and nature of shareholders. Obtaining consents from a large number of share holders or from shareholders (such as other corporations) who must take special legal action to consent might prove difficult or cumbersome. Many of these proposals for amendment to Subchapter S have been advanced in the past.51 Because of more pressing tax problems requiring legislative attention, they have received little consideration by the tax writing agencies Enactment of these changes are, however, basic and congressional committee. to a broadly conceived small business tax reform effort. The changes, together with the SBE taxation system, would achieve workable integration of the corporate and individual tax for the entire small business sector. This would go far to help solve the chronic problem of obtaining long Kalupa, "Remedy of Defects in Subchapter S Asked by ABA Taxation CHAPTER 7 TAX EROSION OF EARNINGS THAT WOULD OTHERWISE BE RETAINED FOR USE IN THE BUSINESS 1 The inaccessibility of traditional outside financing sources forces small businesses to finance themselves largely by reinvestment of earnings. The reinvested earnings must be sufficient both to maintain current operations and to finance expansion. In addition, sufficient capital must be generated to cope with the specific economic problems cause by inflation, and to maintain a sound capital structure during periods of recession. A recurring complaint of small businesspersons is that the problem is compounded by the fact that taxation substantially reduces the amount of earnings which otherwise might be reinvested. Large businesses, because of their broader financial bases have easier access to traditional financing sources to support their current operations and expansion. It seems odd, therefore, that the taxing system, which supposedly imposes the greatest tax on those with the ability to pay, consistently taxes small enterprises at higher effective rates than large enterprises. "Although the statutory maximum corporate tax rate is 48%, one out of every five big companies pays less than 43% and the largest 100 corporations consistently pay between 25% and 30%. In contrast, smaller companies trying to grow so as to be effective competitors must often pay the full statutory rate of 48%. 2 2/ Statement of Senator Gaylord Nelson, Chairman, Senate Select Committee on Unincorporated businesses, because of steeply graduated individual rates, often pay tax at rates in excess of 48%. Thus, the system, as a practical matter, works exactly opposite from the way it is supposed to work: it imposes the heaviest tax burden on those taxpayers least able to bear it. This upsidedown system results from tax incentives slanted in favor of big business. It is true that these incentives are also available to smaller firms. The tax benefits are granted, however, to types of activities and levels of economic 3 income not often encountered by small business firms. This bias in the system against small business has invoked many suggestions for its revision. Some of these suggestions have been incorporated into the For instance, the allowance of additional first-year depreciation and imposition of lower tax rates on lower levels of corporate income are designed to benefit small business. Most small business relief provisions have not been as effective for promoting earnings retention as they might have been, They are available to big business as well as small business. 3/ For Example: The Foreign Tax Credit Internal Revenue Code (IRC) activities, the areas of economic endeavor most often pursued by small business. Two proposals are invariably advanced as facilitating greater retention of earnings for small business. One is the reduction of corporate tax rates and the other is the increase of the accumulated earnings credit. Both of these suggestions are rejected by this study as having unwarranted negative revenue impact. Other relief provisions are recommended which are specifically designed to address the typical activities of the small business sector. It is believed that these recommendations effectively facilitate retention of earnings without creating unwarranted tax "windfalls." The other proposals are so persistent, however, that discussion of the reasons for their rejection is appropriate. Reduction of the Corporate Tax Rates Suggestions for reduction of corporate tax rates would most often be 4 implemented by increasing the corporate surtax exemption." Although this action unquestionably reduces the tax burden for profitable corporations, thereby increasing the amount of their after-tax earnings, it is not the most effective method for increasing earnings for reinvestment in small business. If the recommendations of this study are adopted, most small business corporations will not be subject to the corporate tax. Creation of the SBE tax entity and simplification of Subchapter S will cause most eligible corporations to opt for full integration of corporate and individual taxes. The only corporations remaining subject to the corporate tax will be those electing not to be taxed as SBES, and MBES not electing to be taxed under Subchapter S. Shareholders taking such action which results in subjecting their corporations to the corporate tax presumably will do so only to shield themselves from individual tax at a rate higher than the highest corporate rate. This is accomplished by leaving the earnings in the corporation. Such shareholders are probably in a financial position to obtain funds for business operations and expansion from other sources if necessary. They therefore do not have a pressing need for funds generated from the business. Such affluent taxpayers should be required to bear their share of the tax burden according to their ability to pay. Granting them tax relief in the form of corporate tax reduction is not appropriate. Further, granting such relief will lower the threshold for making it advantageous to opt out of tax integration. This is contrary to objectives of the recommendations of this study which advocate integration of the corporate and individual tax as a policy to promote capital formation (See discussion in Chapter 6). 5 5/ It is interesting to note that the Joint Committee on Taxation concluded, on Capital Formation of the House Committee on Ways and Means, April 4, 1977, |