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Annette Nellen
Annette Nellen
The Many Sizes of ‘Small’

Tax policies geared to provide relief or incentives to small businesses beg the question of just what a “small” business is.

October 28, 2010
by Annette Nellen, CPA, Esq.

For decades, the tax law has included special rules to provide various benefits or incentives to small businesses or to exclude them from a burdensome rule. Yet, the federal tax law has no single, uniform definition of small business. Instead, as recently illustrated by the Small Business Jobs Act of 2010, such businesses may be defined based on gross receipts, assets, capital, entity type, number of shareholders or amount of some outlay, such as start-up expenditures. Even with the same base, such as gross receipts, small is defined with varying dollar amounts. We frequently hear elected officials talk about helping small businesses with no reference point or measure offered to define the term.

This article examines the variety of ways that “small” is defined and used in Small Business Administration (SBA) rules, which defines “small” with a broader brush, are also discussed. Two state proposals calling for exemptions for small businesses are noted along with whether improvements can be made to our current system of identifying small businesses.

The Need for a Definition of Small

“Small” is used in the federal income tax law is to provide a benefit or incentive to small businesses. For example, eligible small employers can receive a tax credit for providing health coverage to employees (§45R). Another reason for identifying small business is to except them from some rule deemed too burdensome or unnecessary for small businesses. For example, C corporations with an average annual gross receipts over a three-year period of $5 million or less are excepted from the required use of the accrual method (§448).

State tax proposals from Congress and the Multistate Tax Commission (MTC) call for exceptions for small businesses, but do not define the term, leaving it open for discussion in reaching a final proposal. The Main Street Fairness Act (H.R. 5660 (111th Congress)), would allow states that have adopted the Streamlined Sales and Use Tax Agreement (SSUTA) to collect sales from remote vendors. One catch is that the simplified system must include a uniform small seller exception.

The MTC’s draft Model Sales-and-Use Tax Notice and Reporting Statute follows the Colorado approach to improving use tax collection. It would require remote vendors to notify buyers of use tax obligations and to issue an annual report of purchases to buyers and the state government. An exception would be included for small sellers. (MTC memo (PDF) of July 15, 2010 on the model statute.)

The Range of ‘Small’

The varied ways that “small” is used in the federal tax system is illustrated well by the Small Business Jobs Act of 2010 (P.L. 111-240) enacted September 27, 2010. Provisions of this Act directed to small businesses can be categorized as shown in the table below.

Classification/

Provision

Start-up Costs

Current Year Asset Acquisitions

Total Assets

Gross Receipts

Type of Entity

Number of Shareholders

§1202 benefit

 

 

Total assets of $50 million or less

 

Investment by non-corporate taxpayers in a C corporation

 

§39 credit carryback and AMT change

 

 

 

Average annual gross receipts of $50 million or less in past three years Non-publicly-traded corporation
Partnership
Sole proprietorship

 

§1374 modification

 

 

 

 

 S corporation 100 or fewer
§179 expensing increase

 

Less than $2.5 million of eligible assets

 

 

 

 

§195 start-up expenditures increase Start-up expenditures under $60,000

 

 

 

 

 

SE tax and health insurance

 

 

 

 

Sole proprietors

 

The Act highlights that the term “small” business can mean many things. It also illustrates that a business may be considered small for one rule, but not another. For example, a retail business with gross receipts greater than $10 million but not exceeding $50 million is not considered small under the Unicap rules (§263A), but is small under the special credit rules (§38).

The six different techniques for describing “small” used in the Act illustrate only a subset of the range of parameters used in or considered for federal taxes. Additional parameters are listed below (not an exhaustive list).

  • Capital: Section 1244, Losses on Small Business Stock, defines small as $1 million or less of capitalization.
  • Gross receipts: Average annual receipt thresholds used to define small range from $5 million (§448 providing an exception from the required use of the accrual method) to $7,500,000 (§55(d) providing an AMT exception for corporations) to $10 million (§263A exception from the required use of the Unicap rules for retailers).
  • Assets: The Small Business/Self-Employed Division of the Internal Revenue Service (IRS) serves (1) individuals filing Form 1040 and (2) other business with assets totaling under $10 million. The Division alludes to the limitations of an asset measure by stating:
    • “Some businesses may meet the under $10 million asset test for SB/SE yet be more like a large or midsize business in every other way. … Other businesses may have assets over $10 million yet be more like a small business. These customers may be serviced by the Small Business/Self-Employed Division.”
  • Personal property placed in service in a given year: The §179 expensing election amounts have ranged from $10,000 in 1992 to $500,000 for 2010 and 2011. After the temporary increase to $500,000 expires after 2011, the amount will be $25,000. President Obama has proposed that the expensing amount be $250,000 with the phase-out beginning at $800,000 (General Explanation of the Administration’s Fiscal Year 2011 Revenue Proposals (PDF), Feb. 2010, page 8).
  • Number of employees: To qualify for the full health insurance credit, an employer should have no more 25 full-time equivalent employees. In contrast, an employer must have no more than 100 employees to qualify for a SIMPLE IRA plan (§408(p)).
  • Sole proprietors or Schedule C filers: IRS Publication 334 is entitled Tax Guide for Small Business (For Individuals Who Use Schedule C or C-EZ), implying that small business means a sole proprietor.

Small Business Administration (SBA)

SBA definitions of “small” serve to identify businesses eligible for SBA assistance programs. SBA rules define a “small business concern” as independently owned and operated, not dominant in its field and within the SBA’s size criteria. Size criteria vary depending on the industry. Generally, for each industry, as identified by North American Industry Classification System NAICS codes, a maximum gross receipts or employment number is used to define small. For example, a new car dealer is small if it has 200 or fewer employees. Most manufacturers are small if they have 500 or fewer employees. A family clothing store is small if its gross receipts do not exceed $35.5 million. A small business can operate in any legal entity form.

The SBA is in the process of reviewing its standards to determine “whether existing size standards have supportable bases relative to the current data.” In October 2010, it released revised standards for retail businesses (Fed. Reg. October 6, 2010, page 61597 (PDF)). Some of the existing standards were almost 30 years old. For most of the retail trades addressed, the gross receipts level was double or tripled. For example, the size standard for computer and software stores was increased from $9 million to $25.5 million.

Finding Meaning

The SBA reaches its definitions of small by considering factors such as average company size and start-up costs, as well as industry competition and the size distribution of firms. Public comments are also considered (SBA FAQ). Thus, unlike federal tax rules, “small” for SBA programs is not one size fits all and has data supporting its definitions.

The nature of a particular industry — whether it is capital intensive or labor intensive, the price of goods and the frequency of sales, is not considered in tax law definitions. This can lead to odd results. For example, the expensing amount of §179, ignoring temporary increases, is $25,000. While this may enable a small service business, to expense the cost of a few computers, it provides little assistance to a small manufacturer in need of new or additional equipment. 

The current state proposals seeking a definition for a small seller exception seek to protect small businesses from burdensome rules rather than to provide a tax incentive. Should the same definition of small business be used for each situation? What are appropriate factors to determine if a compliance rule, such as filing annual reports of customer purchases, would pose a significant burden on a business?

While there is a tendency to use gross receipts as the measurement of small, the burden of filing information returns for customers likely correlates better with the number of sales transactions. For example, assume Sellers A and B each has $1 million of gross receipts. The average sales transaction for A is $800 and for B is $30. Clearly, Seller B has a greater compliance burden than does Seller A.

Colorado’s remote vendor notice rule uses a threshold of $100,000 of in-state gross receipts based on customers with more than $500 in annual purchases.

Additional approaches for identifying businesses that may warrant relief from burdensome tax rules include providing an exemption for the first few years of operations or defining small based on number of employees.

Looking Forward

The varied and numerous definitions of “small” used in the federal tax law makes the law complex and inequitable. Some businesses that view themselves as small may not be treated as such under all small business tax rules. Lessons can be learned from the SBA approach to defining small. Defining “small” based on industry characteristics should bring greater logic to the reason for even having special rules for small businesses and better target small business tax provisions to best help small businesses.

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Annette Nellen, CPA, Esq., is a tax professor and director of the MST Program at San José State University. Nellen is an active member of the tax sections of the ABA and AICPA. She serves on the AICPA’s Individual Income Taxation Technical Resource Panel. She has several reports on tax reform and a blog.