on new investments by more than 75 percent.20 Such savings are enormously significant, especially for new businesses for whom access to sufficient capital at reasonable terms remains a principal challenge. We also propose that new businesses with no taxable earnings in particular years during their initial five years be permitted to carry forward the deduction of such expenses for 15 years beyond the year in which the capital expenses were incurred.
Together with the proposed 5 percent flat income tax for the first five years after formation, such favorable and predictable tax treatment will help cultivate new business formation, survival, and growth by allowing new businesses to retain and reinvest most of what they earn, preserving critical cash flow, and eliminating the distraction and burdens of tax complexity and uncertainty.
Pass the Start-Up Innovation Credit Act
On January 31, 2013, Senators Chris Coons (D-DE) and Mike Enzi (R-WY) reintroduced a bill to help start-ups access the research and development (R&D) tax credit.21 As mentioned briefly above, the credit was created by way of the Economic Recovery and Tax Act of 1981, and is intended to incentivize technological progress and innovation by allowing businesses to deduct a portion of the cost of research and product development from their taxable earnings.
The credit is particularly relevant for new businesses, which often incur substantial costs in their early years researching and developing new products and services, methodologies, and techniques—and for whom preservation of cash flow and operating capital is crucial.22 But because many new businesses experience operating losses in their early years, there may be no income tax liability against which to claim the credit.
The Start-Up Innovation Credit Act would allow companies less than five years old with less than $5 million in revenue to deduct the total amount of R&D spending up to $250,000 from the payroll taxes they pay on employee wages in the following year, rather than against income taxes.23
In reintroducing the bill on the floor of the Senate on January 31, 2013, Senator Coons stated:
Companies that invest in R&D generate new products, which spark new industries with spill-over benefits for all kinds of sectors. . . The R&D credit has helped tens of thousands of American companies succeed and create jobs. But there is a critical gap in the existing R&D credit. It isn’t available to start-ups, because they are not yet profitable, and thus they don’t have an income tax liability against which to take a credit. In fact, more than half the R&D credit last year was taken by companies with revenue over $1 billion, well-established, profitable companies. . . [T]his bipartisan Start-up Innovation Credit Act . . . opens this credit to new companies who don’t yet have an income tax liability. . . Rather than shutting our start-ups out of the R&D tax credit, let’s open the doors to these innovators and see what they can do.24
We agree. If new businesses are both the engine of job creation and the source of most innovation in the economy—and they are—an R&D tax credit that overlooks new businesses, however important and well-intentioned the credit may be, is off-target.
As we mentioned in Chapter 2, a recent study by the Small Business Administration found that, between 2002 and 2006, firms with fewer than 500 employees registered 15 times more patents per employee than large firms.25 We strongly suspect that, as with job creation, start-ups are responsible for the vast majority of small business innovation and registered patents. Small companies are also more likely to explore technology subfields in which large firms are less active, and more likely to do their R&D in the United States.26 Senator Coons’ bill sharpens the aim of the R&D tax credit, rewarding research and development in the most innovative sector of the economy.
But we suggest one change—to maximize the impact of the Senator’s proposal, we recommend lifting the $5 million in revenue limitation and simply allowing all new firms to deduct their R&D spending up to $250,000 from payroll taxes for the first five years after formation.
Notes
1. Robert Carroll, Douglas Holtz-Eakin, Mark Rider, and Harvey Rosen, “Entrepreneurs, Income Taxes, and Investment,” in Does Atlas Shrug? The Economic Consequences of Taxing the Rich, ed. Joel Slemrod (New York: Russell Sage Foundation and Harvard University Press, 2002), 427–455; and William M. Gentry and R. Glenn Hubbard, “Success Taxes, Entrepreneurial Entry, and Innovation,” National Bureau of Economic Research, Working Paper No. 10551, June 2004. Also see Robert Carroll, Douglas Holtz-Eakin, Mark Rider, and Harvey Rosen, “Income Taxes and Entrepreneurs’ Use of Labor,” Journal of Labor Economics 18, no. 2 (April 2000): 324–351.
2. Emily Maltby and Angus Loten, “Cliff Fix Hits Small Business,” Wall Street Journal, January 3, 2013.
3. The term refers to Chapter 1, Subchapter S of the Internal Revenue Code. For definition, requirements, restrictions and other details, see www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/S-Corporations.
4. Robert Carroll and Gerald Prante, “Long-Run Macroeconomic Impact of Increasing Tax Rates on High-Income Taxpayers in 2013,” Ernst & Young, July 2012. Also see J. D. Harrison, “Obama Plan to Lift Top Tax Rate Would Plague Millions of Small Businesses, Study Warns,” Washington Post, July 17, 2012.
5. John D. McKinnon, “More Firms Enjoy Tax-Free Status,” Wall Street Journal, January 10, 2012.
6. Taxing Businesses Through the Individual Income Tax (Washington, DC: Congressional Budget Office, December 2012.
7. National Federation of Independent Business.
8. Robert Carroll and Gerald Prante, “The Flow-Through Business Sector and Tax Reform,” Ernst & Young, April 2011. Also see Trip Gabriel, “A Fuller Picture in the Small-Business Tug of War,” New York Times, July 13, 2012.
9. Scott Shane, “The Politics and Economics of Taxing Small Business Owners,” Business Insider, July 16, 2012.
10. See Emily Maltby, “Small Firms Fret Over Higher Taxes,” Wall Street Journal, December 5, 2012.
11. The term “fiscal cliff,” first used by Federal Reserve Chairman Ben Bernanke in testimony before the House Financial Services Committee on February 29, 2012, referred to unique and highly adverse fiscal policy circumstances facing Washington policymakers as of January 1, 2013. Those circumstances included tax increases associated with the expiration of The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, and major defense and non-defense spending reductions mandated under The Budget Control Act of 2011.
12. See “Tax Revenues to More Than Double by 2023, While Top Tax Rates Hit Highest Level Since 1986,” Chairman David Camp, House Committee on Ways and Means, press release, February 13, 2013. Also see Emily Maltby and Angus Loten, “Small Firms Scramble to Redraw Plans,” Wall Street Journal, January 2, 2013.
13. Director Elmendorf discussed the impact of higher rates on jobs beginning in minute 29:30 of a press briefing on February 5, 2013: www.c-span.org/Events/CBO-Report-Deficit-Will-Fall-to-Less-Than-1-Trillion-in-2013/10737437810.
14. Crain and Crain, Impact of Regulatory Costs on Small Firms.
15. Taxes and Spending: Small Business Owner Opinions (Washington, DC: National Federation of Independent Business, March 7, 2013).
16. The original credit’s expiration date was December 31, 1985. The credit has expired eight times and has been extended 14 times.
17. “Startups Advise Obama: Focus on Taxes and Talent As Second Term Begins,” Silicon Valley Bank, January 18, 2013.
18. Gary Guenther, Section 179 and Bonus Depreciation Expensing Allowances: Current Law, Legislative Proposals in the 112th Congress, and Economic Effects (Washington, DC: Congressional Research Service, August 2, 2012).
19. Kevin A. Hassett and Glenn Hubbard, “Obama Discovers Incentives,” Wall Street Journal, September 10, 2010.
20. The Case for Temporary 100 Percent Expensing: Encouraging Business to Expand Now by Lowering the Cost of Investment (Washington, DC: Office of Tax Policy, U.S. Department of the Treasury, October 29, 2010).
21. The bill was originally introduced on July 31, 2012.
22. See Karen E. Klein, “The R&D Tax Credit Explained for Small Business,” BloombergBusinessweek, August 16, 2011.
23. For more information on the Start-Up Innovation Credit Act, see www.coons.senate.gov/newsroom/releases/release/senators-coons-enzi-introduce-randd-tax-credit-for-startup-companies. Also see Jennifer Martinez, “Bipartisan Group of Senators Re-Introduce Start-Up Tax Credit Bill,” The Hill, January 31, 2013.
24. Also see Senator Chris Coons and Senator Mike Enzi, “R&D Tax Credit Spurs Innovation,” Politico, March 7, 2013.
25. Anthony Breitzman and Diana Hicks, An Analysis of Small Business Patents by Industry and Firm Size (Washington, DC: Small Business Administration, Office of Advocacy, November 2008).
26. Laura Tyson and Greg Linden, The Corporate R&D Tax Credit and U.S. Innovation and Competitiveness: Gauging the Economic and Fiscal Effectiveness of the Credit (Washington, DC: Center for American Progress, January 2012), 15–16.