An outstanding example of this tunnel vision was the development of an annual retirement plan return (Form 5500). The proposed form was to be used by all employers regardless of whether they had one employee, or 100,000 employees, and regardless of whether their plan had $1,000 or $1,000,000 in assets. The burden that this proposed return would have imposed upon small plans, which comprise approximately 90 percent of all plans, was in the magnitude of $135 million annually.

Many small businesses cannot afford professional assistance in the preparation of their tax returns and the maintenance of their accounting records. Therefore, when they try to cope with the same laws which apply to IBM or General Motors, they make errors and, in many cases, they violate laws and regulations unintentionally. Why should the small business person have to understand the academic nicety of the "accural" basis of accounting or the necessity of capitalizing certain indirect expenses so that the ending inventory of work-in-progress precisely reflects his costs? The Internal Revenue Code, "one law for all", not only imposes a relatively costly burden on small business, but also imposes a costly enforcement burden on IRS. Both of these problems could be overcome through the adoption by Congress of a concept set forth in the 1976 COSIBA "Small Business Growth and Job Creation Act": Allow all businesses whose ending inventories are less than $200,000 to report their taxable income on a "cash" basis. Eliminate the compulsory "accrual" basis and all of its complicated interpretations. The temporary losses in revenue to the Treasury Department would be recovered in future years as the "cash" basis merely defers taxes. The Tax Reform Act of 1969 gave birth to the "Assets Depreciation Range" systetm (ADR). One of the main benefits of this Act was to allow a greater depreciation write-off in the year in which an asset was acquired. However, in order to qualify for this bonus, the taxpayer is confronted with a maze of rules and regulations. This has caused the ADR system to become almost the exclusive tool of large companies. The system is written and geared for large companies. Congress could have allowed small companies an election that any asset purchased within the first 182 days of the taxpayer's fiscal year, could be depreciated for a whole year and any asset purchased subsequently, could be depreciated for 1⁄2 year.

In conclusion, Mr. Chairman, I would like to make it clear that many of the options proposed and discussed by the Ways and Means Task Force on Capital Formation in its recent report do not address the problems of small, independent business. In many cases they are simply not beneficial and some of the suggestions, such as ending the taxation of corporate dividends, could prove harmful. These are some of the areas in the tax code that concern the small business community. There are, of course, more, but the tax writing committees are starting to look at small business matters and we are confident that once these inequities are known they will be corrected.

We are especially pleased that you, Chairman Byrd, are holding these hearings and we are grateful for the opportunity to appear before you and your Committee. We need more help from Congress and feel that this type of hearing is very important since we see little concern for small business in the Department of Treasury.

Thank you.

PREPARED STATEMENT OF EDWARD H. PENDERGAST, CPA, REPRESENTING THE SMALLER BUSINESSS ASSOCIATION OF NEW ENGLAND

Mr. Chairman, thank you for the opportunity to present the views of the Smaller Business Association of New England on the problems of small businesses when dealing with the federal tax laws and the Internal Revenue Service.

INTRODUCTION

Small businesses, generally considered to be those employing 500 persons or less, comprise 97 percent of all businesses in the United States. As reported by the Small Business Administration, more than one-half of all business receipts are generated by their operations. Perhaps more importantly, they employ more than one-half of the United States business work force.1 Commencement and

1 Report of the SBA Task Force on Venture Equity Capital for Small Business, US Small Business Administration, January, 1977.

expansion of new small businesses each year add significantly to the growth of our economy. This stimulant, coupled with the fact that small business is demonstrably labor intensive, means that when small business flourishes, the problem of unemployment is reduced. Further, it is recognized that the cutting edge of technological innovation is honed to its sharpest by small businessmen who must "build a better mousetrap" simply to survive. I am a volunteer representative of thousands of small businesses located across the Northeast from the industrial cities of Connecticut to the islands off the northernmost tip of Maine. My constituency is hard working, inventive in the best Yankee tradition-and frustrated.

The tax laws and their implementation seem to inhibit healthy growth of small business. Part of this is due to the basic cost of complying with tax laws not increasing proportionately with size. As a result our federal paperwork and regulatory burdens fall disproportionately on small business. When compliance becomes too difficult or too expensive, there will be a revolt. If lucky, it will be a quiet one. Bruce Fielding from the National Federation of Independent Business who is testifying here today can amplify on one example. NFIB surveyed its members with less than $100,000 of inventory. The tax laws require them to use inventory values when calculating taxable income. The survey results were that over half were reporting income on a cash basis. The law is impractical and unenforceable. The taxpayer equals with his actions the laws that are unworkable.

SUMMARY

The small businessman desires a simpler tax structure. Rules, forms and procedures adopted to implement the tax laws can add unnecessarily to the complexity he faces. The small businessman desires fewer opportunities for controversy with the IRS. Further, he believes that legal issues under the tax laws should be resolved without protracted litigation.

I would like to concentrate my testimony on three areas that impact small business. The first area is the Internal Revenue Code itself, followed by the implementation by the Internal Revenue Service and finally the specific issue of the proposed elimination of double taxation on dividends.

DISCUSSION

The Internal Revenue Code, regulations, ruling, procedures, forms, and court cases create a dense thicket of tax rules even for the specialist. To the average small businessman without employees having tax expertise this maze can appear almost impenetrable. Compliance costs are burdensome in terms of after tax net profit, and the smallest of the small businesses must frequently apply the same knowledge and effort to follow the rules as his larger competitors.2

SUGGESTED CHANGES IN THE INTERNAL REVENUE CODE

Depreciation of physical assets

One area of significant concern to small businessmen is the allowance for depreciation provided under code section 167. A little over ten pages of the code and 100 pages of regulations are devoted to setting forth the complex rules on this subject. In an inflationary economy it is vital for the small businessman to have the opportunity to recover the cost of physical assets as rapidly as possible through depreciation deductions. In 1971, in an effort to minimize disagreement with taxpayers over the useful lives and repair of assets, the Treasury Department adopted the class life ADR System. This reduction of controversy purpose is started in the Section 167 ADR (asset depreciation range) regulations. The theory of ADR is excellent. By and large it permits more rapid write-offs of costs related to productive assets than would otherwise be the case under

2 A standard bound edition of the Internal Revenue Code with nine by six inch pages is over 2,100 pages long. Final and proposed regulations exceed 6,000 pages. IRS Revenue Rulings and Revenue Procedures published weekly in the Cumulative Bulletin number many thousands, and finally, a welter of court cases in the Tax Court, Court of Claims, Federal District Courts, Federal Appellate Courts and Supreme Court of the United States fill over 100 volumes. (See Internal Revenue Code including 1976 amendments, Income Tax Regulations as of March 18, 1977 (3 volumes) both published by Commerce Clearing House, Inc.) A well-known tax information service in 1977 expanded its 7 volume loose leaf service on the Federal income tax law to 28 separate volumes. Tax Action Coordinator, Research Institute of America.

conventional tax depreciation rules. But the implementation of this program has been characterized by such obtuse language, sporadic but frequent changes, complexity and high cost of administration that the typical small businessman has been unable to take advantage of it. Revenue Procedure 72-10 which was adopted by the IRS to implement the ADR System has been amended no less than 22 times by additional Revenue Procedures since it was promulgated in 1972. The regulations drafted by the Legislation and Regulations Division of the IRS Chief Counsel's office to define this program are so complicated that 25 separate terms require special definitions. The following single sentence from these regulations is characteristic and evidences why small businessmen cannot reasonably be expected to comprehend, apply, and benefit from the ADR program. Many other regulations under section 167 are no less complex.

"In the case of eligible property first placed in service in the taxable year of election (and not otherwise properly excluded from an election to apply this section) the taxpayer may not compute depreciation for any of such property in the asset guideline class under a method not described in Section 167 (b) (1), (2), (3), or (k) unless he (1) computes depreciation under a method or methods not so described for eligible property first placed in service in the taxable year in the asset guideline class with an unadjusted basis at least equal to 75% of the unadjusted basis of all eligible property first placed in service in the taxable year in the asset guideline class and (2) agrees to continue to depreciate such property under such method or methods until the consent of the Commissioner is obtained to a change in method." Regs. Sec. 1.167 (a)−11(b) (5) (v) (a).

Omitting the use of ADR, many small businesses have continued to be harassed by the IRS over such matters as useful lives and salvage values of depreciable assets and repair allowances. The IRS should be encouraged to extend the spirit of ADR in ways that will benefit small businesses. At the very least, for example, the Service should refrain from making meaningless roll-over adjustments for depreciation the sole effect of which is to shift deductions. between years.

In addition, we recommend that the small businessman be given the opportunity to eliminate disputes with the IRS over depreciation deductions by following a depreciation method which he can easily understand. Specifically, Congress should allow a deduction for the full cost of the first $200,000 of depreciable personal property and depreciable real property. The timing of this deduction should be totally within the control of the taxpayer; if he wished he could claim a deduction in a particular year of up to $200,000 of such costs.

This proposal will not result in a net revenue loss to the Government. It will simply delay the receipt of tax dollars. It eliminates the need for a small businessman to prepare detailed depreciation records on each item of property which he acquires and reduces potential controversy with the IRS. It also eliminates the present temptation to expense some items because of frustration with the complexity of current depreciation rules and a perceived inability to take full advantage of those rules at a reasonable cost.

Tax rates and the surtax

The surtax exemption which has effectively been raised to $50,000, should be increased to $150,000. Absent this we should adopt a graduated income tax structure. The establishment of $25,000 as the surtax base was in the early thirties. Inflation alone has increased this to over $150,000. In addition, studies have shown that smaller corporations pay a higher effective tax rate than large corporations. For some reason, it becomes extremely difficult to have this legislation adopted and when it is adopted it is only temporary. We of small business do not have the resources to return to battle every year or so about the same issue. We tend to state our case and expect fair consideration. This is an expensive piece of legislation but is so fundamental to the growth of the small and medium size business it must be passed. As an added point, we wish relief for the cyclical business to allow him to carryover unused surtax exemption, giving him a form of income averaging. Under the present laws, a corporation that makes nothing in one year and $100,000 in the second year pays $34,500 in taxes. If the same business made $50,000 each totalling the same $100,000 he would pay $21,000 or $13,500 less although the combined two year income for both is the same!

Capital gains

When a business is sold, the present tax law encourages an exchange of stock

for stock to effect a tax free exchange. This shifts capital from small business to large business because the seller does not want to take shares in a smaller non-publically traded corporation so he sells to a large publically held corporation. Under our proposal, he could sell to the small non-publically traded corporation for cash. If the money were reinvested in another qualified small business investment within a specified time the capital gains tax would be deferred until sale of the new stocks. This would not be a revenue loss bill. Its purpose would be to retain capital in the small business sector rather than shifting it to the large business.

Small business stock

Section 1244 allows a deduction against ordinary income of qualified small business stock losses up to $25,000. This should be increased to $50,000 and increase the limit on an offering from $500,000 to $1,000,000 and the limit on the size of the issuer should be raised from $1,000,000 to $2,000,000. The election should be removed and 1244 should become automatic. The present law does not protect small companies without the knowledge of this code section. Elective versus automatic laws

Many sections of the code require positive assertion through a proper election. In many of these cases the election provision is unnecessary. The Small Business Stock is a good example. Sub-Chapter S election is another. The filing of the return should be the election. The election type of law can trip up the unsuspecting, provides for more paperwork and adds to the income of tax specialists. No doubt many of the elections require separate filings but if not necessary this should be eliminated.

Implementation of law

If Congress deserves criticism in any area it is never clearer than when a law is passed hurriedly requiring prompt implementation. ERISA and OSHA are not the only examples. The Tax Reform Act of 1976, signed on October 4, 1976 could not be digested in time to deal with some of the choices that needed to be made before December 31, 1976. It is little wonder that the humorists call this the Accountants and Lawyers Relief Bill.

Capital formation

Perhaps the greatest economic problem facing our nation is the generation of the capital required to modernize and expand our industrial plant. One important way in which a small business expands its capital is to retain after tax earnings. The small businessman questions whether the IRS fully comprehends and appreciates this fact of business economic life. He sees IRS applying the rules of Section 531-the penalty tax on accumulated earnings-in a heavy handed way.

When the IRS locks onto this issue the taxpayer is faced with coming forward with evidence on the issue of the reasonable needs of the business under largely subjective criteria established in the regulations. In some instance, the taxpayer has been successful in quantifying these criteria through acceptance by the courts of an operating of an operating cycle approach to determine the amount of needed working capital. Generally speaking, however, the broadness of the regulation gives the IRS ample maneuvering room to advance many theories in support of its charge. Faced with an IRS challenge under Section 531 the small businessman is frequently persuaded that it is cheaper in the long run to compromise than to fight the Government's abundance of resources for litigation.

The impact of Section 531 should not be measured only by the results of litigated cases or agreed deficiency assessments. Its full impact must take account of its in terrorem role which influences the small business corporation to pay dividends absent solid evidence of business needs in a hesitant economy. As an alternative to dividends, a corporation may adjust compensation to reduce the accumulation of earnings. This practice, however, creates the possibility of another controversy which the IRS pursues with vigor: Was the compensation "reasonable" or "unreasonable" under Section 162?

3 Code section 368 incorporate the various types of mergers and reorganizations generally used to effect tax free exchange of securities.

4 Treas. Regs. Sec. 1.537-2.

5 See Bardahl Mfg. Corp. 24 TCM 1030 (1965).

The IRS should soften its audit routines under Section 531 and Congress should review the rationale for this section in the light of the Tax Reform Act of 1976 and other changes in the Internal Revenue Code enacted since the tax on accumulated earnings was first adopted in 1939. Most particularly, we believe that the carryover basis rules of Section 1023 and the increase in the minimum tax under Section 56 reduce markedly the need for concern as to whether a shareholder is currently taxed on the income of a corporation. Indeed, the strong sentiment present throughout our land and in Congress itself in favor of some relief for the double taxation of dividends could find an appropriate outlet in the repeal of Section 531 of the Code. This step would certainly serve the twin objectives advocated by small businessmen: Simplification of the tax laws, and reduced opportunity for controversy with the IRS.

ERISA

COMMENTS ON THE INTERNAL REVENUE SERVICE

Since most small businesses are labor intensive, taking a deduction for the amortization of human capital is an important tax minimization method. One form of this deduction is a contribution to a qualified pension plan. As we all know, ERISA radically changed the Internal Revenue Code rules pertaining to such plan.

Your Committee has no doubt been made aware of many of the ambiguities and uncertainties surrounding ERISA which have discouraged the use of qualified plans by small business to protect against the amortization of human capital. We believe that if the IRS, however, had proceeded forthwith to use plain English in the establishment of rules and guidelines for the implementation of this law, many of the law's critics would have been silenced and the program would have moved forward as intended. This history of the announced guidelines, regulations, and forms under ERISA is replete with examples of requirements for establishing an ERISA qualified plan which are baffling in their complexity. Perhaps one of the most striking examples of the IRS penchant for transforming the simple into the complex is found in Revenue Procedure 75-31.9

Section 3001 (a) of ERISA requires an applicant for a determination letter from the IRS to "provide evidence satisfactory to the (IRS) that the applicant has notified each employee who qualified as an interested party. of the application for a determination." In Revenue Procedure 75-31 the IRS proceeded to turn this straight-forward one sentence rule into five tightly packed pages of explanations, instructions, and a sample notice which may be given to employees. A copy of this notice is included in Exhibit A to this testimony. We submit that this notice simply cannot be understood by the average plan participant. In short, it subverts the requirement of Section 3001(a) of ERISA. More importantly for my constituency, if the elaborate notice procedures outlined in Rev. Proc. 75-31 are not followed to the letter, the IRS can summarily return a firm's application for determination as incomplete and the whole notice procedure must be repeated. If the applicant's 1976 tax return has already been filed, and further amendments to the plan are ultimately found to be necessary by the IRS, the firm's initial failure to comply perfectly with the notice procedure may cost it a tax deduction for its 1976 contribution to the plan. Some aspects of ERISA may require complicated administrative rules. However, we fail to see why the IRS cannot adopt simple rules wherever possible to implement this legislation.

The ERISA notice procedure which I have just outlined is an example of the landslide effect of Congressional legislation on the public. Congress reposes at the peak of a rule making mountain. It casts a pebble down the slope of the Federal bureaucracy. Legions of civil servents spring into action, and by the time that pebble has come to rest, a landslide of related rules and regulations has decended on the population below. The small businessman is being crushed by an avalanche of words.

Another problem with the implementation of ERISA is the delay between the effective date of the law and the issuance of necessary regulations. Effective for taxable years beginning after December 31, 1975 a business with self-employed

PL 93-406, September 4, 1974.

See for example "Employee Benefit Plans: Completing New Form 5301 Poses Some Knotty Problems", Clark R. Byam, Journal of Taxation, November, 1975.

8 Rev. Proc. 75-31 has its origin in Treas. Regs. Sec. 601.201 (0) (3) (xv). It was subsequently modified by Rev. Proc. 75-37 and amplifies Rev. Procs. 72-6, 74-38 & 75–5.