Tax Exempt Income SBE status is denied to an enterprise receiving income exempt from income tax. There is an exception for tax exempt proceeds from insurance on the life of a deceased equity owner if such proceeds are received pursuant to a valid buy-sell agreement. The prohibition of investments in tax-exempt securities is to prevent equity owners from using the reinvested earnings deduction (see Chapter 7) to generate untaxed funds to finance such investments. If the cash position of the enterprise permits, funds may be withdrawn and invested in tax-exempt securities by the owners Such withdrawal will trigger recapture of the deferred reinvested themselves. income as described in Chapter 7. The exception for proceeds of insurance on the life of a deceased equity owner is to facilitate the continuation of the business by the surviving equity owners. This is in accord with the policy of preserving small business units. Enter Income from Natural Resource and Timber Operations prises engaged in natural resources and timber oprations currently receive pref21 erential tax treatment. These incentives are adequate to encourage these activities. There is little reason why such enterprises should be granted additional tax relief available for SBES. Further, the technical problems of passing through some of the special tax characteristics of such enterprises to the equity owners would substantially complicate SBE tax treatment. ingly, enterprises engaged in such activities are denied SBE status. Accord 21/ See Subchapter H (Sections 611-638) of the Internal Revenue Code. Foreign Income Most enterprises within the conceptual framework of the SBE are not engaged in foreign activities. Such income produces Prohibition complexities which are among the most troublesome in the tax law. of foreign income substantially simplifies the tax scheme for SBES without imposing undue hardship on the taxpayers. Firms exporting goods could either 22 structure transactions to produce U.S. source income, or utilize the existing Domestic International Sales Corporation (DISC)23 which allows substantial deferral of income tax. Determination by a Small Businessperson of His Eligibility for SBE Status Because of the multiple requirements for qualifi cation for SBE status, the small businessperson must be provided with an easy method for determining whether his business is an SBE. This is provided in the form of Part I of the suggested Form 1120 SBE, designed to be utilized for reporting the income of the SBE. (see Appendix A) Simply by filling out this part of the form, the small businessperson can determine his tax status. The form is designed to accumulate information readily available to the equity owner, either from his accounting records or from tax returns. One item is worthy of special note. In Box D at the top of the form, the business is required to give its Standard Industrial Classification (SIC) code number as set forth in the Standard Industrial Classification Manual issued by the Office of Management and Budget. This classification system is used by other data collecting agencies for business such as the Department of Commerce and Dun & Bradstreet. The system is not currently used by the Internal Revenue Service 22/ By arranging the sale in the U.S. See IRC Section 861 (a) (6). 23/ IRC Section 991 - 997. Summary of the Small Business Enterprise Definition A Small Business Enterprise is defined as any proprietorship, partnership or corporation operating an active trade or business which has: No more than ten equity owners (fifteen in cases where extra owners acquired their interests by inheritance, or where the SBE has been in existence for five years); No equity owners other than individuals, estates of decedent equity owners, certain trusts, and Small Business Investment Companies; No equity owners who are nonresident aliens: No equity owners who control more than one SBE (using constructive ownership rules); Only one class of equity ownership; Equity not in excess of $500,000 as averaged over a five Annual gross profit (defined as gross receipts less cost of goods sold) not in excess of $1,000,000 as averaged over a five year period; No investments unrelated to its business in excess of 5 % of its total equity; No tax-exempt income other than proceeds of insurance on the life of a deceased equity owner received by reason of a "buy-sell" agreement; No foreign income; No income from natural resource or timber operations. CHAPTER 5 TAXATION OF THE SMALL BUSINESS ENTERPRISE Consistent with the SBE status as a tax entity, the SBE tax rules apply to all proprietorships, partnerships, corporations and trusts conforming to its definition. This approach, rather than the elective approach under Subchapter S, is adopted to require uniform tax reporting for all economically similar enterprises and to obviate tax considerations in the choice of a legal form of organization. There is one exception to the general rule in the case of a corporate SBE. Such a corporation, when formed, can irrevocably elect to be taxed as a regular corporation. This is to permit tax deferral at the shareholder level on income accumulated in the corporation. The possibility of tax deferral would encourage high income taxpayers to commit equity funds to SBES. Such taxpayers presumably possess the resources or sophistication necessary to determine when the election is desirable. Abuse of the deferral opportunity is curtailed by the existing penalty tax on unreasonably accumulated earnings. Although the SBE is a tax entity, it is not a tax paying entity. Like a partnership (and to a lesser extent an electing Subchapter S corporation), it is a conduit for passing income, deduction and credit items through to the equity owners. The rules are designed to preserve the tax characteristics of the items in the tax returns of the equity owners. Specific tax rules for the SBE reflect the conceptual simplicity of this type of enterprise. Tax treatment is basically similar to that of partnerships, |