Congressional Testimony: Statement for Record on the Tax Code and Entrepreneurship
By SBE Council at 15 February, 2017, 8:22 pm
Start Ups Stalling? The Tax Code as a Barrier to Entrepreneurship
February 15, 2017
Statement for the Record
President & CEO
Small Business & Entrepreneurship Council
Committee on Small Business
United States House of Representatives
The Honorable Steve Chabot, Chairman
The Honorable Nydia Velazquez, Ranking Member
The Small Business & Entrepreneurship Council is grateful that the Committee on Small Business is investigating the challenges of the U.S. tax code as they related to entrepreneurship and small business growth. Small business owners are excited about the prospect for tax reform in the coming year. We are hopeful that the Congress will move forward with a modern framework that brings simplicity, fairness and lower taxes to our nation’s small businesses and entrepreneurs. As committee members well know, strong and sustainable economic and job growth is dependent upon a successful small business sector, as well as healthy startup activity.
The Small Business & Entrepreneurship Council (SBE Council) is a nonpartisan advocacy, research and education organization dedicated to protecting small business and promoting entrepreneurship. For twenty-four years, SBE Council has worked to advance a range of initiatives and policies to strengthen the ecosystem for startups and small business growth. Our organization and its members deeply appreciate the work and dedication of Small Business Committee members, and we have been honored to work with the committee since our founding.
While entrepreneurship in the U.S. has improved over the last several of years, the downward trend in new business creation remains. This started well before the Great Recession but obviously new business creation tumbled hard during this dark economic period. Unfortunately, entrepreneurship has never fully recovered. From 2009-2011 there were more business closures than startups, according to the SBA Office of Advocacy. The trend has slightly reversed course, but our economy does not have near the volume of entrepreneurial activity and business entities (as a share of the relevant population) that existed prior to the Great Recession.
According to an analysis published by SBE Council’s chief economist Raymond Keating, the significant decline in new business creation during the last decade has been felt across the board – among unincorporated and incorporated self-employed, startups and employer firms. Mr. Keating’s “gap” analysis finds an estimated shortfall of anywhere from 867,000 to 4.8 million businesses over the past decade, with “3.7 million missing businesses being quite reasonable based on a combination of the most often cited self-employed and employer firms data.”
Economic conditions and uncertainty, access to capital, regulatory uncertainty, and the aversion to risk are some of the reasons as to why individuals have not pursued, or are not pursuing, entrepreneurship. From SBE Council’s perspective, making policy changes that help to reduce risks along with reforms that lower government costs and burdens is especially critical to enabling higher startup activity. The tax code is one such area that requires an overhaul, with small business health and growth being a priority for how this is accomplished.
SBE Council is on record supporting various principles and proposals for tax reform, including: lower rates for all businesses entities, full expensing, low capital gains taxes, the elimination of AMT and death taxes, and making reporting and compliance as simple as possible.
It is our hope that members of Congress also use this opportunity to update or modernize various measures in the tax code that advance simplicity and cut compliance costs, which are especially painful for startups and new business owners.
Here are some of those ideas:
Update the Threshold for Self-Employment Taxes: When I talk to people who help teenagers and young entrepreneurs start businesses, they continually report that these risk-takers are totally turned off by a complex tax code that immediately eats their profits. Self-employment taxes kick in at $400, which is 15.3 percent of profits. The $400 threshold has not been changed since the 1950s, yet the standard deduction on federal income tax is adjusted annually. If the self-employment tax floor had been adjusted at the same rate as the standard deduction, it would be more than $6,000. It makes sense to update it, and relieve entrepreneurs of the burden that hits their businesses at such low business revenue levels.
Liberalize the 100% Capital Gains Exclusion for Startups: SBE Council fully supported efforts that made the 100% capital gains tax exclusion permanent for startups. But the exclusion needs to be improved upon so that more startups benefit from it. First, the exclusion is limited to C corporations, and SBE Council believes it should be made available to S corps, LLCs and other business entities. Secondly, the exclusion is disallowed in ventures involved with personal services, law, banking, finance, leasing, hospitality, health, farming and mining. There is innovation occurring in all these spaces, and in several of these sectors consumers and small businesses would benefit from more competition and choices. The targeted and limited exclusion, as it now stands, is picking winners and losers in the marketplace and ignores how most businesses – and in this case new businesses – are organized. Ideally, capital gains taxes would be eliminated altogether, but if the current exclusion is going to be retained it can be made more robust to help drive startup activity across all industry sectors.
Update and Clarify the Independent Contractor Test: SBE Council believes it is important to modernize the current test given the prevalence of the “gig” economy and the need for clarity. The current 20-factor test is arbitrary, but can be simplified to three or four factors. We believe there is an approach to reforming the 20-factor test that demonstrates contractor independence through written contracts, how the contractor is compensated, expenses incurred by the contractor, and how the work is performed. Businesses should be encouraged to do business with individuals who want to contract on a per-project basis, and on their own terms. The “gig” economy supports this freedom, and the government should not deter opportunity through the subjective and outdated 20-factor test.
Indexing 1244 Small Business Stock to Inflation to Boost Capital in Startups: Again, here is an opportunity to update existing law, which has not been done since 1978. This minor change could unlock and mobilize more capital toward startups. Qualified small business tax (loss) treatment under Section 1244 of the tax code allows for investors to deduct losses taken on investments in C Corp startups to be deducted against ordinary income. This measure was passed as part of the Small Business Investment Company Act of 1958, the aim of which was to mobilize more capital into job-creating startups.
The current thresholds under Section 1244 were last updated in 1978, which are: First $1,000,000 of outside, individual tax payer(s) (angel investors) capital gets 1244 treatment; $100,000/yr of 1244 losses deductible against ordinary income (for joint tax returns); and $50,000/y of 1244 losses deductible against ordinary income (for filing single).
The Consumer Price Index has risen 363% since 1978. If the above thresholds were inflation adjusted, the levels would be: $3,630,000 of outside investors’ capital would qualify for de-risking under 1244; $363,000/yr of 1244 losses could be deductible for joint filers; and $181,500/yr for single filers.
Tax reform is a key opportunity to help startups grow and thrive, existing small businesses to better compete and take more risks through smart investments, and encourage greater levels of entrepreneurship. SBE Council and our team of experts and small business member-advisors look forward to working further with the Small Business Committee to identify additional opportunities to fix the tax code for entrepreneurs, and advance a bill to the President’s desk for his signature. Thank you for the opportunity to submit this statement for the record.
Karen Kerrigan, President & CEO, Small Business & Entrepreneurship Council