Columbia Gniversitp inthe Citpof Hew Pork THE LIBRARIES SCHOOL OF BUSINESS ™m wn Ee bea Me 2} ee Ha 4 = wy Fy 2) B oO tH October 1947 m f Tax Research, Treasury Department TAXA ision 0 Divi Taxation of Small Business A widely shared belief in the social and economic importance of small business and concern about its financial problems have stimulated many tax proposals for the special benefit of small business, This report analyzes several types of proposals that have been advanced, These include vroposals intended to refine or revise the income tax base and rates, proposals intended to equalize taxes on small incorporated and unincorporated businesses, and proposals to provide tax exemption for new or small businesses or for investors in them, No policy recommendations are made in this study, but the probable effectiveness of the various types.of proposals is appraised and problems that would be raised by their adoption are discussed, _. The study was prepared in the Business Tax Section of the Division of Tax Research, In its prepsration valuable assistance and suggestions were received from other members of the Treasury tax staff, including consultation with members of the Office of* Tax Legislative Counsel on legal matters and of the Bureau of Internal Revenue on administrative matters. Division of Tax Research U.S. Treasury Department October 1927. SUMMARY eo e«© 6 @ &¢ @ I. Introduction . Taxation of Small Business TABLE OF CONTENTS e e s . e e e ° ° s ° ° Bit As Importance of small businesses. . . Be Problem of defining srall business. « « « « C. Relative position of cmall business. « « « « D. Interest in the problems of small business. E. Purpose and scope of the present report. . Analysis of tax proposals for the special benefit of small business 2. « » «se es A. Proposals for modification of the base or rates of taxes on income of small businesses. « » « e « » © 1. Graduation of corporation income tex rates . » « » «© = « ® de Ce ey a h. Nature of. proposals and scope of present discussion . Present rate schedule . 2. 2» 6 ee ee 2 oo oe wo 8 Justification of graduation of corporate income tax rates » . 2s se ss ee oe Limited versus fiv.l graduation. « « » « «© « © © © © @ Wethges af pradurtion 4b. i yok os 6 6 Geass oH Relation between the startinz rate on corporations and the first-bracizet rate on individuals 2. « » » « « The problem of spfit-ups. +» « «ee ee ee we wo oe Peete 100S 6k ew ee es ee 8 eRe 8 ee ee 2. Modification of Section 192 of the Internal Revenue Code , Ae De /“CONCLUSEONGS coe 6 se Jel ws ee eo a e: 6 6 6 ‘se © 6 Nature and purpose o2 Section 102 2. « «2+ se ++ « Application of Sectf$on 102. «2 « eee © wo Problems raised by proposals for an exemption under Section 102. . +. ees WONCLUSTONS — 4 6 es § a ells as @ 0 6 6 8 6 offsets and the taxati...1 of small business, one Purposes of loss offsefitcs « 6 «2 «© + +» we ee wo ww 6 Administrative problems of loss offsets « . . «+ + « Special advantages of less offsets for small business eo «© @ TABLE OF CONTENTS - 2 4, Accelerated depreciation for small business. Nature and purposes < , . . » e COVEEAZCS 26) 6 se 2 6 ss Meenomic GffSCtS. 2 - -« s+ « Howity considerations « . + « Administrative considerations CONGINGIONS «4 5 © 6 « 6 s ee e B. Proposals intended to equalize taxes on small incorporated and unincorporated businesses. 2 « » » » « 5. Partnership tax treatment for certain corporations ae Natcuxe and UrpOSeS 6 << is 6 0 6 « 6 sie +-< be Hligibility for partnership treatment . ... Cc. Types of corporations that would benefit from partnership tax treatment. ad. Economic considerations . .« e » e. Equity considerations . . « » « f. Administrative considerations . fie UOOMCIUSIONS tice «sc 6b se 88 6. Corporate tax treatment for the reinvested earnings of unincorporated businesses, « 5 « » ee eee Qe Navure and purpose of proposal, . «6 « «és <3 « « @ be. Extent of possible tax discrimination against retained earnings of unincorporated firms under present law. Ce Economic CONSIGCrATTONS sie 6 6 ee 6 «<6 cs 6 4 6 de. tauity Considerations . 46 2 i e's aS ee we €. Administrative considerations » o 2 6» e ie Conclusions oo fe © © © © ee oe 8 C. Proposals for tax exemptions for small or new businesses or for investors in them, . <6 s e * {+ T exemption for retained earnings of businesses. Nature and purpose of proposals eevee Economic considerations . » « « moe 6 Equity considerations « se. » 6 ee 8 6 Administrative considerations . eee Conclusions ¢o eo © ee eB € e e s e¢ 8 exemption for equity investors in small businesses... Nature and purpose of proposals Economic considerations « + «-« Equity considerations » e« « » » Administrative considerations , CONCTUSTONS 6 « +e 3 9's oe TABLE OF CONTENTS — 3 9. Tax exemption for new small businesses for a limited period of years. ... @, Nature of proposals , wee Gs b, Economic considerations .... Cp, quity considerations ..,.. d, Administrative considerations Ge Conelusions ¢ 406i 6 3 4 8 ks III, Choice among types of tax measures for the benefit of small business. , APPENDIX A — Definitions of Small Business wee eS ee APPENDIY B — Selected Statistics on the Relative Importance of Small Business, . 3 2... oe ee eck Be _ APPENDIX C — Selected Data on Financing of Small Business. ... APPENDIX D — History of Graduation of the Corporation Income Tax TABLE OF CONTHITS - 4 TABLES Net Operating Loss Deduction Related to Net Income and Deficit,. Corporations with Balahce Sheets Classified by Size of Assets, 1940-192, e ° ry ° e cd ® e e © e e © e * e ® e ° e e e e ° e 2 eo 4 e Net Income Related to Total Assets and Gross Sales; Gross Sales Related to Total Assets, Net Income Corporations with Total Assets of Less than $250,000, 19ue, e¢ © ® ® e e ° e e ° ¢ ® e ° ® e @ e e e Importance of Small Establishments in Sclected Incustry Groups, 1939 Corporation Returns in Selected Industry Groups Classified by Size of Total Assets, 10U2, ... se ee ees Corporation Returns with Net Income Gbeseified by Size of Net Income, 1942. . «se ss os 8 ot Cost of Flotation of Securities by Size of Issuer, 193191. Average Interest Rates on Short-— and Long-Term Business Loans Member Banks, by Size of Borrower, November 20, 1946 ....5e-eee6 Average Interest Rates on Business Loans at Member Banks, by Size of Loan and Size of Borrower, November 20, URE sa ee Retained Net Warnings as a Percentage of Net Income After Taxes, @erperations with Not Imecome, 199-1913 . «kk se bee he 8 sO Taxation of Small Business SUMMARY I, Introduction A widely shared belief in the social and economic importance of small business has stimulated interest in its problems and tnx proposals for its benefit. The present report analyzes a number of the tax proposrls thet have been advanced for the special benefit of smoll business, A varicty of definitions of small business have been used, and there is no one generally accepted measure, On the basis of any of the definitions commonly used, however, it appears that small businesses account for a large majority of the number of firms and a sizable part of production and employment. The Department of Commerce has @efined a small business as a retail store or service establishment with annual net sales or receipts of less than $50,000, a wholesale establishment with annual net salos -f less than $200,000, or a menufacturing establishment with fewer than 100 employees, On the basis of this composite definition, more than nine-tenths of all business establishments were "small" in 1939, and in that year they employed about 4O percent of all workers and active proprietors anc handled about one-third of salese A small business has nfton been defined as one with less than $250,000 of total assets. In 1942, four-fifths of all corporations filing balance sheets with the Burecu of Int ernal Revenue fell in this caterory, but these corporations made only 15 percent of gross sales and realized only 5 percent of net income of all corporations filing balence sheets, In 1942, almost nine-tenths of all corporations with net incoric reported loss than $50,000 of net income, but the aggregate net income of these corporntions was only 7 percent of the total reported by all corporntions, Doubtless, an even greater percentage of unincorporated businesses fell in the smaller asset and net income groupSe Available informetion indicates that there was a sharp decline in the number of firms in business during the years 1941-1943, Since then, however, the number of firms in business has incrersed rapidly, and by mid-1946 the number of firms exceeded the pre-war peak. Recent increases in the number of firms have been almost entircly among small bhusinessese a ee II, Analysis of tax proposals for the special benefit of small business Tax proposals for the benefit of small business stem from two different points of view, One view is that the tax system should be deliberately biased in favor of small business in order to offset some of its non-tax disadvantages. The other view is that the tax system should not discriminate against small business but that special measures are necessary to assure substantially equal treatment. This section discusses a number of different proposals that have been advanced for the special bencfit of small business, It appraises their probable effectiveness in reaching declared or implied objectives. and considers whether their adoption would raise new problems or accentuate old problems of equity, economic effects, and administration, Most of the proposals raise the problem of the proper definition of small business and how eligibility for the special treatment can be equitably and effectively determined, Moreover, the proposals would all result in some immediate loss of revenue and must, therefore, be appraised in the light of alternative tax reduction possibilities and the budgetary and economi¢ situation, A$ Proposals for modification of the base or rates of taxes on income of small businesses faxes on income of small businesses lé Gradustion of corporation income tax rates At the present time, the rates of the corporation income tax are graduated for net incomes up to $50,000, The brackets are as follows! on the first $5,000 of net income, 21 percent; on net income between $5,000 and $20,000, 23 percent; between $20,000 and $25,000, _ 25 percent; between $25,000 and $50,000, 53 percent, If the corporation's net income is more than $50,000, the rate is 38 percent on the whole net income. The 53-percent rate on net income between $25,000 and $50,000, Which is the so-calle@ "notch" rate, is used to make the transition from reduced rates on net incomes below $25,000 to the standard rate on net incomes above $50,000, The relatively high notch rate on incomes between $25,000 and $50,000 has been widely criticized and its elimination often suggested, Although the total tax elways amounts to less than 38 percent of an income below *50,000, the rate on the lnst part of income of a corporation in the notch area is higher than that paid trv a larger. corporations A notch rete higher than the standard rate is necessary under any sche@ule that restricts graduation to small corporations. In the absence of the notch rate, at some point an increase in a wilt = corporation! s net income before tax would decrease its income after tax, The notch rate could be, eliminated only by adopting a system of full Eatin which would apply reduced rates to the first part of income of all corporations, A full graduation system would eliminate the problems raised by the notch rate but would reduce the difference between the effective rates of tnx on small and large corporstionss In addition to the present bracket method of graduation, it would be possitle to achieve ear by means of graduated effective rates or by an exemption of a specific mount of net income, Under the method of graduated sepauite rates, the rate applied to the whole income would incrense with size of income over a certain ranges - With an exemption, the effective tax rate would begin at zero and rise as the exemption became a smaller fraction of the taxpayer's income. Graduated bracket rates ere simpler than graduat ed effective rates, but the latter may be less likely to deter expansion of income since they do not call attention to the tax rate imposed on an addition to income, Graduation by means of an exemption is relatively inflexible, and the starting rate must be zero. Moreover, any schedule providing a lower starting rate for corporations than for individuals would raise a problem of possible unfnir discrimination against unincorporated enterprises an@ would offor stockholders a@ditional opportunities for: tax postponement or avoidances 2, Modification of section 102 of the Internal Revenue Code Section 102 of the Internal Pevenue Code imposes a special surtax on corporations improperly accumulating surplus for the purpose of per- mitting stockholders to avoid ind@ividunl income tax on their part of profits, The rates of this svecial surtax are 27.5 percent of the first $100,000 of undistributed net income and 38,5 percent of any amount in excess of $100,000. It has been contended that fear of application of this specinl surtax has prevented small corporations from retaining enough earnings to provide adequate working capital and to finence exnansions For this reason it has been suggested that a limited amount of net income be exemot from section 102 surtax, Section 102 is not intended to vrevent retention of profits for reasonable business purposes, or the individual tax avoidance or postponement incidental thereto, but rether to protect the individual income tax from unreasonable accumulations of corporate surpluses for the purpose of avoiding surtax on stockholders, It appears that the law anéd reguintions allow adequete accumulations for »11 reasonatle business purposes inclucing both cxpansion and working eapitel, In the administration of section.102, careful consideration is given to the circumstances of each corporation and its need for retained _ earnings, Therefore, an exemption under section 102 seems unnecessary, Moreover, such en exemption would seem to be an invitation to tax avoidance, and avoidance possibilities might well be multiplied by split—ups of existing or new corporations, The remedy for any existing deterrents to legitimate accumulations appears to be further dissemination of information as to the purposes and administration of section 102, 3- Loss offsets and the taxation of small business Under present law a business net operating loss sustained in any one year may be carried back against the income of the two preceding years and any unabsorbed balance may be carried forward against the income of the two succeeding years, An extension of the loss—offset period has often been recommended as a tax revision that would especially benefit small business, Moreover, it has been contended that loss carry— forwards are more desirable than loss carrybacks. Loss offsets have the equity advantage of improving the definition of taxable income and the economic advantage of reducing tax deterrents to risky investment, There is some evidence that the income of small businesses fluctuates more widely than that of large firms and hence : that liberal loss offsets are especially advantageous for small businesses, In 1940-l2, the then existing two-year carryforward of net operating losses resulted in a significantly larger deduction for small corporations than for large corporations, An improvement ané liberalization of present loss offset provisions would be a general tax measure that could be expected to be especially beneficial to small business, { 4. Accelerated depreciation for small business In lieu of normal depreciation, it has been proposed that small businesses be allowed to trke accelerated depreciation for tax purposes by writing off assets in a period shorter than their normal useful lives, Accelerated depreciation has been suggested as a means of easing the capital problems of small firms and of reducing the risks of investment by them. As a small business measure, ‘accelerated depreciation would be limited to a stated amount. of assets and misht be restricted as to type of assets covered, Accelerated deprecistion would permit a firm to. recover its invested capitsl more rapidly than does normal Geprecistion, Income taxes would be vostnoned, and during the period when accelerated depreciation was being taken the investing firm would have the use of funds that would otherwise be paid to the Government in taxes, Since accelerated depreciation would permit more rapid recovery of capital, it would decrease the risk of loss attributable to the disappearance of an asset's cenntne power re the later years of its normal ie Unless combined with liberal loss offsets, accelerated euecbatacn would be of limited usefulness in many periods because small businesses would not have enough income to absorb the additional depreciation deductions, The existence of a long carrvover of business losses, however, decreases the importance of accelerate@ depreciation because it lessens the danger that normal depreciation deductions will run to waste. Accelerated depreciation would be especially helpful to growing firms in industries requiring substantial capital investments, but it would be less significant for mature firms and for industries requiring relatively small investments in depreciable assets, Accelerated depreciation would present some administrative problems and might give rise to some abuses, such as swapping of assets among taxpayers to take advantage of the additional depreciation allowances, B. Proposals intended to equalize taxes on small incorporated and unincorporated businesses 5. Partnership tax treatment for certain corporations The partnership method on an optional ‘basis has been proposed as a method of eliminating differences in taxation of profits of small incorporated and unincorporated businesses, Under this method there would be no corporate income tax, but stockholders would be taxed on their proportional part of both distributed and undistributed profits. It has sometimes been suggested that the partnership method be restricted to corporations with no more than a stated amount of net income or asscts, However, a stronger case can be made for extending the option to corporations that-resemble partnerships in ownership and operation, with only secondary attention to size. The option might be restricted to corporations with no more than 10 to 15 stockholders and only one class of stock. In practice, this would make it primarily a small corporation measures . The partnership mothod would eliminate the so~called double taxation of distributcd corporate profits, Hence it would result in an immediate reduc— tion of taxes on the income of any corporetion currently distributing all or a large proportion of its profits, It would also reduce current taxes on the retained earnings of corporations owned by low-income stockholders, since the individual tax rates would be lower than the corporate rates. . But in the case of corporations owned by high-income stockholders, the partnership mothod would increase current taxes on undistributed profits, © The partnership method might increase somewhst the flow of new equity espitel into small corporations, but it would not be especially well adapted to short-run solution of the enpital problems of small business, The equity problems with respect to the partnership method would be less serious then with respect to most other special measures, inasmuch as stockholders woul be taxed at the reguler individual rates on their full share of corporate profits. The partnership method would raise some difficult administrative problems, but, if restricted to corporations with few stockholders and Simple capital structures, it would probably be feasible, 6. Corporate tax treatment for the reinvested earnings of unincorporated businesses ane po maven dusinesses It has been suggested that reinvested earnings of unincorporated businesses of a commercial or industrial type be taxed at the corporate income tax rates, This proposal has been supported on the grounds that the higher indivieual income tax rates applicable to proprietors and partners with large incomes discriminate against unincorporated businesses and make it harder for them to erow from retained profits than it is for corporations, The extent nnd importance of any Aiscriminsation ageinst unincorporated firms, however, anperr to be limited, M™arnings of unincorvorated businesses are taxed at rates highcr then the corporate rates only in the ease of businesses owned by persons with relatively lerge incomes and in which a large proportion of profits is reinvested, The top individual tax rate exceeds the standard 38 percent corporate tax rate only in the case of individuals with more than $12,000 of taxable income, In 192, it apnears thet shout three-fourths of all proprietorship and partnership profit reported on individual tax returns went to persons with less then $12,000 of taxable income, More— Over, in the latest vear for which data are available less than 2 percent of sole proprietors filing tax returns reported net income in excess of $12,000, These figures include proprietors and partners who withdrew all or substantially all of their profits from their businesses as well as those who reinvested.a significant portion of their profits, Finally, . most businesses can be easily incorporated if their owors prefer the corporate tax treatment, ee Corpornte tax treatment for the retained earnings of unincorporote@ businesses, with present tax treatment for distributed enrnings, would appear to give proprietors and partners an unfair advantage over stockholdcrs. Owners of unincorporated businesses would escape so-called double taxation of vrofits withdrawn from the business and, at the same time, avoid individual surtaxes on reinvested profits. Administration of the plan would raise problems relating to the definition of an unincorporated business and to the distinction between the income and assets of the business and of its owners, C. Proposals for tax exemption for small or new businesses or for investors in then. There have also been a variety of provosals for partial or complete tax exemption for new or small businesses or for investors in them. These proposals sre intended to stimulate investment in such enterprises and to improve their capital position, All proposals . for tax exemption raise fundamental problems of tax equity because of the strong presumption in favor of uniform taxation of persons with the same incomes and in similar versonal circumstances. This presumption can be overcome only by a4 convincing Aemonstration of the social and economic desirability of the exemption, A tax exemption has the same immediste effect on the budget as an additional expenditure, and it must be comorreé with public expenditures intended to achieve the same or similar purposes. Moreover, a tax exemption results ina shift of the relative tax load, and any Undésirable effects of such a shift must be compared with any desirable effects of the exemption. 7. Tax exemption for retnined earnings of small businesses Proposals for tax exemption for retnined enrnings of small businesses are prompted by the difficulty that small firms have in raising outside capital. The »rgument that has been advenced in support of such proposels is that at » certain stage in the establish- | ment of a firm a rapid increase in capitnl becomes necessary, If the additional capital can be obtained the firm may enter a period of healthy growth but without the additional capitel it may slip backward into bankruptcy. It has been contended that at this critical stage a tox exemption for retained earnings may supply the key amount of capital and that in the long run the increase in the tax base will make uD for any immediate loss of revenue attributable to the exemptione —- vili — A tax exemption for retained earnings of small firms would increase the funds at their disposal and in some cases might contribute significantly to the establishment of a successful and vigorous enterprise. But a part of the additional internally financed investment in firms enjoying the exemption woul¢c probably merely take the place of investments that would otherwise have been made by other firms, The resulting pattern of investment might be less efficient than that which would otherwise exist, The tax exemption would discriminate in favor of one kind of savings as compared with others and might be subject to abuses which would accentuate the equity problems. A grave administrative voroblem, which would be especially difficult in the case of unincorporated enterprises, would te to make sure that retained earnings were used for legitimate business purposes and not merely as a means of tax avoidance. 8 Tax exemmtion for equity investors in small businesses Exemption from the indivi¢uel income tax for eauity investors in small, businesses might apply cither to the principal amount invested. or to the return on the investment. “hese proposals are intended to overcome tax detorrents to risky investments in small businesses and to make such investments more attractive as compared. with securities of large corporations an¢ governments. The economic, equity, and administrative considerations with respect to these exemption proposals are similar to those with respect to the proposals for exemption of retained earnings of small tusinesses. One special administrative problem would be the proper @efinition of equity capitals 9, Tax exemption for new small businesses for a limited period of years Exemption from income tax for the first few years of the life of new businesses has been. proposed as a means of stimulating investment in new firms and of vermitting them to establish themselves by accumulating capitel out of earnings. A temporary tax exemption would have its greatest appeal in fields that promise large profits at the outset but which have an uncertain future. In such fields, however, prospective returns are likely to be so high that the income tax will not be a serious deterrent to investment. The most plausible case for temporary tax exemmtion is to permit investors to recover their c»pital more quickly than would be vossible with normal depreciation deductions under an income taxe This objective, however, could probably be more efficiently attained by accelerated depreciatione a Se In the rather typical case in which a new firm must look farward- to losses for the first few years, a temporerTy income tax exemption would have little stimulating effect. The temporary tax exemption would offer an incentive,to the establishment of new firms and the abanéonment of old ones and thus might contribute, to instability in the small business ficld. Tax exemption for new small businesses would discriminate against established businesses. It would be extremely hard to identify genuinely new businesses. III, Choice among types of tax measures for the benefit of small business The assumption underlying the tax proposals a€iscussed in this report is that tax revisions are needed to promote the sound develop= ment of small business. Even on this assumbtion, however, @ basic policy question is involved. in the choice between special tax measures for the particular benefit of small business and general tax revisions. The most important condition to prosperity of both small anc large businesses is a high and stable level of national economic activity. Therefore, the most important contribution the tax system can make to the healthy growth of small business, as well as of large business, is through general tax revisions that improve the equity of the system and minimize any adverse effects on investment and consumer cemande Reliance on general tax measures is likely to involve fewer economic, equity, and administrative problems than does use of special small business measureSe It may, nevertheless, be desirable to give consi¢eration to certain measures designed especially for gmall business. In choosing: the appropriate measures, the soundest approach would appear to be to begin with consideration of revistons of tax base and rates and then to proceed to measures intended to equalize taxes on incorporated and unincornorate@d businesses, Finally, attention could be given to the various tax exemption proposals. These exemption plans, however, raise grave problems of equity and involve the danger of uneconomic @istortion of the business structure and of investment patterns. Taxation of Small Business I. Introduction A, Importance of small businesses In January, 1946, in his message on the state of the union and the bu¢get, President Truman expressed the national interest in small business, as follows: "A rising birth rate for small business, and a favor-— able environment for its growth, are not only economic necessities but also important practical demonstrations of opportunity in a democratic free society » « « e "It is obvious national policy to foster the sound development of small business, It helps to maintain high levels of employment and national income and consumption of the goods and services that the Nation can produce. It encourages the competition that keeps our free enterprise economy vigorous and expanding, Smell business, because of its flexibility, assists in the rapid exploitation of scientific and technological dis— coverics, Investment in small business can absorb a lerge volume of savings that might otherwise not be tapped. "The Government should encoursge and is encouraging small business initistive end originnlity to stimulate progress through competition," 1/ The President's statement exemplifies the widely, shared belief that the imsortrace of small business lies not only in its economic contribution to full production in » belanced economy. Small busi- ness is valned also for its contribution to the development of opportunity and individuel initiative — to freedom in the broadest sense, "Message of the President on the State of the Mnion end Trens— mitting the Rudget," Budget of the Mnited States for the Fiscal Year ending June 30, 1907, p. XXXII,.: -2-— B. Problem of defining small business Despite widespread interest in small business and its role in the economy, there is no settled definition of small business, Many different definitions have been used, 1/ Perhaps the most common definition is based on total assets, with $250,000 of assets the most usual dividing line between large and small business, Wet worth or equity capital is a related but less often used basis of definition. Other definitions run in terms of annual volume of sales or receipts from operations and number of employees, The Federal income tax statutes contain an implicit definition of a small corporation in connection with the graduation of rates for corporate incomes of less than $50,000. One important source of difficulty with all general definitions. is that smallness is necessarily a relative term. There is great diversity in the scale of operations typical in different industries, For example, manufacturing is likely to be carried on in larger units than retail trade, Moreover, measures such as volume of sales have different meanings, depenéing on whether goods brought from suppliers are sold quickly in their original form or only after extensive processing or the performance of a large number of services for customers, Considerations such as these have led the Department of Commerce to adopt different definitions of smallness in certain broad industry grouns, It defines a small retail store or service establishment »s one with annual net sales or receipts from operntions of less than $50,000, a small wholesale establishment as one with annual net sales of less than $200,000, and a small manufacturing establishment as one with fewer than: 100 employees, Even within broad industrial groups such as manufacturing, however, ony one definition of smallness will not be equally apvoroprinte for all subgroups, For example, the number of employees in . small steel mill may be much greater than in a large cheese factory. Moreover, the mensure of smallness in a retnil store, for ex»mple, is to some extent dependent on the size of the community, 1) For a fuller discussion, see Appendix A, "Definitions of Small Business," 23 C. Relative position of small business However small business is defined, it seems clear that it occupies an important place in the economic system, On the basis of any of the definitions commonly used, small businesses recount for a large majority of the number of firms and a sizable part of production sné employment 1/ On the basis of the composite definition of the Department of Commerce, more than nine-tenths of all business estnblishments in 1939 were "small", These estrblishments employed about 40 percent of workers and active proprietors an@ accounted for sbout » third of the value of output or sales, 2/ In 1942, four-fifths of corporations filing balance sheets with the PRureau of Internal Revenue had t ‘al assets of $250,000 or less, “hese smaller firms, however, made only 15 percent of total gross sales and realized only 5 percent of aggregate net. income. 3/ In ole, almost nine-tenths of 211 corporstions with net income reported less than $50,000 of net incomo. The aggregate net income of all these corporations amounted to only 7 percent of the total reported by 211 corporations, 4 Evidence on trends in the development of small business and its relative position is not entirely satisfactory. The following general- izations, however, are based on the work of careful. investigatorss (1). From 1918 to 1929, the number of business firms ineréased faster than the population, but the proportion of business in the hands of very large firms incrensed rapidly. (2) ‘During the period 1929 to 1941, the number of firms decreased sharply up to 1933, but by 1041 the ratio between the number of businesses an@ the populrtion had risen past that of 1929, Probably smrll business somewhat increased its share of total business, (3) From 1941 through 1943, the number of firms decreased sharply. The proportion of business done by smell firms, but not the: absolute amount, declined. 5/ (4) Since 1943, the number of firms in business has inercased sharply, By mid-19U6, all of the wertime : This Section is based on statistics given in greater detail in Appendix B, "Sclected Statistics on the Relative Importance of Small Business." : Based on census data, See Anpendix B, Table 3. ae Based on Statistics of Income for 1942, Part 2. See Appendix B, Table 4, : Thid, Table 5. : : Hownrd R, Bowon, "Trends in the Business Population," . Survey of Current Business, March, 1944, See Anpendix B for more detail. pe ye decrease in the number of firms had been wiped out, and the number of firms in operation exceeded the prewar peak, The increase in the number of firms in the period 1944-1946 was almost entirely smong small businesses. 1 D. Interest in the problems of small business During reecnt years there has been widespread interest in the economic problems of smoll business and in all kinds of proposals for its assistance, There hns been much Ciscussion of the financial problems of small business and means of solving them, ond of technological and managerial problems and Ways of helping small business in these areas, There has also been a ercat deal of discussion of the tax problems of small business, expecially as taxation relates to small-business finances Businessmen, legislators, and tax administrators are agreed on the importance of the subject. Nevertheless, no generally accepted conclusions have been reached as to the effect of the present tax system on small business, the proper objectives in taxation of small business, or the most desirable ways of reaching objectives once agreed upone ®. Purpose »né scope of the present report The present report anelyzes a number of tax proposals that have been advanced for the special benefit of small business, The purpose of the report is not to make recommendations but to present an objective appraisal of the effectiveness of the various proposals in reaching their avowed or implicit objectives. The report also considers whether the proposals would raise now ané difficult problems of equity, economics, or administration. II, Analysis of tax proposals for the special benefit of small business Tax proposals that have been advanced for the special benefit of small business stem from one of two noints of view. Onc point of view is that small business is so essentinl to 2 orospverous and demoerntic free-enterprise economy that the tax system should be icliberately biased in favor cf small business in order to offset some of its non- tax disadvantages, such as difficulty in securing enpitsl, The other Donald W. Paden and Alice “ielsen, "Reeont Trends in the Business Populntion," Survey of Current Business, May, 1946, pp. 16-2); Melville J. Wimer, "The Postwar Business Population," Survey of Current Business, January, 1947, ppe 9-18 See Appendix B. a5 point of view is merely that the tax svstem should not discriminate against small business, but that to assure this certain spesial measures are necessary. Since, however, the objective of any one proposal is subject to different interpretations, no attempt is made in this report to classify proposals on the basis of the point of view that they revresent, This section Aiscusses some of the principsl types of tax proposals that have been mode for the special benefit of small business, These provosrls may be divided into three groups—A, proposals intended to make refinements or changes in the base or rates of taxes on net income; B, proposals intended to equalize taxes on incorporated and unincorporated businesses; C, proposals intended to offer exemptions to new or small businesses or to investors in such enterprises, for the purpose of stimulating investment in them, Of course, no sharp lines can be drawn between the various types of proposals, ane the following classifieation is to some extent arbitrary, The "A" group of proposals, as here classified, includes two proposals with respect to corporations only -—- (1) graduation of eorperation income tox rntes and (2) mo@ification of section 102 surtax on corporntions improperly accumulating surplus — and two proposals with resvect to both incorporated and unincorporated business—-(3) loss offsets and (1) accelorated Aenreciation, The "B" croup includes two opposite approaches to the problem of caunlizing taxes on incorporated and unincorporated husiness—~(5) partnership treatment for certain corporations ané (6) corporate tax treatment for the reinvested earnings of unincorporated businesses, The "C" group includes: (7) tax exemption for retained earnings of smoll businesses} (8) tax exemption for equity investors in small businesses; and (9) tax exemption for new smnll businesses for » limited period of years. Proposals for reduction of the general level of individual and eorpora— tion income tax rates are not eonsi@ored in this stu¢y, No attempt is made to mention every variation of the fifferent major proposals nor to list every person who had publicly advanced a particular vreposal, The @iscussion is eonfined to broad matters of tax policy and tax structure, with particular rates, size limitations, ane the like mentioned primarily for illustrotion, \ ie Most of the proposals fre intended to be restricted to small businesses ané hence raise in more or less acute form the problem of the proper definition of small business, As has already been indicated, there are a great variety of definitions of small business, none of them wholly satisfactory. Moreover, all of the proposals would involve some immediate loss of revenue, Hence they must be considered in the light of the general budgetary and economic situation and must de compared with alternative tax reductions, A. Propossls for modification of the base or rates of taxes on income of small businesses nen see oe MALL SUSINeSs es 1. Graduation of corporation income tax rates a COT poratron income tax raves a. Nature of proposals and scope of present discussion A number of proposals for the benefit of small irtorporated business call for changes in the present method and extent of graduation of corporation income tox rates, There have been vroposals for further reductions in rates on small corporate inenmes in order to widen the difference between rates on smnll and large incomes, Several proposals call for reduced rates on the first $100,000 of income, rather then on the first $50,000, as under present lnw, The present notch-rate system for meking the transition from reduced rates on small incomes to the general rate on incomes in excess of $50,000 has deen a target for criticism, and its climination has frequently been suggested. if ay On the graduation of corporation income tax rates, see, among others, the suggestions made in: Smaller War Plants Corporation, Taxation (Economic Report, 1945); "Digest of Suggestions for Relief of Small Business in Matters of Taxation," memorandum from Mr, Dan Fastwood to Representative Wright Patman, Select Committee on Small Business of the House of Representatives, February 17, 1945: J, Keith Butters and John Lintner, Effects of Federal Taxes on Groving Enterprises (Boston, 1045); Hearings of the Fouse Small Susiness Committee; letter from Mr, 4. W. Kimbnll, Director of the Washington office of the National Small Businessmen's Association, to Representative Charles R, Robertson, May 20, 19U7 (Congressional Record, 80th Cong., 1st Session, vol. 93, Dp. A2515). = 72 The following discussion of graduated corporate income tax rates concerns mainly the general structural question of how rate graduation can be achieved and briefly considers advantages and disadvantages of v-rious methods of graduation, Specific schedules referred to are intended merely for illustretion, No attempt is made to settle on a method of graduation or a recommended rate schedule, b. Present rate schedule At the present time, rate graduation in the corporate tax is restricted to corporations with net income of less than $50,000, For corporations with net income in excess of $50,000, the tax rate is 38 percent of the entire net income. 1/ For corporations with net income of less than $25,000, the following three bracket rates are vrovided: On the first $5,000 of net income, 21 percent; on the next $15,000, 23 percents; on the next $5,000, 25 percent, 1/ On net income in the so-called notch areca, between $25,000 and $50,000, the rate is 5% percent, 1/ c. Justifiertion of ernduation of corporate income tax rates Se ee EAVES During mast of the life of the corporate income tax, its effective rates have been graduated to some extent, by means either of an exemption or a schedule of graduated bracket rates. 2/ Yet there is no general agreement as to the justification of graduation or its purposes, The usual justification of graduated income tax rates for individunls, based on the doctrine of ability to pay, measured in terms of personal sacrifice, is clearly not applicable to corporations as such, Nor can graduation of corporate tax rates be readily defended as a means of achieving greater graduation of taxes on stockholders, It is true that stock in small corporations is more likely to be owned by persons with smell incomes than by persons with large incomes, but low-income stockholders as 9 group probably receive a greater proportion of their dividends from large corporations than from small corporationg 3/ Combined normal tax and surtox rates, For » brief history of graduation of the corporate income tax since 1909, sce Appendix D, Data for 19%6 on dividends reported on individusl tax returns, classified br size of assets of the corporations paying the dividends, appear to offer some support for this generalization, In that year, a significantly greater proportion of reported dividends came from small corporations in the case of individuals with net incomes of less than $5,900 than in the case of individuals with higher incomes, Nevertheless, 2 much greater proportion of total dividends reported by individuals with net incomes below $5,000 came from the largest corporations than from small corporations, Treasury Bulletin, January, 1943, pp, +6, 8 It is, nevertheless, often contended that big corporations have greater ability to pay taxes then small corporations, Presumably, this argument means that big corporations can pay with less harm to their business operations, Graduation of corporate income tax rates seems to have the same fundamental purposes as other tax measures for small businesseéither to favor;small businggs or to offset its comprrative disadvantages, The benefits of graduation, it should be noted, are available to all corporrtions with small incomes in-any year, whatever their invested enpital, snles, or relntive position in their industry. Strictly spveaking, graduation is a small corporation measur® only if smallness is defined annually in terms of net incomes Graduation of corporate tax roates offers a tax advantage to small corporations as compared with lerge corporations, but it raises certain economic problems, In some instances, a sharply graduated tax may be 9 greater deterrent to efforts to expand the corporation's net income than a flat-rate tax would be. Moreover, under graduated rates, a risky business with widely flucturting income will be taxed more heavily than a stable business renlizing the same total income over a period of years, A loss carryback or carryforward will help prevent this, but loss offsets will be less effective in maintaining the incentive to invest under 2 graduated tax than under a flat-rate tax. Under 1 flat-rate tax, if losses on an unsuccessful investment can be offset against taxable income from other sources, the Govern-— ment shares equally in gains from successful investments and losses from unsuccessful investments, Under » graduated tex, however, the income agninst which a loss is offset is likely to be subject to a lower tax rate than would have applied to the last part of income if the investment had been successful, Hence, under a graduated tax, even with loss offsets, the Government's shere in losses will be smaller thon its share in gains. d. Limited versus full graduation There are two basic approaches to gradustion of corporate tax retes, The limited graduation approach, which is followed in present law, applies a reduced rate only t> corporations with small incomes; above a certain amount of income, the effective tax rate is the same on the whole ineome, regardless of its size, The full-graduation approach would apply reduced rates to the first. income earned by all corporations, regardless of the size of the totel income; as income inerenses the effective tex rate would anprnach but never quite reach the rate applied to the last part of income. The full-gracuction system would be somewhat similar to the method of graduation used in the individual income tax, but most proponents of full graduation weuld favor use of a much smaller number of brackets in the corporation tax than in the individual tax, =~ 9- Limited graduation permits the tax benefits to be confined strictly to businesses which it is desired to relieve, Thus, limited graduation offers a relatively greater advantage to small corporations than does full graduation, Limited graduation also involves a slightlv smaller revenue loss, Limited graduation plans, however, sre somewhat more complicated than full graduation and are less readily understood by taxpayers. More important is the fact that limited graduation requires a higher rate of tax on the last part of incomes of intermediate size than on the largest incomes, An arrangement of this nature is necessary to provide a smooth graduation of effective tax rates and te avoid the anomaly of an increase in income before taxes resulting in a deercase in income after taxes at some point, The necessity of a special rule for incomes of intermediate size under a limited—graduation system may be illustrated by examination . of the present notch rates on incomes between $25,000 and $50,000. The present rate schedule results in a tax of $5,750 on a net income of $25,000, or an effective rate of 23 percent. Under the goneral rule, the tax on a net income of $50,000 is 38 per— cent, or $19,000, Inorder to bring the tax up from $5,750 on a net income of 45 000 to $19,000 on a net. income of $50,000, it is necessary to assess the $13,250 difference in taxes against the income between $25,000 and $50,000. This requires a rate of 53 percent on this second $25,000 of income, Or to put the matter another way, sinee the effective rate of tax of 23 percent at an income of £25,000 is 15 percentage points less.than the genernl effective rote of 38 percent, it is necessary to impose a rate 15 percentsge points higher then the gersral rate on ineome between %25,000 and *50,009 to bring the tox to an effective rate of 38 percent at *50,000, If no notch rate were provided, a eorperstion would find thet on incrense in its net inesme from £50,000 to slightly more than °50,000 would acturlly decrease its profits after toxes. t/ Although the tax rete is higher on the last part of income of corporations in the notch area than on larger incomes, the effective tax rate is alwsys lower on net incomes below $50,000 than on net incomes above. $50, (elele) e This anomaly may be illustrated by assuming the present notch rate to be eliminated and the 25—percent bracket rate extended to enver income between $25,000 and $50,000. Then the tax on an income of $50,000 woule be $12,000, leaving the corporation $38,000, after tax. But on an income of $51,000 the tax at a 38-percent rate on the whole income, would be $19,380, leaving the corporation only $31,620 after taxe i O & Although any limiteé graduation system necessarily requires a notch rate higher than the standard rate, flexibility in the notch rate can be obtained by verving the width of the notch arede The wider the notch area, the less the notch rate needs to exceed the standard rate, For example, if the notch area were extended to cover net income between $25,000 and $75,000 instead of the present $25,000 to $50,000 ané rates were otherwise unchanged, the present | notch rate coulé be reduced to 45.5 percent; if the notch area were extended to $100,000, the notch rate could be reduced to 43 percent. A limited graduation system, however, must always impose 2 higher top rate on incomes of intermediate size than on larger incomes. This feature has been criticized as inequitable and as a deterrent to expansion, The necessity of its use is a disadvantage of limited graduation. e. Methods of graduation Three methods of obtaining graduation, under either the limited or fullegradustion appracch, are possible, These are: (a) graduated bracket rates; (b) graduated effective rates; and (c) an exemption. The different methods may be combined in a single schedule. The method of graduated bracket rates divides net income into brackets and imposes hisher rates on the upper brackets of income than on the lower bracketse This metho? is now used for both the corporate and individuel inceme taxes, I the low rates on the first brackets of income are restricted to taxpayers with net incomes. below a certain size, as in the present corporate tax, the bracket method results in limited gradustion, If, however, the low rates on the first brackets are available to all taxpayers, asin the present individual income tax, the result is full graduation, The bracket— rate method has the advantage of flexibility, since any desired number of brackets and rates can be use’, It is reasonably simple, especially if the full graduation approach is followed, The bracket system, however, hrs the disadvantage of forcefully enlling the taxpever's attention to the fact that an expansion of income may raise the corporation into a higher tax bracket, and hence it may have bad effects on business incentives. The method of graduated effective rates is more complicated, and is not used in the present tax system. Unter this methoe, the effective rate of tex on the whole ineome of a enrporation would inerease in direct proportion to income over some range, For example, the corporate tax rate might be stated as a rate equal eo Me oe to that proportion of 38 percent which the corporation's net income bears to $50,000, but in no case more than 38 percent. Thus, if the corporation's net income were $25,000, which is one-half of $50,000, its tax rate would? be 19 percent, which is one-half of 38 percent. If, however, the corporation's net income wore in excess of $50,000, its tax rate woul@ be 38 percent. This schedule would be an example of limited graduation obteined by graduation of effective tex rates, One advantage of the method of grodunted effective rates is that it provides smooth graduation without any sharp uoward jumps in top rates such as occur under a bracket system. Another advantage is that it does not snecifically call the taxpayer's attention to the proportion of any additional income taken by taxation and hence is less likely to have an adverse effect on the incentive to expand ineome than is the bracizet system, The chief disadvantage of the method of graduated effective rates is that it is complicated, each taxpayer being required to compute his own rate. An exemption is a thir’ method of achieving graduation, With a constant nominal tax rate, an exemption of ony given amount of income will reduce the effective rnte of tnx tr zero in the case of the smallest net inenomcs, As the income increnses in size, the exemption will be a smoller proportion of the totnl income, and the effective rate nf tox will gradually increase until it approaches the nominal rate, Any exemption thet is available to all corporations will result in full graduation, although the significance of » small exemption may be negligible for the largest corporations, If it is desired te limit the gratuation to corporations with net incomes below a certain size, the exemption can be made to decrease as income rises and finally to disappear entirely. This is ordinarily called a vanishing exemption, 1/ A constant exemption is simple, but a ry A venishing exemption plnn msy be illustrsted as follows: An exemption of $5,000 for all corporations with net ineomes of less than $25,000; no exemption for cormorations with incomes of $50,000 or more; for corporations with incomes between $25,000 and $50,000, an exemption of $5,000 less thet propertion of $5,000 that the excess of income over $25,000 bears to $25,000, Under this particular sche@ule, a corporation with a net income of $5,000 would pay no tax; a corporation with any income between %5,000 and $25,000 would deduct a $5,000 exemption from its taxable income; an@ a corporation with an income of $50,000 or more would be taxed on its whole incomes. A corporation with net income of $30,000, for example, woule have an exemption of $4,900; with a net income of $0,000, an exemotion of $2,000. a aes vanishing exemption is likely to be rather complicated. If the exemption is smoll, this method of graduation is not likely to offer any important deterrent to expansion of corporate income, The exemption method, however, has the disadvantage of being relatively inflexible, The starting rate of tax is always zero, and the speed of graduation is rigidly fixed by the size of the exemption, If greater flexibility is desired, an exemption must be combined with one of the other methods of graduation. Moreover, the exemption metho? would reise a problem of unfair discriminstion against small unincorporrted businesses as compared with small corporations, Under the exemption metho, part or all of profits retained in small corporetions would be wholly free of current taxation, while profits reinvested in small proprietorships or partnerships would be currently taxed, if in excess of the owners! personal exemptions and credits for dependents, It would-be very hard to work out a feasible method of offsetting the corvorste exemption against the personal exemptions of stockholders, f, Relation between the starting rate on orations and the first—bracket rate on indivicuals Although the present @iscussion is concerned mostly with the nethod of graduation rather than with specific rate structures, the relation between the starting rate on corporntions and the first— bracket rate on indivifuals requires mention, The starting rate on corporations has usually been equal to, or greater than, the first bracket rate on individuals, Most proposals for rate chenges appear to be intended to preserve this relstionship, Some proposals, however, call for » starting rate on corporations lower than the first—bracket rate of the individunl income tax, This is always true of the exemption plans. The reletion between the two rates raises the problem of Aisrrimination between incorporated and unincorporated businesses. Under the present system, owners of small unineorperated businesses have the benefit of personal exemptions, which give them a zero strarting rate, whereas the starting rote on corporations is now 21 percent, However, with present low nersonal exemptions, the extent of discrimination on this account is not great. Moreover, storkholders in small corporations usually have income other than dividends—even if it is only salary from the corporntion-—against which their personal exemptions may be applied, A starting rate Sc on corporations lower than the first—bracket rate on individuals would widen the area in which retained corporate profits are taxed more lightly than income reinvested in an unincorporated business and would offer stockholéers additional opportunity for tax post— ponement or avoidance, These considerations suggest the advisability of keeping the sterting rates on corporstions at least as high as the first—bracket rate on individuals. & The problem of split—uns eae Pe ee Oe Spr lue ApS: All methods of graduation of the ecrporste tax raise the problem of split-uys of existing or new enterprises, motivate by the owners! desire to take multiple advantage of the low rates, Different de- partments or branches of many enterprises can easily be incorporated Separately in ordcr to reduce taxes, This oroblem would be likely to be most serious under a svstem previding a sizable exemption, h, Conclusions Gradustion of, cornerstion income tax rates is well-established in practice, althouch its basic Justification is open to question, Graduation can offer > tax advantace to small ecrporntion, but it reises certnin economic and equity questions, especially with respect to taxation of fluctusting ineomes, Gracuation may be limited to small corporations, or may be extended to all corporntions under n full-groduntion system, Limited graduation restricts benefits to smnll corporations and involves some. what less revenue loss than full erodustion, Limited graduation, however, is. more complicated an@ requires imposition of a relatively high rate on the lnst part of incomes of intermedinte size, which may Aiscournage eorporate expansion, Limited or full graduction may he achicved by means of graduated bracket rates, gradusted effective rotes, or an exemption, Grndunted bracket rates are simpler than éradunted effective rates, but the latter have the adventage of not calling attention to high rates imposed on an addition to income, Graduation by means of an exemption is relatively inflexible, and the starting rote mist be zero, Moree over, an exemption under the corporste tax raises an equity problem of possible unfair discrimination against unincorpornted enterprises, aye 2e Modification of Section 102 of the Internal Revenue Code It has been complained that the surtax imposed under Section 102 of the Internal Revenue Code on corporations improperly: accumulating surplus is a deterrent to the growth of small corporations, which have more to fear from it then large widely held corporations, It is argued that fear of application cof the surtax keeps many small corporations from retaining an adequate portion of their ersrnings to finance expansion and for contingencies. i) For this reason, it hes heen suggested that some limited amount of net income be exempt from Section 102 surtax. a, Nature and purpose of Section 102 Section 102 of the Internel Revenue Code imposes a special surtax on the undistributed net income of a eorperatinn "formed or availed of for the purpose of preventing the imposition of » surtax on its share- holders, or the shnreholders of sny other eorporetion, through the medium of vermitting earnings or profits to nccumulate instead of being divieeA or Aistributed, . - -' The surtax is 2745 percent of the first $100,000 of uncistribute? net inenme ont 38:5 percent of any amount in exeess of $100,000, In computing the undistributed net income, deductions »re allowed for Federsl income taxes, dividends paid, the net operating loss enrryover, an® certain items not allowed as deductions for purposes of the corporation ineome taxs The fact that the earnings or profits of » corporation are permitted to accumulate "beyond the reasonable necés of the business" is held to be determinative of the purpose to avoid surtax on the shareholders, unless the corporation can prove the contrary by a clear preponterance of the evitence, The necessity of o provision in the tax law to prevent the use of corporations for purposes of in@iviéunl income tax avoidance on the part of stockholders has been recngnized ever since the present income tax was first enacted in 191%. Prior to 1921, the statutes required, in cases of improper rccumulnations, thot there be included in the stockholder's income the share of vrofits to which he woul@ have heen entitled if there had been a distribution, Since 1921; a penalty tax has been imposed on the corporntion thet improperly nccunulates surplus. 2). Edwin B, George and Robert J, Lanfry, "The Sha@ow of '102!' on Dividend Policies," Dun's Review, Supplement, 1947.. : For 9 brief legislative history, see Jacoh Mertens, The Law of Federal Income Taxation (Chicago, 1943), Vole 7, pO» 328-330. - 15 - Section 102 is intended merely to strengthen the individual income tax by preventing accumulation of profits in a corporation for the purpose of avoiding individual income tax, The section, however, Goes not attempt to prevent tax aveidance. or pestponement incident to the retention and reinvestment of corporate profits for oréinary business purposes. A shrrp line is drawn between accumulation of profits for reasonable business purposes 2n¢@. improper accumulation for purposes of tax avoidance, In this respect, Section 102 differs fundamentally from an undistributed profits tax of the tyne that was in effect in 1936 and 19%7, which, with minor penentaens; aié not distinguish among uses of retained profits. De Application of Section 202 - In applying Section 102, both the Bureau of Internal Revenue and the courts have liberelly construcd "the. reasonable neefs of the business,” Undistributcé? income is held to be properly accunulat ed if retained’ for working capital neefed by the business, or if invested in additions to plant reasonably require’ by the business, or if put into e sinking fun? for retirement cf honés in aceor@ance with a contractund obligstion of the corvoretion, 1/ In 193, the Treasury's policy ‘was Puthoritatively stated to be such thet, "No ‘operating corporation aceunulnting surpluses an‘ using the game in the business in which it is engaged. shonld be apprehensive," 2/ Collectors of internal revenue and other officers ane employees of the Bureau of Internnl Revenue have been instructed to give close attention to the returns of the followine types cf corporat inns. in dctermining whether Section 102 is anplicahle: (1) Gorpokattond which have not Aistribut of at least 70 percent of their earnings; (2) Corporations which have investe@ earnings in securities or other property unrelate? to their normal business activities; (3) Cerperstions which have made loans ‘te otticcrs or. sharcholders out of funds from which taxable Aivieends might have been ceclnred; Cornorstions, a majority of whose. stock is held by a family group or other smell group of. indivicuals or by A, trust for the henefit of such ETOUPS} | es Regultions il relating to the ineonie tnx, see, 29. ee 2/ "Treasury press release, Decenher 17, 19%, -16- (5) Corporations whose distributions exceed 7O percent of their earnings but which, nevertheless, appear to be inadequate in the light of the nature of the business and its financial condition. 1/ It has been contended that the 7O-nercent distribution and closely held stock criteria discriminate against small corporations, which need to retain a larger portion of their earnings than do big corporations an¢ which are usually owned by a smoll number of stock holders, These and other tests, however, are not applied in a mechanical way but are intended merely to Cirect the attontion of collectors to cases that may necd ecnreful consideration, In actual practice, the Section 102 surtex has been imposed in only a relatively small number of cases, and in only a small portion of these cases have the corporations involve? been orfinary mercantile or industrinl businesses, Ina large percentoge of the cases in which the surtax has been applied, there has been evidence of flagrant avoidance schemes, such as loans to officers or stockholders, large accumulations of cash, or investments in securities unrelated to the business, During recent years, the great uncertainties of the war and transition neriods gave at least the semblance of reasonableness to most accumulations of esrninss by orfinery business firms. “ith the end of the war and the immeciste transition, however, meny of the grounés on which large accumulstions of earnings had heen justitied Curing the war became no lonecr valid. The Rurenu of Internal Revenue has not change its long-established, policies with respect to Section 102, but on effort is being made to revert to normal peacetime standards, Despite the lack of a substantial foundation for such an attitude, it may be true thot officers and Cirectors of some small corporations are so apprehensive about Section 102 that they are failing to retain earnings for legitimate business purposes, But it is hard to see how this situstion, if it actually does exist, can be remecied by legislative action, without encountering problems of the type mentioned below. T, D. 4914, July 26, 1939, Cumulstive Bulletin, 1939-2, DD. ene August 12, 19U0> Cumuletive Bulletin, 19Uu, pe 194, are Ce Problems raised by proposals for an exemption under Section 102 In order to prevent vossible Aiscouragement to legitimate retentions of profits, it has been proposed that a limited amount of net ineome, say $25,000, be exempt from the surtax imposed by Section 102, Such an exemption, however, would raise grave problems of tax avoidance ond unfair discriminetion, At present high indivieual tox retes, - flat exemption under Section 102, without regard to the use made of the retainec funés, woule be an onen invitation to tax avoidance, The nmonnt of tax avnifance or postnoenement possible under such an exemntion would vary cirectly with the size of the stockholder's income, being much greater for those with hich incomes than for those with lower incomes, There would be no legal obstacle to prevent wealthy persons from seprretely incorporating 9 number of enterprises, or aifferent narts of the same cnterprise, an¢ retrining the exemnt amount of income in ench corporation, This woul€ be an especially attractive possibility in view of the general exvectation that tax rates will @ecline in future yerrs, Rut even if tex rates did not Aecline, there would be possibilities for renligetion of the retained enrmings in the form of capital gains through sole of stock, subject only to the ‘ 25—percent maximum rate on long-term ennitnl gains, and for with@rawing dividends in vears in which the stockholéers! taxable incomes were lowe The only atvantage that could be offset agninst such inequities and tax avoidance possibilities would be the elimination of fear of the application of Section 102, which is allefeé to deter Cesirable accumulations of profits. Yet, neither Section 102 itself nor the record of its past application gives any substantial besis for such a feare d. Conclusions A provision with the same general nurpdses as Section 102 has been recognized by the Congress as a necessary feature of the tax structure ever since 1913, Section 102 and Treasury policy with resnect to it sllow ample leeway for retention of corpornte earnings for all reasonable business purposes, An exemption uncer Section 102 would open the way for flagrant tax postponement and avoidance, It would annear thet any ceterrent to legitinate retention of earnings for business purposes can best be removet by further diffusion of information about the purposes of Section 102 and its ndministration. aoe 36 An extension of the nerio¢c during which operating losses may be offset agninst taxable income has often been recommended as a tax revisicn thet would esnecinlly benefit smell business. 1/ Present law allows a two-year carryback and a two-year carryforward of net onerating loss. 2/ Propose@ changes call both for extending the perio? during which loss offsets mry be made and for shifting the emphasis teward carryforwards and away from carrybdacks. These proposed changes, unlike others discussed in this report, would not be restricte?d to small businesses, They would be general tax revisions, which, however, sre regarde? as especirlly beneficial to small business, : This report does not attempt a complete snalysis of loss offsets. It first Ciscusses briefly the purpose of loss offsets, Then it examines the proposition that loss offsets are esnecislly important for small businesses, @®- FPurnoses of loss offsets The primary equity advantage of loss offsets is an improved definition of taxable income, If loss offsets are not allowed, firms that sustain losses will not have the opnortunity to deduct all costs but may nevertheless pay a tax supposedly based on net income. In consequence, the tax will fall partly on capital rather than exclusively on net income, There will be a discrimination against businesses with fluctusting incomes as compared with businesses with stable incomes. Letter of Representative Patman to Representative Doughton, op. cite; Cigest of 350 Ietters on taxation received by the House Small Business Committee, op. cite; Smaller War Plants Corporation, Taxation, om. cit.; Research Committee of the Committee on Feonomic Development, Postwar Federal Tax Plan for High Employment; Report of the Small Business Advisory Committee to the Secretary of Commerce, May 28, 1945, p. 8 This recommendation has also been made by many witnesses ot congressional hearings anc by many writers on taxation. 2/ Internal Revenue Code, secs 122. The chief economic purpose of loss offsets is to reduce tax impediments to the incentive for taking business risks, If loss offsets are not allowed, the tax svstem will reduce possible returns from successful risky investments but will not reduce losses from unsuccessful investments, This loading of the scales mav often tip the balance against investment, At best, failure to allow adequate loss offsets will result in a change in the quality of investment in the direction of conservative investments and away from venturesome undertakings, Still worse is the probability that the aggregate amount of investment will be reduced, If, on the other hand, all losses may be offset against taxable income, a proportional income tax will not reduce the possible percentage return on the net amount at risk. Complete loss offsets, therefore, would eliminate a principal tax deterrent to investment. Vy It must be recognized, however, that loss offsets are possible only if the investor has enough taxable income to absorb the loss during the allowable period. In cases of single ventures by corporations or individuals with little taxable income from othor Sources, statutory provisions allowing loss carrybacks or carryforwards have little or no effect on the anticipated risk of investing, Loss offsets or their absence may affect not only the agefegate amount and overall quality of investment but also its distribution among types of firms, The basis for urging loss offsets as a measure | especially beneficial to small business is the belief that failure to allow adequate loss offsets discriminates agninst small firms and promotes concentration of investment, thoreby adding to rigidities in the economic system. yy See A, P, Lerner, "Functional Finance and the Federal Debt," Social Research, Vol. 10 (193), vp. UR-UG6s Bvsey D, Dormar and Richard A, Musgrave, "Proportional Income Taxntion ana Risk Taking," Quarterly Journal of Feonomics, Vol, LVIII (194), pp. 388-422, Losses from one venture may sometimes be deducted from income from other ventures, in the same year, even though carryforwards ané enrrybacks are not allowed, This is the case when the differezt ventures are carried on by the same taxpayer or when consolidated corporrte returns are allowed, Boe ae b. Administrative problems of loss offsets The primary limitation on the period during which losses sustained in one year may be offset against income of other years srises out of the administrative difficulties of » long offset period, The longer the period, the greater the problems of keeping open or reopening returns and of anciting transactions of years long pest. In general, such administrative problems would be grester for carrybacks than for carryforwards, and this considerntion srgues in favor of carryforwards in preference to carrybacks, In the final anelysis, however, the length of period required and whether the emphasis should be on carry- forwards or carrybacks must be decided in the light of economic and equity consequences as well as administrative considerations. Ce Special advantages of loss offsets for small business It is generally assumed that loss offscts -re more important for small firms than for lrrge, One renson for this belief is the fact that large firms are more likxely to be diversified ns to activities and as to markets, This suggests thot the income of lnrge firms is less likely to be subject to fluctustions arising out of conditions peculiar to one line of activity or to one locality. Losses sustained from one activity or in one locality can often be offset in the year of occurrence against income from other sources. Moreover, large firms may be in a better position to strbilize their incomes by use of trademar’s, advertising, and esteblishee distribution arrangements, There is some statistical evidence indicating that the profits of small corporations heve in fact fluctunted more widely over a period of yeers than the profits of large corporrtions. uy The interpreta tion of such statisticnl data, however, is open to question because of the difficulty of making a proper »llowance for the earnings of active stockholder—-menagers of smell corporations. An analysis of loss offsets taken in 1940-1942 under the two- year carryforward allowed for those years indicates that the net operating loss deduction was much more importent for small corporations then for large. Table 1 shows that in 1940-l2 the deduction was 10 percent of net income in the smallest asset group (under $50,000) and that it decreased in every larger asset class until it reached é of 1 percent in next to the lergest class and then rose to more than ae L, Crum, Corporate Size and Warning Power (Cambridge, Pe 249. -e2le- 1 percent in the largest class. a) Further analysis shows that the increasing importance of the loss deduction in the largest asset class was attributable almost entirely to the transportation industry, expecially the railroads, Table 1 shows the figure, both including and excluding the transportation industry. This statistical evidence is not conclusive, but it does support the reasonable deductive argument thet small firms would be more likely than big firms to benefit from liberalized loss offsets. The relative advantages of carrybacks 2s opposed to carryforwards of net operating losses are not discussed in detnil in this report, It should be noted, however, that new firms could benefit only from carryforwards, Carrybacks would not only be of no value to new firms but might be positively disadvantageous, in that they would give established firms a competitive adwntage, On the other hand, carry— backs may be esvecially helpful to established small firms because the resulting tex refund may come in a period of losses when the firm's cash position is likely to be werskest. de Conclusions Liberrl opportunities to offset operating losses against taxable income are». desirable feature of env income tax. Loss offsets make the income tax more equitable and lessen its possible restraint on investment. Loss offsets over 9 period of years are esnecially important for small, undiversified firms; large firms producing a varied output can often offset losses ageinst other income in the same year. Improvement of nresent provisions for loss offsets would be a highly desirable kind of tax relief for small business, The change would prob-bly benefit sm-ll business more than big business, but it also merits support on other grounds, This finding is more striking when it is remembered that in the period under consideration (1939-192) meny corporations were shifting upward in the asset serle because of a general expansion of business activity. Therefore, the operating losses were often reported as deducted in a lerger asset class than that in which the deficits to which they related were reported. -~22-. Table 1 Net Operating Loss Deduction Related to Net Income and Deficit, Corporations with Balance Shects Classified by Size of Assets, 19401942 Net operating loss deduction, : 3 1940-2, as a percent of Size of assets Amount : Net income, et + Te :(in mil-: Including: "xcluding : Including :Excluding liong) : trans— : trans- $$ trans- ¢ trans— portation: portation : portation tportation Fo ‘. ‘ to to to to 1,000 bet et et HOPE Vinin wo . id e @ Me ee ee: YH POWOW A LINN aa to 5,000 to 10,000 to 50,000 to 100,000 100,000 and over “oe «se @ @ ee 1 OT OA™N OT LO He > eo @ *» mAmamMmowW NIALSR ne) WN 6 e Total a) ae) oS ~ Source: Derived from Statistics of Income. eae uu. Accelerated depreciation for small business a. Nature and purposes For purposes of the income tax, deprecinble property used in a trade or business may be depreciated over its useful life, if It has been proposed, however, that both incorporated and unincorporated businesses be allowed to take accelerated depreciation, that is, to write off assets for tax purposes over & shorter period than their anticipated useful lives, 2/ Accelernted | depreciation has been proposed as a means of easing the capital problems of small business and of reducing the risks of investment by small firms, be Coverage _ This report treats accelerated depreciation as a specisl measure restricted primarily to small business. It does not consider the broad revenue and economic problems that would be associated with general accelerated depreciation, The @iscussion relates to the probable effectiveness of limited accelerated depreciation plans in meeting the economic problems of small business and the equity and administrative issues connected with such plens, Accelerated depreciation plans of the type considered here would be limited in two respects: First, as to the amount of asscts eligible for accelcrat ed depreciation; and, second, as to the type of assets eligible, Depreciation must be spread over the whole useful life according to a reasonably consistent plan, but not necessarily at a uniform rete each year, Regulations 111, section 29.23(1)-1. The usual procedure, however, is the straight-line method, For examples of accelorated depreeintion proposals, sce the testimony of the following persons in the Hearings of the Fouse Small Business Committee on the financial problems of small business: Charles Y, Neumann, Argus Fngineering Company, Hertford, Connecticut, pp. 878-884; S, Abbot Smith, Thomas Strachon Company, Boston, Massachusctts, -p, 909; Trederick S. Blackall, Jr,, Taft~ Pierce Manufacturing Company, pp. 961-963; MM, Fineberg, Standard Valve Manufacturing Company, Boston, Massachusetts, pe 864, See also: Smaller War Plants Corporation, Taxation, OPPs Cite, De 370 Plans for formal acecclerntion of depreciation, such as are discussed in this section, may be distinguished from proposals to allow tax- payers great or unlimited freedom in Selecting their depreciation rates, which, on the average, would probably also result in depreciation over a shorter period than the normal useful lives of asscts, at eu & As to the amount of assets cligible, the limitation would be set no higher than necessary to meet the needs of most small businesses of the type to be assisted, This figure would have to be originally decided largely on the basis of opinion, and then tested by experience, To make the following fiscussion more concrete, it is assumed that the maximum amount of assets subject to accelerated devrecistion at any one time would be limited to a total of sbout $50,000 worth of assets acquired after the inauguration of the plan, However, there is no intention of implying that $50,000 would actuslly prove to be an appropriate limit if some accelerated—depreciation plan were adopted, As to type of assets covered, two questions would arise in the formulation of a limited accelerated—deprecistion plan, The first question would be whether the vlan should extend to all types of depreciable assets or whether it shoul¢ be restricted to machinery and equipment, with buildings and patents and other intangibles excluded, In favor of excluding buildings, it may be argued that their long lives and the lumpy character of investment in them would give rise to specinl problems if they were eligible for accelerated depreciation, As is pointed out in the next section, any accelerated—deprecintion formule which permitted all types of assets to be written off in the same fixed veriod would favor long-lived asscts and might give windfalls to investors in -ssets such as buildings. Morcover, buildings probably present a less serious financial problem for small business than other assets because of the possibility of ronting and because of relatively well-developed mortgage lending facilities for credit purehnses of land and buildings, On the other hend, buildings ere an important part of total investment and their useful lives are no longer than those of meny types of machinery. Patents and other intangibles are probably on the whole relatively unimportant for small businesses, The second question would be whether accelerated depreciation should be extended to both new and secondhand assets or only to newly produced assets, Since a significant part of investment. by small firms takes the form of purchase of secondhand »sscts, it would probably be advisable to include both new ané secondhand assets in any limited accelernted depreciation plan for the special benefit of smell business, As is pointed out in the discussion of administrative considerations in a later section, however, inclusion of second— hand assets would give rise to troublesome a@ministrative problems, - oS Ce Economic effects In the early years of life of eligible assets, accelerated depreciation would reduce taxable income below net income as determined for other purposes, Hence, it would reduce taxes in these yeers, Ina senso, it would be cauivalent to an advance from the Government, to be repaid in the form of higher tax liabilities in later years when deprecintion of the capital asset had been completed. If, however, a business purchased assets at a constant or continuously increasing rate each year, it could indefinitely defer repayment of this advance, Such advances could be very helpful to small business because of its traditional difficulty in obtaining capital and its consequent reliance on expansion from earnings. Borrowed money, when available, is likely to be loaned on terms shorter than the lives of necessary machinery and equipment, and accelerated depreciation would assist in permitting amortization during the terms of the loanse Since accelerated depreciation allows more rapid recovery of the original cost of a depreciable asset, it reduces the risk of the investment. So long as an investment has not been fully recovered through depreciation, there is always the possibility that an asset may lose its earning power with the result that any remaining depreciation deductions will be wasted because of lack of taxable income against which to apply them, Shortening the depreciation period for tax purposes would be especially advantageous to certain types of small businesses, where prospects for immediate profits are. good, but the long-run future of the businesses are uncertain. Accelerated depreciation would slso improve somewhat the yields on investments in depreciable assets, If the depreciation allowed on an asset shifts taxes from the present to the future, interest can be earned’ on the funds not used to pay taxes, increasing the yield on the investment bv that smount, This is not so important for small business, however, as the problem of availability of funds, and this increase in yields might not alone be sufficient to attract an appreciably greater amount of capital into small business, The increase in availability of capital, decrease in risk, and interest gain from postponement of tnxes would be greater the shorter the depreciation period in relation to the useful lives of assets, If the accelerated-depreciation plan provided the same abritrary period for all kinds of assets regardless of their normal = 26:= lives—for example, one year or five years—it would stimulate : investment in long-lived assets more than in short+lived assets, Since there are marked differences in the average useful lives of asscts in different industries and among firms of different sizes, such a plan would affect the direction of flow of invest— ment funds, If, however, accelerated depreciation took the form of » stepping-up of normal depreciation rates-—for example, double deprecistion—-such an effect would be less pronounced. One limitation on the usefulness of accelerated depreciation arises out of the fact that the additional deprecintion is of no benefit to a taxpayer unless it offsets income that would other- wise be taxable. For exemple, a small manufacturer starting in business would have to make profits of -20 percent on his invest- ment in depreciable assets in each of the first 5 years in order to take currently full advantage of 5-year accelerated depreciation. The magnitude of this problem is lessened as the depreciation period is lengthened, as the ratio of deprecisble assets to total assets Geclines, and as the ratio of newly acquired depreeiable assets to all capital assets declines. Accelerated depreciation would need to be combined with liberal loss offsets, because investments by small business tend to be lumpy. Unlike a large business, a small business does not ordinarily make a steady stream of capital asset purchases. The capital asset unit is large in relation to the total assets of the business, and capital investment for a period of years is likely to be concentrated in a single purchase, Therefore, income would often not be large enough to absorb the additional @epreciation, unless 2 carryover were allowed, It should be noted, however, that the existence of a long carryover of business losses lessens the danger that normal depreciation deductions will run to waste and hence decreases the importance of -ccelerated depreciations Furthermore, to the extent that a long carryover of "losses" is necessary to absorb the additional deprecintion allowances under an accelerated depreciation plan, the difference between accelerated and normal depreciation is materially reduced, d, Equity considerations Limitation of the amount of assets eligible for accelerated depreciation would raise a problem of discrimination against larger firms, but this is a problem common to all special measures for the tax benefit of small business,.. Among small businesses as a group, howéver, accelerated depreciation would offer unequal advantages to Lot = different firms and industries, Accelerated depreciation would be distinctly less advantageous to firms in industries requiring relatively small investments in capital assets than for firms in other industries, Wice differences among industries are shown in the following figures on capital assets less reserves and less land as a percentage of total assets for corporations with assets of less than $50,000 in 1943, 1/ $ Capitel assets as Industry ; «percentage of : total assets All industrial groups 30.3 percent Mining and quarrying 55.4 Manufacturing 29,4 Public utilities u7,ut Wholesale trade 12,4 Retail trade ; 18,3 Service 40,3 Finance, insurance, etc. 42,3 Agriculture, forestry, and fishing 3943 These figures incicste an important limitation on the effective— ness of accelersted deprecirtion as an aid to small business, Of an estimated total of 2,758,000 small business establishments 2/ in the fields of manufacturing, wholesale and retail trace, service, hotels, construction, and amusement in 1939, 1,686,000 or over 60 percent, were engaged in wholesale and retail trade 3/ in which accelerated depreciation of machinery and equipment would be of limited value. While the effects of nccelerated depreciation would be unequal, businesses helped most would be the ones that are most likely to be handicapped by the present tax system. First, accelerated deprecia— tion would favor businesses with a high proportion of their capital Returns with balance sheets, Bureau of Internal Revenue, Source Book, 1943, Small according to the composite definition of the Department of Commerce? menufacturing, less than 100 employees; wholesale trade, annual net sales of less than $200,000; other industry groups, annual net sales or receipts from operations of less than $50,000. 3/ Appendix B, Table 3. — 25 = in depreciable assets, This can be defended on the grounds that it is more difficult for small business to get long—term capital for investment in capital assets than to horrow short-term working capital. Second, accelerated depreciation would favor new and expanding businesses, since they are in greater need of capital and since 9 higher share of their capital assets would he eligible for the accelerated rates. In defense of this it can be argued that existing taxes make it hard for new and small businesses to expand through earnings to a position equivalent to that of their better established competitors, Third, accelerated depreciation would favor the more risky enterprises, since it gives investors an opportunity to clear the cost of their investments more rapidly than would otherwise be possible, This would counteract 9 tendency present taxation of high yields from speculative investments has to discourage development of the more risky types of enterprises, e, Administrative considerations Accelerated depreciation would not simplify the determination, of proper depreciation allowances, so long as the deductions were related to the useful life of depreciable assets in any formal way. Use of a single, arbitrary depreciation period would eliminate the problem of determining useful life for eligible assets, but it would be weighted heavily in favor of businesses acquiring long lived assets, Since the value of assets eligible for accelerated depreciation would be limited for each business, there is danger that corporations would form subsidiaries in order to take accelerated depreciation on a greater share of their facilities, Another danger is that acceler— ated depreciation allowances might be used to convert ordinary income into capital gains, since a businessman might sell a fully depreciated asset that still hed a substantial value, paying a tax on the capital gain and avoiding the taxes on its income that were deferred during the period of accelerated depreciation, This type of avoidance could be overcome by requiring that if the taxvaver elects to use acceler- ated deprecistion, gain to the extent of the excess of accelerated over normal depreciation must be treated as ordinary income, If all newly acquired capital assets, including used fncilities, were made eligible for accelerated depreciation there is a possibility that businesses would swap old facilities in order to make them eligible. Prevention of this abuse would be difficult since no clear line would be drawn between legitimate business trade, and trades for the purpose of increasing depreciation deductions, = 29 & Businesses might use accelerated depreciation to avoid taxes by timing their investments so that the highest depreciation allowances would be taken in years in which income falls in the higher tax brackets. And, even without careful timing of the investmants, many individuals would be able to deduct from other incomes accelerated depreciation in excess of the profits of the unincorporated businesses in which the investments were made, f. Conclusions Accelerated depreciation woulé help solve some, but not all, of the tax problems of small businesses, Accelerated depreciation for a limited amount of assets would help small business finance capital outlays in manufacturing and other industries in which relatively large amounts of depreciable assets are required, Risky anc growing. enterprises would be especially benefited, Accelerated depreciation would be less helpful to mature ané stable businesses and to all firms engaged in wholesale and retail trade and other industries requiring relatively small investments in depreciable assets, As a means of improving the accessibility of capital an‘ of removing tax deterrents to risky investment, accelerated depreciation would be more effective than a reduction in tax rates costing the same amount of revenue, ™o prevent the additional depreciation allowances from being wasted, accelerated depreciation would need to be combined . with a liberal carryover of net operating losses, but the existence of such a carryover lessens the importance of accelerrted depreciatione Even in combination with a liberal carryover, the usefulness of accelerated devrecistion would be limite? in meny cases by the fact that profits of small businesses would be insufficient to absorb substentielly more than normal depreciation. B. Proposals intended to equalize taxes on small incorporated an¢ unincorporated businesses Under the present tax system, earnings of incorporated businesses are subject to the corporation income tax, and dividend income of stockholders is subject to the regular individuel income tax. Harnings retrained in the corporation for reasonable husiness purposes are subject only to the corporation income tax, In the case of unincorporated enterprises, »1l earnings, whether reinvested in.the business or with- Arawn, are included in the income of the proprietor or partners and are subject to the regular individual income tax. - 30 - The existing differences in taxation of profits of incorporated anc unincorporated businesses have been criticized as inequitahle and as a hancicap to investment and expansion, While these criti- cisms have not been confined to the taxation of small businesses, they have most often been addressed to this aspect of the problem. This section considers two proposals intended to equalize taxes on incorporsted and unincorvorsated enterprises, which are mainly, but not exclusively, small business measures, One proposel would approach the problem of taxing certain types of corporations like partnerships, The other proposal would take the opposite approach and tax the retnined earnings of incorporated enterprises at the corporate tax rates, The present report does not consider several other approaches to the objective of reducing or climinating existing differences in taxntion of earnings from incorporated and. unincorporated businesses, since these other approaches are not primarily concerned with the tex problems of small business, 1 5. Partnership tax treatment for certain corporations a, Nature and purposes The partnership method has often been proposed as a means of eliminating differences in taxation of profits of small incorporated and unincorporated businesses, 2/ Under the partnership method, no tax would be imnosed on the corporation as such, but stockholders would be taxed'on their proportionate part of both distributed and undistributed corporate profits, Under the nure partnership method, stockholders woul@ also take account of their proportionate part of corporate losses, Dividends paid from profits previously taxed to stockholders would not be subject to indivicual income tax, In determining the amount of capital gains or losses for tax purposes, the basis of stock would be increased by the amount of undistributed profits taxed to stockholders and decreased by the amount of operating losses and dividends paid from profits previously taxed to stockholders. For a discussion of several approaches to the general problem, see The Postwar Corporation Tax Structure, Treasury Department, Division of Tax Research study (1946), See, for example: National Tax Association, Committee on Federal Taxation of Corporations,"Final Report," Proceedings of the National Tax Association, 1939; Richard W. Lindholm, The Corporate Franchise as_a Basis of Taxation (Austin, Texas, 1944), p, 246: testimony of Clifford McAvoy, representing the CIO and 15 other national organizations, Senate Finance Committee Hearings on the Revenue Act of 1945, pp, 101, 2723 Randolph EB, Paul, Taxation for Prosperity (Indianapolis, 1947), pe 374. — - 31 - Although there have been proposals both for mandatory and for optional partnership treatment of certain types of corporations, the present discussion approaches the matter from the standpoint of a tax-relief measure and concentrates attention on the optional partnership treatment. The objective of an option for certain corporations to be taxed like partnerships would he to give such corporations and their stockholders the opportunity of paying no more tax then owners of unincorporated enterprises on both distributed and undistributed profits. This objective involves: (1) elimination of so-called double taxation of distributed profits; and (2) taxation of undistributed profits nt the individual rates of stockholders instead of the corporate rates, in cases where this would be advanta— geous. In contrast to the optional or tax-relief epproach, the mandatory partnership method could also prevent tax avoidance or postnonement with respect to earnings retained in corporntions owned by stockholders subject to individual income tax rates higher than the corporate rates. b, Eligibility for partnership treatment Some have suggested that partnership treatment be mace available only to corporations with no more than some stated amount of net income or assets. 1/ Others have suggested more . general application of the partnership treatment, but have differed as to the basis for determining eligibility, One view is that the partnership method is the ideal method of taxing all corporations and their stockholders, although administrative difficulties may prevent its application to corporations with many stockholders and complicated capital structures, 2/ The other view is that ’ For exemple, McAvoy, loc. cit., suggests that the partnership option be restricted to corporations with no more than $100,000 of net income, 2/ The National Tax Association Committee on Federal Taxation of Corporations recommended that the partnership method be "extended to the limits of its legal and administrative possibilities," Proceedings, 1939, De 555. = a the partnership method is appropriate only for corporations with the characteristics usually associated with partnerships, such as ownership by a small number of persons who are in a position to take an active part in control of the enterprise, 1/ For both conceptual ane practical reasons, there would seem to be a stronger case for determining cligibility for the partner— ship treatment on the basis of characteristics such as distribution of owmership and capital structure then on size as measured bv net income or assets, Net income, in particular, would be an, unsatis— factory basis, because of its year-to-year fluctuations and the objections to moving in and out of the partnership option. The exact standards of eligibility under any partnership option would necessarily be to some extent arbitrary, but two types of criteria seem reasonable. First, the partnership option might be restricted to eompcuy one with no more than, say, 10 to 15 stockholders in which all or a large majority of the stockholeers consented to partnership treatment. Second, the option might be restricted to corporations with only one class of stock outstanding, none of which is owmeé by another corporation, These criteria would help confine the option to 1/ Randolph Paul recommenés the partnership method for corporations | that do not derive sufficient advantage from economic separateness of stockholders and the corporation to justify separate taxation, He states as "a guiding principle . . . a selection between corporations which are economically, not merely legally, separate from their stockholders and those which are not. There are,’ he says, "several possible tests for this selection, Do the stock- holders have a real voice in the formulation of important corporate policies, such as wage, price and dividend policies? Does the fact of incorporation bestow substantial economic advantage, such as accessibility to national, and perhaps world, capital markets? Are corporate choracteristics--such as limited lia bility of stock— holders, easy transfer of ownership and perpetual life—essential to the very manner of doing business? These attributes suggest the economic separnteness of the corporrtion and justification for a corporation tax, If they are missing to a marked desrecs the imposition of a corporation tax is much more questionatle," "Taxing for Better Living," address hefore the Tax Executives Institute, New York, May 15, 1946 (mimeographed), reprinted in Commercial and Finencial Chronicle, May 16, 1946, aes corporstions similar in many essentinl resvects to genuine partnerships and would greatly simplify administration, i/ Thus restricted, the partnership option would not be purely a small business measure, but its spplication would be mainly to small corporations. Certsin large enterprises would be eligible for portnership treatment, but it is Aoubtful thet many of them would elect it, since the individual income tax on retained earnings would be likely to be considernbly higher then the corporate rate. Cy Zypes of corporations that would benefit from partnership tax treatment Two types of corporations would benefit from partnership tax treatment, These are: (1) all corporations currently distributing a large proportion of their profits; and (2) corporstions retaining a lerge proportion of their profits, provided the marginal income tox rates of their stockholders were lower than ane corporate tax rates, The pertnership method would reduce the total tax on the distributed pert of profits of any corporation. Distributed profits would be subject only to the ineividuel income tax rather than to both the corporstion income tax and the individual income tax. The amouut of reduction would, of course, depend on the alternative corporate tax rate in comparison with the tax rate on stockholders, The partnership method would reduce the total tax on a dollar of profits distributed to a low-income stockholder subject to a low marginal tax rate more than on 1 @oller of profits @istributed to a high-income stockholder subject to a high merginal tax rates 2/ The reason for the requirement -s to canital structure is largely administrative, It woul@ be almost impossible to allocate corporate income satisfactorily among owmers of verious classes of stock, In many cases the claims of owners of Aifferent Glasses of stock to esrnings do not become definitive until long -fter profits are earned, For example, common stockholfers, as residual owners, would presumably be allocated any profits retained in anv year -fter satisfaction of prior claims of preferred stockholéers, In later years, however, these earnings might be distributed as preferred dividends, This is due to the fact that stockholders subject to high marginal tax rates would pay in personal taxes a large part of added profits made available by elimination of the corporate tax. Stockholders subject to low marginal tax. rates would pay in personal taxes only a small part of their share of the corporate profits previously taken by the corporate tax, Hence, low-income stockholders would enjoy a ereater percentage ‘inerease in net yield from stock. we Hb aw But the partnership treatment would always be advantageous to all stockholders of any corporation that currently distributed all or a large proportion of its profits. Whether the partnership treatment would reduce current taxes on undistributed corporate profits would devend on the relationship between corporate tax rates and marginal tax rates of stockholders, Generally spesking, the partnership method would reduce taxes on undistributed profits of corporations owned by,low—income stock— holders but would increase taxes on undistributed profits of corporations owned by high-income stockholders, Under the present system, high-income stockholfers derive at least » temporary tax advantage from retention of earnings in corporntions, Rut graduation of the corporate income tax considerably narrows the area of tax advantage of the partnership method for stockholders in small corpora— tions that retain a large proportion of their profits. In contrast with the partnership method, graduation of the corporate income tax may offer a tex advantage with respect to retained earnings in small corporations owned by high-income stockholders, Under the present system, it is true that if retained earnings are finnlly pai out in Cividends they are taxed under the individual income tax. But this does not wholly cancel the tax advantage enjoyed by high-income stockholders, Stockholders have had the advantage of tax postponement and perhaps of an informal avernging of taxable income, The corpora— tion has ‘had the use of the retained earnings, Moreover, retained earnings may be made a permanent part of a corporation's capital and- never paid out in dividends, Although earnings are permanently retained in the corvoration, the in@ivitual stockholder can realize on them by selling his stock, If he has hel¢ the stock longer than six months, he is subject only to the low-rate tex on long-term capital gains, ad. Hconomic considerations The partnership method probably woul offer its greatest economic incentives to investors looking for regular dividend income from small corporations, As already indicated, partnership treatment would be advantageous in any case in which the corporation regularly distributed the major vart of its profits, But, in. the past, small corporations as a group have retained a significantly larger percentage of their profits than have large corporations, It is not possible to say what proportion of stockholders in small corporations are subject to marginal individual tax rates lower than the grecuated corporate rates, "sually, however, more concern is shown for the effects of taxes on incentives of high-income investors than of low-income investors. : - 35 - Partnership treatment of corporations retaining a large proportion of their profits probably would be advantageous only for low~income stockholders. Mandatory vartnership treatment might even discourage investment in small corporations by high-income investors. Many high-income investors may now be attracted by the possibilities of realizing their returns in the form of capital gains, based on retained profits, rather than as dividends paid from current profits. The onvportunity of deducting corporate operating losses from other income under the partnershin method, however, might apneal to high-income individuals contemplating speculative investments in new enter- prises. The partnership option might somewhat increase the flow of new equity capital into small corvorations. However, it would not be especially well adanted to short-run solution of the capital problem of small business. e. Equity considerations The equity problem of reasonable classification arises in connection with every proposal for tax relief of small business. It seems, however, that this equity problem would be somewhat less serious in connection with the partnershin method than in connection with most other nroposals. The partnership method, like other vroposals discussed in this report would be a valuable tax concession to many stockholders. But, unlike most of the other proposals, the partnership method has strong claims to being regarded as an equitable tax method in its own right. In this resvect it is superior to proposels. based solely on expediency. The vartnership method would come closer to equal treatment for all stockholders of small corporations, who have equal incomes. It would not create new kinds of inequity. There would be less chance for abuse of the nartnership method by splitting up large corporations owned by wealthy investors than there would be under other tax-relief proposals. Therefore, the equity problem raised by the partnership method would be almost entirely a classification problem--a problem of where to draw the line between those to whom the treatment would >5e extcnded and those to whom it would be denied. = te f, Administrative considerations An important technical problem under the partnership method would be that of allocating corporate profits and losses among stockholders, Strictly construed, the partnership method would require that every person who was a stockholder at any time during the taxable year be allocated his exact proportionate part of profits or losses. Moreover, the strict partnership method would require separate allocation to individual shareholders of peculiar kinds of income and deductions, such as wholly or vartially tax-exempt interest, capital gains and losses, excess of percentage depletion over cost depletion, charitable contributions, and foreign tax credits, But such a refined allocation would be extremely burdensome If the partnership method is viewed primarily as a means of tax relief for small business, it might be acceptable to overlook many refinements appropriate to the method as a general means of equalizing taxation of stockholders and other income recipients. The less exacting requirements of tex relief for smal] business might well be met by a procedure that allocated profits and losses only to shareholders at the close of the taxable year. No attempt would be meade to allocate a share of profits or losses to stock— holders who had sold their shares before the end of the tax year. Nor would special items of income and deductions be traced through the corporation to stockholders, g. Conclusions By reducing taxes on distributed profits, the pertnership method might make it somewhat easier for small corporations to get outside equity capital. The partnership metho? might also reduce taxes on retnined earnings of corporations owned by low- income stockholders, It seems unlikely, however, that the pertnership method would greatly ease the financial problems of most growing small corporations, which ordinarily retain a large portion of their profits, On the whole, it seems that the method would be most likely to be attractive to mature small corporations able and willing to pay out most of their profits as earned. « 37 < The partnership method would appear to be more in harmony with usual standards of equity than most other proposals for tax relief of small business, It would not open the way for tax postponement or avoidance, The partnership method would minimize the problems arising out of splitting up of large businesses in order to take adventage of tax relief intended for genuinely small businesses, Any refined partnership method would give rise to very difficult technical and administrative problems, Viewed, however, as a tax relief device, the partnership method might be simplified enough to make it workable, At best, administration of the method would be difficult. . 6, Corporate tex treatment for the reinvested earnings of unincorporated _businosses a. Nature anc purpose of proposal It has been suggested that the reinvested earnings of unincor-— porated businesses be taxed at the corporation income. tax rates in order to prevent an unfsir discrimination against unincorporated businesses, 1/ In support of this proposal, it is pointed out that all earnings reinvested in an unincorporated business are subject to the top individual income tax rates applicable to the income of the proprietor or partners, which may reach a maximum of 85.5 percent, whereas the retained earnings of corporations are subject to a maximum rate of 38 percent, For this reason, it is argued that the tax system makes growth from reinvested earnings harder for proprietorships and partnerships owned by persons with high incomes than for corporations. The remedy that has been proposed is to segregate the business income of persons engaged in capitel-using businesses of a commercial or industri: nature from their other income and to allow them the option of being taxed at the corporate rates on the portion of their business income reinvested in the enterprise, Earnings currently withdrawn from the business would presumably be taxed only at the regular individual rates, but it is not clear how withdrawals of profits accumulated in prior years would be treated, Active proprietors and partners would be required to include in their taxable personal incomes an amount equivalent to reasonable compensation for servicese lJ F. N. Bard, “Federal Taxation of Provrietor ond Partnership Venture Capital on a Corporation Basis," Hearings of the Senate Finance Committee on the Revenue Act of 1945, vp. 267-270. a3e The suggestion to tax reinvested earnings of unincorporated businesses at the corporate rates is the opposite of the more: usual proposal that small corporations be taxed as partnerships. Partner— ship treatment for small corporations has been suggested on the grounds that it is unfair to impose a heavier tax on profits merely because the business is carried on in the corporate form, Other proposed revisions of the corporation tax structure are based on a similar view, at least with respect to distributed profits. On the other hand, the proposal under discussion in this section is based on the view that it is unfair to deny owners of unincorporated enterprises » tax opportunity with respect to retrincd profits, which is now open to stockholders in corporations, be Fxtent of possible tax discrimination against retrined earnings of unincorporated firms under present law Any possible tax discriminstion against the retained earnings of unincorporated firms under present law appears to be limited in extent. Income taxes sare significently higher on the profits of unincorpornted firms than on corporations only in the case of firms which sre owned by persons with relntively large incomes and in which a large proportion of the profits is reinvested in the business. There is no possibility of discrimination against an unincorporated business unless the income of the owners is subject to a marginal tax rate higher than the corporate rate applicable to a corporation with the same amount of income as the proprietorship or partnerships Individuals with surtax net incomes of less than $4,000 pay a lower marginal rate than corporations with net incomes of less than $20 ,0003 individuals with surtax net incomes of less than $6,000 pay a lower marginal rate than corporations with net incomes of less than $25,000; individusls with surtax net incomes of less than $12,000 pay a lower marginal rate than corporations with net incomes of more than $50,000; and individuals with surtax net incomes of less than $20,000 pay a lower marginal rate than corporations with net incomes between $25,000 and $50,000, In 1942, it appears that more than one-half of all proprietorship and partnership profit reported on individual tax returns went to individuals who probably had less than $4,000 of surtax net income, a little less than two-thirds of the total to individuals with less than $6,000 of surtex net income, and about three-fourths to individuals 2 90 = with less than $12,000 of surtax net income, 1/ Moreover, in 191. (the latest vear for which such data are available), more than 90 percent of the number of persons reporting business profits had total net incomes of less than $5,000, and more than 98 percent had net incomes of less than $12,000, 2/ These figures, however, may give an exaggernt ed impression of the possible area of appeal of option for unincorporated commercial and industrial enterprises to be taxed at the corporate rates on reinvested profits, inasmuch as a considerable portion of the vartner~ ship profit reported in higher income brackets is doubtless from profes— sional and other personal service activities and would not come within the scope of the option. 3/ Furthermore, even in cases where owmers of unincorporated businesses pay tax rates on reinvested profits thet sre higher than the corporate rates, they may suffer no net tax disadvantage with respect to their whole business incomes, The individual tax is the only tax imposed on the portion of profits withdrawn from an unincorporsted business, whereas distributed corporate profits are subject to both the corporation income tax and the individual income tax. This freedom from so-called double taxation of profits withdrawn from the business will in many enses counterbninnce the effect of - higher tax rate on reinvested earnings even in the case of proprietorships and partnerships owed by individuals with large income, Finally, most businesses can be incorporated rether easily and at no great expense if their proprietors wish to take advantage of the tax treatment of the corporate form. There rre some incidental in. conveniences related to Going business as a corporation, but in most 1/ Statistics of Incone for 1942, Part 1, The statements in the text assume thet persons who reported profits from unincorporated business hed an avernge of $1,000 of personol exemptions and eredit for dependents, This figure is close to the average for all taxable returns but is low for the classes near the breaking points mentioned in-the text, Statistics of Income for 1941, Part Ly De Oh ‘In 1939, 22 percent of portnership returns with ordinary net income in excess of $5,000 fell in the "service! clessifiention, Computed from Supplement to Statistics of Income, 1939, Part 1, De 9 = NO = cases, they do not seem serious, a] In some few ficlds, as for example, . stock brokerage, incorporation may be barred by law or custom, but the plan under discussion is apparently not intended to cover such businesses, Ce Economic considerations ee Me OS It seems that the limited aren likely to be covered by a plan granting optional corporate tax treatment for the reinvested earnings of unincorporated enterprises would mean that such a plan would not have major economic significance, It might stimulste some firms to disincorpornte, and in some instances it might improve the incentive to invest and also incrense investment funds, Unless, however, the plan were very liberally drawn, it scems unlikely that its effect on investment or saving would be important, qd, Equity considerations Despite its probsbly limited apvlicability, an option to owners of unincorporated businesses to be taxed on reinvested earnings st the corporate rates would raise some questions of equity, ven if a case can be made for allowing »n option for unincorporated businesses, equity would seem to demand that the choice be between the present treatment and the full corporate trentment, Under the plan that has been suggestcd, proprictors and partners would have the best of two worlds, They could continue to esenpe so-called double taxation on profitg withdrawn from the business and, at the seme time, avoid individyal surtaxes on profits reinvested in the business, The option th»t has been proposed would @iscriminste against corporations, The plen would also diseriminate in favor of the savings of individuals slready in business »s comp-red with the savings of others who are nceumulating enpital to go into business, It would offer individuals with large incomes a privilege not available to persons with sm-ll incomes, It would decrease the over-all progres— sivity of the individual income tax. Bard, loc, cit., asserts, "Operating as 2 proprietor or pertner has certnin advantages and conveniences which, while not contributing materially to the profit of the operation, may contribute materislly to the ease of operation," Among these advantages and conveniences, he mentions freedom from ant erference by minority stockholders, flexibility of m=nrgement, freedom from certain regulations and record-keeping requirements, and taxes, He also contends, "It is un-American to force anyone to carry on their business in a prescribed way by a threat of heavy taxation," Soli €. Administrative considerations ne consiccerations Any plan for special tax treatment of the reinvestcda earnings of unincorporated businesses would raise some very serious administrative problems, The major problems would be related to (a) the definition of an unincorporated business enterprise, and (b) the distinction between the income and assets of the business and of its proprictor or portners, There is no clenr-ent distinction between business activity and personal activity. This problem would be most difficult in the case of personal service businesses, and would be less serious if the tax plan were restricted to commercinl and industrial enterprises, as its Sponsors apparently contemplate, Nevertheless, many close questions would doubtless arise, The absence of difference in legal title to business and personal income and »ssets in the case of proprietorships and partnerships would complicste the necess*ry Segregation, Certainly, rather full and elnborate records would be essential, In particular, the concent of distribution of esrnings is ambiguous in the case of an unincorporated business, Legally, 11 of the assets of the business ro at the personal disposal of a sole proprietor, Business debts and personal debts may be recovered from any assets to which the proprietor has title, Problems would prise in determining the smounts of eapital gains or losses and ordinary gains or losses at the time of termination or transfer of -n unincorporated business, The spirit of the present income tax system would require that only earnings required for the reasonable business needs of an unincorporated entervrise eould be retained and taxed at the corporate rates, ay But such a proviso would five rise to all the difficult determinations now necessary under Section 102 of the Internal ‘Revenue Code, which inposes a surtax on corporations improperly accumulating surplus, f. Conclusions ao USLONS' The proposal to offer an option to unincorporated businesses to be taxed at the corporate rates on reinvested earnings seems to be addressed to a problem of relatively small importance, Unincorporrt ed businesses suffer n net tax disadvantage, as compared with corporations, i/ Bard does Suggest this, loc. cit, ; & UO only if they are owned by persons with relatively high incomes anc if a large proportion of the profits are reinvested in the business, Moreover, most businesses can be incorporated with little difficulty or expense, The option would probably have limited economic signif— icance, On the basis of equity, it is hard to justify allowing owners of unincorporated businesses to continue to escape so-called double taxation on earnings withdrawn from the business, and, at the same time, to avoid individual surtax on reinvested earnings, The plan would be hard to administer because of the difficulty of defining an unincorporated business enterprise and of distinguishing between, the income and assets of the business and of the proprictor or partners, It would also be hard to determine whether amounts reinvested were reasonable in the light of the needs of the business, C. Proposals for tax exemptions for small or new businesses or for investors in them The proposals @iscussed in this section go beyon? those considered in the preceding sections, They call for partial or complete tax exemptions for new or small businesses or for investors in them, These proposals are intended to stimulate investment in such enterprises and to improve their capital position. One group of proposals calls for exemption or reduced—rate taxation of the retained earnings of small businesses, Another group of proposals suggests partial or complete tax exemption of equity investors in smnll businesses, The exemption might be in the form of either a defuction from taxable income of the principal amceunts invested or an exemption of part. or all of the return on investments in small enterprises, A third group of proposals calls for tax exemption for new small businesses for a limited period of vears, Presumably, all three groups of proposals might anply to both incorporated an¢@ unincorporsted businesses. All such proposals for tax exemption for certain kinds of income raise fundamental problems of equity, There is a strong presumption in favor of uniform taxation of all versons with the same amount of income and in similar personal circumstances, This presumption can be overcome only if it is determined that the end sought by tax. exemption has great social importance and that tax exemption is an effective means of promoting the sccial objective. This report does not attempt to evniuate the social importance of small or new businesses. It is appropriate to note, however, that recently there has been a rapid growth in the number of new small -~43- businesses, without the benefit of any tax exemption. if Moreover, there is some statistical evidence that small firms grew relatively more @uring the war years than did large firms, 2/ Some specific. comments on the probable effectiveness of the exemption schemes will be made in the discussion of the particular types of propos7ls, At this point, two types of general considerations, applicable to all of the exemption plans, should be mentioned. First, the direct effect of a tax exemption is a decrease in revenue, Unless this decrease is made up by increasing some taxes, the tax exemption has the same immediate effect on the budget as an increase in Government expenditures, Hence, the effectiveness of tax exemption may be compared with alternatives such as increased Government exvenditures for direct and guaranteed loans, services to business, and similar purposcse Second, a tax exemption results in a shift in the tax load away from the exempt businesses to non-excmpt businesses, If tax rates are increased to maintain revenues, the possible deterrents to taxable enterprises and investors must be offset »gainst any additional incentives to those enjoying the oxemption, Hven if taxes are not increased to maintain revenues, taxable enterprises may suffer a competitive disadvantage, which will cause them to curtnil their investment programs. In either case, additional investment in tax-exempt businesses will not all be a net gain to the economy. 7. Tax exemption for retained enrnings of small businesses a, Nature an@ purpose of proposals Several proposals have been made to attack the capital problems of small businesses by exemption or low-rate taxation of their retaine@ crrnings, These proposals differ somewhat from the proposal to tax the reinvested earnings of unincorporate? businesses at the corporate rates 3/ in that they are not presented as methods of equelizing tnxes on different forms of businesses but rather as propossls for especially favorable tax rates for small businesses, 1/ See Avpencix B, : 2/ F.C. Dirks, "Wartine Earnings of Smell Business," Federal Reserve Bulletin, Jenuery, 1945, pp. 16-26, and "Wartime Financing of Manufacturing and Trade Concerns," Federal Reserve Bulletin, April, 1945, pp. 313-330; Roy A, Foulke, "Expansion from Retained Earnings," Dun's Review, November, and. December, 1945, - 3/ See Section II, B, 6. : — Wy - Some of the exemption proposals are intended to apply to both incorporated and unincorporated businesses and others to only one or the other type of firme Some propossls merely call for a tax credit with respect to retained esrnings of small business without specifying any limitation so long as a business is eligible, 1/ Other proposals would limit the. amount of retrined earnings on which credit would be allowed 2/ or would extend the plan only to new corporations for a limited period of yearse 3 b. Economic considerations Small businesses are especially Aépendent on retained earnings for additional enpitel. Furthermore, it is obviously true that they woulé be able to retrin more carnings and grow more rapidly if they did not have to pay income tax on their business savings, This type of interference with private plans is the universal and inevitable fenture of any tax system. As has been pointed out in the general discussion of the exemption proposals, a more compelling kind of argutient is necessary to support removal of taxes in one particular Areas American Small Business, Additional Report of the Special Committee to Study and Survey Problems of American Small Business, Senate Report No. 12, 78th Congress, Ist Session, January 18, 1943, p. 113; and statement of Charles C, Fichtner, Department of Commerce, in Hearings before the Special Senate Committee to Study and Survey Problems of Small Business Enterprises, Mnited States Senate, 77th Congress, end Session, De. 189. Marriner S, Eccles, Chairman, Board of Governors, Federal Reserve System, suggested in his testimony tefcre House Small Business Committee, (Hearings, ope Cite, Pp. 1206) that all corporations be given a tax credit for dividends paid and that the first $50,000 . of retained income be given the same treatment as divicends to vrotect small corporations in need of funds for capital expansion. Harold M, Groves in Production, Jobs and Taxes suggested that small enterprises be allowed to: reinvest all or a part of their earnings free of the withholeing tax he vroposec for other corporations. (pe 34) In 1945, Representative Patman, in a letter to Representative Doughton op. cit., outlined a plan for issuance of certificates to small businesses that would permit them to retain carnings free of tax for three years and at reduced rates fer the next two years, with the regular tax rate applicable thereafter. — 95 - The argument that has been advanced in favor of a tax exemption for retained earnings of small businesses is that at a certain stage in the establishment of a firm a rapid increase in both fixed capital and working capital is likely to become necessary. If the firm can obtain the required capitnl, it may be able to enter a period of healthy growth and to establish itself firmly. If, however, the key amount of additional capital cannot be obtained’, the firm may not only be unable to grow but may slip backward into bankruptcy. It has been argued that a tex exemotion for reinveste? enrnings at this critical stage may help supply the additional canital and thus mean the difference between successful growth and failure, It has been contended that in the long run the enlargement of the tax base that occurs when the small firm is successful will more than compensate the Government for the revenue cost of the exemption. In the tyne of case just described as well as in other less spectacular instances, the increase in funds nt the disposal of small firms, which would result from tax exemption for their retained earnings , could be exnecte? to increase investment hv such firms. Doubtless, however, a part of the afditional internally—financed investment in small firms would merely take the place of investment in larger firms or in small firms financed from outside sources. The tax exemption might stimulate a pattern of investment @ifferent from that which would otherwise obtain, It would favor investment in established and vrofitable small businesses as compared with new or less profitable small enterprises, It is often argued thet internally—financed investment, especinlly when it depends on tax advantages, is likely to be poorly allocated and relatively inefficient. ec. Equity considerations The general equity problems with respect to tax exemptions have already been mentioned, One specific rspect of the equity consider— ations, however, merits further mention, The proposals for tax exemption for retained earnings of small businesses would discriminate in favor of one kind of savings as compared with all other types of savings. The plan would discriminate in favor of owners of small businesses as compared with persons who choose to provice for their future through other forms of savings, such as investment in Govern— ment securities, This would be true even if it were possible to administer the exemption so that *1l retained earnings were used for legitimate business purposes and not merely as » means of tax avoidance or nostnonement. The inequity woul¢ he more egloring, however, if in actual practice the exemption plan were a>used or used as a cloak for retention of earnings not used for ortinary business PUTPOSES » 5 = Hh. d. Administrative considerations Although not all vroposals are explicit on this point, the economic rationale for the exemption plans woule require that retained earnings be exempt only if used for reasonable business vurposes, However, supervision of the exemption to prevent retention of earnings for purposes of tax avoidance would give rise to the same difficult problems now encountered in the acmin— istration of section 102 surtax on corporations improperly accumulating surplus, As was pointed out in tne discussion of the plan to tax reinvested earnings of proprietorships and partnerships at the corporate rates, the administrative vroblems would be especially difficult in the case of unincorporated businesses, where there is no legal distinction between the business and its owmers, It would be optimistic indeed to : suppose that an exemption for retained earnings could be confined to cases of genuine need with toleratle efficiency and uniformitye ee Conclusions Compelling evidence of need and social desirability is necessary to justify a tax exemption for the retained earnings of small businesses, In some instances, an exemption might help smell firms obtain an indisnensable increase in eapital with, which to finance a healthy growth but without which a decline and ultimate failure would result, A part of the investment stimulated by the tax exemption would, however, merely replace investment in other firms, Moreover, it is possible that the internally financed investment so stimulated would be less efficiently allocated than other investment. Exemption of retained earnings would discriminate in favor of one kind of savings as compared with other kin?’s, "quitable and efficient administration would be difficult, especially in the case of unincorporated enterprises, 8 Tax exemmtion for equity investors in smell businesses a. Nature and purpose of vrovosals Proposals for tax exemption for equity jnvestors in small businesses, like plans for exemption of retained enrnings, have the aim of helping solve the capital problems of such enterprises, Proponents of such plens contend that » tax concession is desirable to overcome deterrents to investment in smnli businesses, such as a7 risk and high taxes, and to make such investment more attractive as compared with securities of large corporations and governments. The proposals that have been advanced. have been intended to apply mainly or exclusively to small corporations, but much the same arguments pro and con might be used with respect to small unincorporated businesses. There are two types of exemption proposals intended to give a tax incentive to equity investors in small business. The first type of proposal would exempt from the indivi@uel income tax amounts invested in small business through the purchase of certain types of securities. The second type of proposal would exempt from tax part or all of the income received on equity investments in smell business, The second tyne would allow the taxpayer to be taxed at one-half the effective rate applicable to his total income on the amount of dividends received on new equity issues. 1/ A less specific proposal of this type calls for exemvtion of some unspecified percentage of the return on equity investments in small business, 2/ Another proposal would provide for issuance of 5-year tax exemption certificates to investcrs in common stock of corporations with equity capital not in excess of $20,000. 3/ It is not clear whether the certificates issued under this proposal would. provide. tox exemption only for the amount invested or for earnings on the investment, or both. Another proposal would partly or wholly exempt @ividen?s received from investment companies investing in the securities of small business., This sucgestion was made in conjunction with a proposal to exempt the investment companies them— selves from the corporate income taxe 4] Louis 8, Kimmel, Postwar Tax Policy an? Business Expenditure, Pamphlet Yo. 5%, Brookings Institution (/nshington, 1943 Statement of Charles C, Fichtner, Hearings before the Senate Snecirl Committee to Study an? Survey Problems of Smell Business ° Entervrises, Op, Cite, De 789, also referred to in American Small Business, Senate Report No, 12, 78th Congress, lst Session, ODe cit., De alle Letter of Representative Patman to Representative Doughton, op. cite Flisha M, Friedman in testimony before the House Small Business Committee suggested that stockholders of such investment companies be exemmt from normal tax on dividends receiver, Hesrings, ODeCite, Pe 1720 - 4g . be Heonomic considerations It is usually argued that the primary necd of small business is more equity capital rather than more borrowed capital or credit. Certainly excessive fixed commitments arising out of borrowing endanger any business, However, some questions have been raised about the appropristeness of equity issues for small corporations and the willingness of the small businessman to accept new equity capital. Revise? bankruptcy and reorganization laws have facilitated readjustment in ceases where credit obligations cannot be met, Many owners of small business are reluctent to cede control over their firms to acquire equity capital and vrefer long-term loans, i/ if loss of control to absentee owmers is the price of new equity capital, small business may lose many of its unique advantages. Considerations with resvect to the effect of tax exemption for investors on the volume of investment in small businesses and in the whole economy mare much the same as those with respect to tax exemption for retaine? earnings of small businesses, The plans woul? probably somewhat stimulate investment in the particular firms benefited, but it is less certain that they woul? moterially increase total invest~ ment, The exemption plans would introduce a new factor into the allocation of investment among different types of enterprises, and it is not clear that the resulting allocation would be more, efficient than the present one, There is danger thot westeful expansion of some businesses would be encouragetat the expense of others. ce Hquity considerntions The equity questions raised by vronosals to exempt certain kinds of investments or their proceeds from infivieunl income tax are similar to those with respect to proposals for special tax treatment for retained emrnings of small businesses, discussed in an earlier section, These include discrimination among types of savings and savers and among ciffecrent types of businesses, a, AAministrative considerations One administrative problem in ecnnection with a plan to provide tax exemptions for equity investors wouldrelnte to the definition of equity capital. Equity capital is not a clear ané unambiguous Walter C, Louchheim, "The Problem of Long-Term and Equity Capital," , Law_and Contemporary Problems, Vol. XI (Summer—Autumn, 1945); Butters and Lintner, ™ffect of Federnl Taxes on Growing Enterprises, ~ ig . terme Corporate securities cover a whole range of types of claims on earnings and assets, and it is often hard to draw a fixed line between equity and borrowed eapital, Probably the most feasible @istinction would turn on the question whether the return on the securities was: deductible for tax purposes by the corporation paying it. However, the present difference in tax treatment of interest and dividends paid has often been attaeked as baged on legalistic rather than real economic Aifferences in security issues, To prevent wholesale tax avoidance it would be necessary to try to make sure that funds obtained from equity investors were used for legitimate business purposes, Otherwise, some small corporations might merely invest funds in securities or extraneous activities on behalf of individuals in order to allow them to take advantage of the tax exemption, supervision to prevent such malpractices would be complicated and would require the Commissioner to use a high degree of judgement. As in the case of the other exemption plans, an especially difficult problem would arise if the exemption were extende? to investors in proprictorships and partner- ships as well as corporations. ee Conclusions The considerntions with respect to tax exemption for equity investors in small businesses are much the same as with respect to exemption of retnined earnings of small business. The exemptions : might somewhat increase investment in eligible firms, but a part of this inerease would undoubt edly merely replace other investment, The tax exemption would introduce a new factor into the allocation of investment, - factor not related to technological efficiency or market Cemen¢, The exemntion woule raise the equity problem of aiserimination in favor of one king of savings anc investment as compared with others, There would be administr>tive problems in @efining equity capital and in preventing abuse of the exemption for the purpose of tax avoidance, = 50 = 9. Tax exemption for new small businesses for a limited period of years a. Nature of proposals There have been a number of proposals for tax exemption for new small businesses for a limited period of yerrs, 1) Most of these proposals re little more than endorsements of the idea of partial or complete tax exemption for new firms for the first few years of their life. Details of possible plans are usually | not provided, nor do their sponsors usvally present any extensive analysis of the purposes and probable results of their proposals. a The present discussion relates only to exemption from net income TAKES» 1/ See, for examples: Kimmel, Postwar Tax Policy and Business Expansion, ope cite, De 173 Harold M, Groves, Production, Jobs and Taxes (New York, 194U), pp, WES: and Postwar _ Taxation and Economie Progress (i'ew York, 1946), wp. 102-105; Frank D, Graham, Social Goals and Economic Institutions, quoted by Rudolph L. Weissman, Small Business and Venture Capital (Yew York, 1945), p. 158; testimony of Juices "schner, Treasurer, Smaller Business of America, Ince, Clevelanc, Ohio, Hearings of the House Small Business Committee, pe 750; testimony of S. Abbot Smith, ibid., p. 911; H.R. 365, 79th Congress, lst Session, 1945 (Mr. Buffett). 2/ Two of the provosals that have been spelled out in more-than-average detail are those of Representative Buffett (H.R. 365, 79th Congress, Ist Session, 1945) and Lewis H. Kimmel (ops cite)» Representative Buffett's bill, which was adé@ressed only to the period of immediate postwar adjustment, covered ineome and excess—profits taxes, and payroll, capital stock, and declared—value excess-profits taxes. The exemption was for only the first %4 years of life of new independent corporations with invested capital (including borrowed capital) not in excess of $100,000, Dividends of exempt corpora— tions would have been limited to 6 nercent per year; salaries would have heen required to be reasonable; and payments on leases or other contracts could not have been contingent upon income of the corporation, Mr. Kimmel recommented that new manufacturing corporations be exempt from cornorste surtax for the first three years of their life and he subject to only one-half the regular rate for the next two years, (The corporate surtox ~roposed by Kimmel would be only 5 to 10 percent; on. cite, De l#). He mentioned. certain criteria intended to identify genuinely new manufacturing corporations, a 6) be Economic considerations The economic effectiveness of the exemption of new small businesses would denend mainly on the amount of investment that is stimulated, Tax exemption may stimulate investment trough its effects either on incentives or on available investment funds, Moreover, any stimulstion may be reflected mainly in an increase in the number of new firms that are begun or in an increase in the amount of investment in firms that would have heen in existence in the absence of the tax exemntion, Exemption from income tax would leave new firms that were profitable during the first vears of their lives a larger net return than would be possible if they were subject to regular taxes. This might improve the incontive to invest in new business enterprises and change the relative attractiveness of investing in new and old businesses, It is clear, however, that exemption from income tax would not change an unprofitable venture into a profitable one, The temporary tax exemntion would have its greatest appeal in fields that promise large profits at the outset anc in which the future is highly uncertain, These in many cases would be short-run ventures intended to exploit some temporary m-rket. In such cases, however, it seems likely that the exact size of the net return would be so speculative that a temnorary exemption from income tax woulé not greatly influence decisions to invest, unless the tax from which the exemption was made were very high, Entrepreneurs end investors in such new undertakings are likely to be people of optimism and enthusiasm, who will visualize the new business in such glowing terms thet profit.: prospects will not be greatly dimmed by an ordinary income tex, provided all costs can be deductet from taxable income. In other, probably more typical, cases, investors in new businesses must look forward to a number of years of developmental work before sizable profits can be expectet, In such cases a temporery exemption from income tax would have little significance, Unfortunately, there appears to be no adequate statistical information on the profits records of new businesses, Even if such information were available, there would be no way of knowing how many investors go into new businesses with the expectation of realizing no profits for the first few years. Obviously, ‘the signifiennce of tax exemption would denend to some extent on the number of years of exemption allowed, = 52 = It anpears that a temnorary income tax exemntion would be of relatively little importanqe in casés where several years of losses or very low profits were expeqted. It has been contended that tax considerations are seldom of dominant immertance in the foundation of new firms and original investment in,them. This may be true despite the fact that the expectation of ultimate nrofits is an indisnensable element in the inducement to invest in new businesses. if A temporary tax exemption might encourage investment in new enterprises by permitting recovery of capitel more rapidly than is possible with normal depreciation methods, This objective, however, could probably be better achieved by an accelerated depreciation plan of the tyne that has been discussed in an earlier section. 2/ 1/ Butters and Lintner summarize their conclusions from a study of a number of new and growing business enternrises as follows: "]. Tax considerations seldom dominate decisions to organize small, indenendent enternrises. "2. In particular, taxes typically are given little conscious consideration by the individuals actually resnonsible for the organization of new entervrises. "3. Moreover, taxes generally annear to have relatively little effect on the decisions of outsiders to invest in new companies during the verv early stages of, their development. There is some evidence to indicate that outsiders usually are not interested in a new undertaking until a substantial amount of development work has been successfully comnleted. ml, Ata later stage of development, however, the high individual suptex rates in combination with the very favorable treatment accorded to capital gains by the present tax law frequently act as a positive stimulant to investments in new enternrises which offer prosnects of large canital gains. "5. In one respect, nersonal income taxes frequently have an important, though indirect, bearing on the formation and early pregress of new enternrises. Income taxes restrict the amount of personal funds available to the prosnective organizers of new businesses; they may thereby delay or prevent the organization of new enternrises."! Effect of Federal Taxes on Growing Untervrises, p- 13. : 2/ See Section TI, A. 4, Oo Retained earnings are an especially important source of capital for new small firms, A temporary tax exemption would increase the amount of funds at the disposal of profitable new firms, One argument that has been made in favor of such a tax exemption is that new firms should be given the same opportunity of growing from internal funds as was open to their competitors, which were established at an earlier date when income tax rates were low, If the primary purpose of tax exemption were to increase funds available to small, new businesses, it would be reasonable to restrict the exemption to retrinea profits, The exemption woul?, of course, benefit only those firms that realized profits. A tax exemption for new small businesses might introduce an additional element of instability into the business situations The exemption would offer a special incentive to the establishment of new firms an? to the abandonment of existing businesses, It would offer opportunities to promoters to establish new enterprises with a view to early sale rather than long-range opportunities. c, Equity considerations In common with the other exemption schemes already discussed, tax exemption for new small businesses raises fundamental equity problems of discrimination against those not eligible for the exemption, The exemption has been defended on the grounds that new small businesses are of vital social importance and that tax exemption is desirable to compensate for disadvantages uncer which new firms operate, The validity of these arguments is largely a matter of individual judgment. It should be recalled, however, there has been a rapid increase in the small business population within the last two years, despite the lack of any special tax concessionse de Administrative considerations The only difficult administrative problem under a program for. exempting small, new businesses from income taxes would be to identify such firms, This problem, however, would be a very difficult ones, Obviously, a new incorporation or formation of a new partnership would not. be satisfactory. proof of the establishment of a genuinely new business enterprise, The firm, although legally new, might be economically a continuation of an old business, On the other hand,. some economicelly new business ontervrises are uncertaken bv old firms without any change of legal identity. A tyne of interpretative problem that would often arise would relate to the establishment of — 5 — new units or new departments in an old business, When a retailer opens a second store at a new location in a different section of the city, has he established a new business? If the answer to this question is yes, would he form a new business if he merely added a new department at his old location? The difficulties of defining a new business unit would be especially great in fields such as retailing and agriculture. These difficulties have led some to recommend restricting any tax exemption to new corporations in the manufacturing field. 1/ Such a limitation would somewhat simplify the problem, but difficulties would be met even in the manufacturing field. Moreover, restriction of the exemption to manufacturing corporations would scem to be unwarranted favoritisme Tests that would deny the exemption to all old businesses that had merely changed. their form would be likely to rule out some genuinely new businesses, 2/ The difficulties of identifying genuinely new, small businesses would be so great that administration of the statute would require a great deal of discretion and might well lead both to arbitrary findings and to disputess In administering the exemption for new small businesses, it would appear to be necessary to require owers of the exempt enterprises to pay themselves reasonable salaries for their services. The exemption would presumably be intended to cover only the business income and not to permit individuals to escape personal taxes on their earnings, The determination of reasonable compensation is always a difficult problem, Kimmel, oD. cite; Groves, Production, Jobs and Taxes, Groves, however, has reconsidered his earlier proposal and now suggests that the exemption be extended to retained earnings of new businesses in all industries. Postwar Taxation and Economic Progress, De 103. Kimmel, who does try to lay down some tests, seems to be too strict. He says: "This exemption should be limited to strictly new enter prises. The fact that a new manufacturing corporation had been established could not be accepted as evidence of eligibility, since such a company might represent a consolidation of two or more going concerns. To be eligible, a new company would have to be able to meet one of three tests; (1) operation of a newly constructed plant or plants; (2) operation of a plant which had not previously been used for manufacturing; or (3) operation. of an abandoned or dormant plant which had not been used for manufacturing for a period of something like three yearse" Op. cits, De 176 - 55 - but it would be accentuated under an exemption plan inasmuch as the increase in vrofits resulting from pavment of inadequate comensation would be free of tax. Similar difficulties would arise with resvect to depreciation and other deductions. e. Conclusions A temporary tax exemption for small new businesses would vrobably somewhat stimulate investment in such firms because it would increase the possible rate of return and the amount of capital available from reinvested earnings. Exemntion from income tax, however, is likely to be a factor of secondary. importance in the case of businesses intended to exploit some temporary market which holds wromise of extraordinary vrofits even after tax or where an initial neriod of very low profits or losses is anticipated. Temporary tax exemption would permit quicker recovery of canital out of earnings, but this objective could be achieved more efficiently by accelerated denreciation. The tax exemption would be a factor making for instability in the small business field and might well stimulate an uneconomic turnover of small establishments. The tax exemption would raise the equity problem of discrimination against established firms and other taxpayers. There would also be an administrative problem relating to the proper definition of a new business. It would be hard to deny exemntions in the case of mere split-uns and reorganizations without at the same time excluding some genuinely new undertakings. IIIs Choice among types of tax measures for the benefit of small. business This report has dealt mainly with certain special tax measures that have been proposed for the special benefit of small business. With the exception of liberalization of opportunities for offsetting operating losses against taxable income, all of the measures discussed would anply nrimarily or exclusively to small businesses. The assumption underlying all of the proposals is that some tax revisions are desirable to assure the healthy growth of small business. This assurmtion is, of course, subject to debate. There is, however, ample evidence that small business suffers from certain handicans and competitive dis- advantages. It is therefore anpropriate to examine the tax system to determine to what extent it may accentuate the difficulties of small business and to what extent tax revisions may pnropcrly be used to further the national policy with respect to small business. - 56- If it is decided that some tax revisions are desirable in the interests of small business, thereremains a basic policy issue of choice between general and special measures for the benefit of small business. Choicc between general and special measures depends both on the detailed objective sought and the effectiveness of different kinds of mcasures. Presumably, those who wish merely to make sure that the tax system does not discriminate against small business, would favor reforms of general application in preference tc special measures, provided the gencral reforms were considered effective. On the other hand, those who wish to use the tax system to compensate for non-tax handicaps of small business would probably expect to do so by special, rather than general, measures, Conceivably, of course, some measures might be formally general but in actual application restricted to small businesses The most important condition to the prosperity of all businesses, small and large, is an economic system operating at high and rising levels of production, For this reason, the most important contribution that the tax system can make to the healthy growth of small as well as large business is through general measures thant improve the equity of the present system and minimize any adverse effects on investmont and consumer demand. 1/ General tax revisions are likely to raise fewer problems of equity and administration thm are many special measures for small business, Well-conceived general tax revisions would also avoid the undesirable collateral economic effects that might be associated with many of the special measures that have been advanced for the benefit of small businesse Howard R, Bowen has stated this view as follows: "The gain to be realized by small business from a tax system which promotes high- level production far surpasses any advantage to be derived from special tax adjustments designed specifically in the interests of small business." "The Taxation of Small Business," Proceedings of the National Tax Association, 1946, p. 294. Harold M, Groves expressed the same point of view as follows: "Many of the improve— - ments in the tax system recommended primarily for other reasons. may also be supported as aids to small Lusiness . ... It seems highly probable that a sensible and well—b=lanced tox system, is the best promotion government can give to business, both big and small." Postwar Taxation and Economic Progress, ppe 101-102. 2 bf = Despite the pre-eminent importance of general tax revisions, it may be desirable to give consideration to certain measures designed especially for small business, Since nearly all such measures, wovld result in some loss of revenue, they must be evaluated in the light of alternative tax reductions and expenditure policies. In choosing among various special measures, the soundest approach would appear to be to begin with a careful consideration of measures intended to refine or improve the tax base and rate structure. Especially deserving of consideration in this category are changes in the method and extent of graduation of the corporate income tax, improvenents inloss offsets, and limited accelerated depreciation. Then attention might be given to measures intended to reduce inequalities in taxes on incorporated and unincorporated small businesseSe Of the two measures of this type discussed in , this report, the partnership method for certain types of corporations is the more firmly grounded on recognized principles of tax equity. The various tax exemption proposals for the benefit of small business are open to grave question on, grounds of equity. They raise most emphatically the issue of discrimination among taxpayers and are likely to be subject to abusess In connection with the exemption proposals, special attention must be given to the possibility of uneconomic distortion of the business structure and allocation of investments — 5g ~ APPENDIX A Definitions of Small Rusiness A. Variety of definitions of small business Many definitions of small business have been used. These defini- tions differ greatly both as to measures adopted and as to internreta- tion of particular measures. Differences in usage extend beyond the matter of size classification to the question of what a business unit is. Most often, the business unit considered ig an individual firm, although for many nurnoses firms that are legally sevarate but under the same or substantially the same ownership and/or management are considered a single business unit, Yowever, investigators dealing with problems of technological efficiency have often concentrated on individual plants or establishments as the unit of size, without regard to the number of units under the control of a single top management or under common ownershin. 1/ Census data like- wise are for plants or establishments rather than firms. 1. Quantitative measures of size ae Assets One of the more common measures of size is the total assets of a business. When total assets are used as the measure, $250,000 anncars to be the unner limit most frequently mentioned for a small business. 2/ Some classifications of small business, however, run un to total assets as large as $1 million. 3/ 1/ See T.N.E.6. Monogranh “o. 27, The Structure of Industry (76th Congress, 3rd Session, Senate Committee Print, TOUT), me Ls Theodore . Beckman, "Large versus Small Rusiness After the War," Ancrican Bconomic Review, Vol. XXXIV (March, 194L, sumnlement), n.95. 2/ Sce T.N.F.G. Monogranh No. 17, Problems of Small Business (76th Congress, 3rd Session, Senate Committee Print, LOW) y. 283; Becknan, on. cit., v- 953; Rudolnh L. Weissman, Small Rusiness and Venture Canital (‘lew York, 195), nv. 9; Charles L. Merwin, Tinancing Small Gornorations (New York, 1942), ». &. a Smaller Var Plants Cornoration, 19th Bimonthly Renort to Congress (covering June and July, 1945), ». 30. ‘toward R. Bowen has defined a small business as "one which has canital of less than about a million dollars." "Taxation of Small Rusiness," Proceedings of the National Tax Association, 1946, n. 394. - 59 ~ b. Net worth or equity capital A related measure, which is much less commonly used than total assets, is net worth or equity canital. One student has suggested $100,000 net worth as a nossible upper limit in the definition of a small business. 1/ A bill to aid in financing small business, which was introduced in the 78th Congress, would have provided assistance to companies with equity capital not in excess of $1,000,000. 2/ c. Annual volume of business Another measure of size is the annual volume of business, as indicated by sales, receipts from operations, or value of product. There is, however, a wide range of differences in definitions based on this standard. YWithout specifying the industry, one definition identifies a small business as one with an annual product valued at less than $250,000. 3/ Another definition of small business suggests an annual business volume of $1,000,000 as an upper Limit. 4 The Department of Commerce definitions, which are widely used, set different standards for retailing and wholesaling, According to the Commerce definitions, a retail store or service establishment is small if its annual net sales or receipts from onerations are less than 850,000. A small wholesaler is one with annual net sales of less than $200,000. 5/ Another set of definitions using the same anproach has identified a small retail, amusement, service, or construction company as one with annu»l net sales or receints from operation of less than $250,000, and a small wholesaler as one with annual net sales of less than $1,000,000. 6/ Beckman, op. cit., n. 95. 2/ S. 1777, 78th Congress, 2nd Session (March 14, 1944), Mr. Taft. 3/ T.N.#.C. Monograph No. 17, on. cit., nv. 285. H/ Seekmen, ©p.e1%., 0, 95- 232 5/ Jesse H. Jones, "The Nation's Necd for Small Business" (reprinted from New York Times, March 28, 1943), Department of Commerce, Bureau of Foreign and Domestic Commerce, Small Business--a National Asset, Economic Series, No. 24 (July, 1943), v0. 2. These definitions were included in two bills introduced in the 78th Congress providing for the transformation of the Smaller Yar Plants Corporation into a Small Business Corporation to provide loans and other assistance to small business. H.R. 4801, 78th Congress, 2nd Session (May 12, 194l'), Mr. Robinson; S. 1913, 78th Congress, 2nd Session (May 12, 1944), Mr. Murray. @. Net income Met incone is a fourth financial measure of Q his standard has seldom been suggested as the ifesl basis of de tion by investi- gators and others concerned with small business. With minor exceptions, however, it is the basis for snecial income-ta:: treatment for small corporations under Federal statutes. * business has always been subject to the recular eraduate fers al rates, after allowance of personal exempvions, crotis fenocndents, and defuctions. Moreover, the revenue acts nroviiing for ¢ ion or reduced rates for zormorate net Incomes below a cert sin 18% contain an implicit cefiniti a small corneration n re 4 years, corporate net incomes of tess tha an 9,009 have been Seasd ak reduced rates. e. Wuamber of emniorees to a firm with less the oxtremes sre less th ‘eal 50 Teoelorensl al ese than 1C than 250 ermlorses. 6/ The es aes of Commorce uses tos ie or less as the identifying rie fo = gnall menutacturing cstablishnont, wherens it bases ee defini ‘io f emall retnil, service, and wholes le Dun & Bradstreet has suggested 5s less than three people, tor a nenbers of his Sonia. & i I/ An a EE treatment of Mutual ingureace cormanics cther thar ~ Life or marine. Those with gross roecipts of $75,900 or less are exemnt (Intern:1 Revenue Sote, Section en an’ thos? with gross receints of between $75, 000" ee es Oo 0 are sut os a special notch rate (Internal Reven 2! m.N.§.C. Monogranh No. ays CO} 3/ Snelier Var Plants Corporation, 18th ° snix Renort to Congress (April and Vay, 1945) n. 3; H.R. 35 iS% ist Session (October 21, 1943), 1 Mr. Patan’ and. ae enmanion ‘bi aL S$. RETO) FCA Congress, lst Session (October 21, 1943), Mr. Murray; S. J. tes. Wey 78th Coneres ss, lst Session (March 30, 1942), Ir. Stowart. Two other bills introéucce in the 78th Goneress, end Sessicn, defined - small nanufreturing conmmany as one with less than 500 ermiovees bus us gea other definitions for other industries -- H.R. 4801 ané S. 1913, previcusly montioned. u/ Donald YW. Paden, "Industrial Cencentration of Sm Lornent," Surver of: Garrent Business, April, 1905! ne 10. 5/ Yoissman, op. cit., n. 9. 6/ Becknan, on. cit., v. 5. 7/ commerce, Beconomic Series, No. 24, op. cit., p. 2. &/ Hearings before the Snecial Committee “to Studv ané Survey Problems cf Small Rusiness Entcrvrises, U. S. Sonate, 77th Congress, end Session, Part 15 (February 23, 1943), n. 2125. ee odes 2. Relative measures of size Some investigators make no effort to formulate a general definition of small business, but hold that a definition must be relative to the context of discussion and must vary from in@ustry to industry. This view is given a degree of recognition by those who use different definitions for small business in the fields of manufacturing, whole- saling, and retailing. The Federal Trade Commission, however, has extended the principle and set up different definitions of small companies in the fields of cement manufacturing, steel, petroleum, sugar, ete. In the study of the relative efficiency of large, medium, and small business, which it carried out for the T.".E.%, the Sommigsion arrayed plants and companies in order of size as measured by quantity of production or size of investment and then drew the line between size groups where a considerable break in the series was noted. An attempt was made to have the largest corporation in the small group considcrably smaller than the smallest medium-sized corporation. 4/ One historical study defined small business as the smallest 75 percent of firms or establishments, as measured by assets, net income, or employment. 2/ 2 3- Qualitative definitions of small business Small business is often identified by the qualities it is assumed to possess rather than by any absolute or relative qualitative measure of size. Thus, 7.N.5.C. Monogranh No. 17 states: "The qualities immlicit in small business are those of the self-determined or independent owner-management. The typical small business unit is both owned and directly operated by its active proprietor or proprietors, with no overhead affiliations or control . . . The qualities of small business are secn most clearly in the simple one-man proprictorshins, but they characterize the smell and medium-sized business nartnershins and the smaller 'closely held! business cornorations as well." 3) 1/ T.N.5.5. Monogranh ‘To. 13, Relative Sfficioncy of Large, Medium-sized and Small Business (76th Gongress, end Session, Senate Committee Print, 1941), np. 16. ¢. Veith Rutters and John Lintner in Effect of Federal Taxes on Growing Enternri'ses (Boston, 1945), nn. 8-9, stress the comnetitive asnect of size; "The terms small and large of necessity have different meanings in different contexts. A $25 million company may be small in cometition with a billion dollar commany; a company with a, capital of $500,000 may be large in comparison with smaller cometitors." Yoward R. Rowen, "Trends in the Business Ponulation," Survey of Current Business, March, 194, pn. 8-13. m 3/ T.W-E.C. Monograph No, 17, op. cit., p. 2u7. Ge as In this same vein, but anparently with a more elastic definition in mind, Senator Murray, Chairman of a Senate Snecial Committee to Study and Survey the Problems of Small Business Entervrises, declared, "TI have always considered a concern small if it is free and indenendent and doesn't spread over a number of States, with branches throughout the country." 1/ Another definition, based on the premise that small business is as small business does, vronoses to identify small business by one of the problems it faces. “A working definition of small business which would also cover new business" would, according to one writer, include for purposes of discussion "any business established or projected which either cannot obtain canital funds at all or can obtain them only at exorbitant rates in the canital markets." Further, "A similar definitorvy formula could be based on differential rates for commercial loans as between large, and small or new business." 2/ B. Selection of a definition of small business for tax purnoses 1. Relation of definition to nurnoses A definition of small business suitable either for use in a tax law or for research on the tax problems of small business shoulc meet fairly rigid requirements. The character of the definition that is appropriate for tax purposes is conditioned by the objectives of any snecial tax legislation considered for small business. If the purnose is to compensate for certain disadvantages and disabilities of small business, the appropriate definition of smallness will be 2 measure that includes the area where these problems are tynically acute enough to be considered to necd correction and as little additional area as nossible. If the nurnose is to offer snecial stimulation to the develonment of small businesses because they are believed to offer important social and economic advantages, the avpropriate definition of smallness must try to delimit the area of these peculiar advantages. eee 1/ "Problems of American Small Business," Hearings before the oe 77th Soneress, 2nd Session, Part 2 (March 5, 1942), po. 438. 2/ Walter C. Louchhein, "The Problem of Long Term and Equity Cenital," Law and Contermorary Problems, Vol. XT (Summer-Autunmn, 1945), p. 203. - 63 - 2. Criteria of a satisfactory tax definition ae Objectivity Any definition of smallness for purnoses of tax legislation or for study showing the need for, and soundness of, possible legislation should be based on an objective measure of size. This requires a quantitative rather than a qualitative standard. The identification of smallness may have to be based on an essentially arbitrerv. defini- tion, but it should not be a matter of individual judgement. b. Simlicity Simple and easily available measures are, of course, nrefsrable. This argues for the suneriority of a definition based on gross or net income, in preference to such measures as invested canital, assets, and number of emplorees. c. Indenendent annlicability An accentable definition for tax nurnoses should be one thet can be annlied to a single firm without the necessity of commarison with other firms. The definition will, of course, be formulated by examination of a large grou of firms, but its application thereafter should not have to denend on date for other firms. This critorion bars purely relative stanéards of smallness and bigness. d. Relation to tax base There is an advantage in a definition of smallness measured either by the tax base or by some factor closely related to the base. If small business is to be taxed differently under an income tax than large business, there seems to be a nresumption that smallness should be @efined in terms of income. Conceivably, the relation between the nrimary measure of size and net income might be denendable enough to warrant translation of one into the other. The indications are, however, that neither total »ssets nor eross sales (two of the most common measures of size) bear a uniform enough relation to net income to justify such a translation. As can be seen from Table 2, data for net-income corporations with total assets of. lese than $250,000 show for 1942 wide divergencies among industry groups in the relation between net income and total assets anc gross 6k sales, and between gross sales and total assets: For example, in this asset class, in the manufacturing field, manufacturers of machinery except transportation equipment realized net income of 23 cents per $1 of total assets, or 11 cents ner $1 of gross sales. Manufacturers of tobacco realized net income of 9 cents per $1 of total assets, or lL cents per $1 of gross sales. Among net~income cornorations with assets of less than $250,000, trade cornorations as a groun had gross sales (and receipts from operations) of $3.40 per $1 of total assets! manufacturing corporations, $2.73; service cornorations, $1.85; and public utility cornorations, $1.61. Table 2 Net Income Related to Total Assets and Gross Sales; Gross Sales Related to Total Assets : Net Income Corporations with Total Assets of Less than $250,000, 1942 fee dace ay Net income Yoross sales 3/ pee ot > per $1 of mee or :gross sales 3/: of total ee of total assets 2/ receipts 4/ , assets 3/ All industrial groups $ aie $ S 2.47 Industry group Total mining and quarrying 013 2355 Total manufacturing 16 2.73 Food and kindred products 3.65 Beverages 2 Qeil Tobacco “ 2.33 Cotton manufactures | 3.19 Textile-mill products 3.03 Apparel and other fabrics 4.10 Leather and products : 3.69 Rubber products 2.61 lumber and timber ‘ 2.48 Furniture and finished lumber 2.54 Paper and allied products 2.40 Printing and publications industries 1.79 Chemical and allied products 2.20 Petroleum and coal : 3-07 Stone, clay and glass products 1.80 Iron, steel and products 2.51 Non-ferrous metals and products 2./l Electrical machinery 2.43 Machinery except transportation equipment 2.01 Automobiles and equipment 2.56 Transportation equipment except automobiles 2025 Other machinery ot 293 Manufacturing not allocable 2.40 Total public vtilities 015 1.63 Transportation 2.00 Communication 3 81 Other public utilities 3 Total trade 12 Total wholesale 13 Total retail Total service 015 Total finance, insurance, etc, Construction ol] -06 Total agriculture, forestry, etc. °10 ell Footnotes on next page. ~ 66 + Table 2 -- Continued Net Income Related to Total Assets and Gross Sales; Gross Sales Related to Total Assets Net Income Corporations with Total Assets of Less than $250,000, 1942 Source: Computed from Statistics of Income for 192, Part 2, Table 6. i/ The amount reported for declared-value excess-profits tax computation adjusted by excluding net operating loss deduction (items 31 and 27, respectively, p. 1, Form 1120). 2/ As of December 31, 1942. Adjustments are made in tabulating the data as follows: Reserves, when shown under liabilities, are used to reduce corresponding asset accounts, and "Total assets" and "Total liabilities" are decreased by the amount of such reserves and (2) a deficit in surplus, shown under assets, is transferred to liabilities,and "Total assets" and "Total liabilities" are decreased by the amount of the deficit. "Gross sales" consist of amounts received from goods, less returns and allowances, in transactions where inventories are an income-determining factor. For "Cost of goods sold," see "Deductions." "Gross receipts from operations" consist of amounts received from trans- actions in which inventories are not an income-determining factor. For "Cost of operations," see "Deductions." i 67 Ss APPENDIX B Selected Statistics on the Relative Importance of Small Business It appears that, on the basis of almost any of the definitions commonly used, small businesses account for a large majority of the number of firms and a sizable portion of production and employment. 1. Census data on small establishments, 1939 Se ee ee ee be Table 3 indicates the relative importance in 1939 of establish- ments which arg small business according to the composite definition of the Department of Commerce. i These are manufacturing establish~ ments with fewer than 100 employees, wholesale establishments with annunl sales of less than $200,000, and retail and other establishments with annual sales or receipts of less than $50,000. In 1939, approxi- mately nine-tenths or more of the establishments in each of the industry groups shown in Table 3 except wholesale trade were "small." In all seven industry groups, small business employed more than LO percent of workers and active proprietors and accounted for more than one-third of the value of output or sales. Small businesses were most important in retail trade ond service, but their employment and output were a sub- stantial portion of the total in all of the industry groups shown. 2. Corporate income tax returns classified by size of assets, 1941 Serbo Sie sBeome pax rouumns Crnssitied oy size or assets, Is Table 4 classifics corporations submitting income tax returns with balance sheets for 1941 by size of total assets. The most usual general definition of smallness in tcrms of assets is a firm with less than $250,000 total assets. By this standard, a Large majority of all corpo- rations were small in 1941 in every major industry group. However, the preponderant amount of gross sales or receipts and of net income was realized by corporations with more than $250,000 of assets. Small corpo~ rations, as measured brr assets, were relatively most importent in service and in the unclassified group. 3. Corvorate income tax returns with net income Classified by size of net income, 1941 ee ee ee ee ECON ae In Table 5 corporation income tax returns with net income for 1941 are classified by size of net income. In that year 90 percent of all corporate returns with net income showed less than $50,000 of net income, which is the present uppcr limit for the reduced income tax rntes allowed small corporations. Yet these corporations realized less than 10 percent of the total net income reported by corporetions with net income. if Some ambiguity arises because it is not clear whet should be thought of as a small establishment or a es Mabie 4 Importance of Small Establishments in Selected Industry Groups, 1939 Department of Commerce definitions 1/ ae ) s Ge in thousands) oa : Number of establishments : Number of personnel 2/ Value of output or sales = Industry eS (* Bangg | PeRCent s. a F sungy 2 Percent” ee ee SU.S.. totals 2. | oe business *, SMall = U.S. Petals sj ads os * small :U.S. total : se : small Lo : } SHsiiess 2 poe Bema Manufacturing 184,230 168,814 91.6% 7,886,567 2,358,968 29.9% $ 56,843,025 $17,366,698. 30.6% Wholesale trade 92,79) 7,681 = F4e2 912,795 355,731 39.0 19,418,547 4,100,404 21.1 Retail trade 1,770,355 1,614,310 91.2 6,213,890 3,487,984 56.1 42,041,790 17,836,171 42.4 Service 646,028 637,585 98.7 1,754,538 1,294,724 73.8 3,420,417 2,241,709 65.5 Hotels 273987 25 , 224 90.1 362,047 141,383 >. 30,7 $63,155 229,163 26,6 Construction 215,050 200,299 93.1 1,300,439 3/ 30.2 3/ 4,519,794 1,546,275 34.2 Amusement 44,917 = Ho, 351 89.8 257,200 145,641 56.6 998,079 332,837 33.4 Total 2,981, 361 2, 758,264 92.5 18,687,476 7,754,232 41.5 $128,104,807 $43,653,257 34.1 Treasury Department, Division of Tax Research Source: Department of Commerce, Bureau of Census, Sixteenth Census of the United States, Census of Business, 1939. 1/ Small establishment is defined as follows: manufacturing, less than 100 employees; wholesale trade, annual net sales of less than $200,000; other industry groups, annual net sales or receipts from operations of less than $50,000.. 2/ Including sclf~cmployed except in manufacturing... Number of employees plus number of active proprictors. 3/ Number of personnel not available. Percentage figure based on payroll breakdown, Table 4 Corporation Returns in Selected Industry Groups Classified by Size of Total Assets 19he Net income or deficit 2/ Percent Industry group and 5 total asset class : Number Number of : Gross sales and receipts ; returns 1 : from operations = -. Percent : Amount : Percent : Amount > of total _:: (thousands) : of total : (thousands) : of tota- All industrial groups: 0 -$ 50,000 196,642 50,000 ~ 100,000 58,338 100,000 - 250,000 57365 250,000 and over 71,189 All classes 383,534 Mining and quarrying: 0 -$ 50,000 3,127 50,000 — 100,000 1,185 100,000 - 250,000 1, 347 250,000 and over 1,960 All classes 7,619 Manufacturing: 0 -$ 50,000 32,063 50,000 - 100,000 11,585 100,000 = 250,000 13,104 250,000 and over : 19,582 All classes: 76, 334 Public utilitios: 0 -$ 50,000 9,387 50,000 — 100,000 24239 100,000 — 250,000 2,115 250,000 and ovor 3,132 All classes 16,873 $ 9,139,039 7,494, 350 14,251,622 174,096,164 204,981,175 95, aks 102, 796 233, 822 323182583 3,810, 49 2,009, alt 2,173,409 4,984,895 107,261,157 116,429,285 ee 22 253,792 420,540 16,596,273 17:595,957 Continued on next page $ 131,600 270,020 728,137 21, 816,054 22,945,811 13,134,202 13, 544,145 10, 792 16,180 38,270 3,556,761 3,622,003 Table 4 (continued) _ Corporation Returns in Selected Industry Groups Classified by tite of Total Assets Number of Gross sales and receipts : Net income returns 1 : from operations : or deficit 2/ Percent : «Amount oe Percent : Amount - Percent : al: (thousands): of total : (thousands) : of tota: Industry group and ‘ total asset class % Number ee trades: ' 0 =$ 50,000 50,000 = 100,000 100,000 = 250, 000 250,000 and over All classcs Retail trade and trade not allocatce 0 -$ 50,000 50,000 = 100,000 100,000 = 250,000 250,000 and over All classes Services 0 -$ 50,000 50,000 ~ 100,000 100,000 - 250,000 250,000 and over All classes Finance, ete.: 0 =$ 50,000 50,000 — 100,000 100,000 - 250,000 250,000 and over All classes 16,162 52778 6,225 5,423 332577 53,395 12,513 9,148 5532 80,588 22,265 35882 3,142 2,403 31,692 47,152 ep 19,290 30,252 114, g64 157573537 1,824,193 359324,252 18,520,632 26, 3 034,623 3,489,164 2,296, 309 3,239,674 18,741,091 273 766,238 629 447 419,617 586,660 - 2,421,187 4,256,911 129,472 69,560 117,549 3,296,871 3,613,451 Concluded on next page 1,019,615 62,963 79565 148 , 330 15255.5357 1,526, 396 17,872 23,286 42, 396 273,162 356, 716 ~ 15,043 9,438 32,156 250395570 2,066,121 Table 4 (concluded): ‘Corporation Returns in Select¥d Industry Groups €lassified by ce Total Assets Number of Gross seles and receipts Net income BenahGe opis : returns 1/ : from operctions : or deficit 2/ ‘ C 2 $ ercent mount . ercent total assct class Percent Amount Percen Amo : Perceen * of. tetar _._ (thousands) +: of _tota Number (thousands) : of total : Construction: ce — $ 50,000 28 62.2% $396,687 : $ 5,939 50,000 = 100,000 46 127 282,059 11,213 100,000 = 250,000 13.2 594,757 34, 385 250,000 and over 11.9 3,252,052 264,906 All classes 100.0 4,555,555 - 336,443 Agriculture, Forestry and Fisherics: oe -$ 50,000 25 . BBS3 84,139 Betis 50,000 = 100,000 ce 17.5 59,187 3,523 100,000 = 250,000 06 18.1 112, 738 sa 10,519 250,000 and over Qh 16.3 480, 747 66,168 All classes 100.0 736,811 80,741 Nature of business not allocable: _ @ = $ 50,000 | 67.8 22,169 50,000 = 100,000 10.7 13,427 100,000 - 250,000 8.5 28,735 250,000 and over 13.0 117,569 All classes oe 100.0 181,900 Treasury Department, Division of Tax Research Source: Statistics of Income for 1942, Part 2, Table 6. 1/ With balance sheetse 2/ "Net income" or "deficit!" is the amount reported for declared-valuc excess—profits tax computation egsuahed by excluding net operating ioss deduction. = 72 - Table 5 Corporation Returns with Net ,Income Classified by Size of Net Income Net income : Number of returns 1 Net income e class : Percent Amount Percent (thotsands) : : of total (thousands) _: of total O= 9 5 55. 6% $ 238,585 1.0% $5-=- 10 13.1 253,671 Vi 10 = 15 17,163 6.3 210,610 9 15 = 20 10,523 309 182,621 8 20 25 75455 2.8 167,082 of 25 = 50 17,465 665 615,433 50 and over 31,817 11.8 225384, 357 All classes 269,942 100.0 24 0525 359 Treasury Department, Division of Tax Research Source: Stntistics of Income for 1942, Part 2, Table 7 1/ With net income, 2/ Net income is the smount reported for declored-value excess-profits tax computation adjusted by excluding nct operating loss deduction. “B= 4, Trends in the business population ond relative position of small business, 1900-194 een nee ence cee ror emenen caren ctem ae temaann a at EE A, In o study of available statistical data on trends in the business population and the relative importance of snoll business; which was published in Merch 1944, Howard R. Bowon summarized his conélusions as follows: "Statistical ovidence presented suggests tho existence of four clerrly defined periods in the history of the business population: "(1) From 1900 to 1918, the number of business firms apparently increasod nore rapidly than the hunan population, No comprehensive data on the size structure are availrble for this period, "(2) From 1918-29, the relative increase in number of business firms continued, but the proportion of the econony in the hands of very lerge firms increased rapidly, "(3) During the poriod 1929-41, the number of firns declined abruptly up to 1933 and then increased vory rapidly until, in 1941, the ratio between business firns and huran populntion was greater than in 1929... The rela- tive portion of the cconony in the hands of small and large firms fluctusted during this poriod, with a probably slight gain for snall business. (4) Since 1941, the number of firns has declincad sharply. This decline ceased in the middle of 1943, however, and since then the number has remnined about stationory. During the war period the growth of large business has been such that the proportion of the cconomy accounted for by small firms has apparently declined. These conclusions are subject to two important qualificc:tions. "First, it must be noted that the changes in the distribution of Ancrican business firms by size classes have not beon violent. Throughout the entire period et under study, the general pattern of size distribution has renained renarkably constant. "Indeed, when the firms or establishments of the United States are classificd by size on the basis of assets, net income, sales, or omploynent, the percentage of firms within each class ronains approximatoly the sane even over long periods of time. . .. ~ 7h. "Second, from the fact that the relative position in the econony of small business apparentl: declined during the periods before 1929 and since 1939, it must not be concluded that the absolute importance of snall business also declined. In fact, during both periods, small busi- ness at least maintnrined its absolute level of activity. "Third, the conclusions presented ignore possible increases in the economic power of large firms through various informal controls over smaller firms, ¢.¢g., financial control, price leadership, and control of dealer franchises. 1/" Bowen used as his prinary definition of small business the smnrllest 75 porcent of firms or establishnents as measured by asscts, incone, or employment. Bowen noted that the apprront decline of small business during the war is partly attributable to the great expansion of heavy manu- facturing which is nornally charactcrized by large-scale production. Increased concentration of production appears to be a usurl accom paninent of high-level econonic activity because of the relntively greater importance of durable goods industries in such poriods,. Qn the basis of his study, Bowen found "abundant evidence that small business is an institution of great vitality... ." He thought it highly probable that a postwar resurgence of snall business could be expected, Data for the years 1944-1946 indicate that there has been a repid increase in the number of firms in business. By mid-1946 the business population had surpnssed the prewar peak. The nunber of firns in operation at selected dates has been estimated as follows: 2/ September 30, 1939 3,317 thousand September 30, 1940 3,298 " September 30, 1941 3, 398 September 30, 1942 3,156 Septenber 30, 1943 2,861 Septerber 30, 1944 2,924 September 30, 1945 3,134 June 30, 1946 3,504 ®* (prelimincry) l/ Howard R. Bowen, "Trends in the Business Population," Survoy of Current Business, March 1944, p. 13. 2/ Melville J. Ulmer, "The Postwar Business Population," Survey of Current Business, January 1947, p. 18. - 15- As might be expected, the increase in the number of firms has been prinarily anong small businesses. More than 90 verceent of the net inercase in number of firms (excess of new busi during the years employees. nesses over discontinuance) 1944 and 1945, was in firms with three or fower During that period, the number of firms with 50 or nore employees that discontinued business slightly sie the number of new businesses in this size group. 1 1/ Donald W. Population," Survey Paden and Alice Nielson, "Recent Trends in the Business of Current Business, May 1946, ». - 76 = APPENDIX C Selected Data on Financing of Small Business This appendix briefly summarizes some of the available data on financing of small business, It covers security issues, bank credit, investment by private individuals, miscellaneous credit and capital sources, and retained earnings. The different sources of funds are, of course, of widely verying importance, and available information also varies in completeness and reliability. A. Security issues 1. Experience of small and unseasoned corporations, 1933-1937 Some information on the difficulties experiemced by small and unseasoned corporations in getting additional capital by sale of securities is provided by a Securities and Exchange Commission study of the experience of 584 such companies registering securities under the Securities Act of 1933 between July 1933 and June 1937. 1/ Of the $321 million of securities registered by these 584 corporar tions, only $74 million, or 25 percent, were sold within one year. One~hundred=ninety~one companies reported that none of tho $105 million of securities registered by them were sold. For the remaining 393 companies, sales of $74 million were 34 percent of the securities registered by them, Going concerns were considerably more successful in selling their securities than were new enterprises. Of the 393 companics selling some securities, 161 going concerns sold 44 percent of the amount they registered, while 232 new ventures sold only 27 percent of the amount they registered, Of the 191 companies roporting no sales, 169 were new ventures and only 22 were going concerns. Some 17 percent of the total sales of sccuritics by small ond un- seasoned concerns were made to officors, directors, promoters, and principal stockholders, 2. Cost of flotation of securities, 1938-1941 Table 6 presents SEC data on the cost of flotation of registered securities for the years 1938-1941 by size of tho issuing corporation, This table shows that in the main the cost of flotation of bonds, preferred stock, and common stock was a much larger percentage of the protecds in the caso of small issuers than in the case of large issucrs. 1] Research and Strtistics Section of the Trading end Exchange Division, Selected Statistics on Sccuritics and on Exchange Morkets, o report ‘to the Scecuritics and Exchange Commission (Washington, August, 1939), ‘Pps 34-37. os Table 6 Cost of Flotation of Securities 1/ by Size of Issuer, 1938-1941 Assets of issuer (millions of dollers MPNnphy Fu MPMmuw Fuim 9 5 6 \ 2 ) 4 8 7 6 7 g a8 1 B. Preferred stock heneenenmeemnenome nme ne e e 11.8 12.0 1 5 10 50 100 200 200 and over Treasury Department, Division of Tax Research Source: Securities and Exchange Commission, Research and Statistics Section of the Trading and Exchange Division, Cost of Flotation for Registered Securities, 193%-2939 (Washington, 1541); sho Statis- Ficai Series Relvnses Mos572 (gune 6, 29!i} and No.715 (June 18,1942). 1/ Securities effectively registered under the Securitics Act of 1933, proposed for sale by issuers, iacluding securitics proposed for sale through investment banking facilities and through other channels, Does not include securities “proposed for sale for account of others," 2/ Including both compensation to distributors and expenses, ~ 1g = Table 6 combines securities sold through investment bankers and those disposed of directly by the issuer or through other channels, In general, cost of flotation was higher for securities marketed through investment banking facilities than for securities, of issuers of the same size marketed through other channels. $250- = $500—- + $1,000- * $ 3 : ps : 00 : $1,000 : 000: 1934 5To1 yer 1935 6 52.0 1 28.2 1936 358 28.4 25-9 1937 - 300% 29.4 22,2 1938 50.6 BS 8 295 1939 62.0 63.1 378 1940 62.2 59-2 : Wu3 - 1941 71.4 7208 52.2 ie... fy. ae 26. 5869 1943 45.4 64.3 6 co 56.7 BH WSO (0 1D CA Oa LOW OTOH Gt Gi Gt WO 100. 1 e » e Neon e Treasury Department, Division of Tax Research Source: Computed from Statistics of Income, annual volumes, 1932-1942. Press release No. 8-122 for 1943. aj The low percentage for this year is attributable mainly to heavy dividend payments by small financial corporations. The estimated retained net earnings for nonfinancial corporations in this class are approximately 45 percent of net income after taxcs. = ou History of Graduation of the Corpcration Income Tax Graduation in the corporate income tax was originally obtained by means of a specific exemmtion. Graduated rates were not introduced until 1935. The cornoration excise tax of 1909 anplied only to incomes of over $5,000. The exemption was eliminated in the 1913 act, avparently with little or no discussion of the reason for so doing at that time. An exemption of $2,000 was restored by the Act of 1918, presumably on the theory that corporations should have the same exemption as married individuals. In 1921, the exemption was restricted to cornorations with incomes under %25,000, with a notch nrovision for incomes of slightly more than this amount. This provision remained unchanged until 1928. In 1928, consideration was given to the possibility of allowing the partnership option for small corporations. As an alternative it was proposed to increase the exemption for incomes under $25,000 to $3,000, on the theory that it was desirable to give relief to corporations with small incomes rather than to small corporations as such. Consideration was also given at that time to a plan introduced by Representative Garner to graduate the corporate tax rates taxing incomes un to $7,000 at 5 percent, $7,000 to $12,000 at 7 percent, $12,000 to $15,000 at 9 vercent, and all over $15,000 at 11* vercent. This gradua- tion scheme was onposed by Chairman Green of the Ways and Means Committee, on the ground that graduation for corporations was "not logical." However, the bill as it passed the Fouse included graduated rates. The graduated rates wore eliminated (by a margin of one vote) in the Senate. The dill as finally enacted included the $3,000 vanishing -exemption. This exemption was continued until 1932, when it was eliminated on the ground of revenue needs. In June 1935, President Roosevelt in a message to Congress recommended graduation of the corporate tax rate from 10-3/4 percent to 16-3/4 percent, in place of the 13-3/4-percent rate then in effect. This graduation was desirable, he said, because the advantages and protection conferred by the Government unon corporations increased with their size, snd because large corporations were better able to pay than small, .1/ Robert Jackson,. then Assistant General Counsel I/ Wessage of the President to the Congress, June 10, 1935, Hearings ~ pefore the Committee on Yavs and “Means, House of Representatives, 74th Congress, lst Session, 1935, nm, 2-H. = 27 = of the Treasury, offered as additional arguments for graduation the contention that it would tend to stabilize the revenue, since the income of large cornorations fluctuated less than that of small corporations, and the contention that large corvorations were better able to anticipate and provide for the tax. 1/ The bill reported to the House adonted graduation "in mrincinle" -- with a rate of 13-1/4 nercent on incomes under 15,000, and 14-1/4 percent on the reminder. Graduation was thus limited becuse it was believed that the revenue loss from nore extensive graduation would be too great. The Senate bill, however, vrovided graduation fren 12-1/2 to 15-1/2 percent. As finally enactzd, the rates were 12-1/2 per- cent on the first $2,000, 13 nercent on the next $13,000, 14 percent on the next $25,000, and 15 nercent on incomes over $40,000. These rates never became effective, being superseced by those of the Act of 1936, but the nrincinle cf eraduation, and the brackets, were eontinued in the next two revenue acts. The Revenue Act of 193% introduced the notch into the graduation system. The Ways and Means Conmittee renort recommended graduation of from 12-1/2 to 16 nercent on incomes under $25,000, a notch rate of 32 percent and a general rate for incomes above the notch of 20 nercent less 4 nercent of dividends naid. The Senate renort recommended a vanishing exemntion instead: a flat rate of 18 nercent with an exermtinn equal to 10 percent of the amount by which $25 ,000 exceeded income. As finally enacted, the Rouse provisions for incomes under $25,000 were adopted, with a notch of 32 percent, and a general rule of 19 nercent less (for 193% and 1939) 2-1/2 nercent of dividends naid. Since 1938, the rates have been changed, but the method of graduation has not. Since the Revenue Act of 1942 the notch aren has been net income of $25,000 to $50,000. Above $50,000 the full rates have annlied to the whole net income. \ HN tl aan ae T] Hearings before the Senate Finance Committee on the Revenue Act af 1935, 74th Congress, lst Session, 1935, on. 209-213. COLUMBIA UNIVERSITY LIBRARIES This book is due on the date indicated below, or at the expiration of a definite period after the date of borrowing, as provided by the library rules or by special arrangement with the Librarian in charge. DATE BORROWED DATE DUE DATE BORROWED DATE DUE (MAR 295 nol2sy | ANY, BY ae il ib wh lat be | # ney nN Dy "58 SI fe : « ay e > " *) ~’ 4 _ cs 28 (747) Mioo lag ae NEH N 5 a oc “es ’ VG = bios st tee one _— ~ on ran eae — Pre —s tase | t | en § tm ned Mops ry su 0 ea 22 Tr D : Dp ee De s Ss ine Ss Bu 1 — Po) OL “i on cian a Tax ‘ee gd hb a aa Re ‘ 4 ; = bof. 2 ig: = T Op = ie L i a