Arrangement of Small Business Provisions in the Internal Revenue Code Tax provisions relating to small business are currently scattered throughout the Internal Revenue Code. There is no one place where the small businessperson or his advisors may determine exactly how the tax law specifically relates to small business. It is therefore necessary for the small businessperson to retain a specialized tax expert to insure that he is properly complying with the law, and that he is availing himself of all possible tax opportunities. Attorneys and accountants, although otherwise expert in their fields, sometimes have difficulty coping with the structure of the Internal Revenue Code. It is recommended that the definition of the SBE together with the provisions relating to its operation and the incentives exclusively granted to it be organized in one subject or chapter of the Internal Revenue Code to facilitate understanding and acceptance by the small business community. This subpart or chapter would also contain extensive cross references to other provisions of the Code relating to small business. CHAPTER 9 THE NEED OF SMALL BUSINESS FOR LONG TERM VENTURE, AND EQUITY CAPTIAL Many studies have demonstrated the need of small business for outside 1 long-term financing for expansion. The same studies have concluded that the sources of such capital are rapidly vanishing. The funds that are available are most often provided in the form of debt, partly because of the artificial tax advantages extended to debt financing. This causes a dangerously high debt-equity ratio, making it difficult for many enterprises to establish the equity base necessary for survival during economic reverses. Tax changes to help alleviate this problem must: Create an effective vehicle for investment of private capital in small business; Create incentives to attract private funds to the small business sector; Assure ordinary loss treatment if the investment, whether direct or indirect, is unsuccessful; Assure ordinary loss treatment if the investment, whether direct or indirect, is unsuccessful; Defer taxation of gain from the disposition of a successful investment whenever possible; Encourage the funds so attracted to take the form of equity investment rather than debt. See discussion in Chapter 2 Some recommendations in other parts of this report for incentives to be granted to small businesses facilitate acquisition of capital. For instance, integration of the corporate and individual income taxes promotes capital formation (see discussion in Chapter 6). Also, to the extent that the financial structure of the enterprise is strengthened by retention of earnings (as facilitated by the recommendations in Chapter 7), outside capital is easier to attract. This chapter focuses on incentives to be accorded to potential outside investors. Expansion of Tax Benefits for Small Business Investment Companies and their Shareholders 2 The Small Business Investment Act of 1958 created a new investment vehicle called a Small Business Investment Company (SBIC), to serve as a source of private financing for small business. The requirements for qualification as an SBIC are specified in the Act, and such companies are regulated by the Small Business Administration. In conjunction with the creation of SBIC, certain tax benefits were accorded to it and its shareholders. 3 Recent studies have shown that the SBIC has not been as effective a 4 source of long-term financing for small business as it might have been. other reasons cited for this failure are: O Lack of private capital attracted to such companies; 2/ 3/ 4/ Among P.L. 699, 85th Congress, 2d Session, August 21, 1958, 15 U.S.C. 661 (et. seq) See note 11, Chapter 1 "Evaluation of the SBA Small Business Investment Company Program From Reluctance of SBICS to make equity investments in enterprises, preferring to supply funds in the form of debt. Certain changes in the tax could alleviate these problems. SBICS currently may deduct 100% of the dividends they receive from portfolio investments. corporate SBE (See Chapter 4) requires liberalizing the deduction to include the pro-rata share of SBE income taxed to the equity owner. Actual distributions from an SBE to an SBIC would similarly be tax free. This deduction permits SBICS to accumulate tax-free funds for investment in other enterprises. When such income is distributed to SBIC shareholders, it is taxable to them as a dividend. Example: SBIC is a shareholder in corporate SBE B. In year 1, SBIC SBICS can deduct amounts added to reserves for losses from debt investments. No similar allowance is available for additions to reserves for losses on equity investments. Such losses are deductible in full when the loss 7 is sustained upon sale, exchange or worthlessness. It is recommended that, to provide further incentive for equity investments by SBICS, current deductions be allowed to the SBIC for additions The only special tax advantage allowed to the shareholder of an SBIC is that a loss from sale or worthlessness of SBIC stock may be deducted in full as an ordinary loss rather than being limited to capital loss treatment. It is recommended that as an incentive to attract private capital to SBICS and to encourage SBICS to invest in equity securities, additional tax benefits be accorded to shareholders of SBICS which invest exclusively in equity securities: 9 O Losses from the sale of investments by the SBIC or additions to its equity securities loss reserve (see prior recommendation) be allowed to pass through directly to the SBIC shareholder to be offset against his ordinary income; Capital gain be required to be distributed in cash to SBIC shareholders when realized, and retain the capital gain status in their hands; As under existing law, ordinary income from dividends received by the SBIC would not be taxable to the SBIC shareholder until actually distributed to him. 8 For further discussion on this point in support of a similar proposal see Report of the SBA Task Force on Venture and Equity Capital for Small Business, U. S. Small Business Administration, January 1977, p.12 |