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Annette Nellen
Annette Nellen

New Definition of 'Small' Business and Possible Relevance

How might a new Treasury Department approach to defining small businesses affect tax changes?

September 15, 2011
by Annette Nellen, CPA, Esq.

In August 2011, the U.S. Treasury Department's Office of Tax Analysis (OTA) released a report: Methodology to Identify Small Businesses and Their Owners (OTA Technical Paper 4 (PDF)). The impetus for the report was a desire to improve the approach for defining and identifying small businesses to better understand the impact of the tax law on the business and the owner. OTA also notes that it has new data sources that enable a more refined identification methodology.

The study also informs ongoing discussions about how tax reform can or should affect small businesses and their owners. Understanding the nature of small businesses in terms of revenues, deductions and number of employees can assist lawmakers in crafting provisions intended to benefit small businesses. Also, a better understanding of who owns small businesses can help lawmakers determine the impact of changes in individual tax rates on small businesses.

OTA's new approach also pulls some taxpayers out of the traditional small business category by calling them non-businesses. This new approach may draw new attention from lawmakers and the Internal Revenue Service (IRS) to deny tax benefits.

This article reviews some of the reasons for focusing on small businesses as well as traditional definitions. The OTA report is summarized with commentary offered on what the significance may be to tax reform.

Focus on Small Businesses

Small businesses are often mentioned as being the real job creators. Thus, lawmakers are likely to focus their attention on small businesses in designing approaches to both stimulate the economy and encourage growth. Small businesses often express concern about the competitive disadvantages they may face in accessing capital, obtaining government contracts and dealing with regulations. Thus, proposals are often made with the intent of reducing these disadvantages.

The Organisation for Economic Cooperation and Development (OECD) reports that small and medium-sized businesses represent approximately 95 percent of all businesses and 60 percent to 70 percent of the workforce in most OECD countries. The OECD also observes that in the U.S., these businesses account for a significant share of new jobs. Yet, challenges are noted such as the fact that less than half of these businesses make it past the five-year mark. Challenges noted for the workforce, despite these businesses being a key provider of jobs, are high turnover and low investment in training relative to larger businesses. (OECD, Small Businesses, Job Creation and Growth: Facts, Obstacles and Best Practices (PDF), pages 3 and 7, not dated.)

The U.S. Small Business Administration (SBA) reports that small businesses created 64 percent of the net new jobs in the past 15 years (SBA, "How Important Are Small Businesses to the U.S. economy").

Definitions Vary

There is no standard or official definition of "small" business. The OECD report defines small- and medium-sized businesses as those with less than 500 employees (250 in European Union countries) (page 7). The SBA and the tax law each define "small" differently. SBA definitions vary among industries with the parameters usually based on either number of employees or gross receipts (SBA, Size Standards). The tax law generally applies the same definitions to all industries, but varies the measure in terms of dollars and the base (gross receipts, number of shareholders, capitalization, assets, etc.). See The Many Sizes of Small.

New OTA Approach

The OTA report refers to OTA's existing definition of a small business as both too broad and too narrow. Prior to the new approach, a small business owner was defined as an individual with flow-through income. That income could be from a sole proprietorship, partnership, S corporation, farm or miscellaneous rental income. This broad definition includes entities that might not commonly be considered a business or doesn’t look like a typical business. For example, it includes misclassified employees filing Schedule C and Schedule C filers who are "quasi-employees" (page 8) in that they have few expenses and provide services to a limited number of clients (such as a consultant). It also includes activities that might really be hobbies and vacation homes with minimal rental activity. In contrast, OTA's approach was narrow in that it excluded small C corporations.

The steps taken by OTA in defining small businesses and their owners are explained next:

Step 1. Start with the broad set of possible business filers. This comprises six types of returns or schedules:

  1. Schedule C (PDF) — Sole proprietorship
  2. Schedule E-Part 1 — Rental real estate
  3. Schedule F (PDF) — Farming
  4. Form 1065 (PDF) — Partnerships
  5. Form 1120 (PDF) — C corporations
  6. Form 1120-S (PDF) — S corporations

Step 2. Identify and remove non-business activities from the Step 1 group using a two-part test. The test is based on IRC Section 183 guidance distinguishing a hobby from a business. After examining these rules, OTA came up with a two-part test to identify which returns indicate "substantial" operations carried out in a "businesslike" manner" (OTA, page 5).

De Minimis Test: Are total income or total deductions greater than $10,000 or is their sum greater than $15,000? Income includes gross receipts, rents, dividends, capital gains, royalties and interest. If a loss from sale of an asset is reported, its absolute value is used in this test. Deductions are defined similarly for each test (see below).

The dollar amounts are intended to serve as the minimum level of business activity that indicates whether significant time and effort is required by the owner. OTA notes that amounts below these thresholds may indicate a hobby.

Business Activity Test: This test is based on the premise that a business has outlays for depreciation, inventories, rents and employees. OTA set a threshold that a business must have deductions in excess of $5,000 to "operate in a ‘businesslike’ manner." Entities that primarily generate income from labor services are likely to be eliminated under this test.

Total deductions include wages, interest expense, goods and services purchased from others, rent, repairs, taxes, advertising, bad debt expense, depreciation and miscellaneous deductions. To treat corporations similarly to sole proprietorships and partnerships for this test, officer compensation is not included in measuring deductions for corporations. For some entities that primarily report investment income, interest expense might be ignored for this test.

Modifications: OTA makes various modifications to the tests to address certain entity features that may indicate the entity is not a typical business. For example, to address the possibility of misclassified employees and possible personal element of some sole proprietor expenses, only 50 percent of car-truck and travel, meals and entertainment expenses on Schedule C are considered. To attempt to capture only business-like real estate rentals of individuals, OTA excludes depreciation and mortgage interest from Schedule E deductions. Thus, rental owners must have other expenses such as maintenance and advertising to pass the business test.

Step 3. Apply a $10 million total income and deduction threshold to determine which business entities are small. Total income includes the entity's gross receipts, rents and portfolio income. In addition, the entity's total deductions must not exceed $10 million (on the premise that "deductions can reflect the scale of operations" (page 13)).

Step 4. Identify the individuals that own the entities that meet OTA's small business definition. OTA observes that "newly accessible data" from the IRS enables a better match of individual returns with partnership and S corporation returns. OTA noted that in some situations, it might not be appropriate to label an individual as a small business owner merely because they owned a small business. For example, what if an individual also owned a large business, the individual had a passive interest in his small business or the income from the small business was not a material part of the individual's return. OTA's approach to resolving these issues was to have both broad and narrow definitions of small business owner.

OTA's new approach finds fewer small business owners as illustrated by OTA data below for 2007 (page 22).

 

Old approach

New approach (broad)

New approach (narrow)

Millions of filers

34.7

20.0

9.4

Net business income (billion)

$662

$376

$335

Percent with AGI over $200,000

8

11

8

Above group's share of net business income

75 percent

66 percent

57 percent

Several tables are included in the OTA report showing application of the new methodology to 2007 tax data.

Relevance

The new OTA approach to identifying small businesses and their owners will enable Treasury and others to better answer questions about the effect of tax rate changes on small business owners (under both broad and narrow definitions). The approach might also lead Congress to fine tune tax preferences offered to small businesses (by carving out what Treasury calls "non-businesses").

Some speculate that the new approach helps support any desire to tax large partnerships and LLCs as corporations. (For example, see "Higher Business Taxes May Follow Treasury's Definition of Small," by Zajac, Bloomberg BusinessWeek, August 19, 2011.)

Finally, consideration of corporate tax reform and what to do with expiring tax cuts may result in use of the new OTA approach to support certain changes.


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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 chairs the AICPA’s Individual Income Taxation Technical Resource Panel. She has several reports on tax reform and a blog.