October 7, 2004
The Honorable Jim McCrery
Chair, Subcommittee on Select Revenue Measures
1102 Longworth House Office Building
U.S. House of Representatives
The Honorable Michael R. McNulty
Ranking Member, Subcommittee on Select Revenue Measures
1102 Longworth House Office Building
U.S. House of Representatives
Re: House Ways and Means Committee, Subcommittee on Select Revenue Measures Hearing on Select Tax Issues, September 23, 2004
Dear Chairman McCrery and Ranking Member McNulty:
The American Institute of Certified Public Accountants (AICPA) is pleased to submit our statement in support of allowing small businesses the flexibility to adopt any fiscal year end from April through November for tax purposes, as proposed in the Small Business Tax Flexibility Act of 2003 (H.R. 3225) for the record of the Subcommittee's September 23, 2004, hearing. We believe this bill will improve the Internal Revenue Code and will give small business start-ups the fiscal year options that will improve their chances of becoming productive, viable and valuable contributors to the American economy. Our detailed comments are attached.
The AICPA is the national professional organization of certified public accountants comprised of more than 350,000 members. Our members advise clients on federal, state, and international tax matters, and prepare income and other tax returns for millions of Americans. They provide services to individuals, not-for-profit organizations, small and medium-sized businesses, as well as America’s largest businesses.
Small businesses are the primary source of the Nation’s job creation and economic growth. To make these important contributions, start-up businesses must survive. Census data indicates that 20 percent of start-up businesses fail after only one year. After 10 years, 70 percent of these businesses no longer exist. Small Business Administration research indicates that most small businesses struggle with operational, financial, and tax problems. These problems dominate bankruptcy-filing statistics.
H.R. 3225 would give most small start-ups an additional tool to successfully navigate their turbulent beginnings—the flexibility to adopt any fiscal year-end from April through November. This flexibility would increase the prospects for a small business’s survival by:
- Allowing increased productivity during peak business periods by easing recordkeeping burdens.
- Increasing access to professional advisors by spreading the advisors' workloads out over more of the year.
- Granting access to marginal amounts of additional operating resources through short tax deferrals.
We appreciate the opportunity to continue working with the Subcommittee on Select Revenue Measures, the Ways and Means Committee, Congress, Treasury, and the IRS to reach our common goals of simplifying and improving our tax laws. We would be pleased to discuss this issue further at any time. Please contact me at (202) 414–1705; or Edward S. Karl, AICPA Director, at (202) 434–9228, if we can assist you in any way.
Robert A. Zarzar
Chair, AICPA Tax Executive Committee
AMERICAN INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS FISCAL YEAR
FLEXIBILITY FOR START-UP SMALL BUSINESSES
Small businesses are one of the main drivers of the Nation’s job creation and economic growth. Start-up survivability is a critical area of concern that has been studied by the Small Business Administration 1
and others. Census data, as shown in the chart below, indicate that after only one year, 20 percent of start-up businesses have disappeared. After 10 years, 70 percent of these businesses no longer exist. 2
SBA research indicates that most small businesses struggle with operational, financial, and tax problems. These problems dominate bankruptcy-filing statistics. 3
H.R. 3225 proposes giving most small business start-ups an additional tool to successfully navigate its start-up life cycle by providing the flexibility to adopt any fiscal year-end from April through November. This flexibility would increase a small business's prospects for survival by:
Allowing increased productivity during peak business periods by easing recordkeeping burdens.
Increasing access to professional advisors by spreading the advisors' workloads out over more of the year.
Granting access to marginal amounts of additional operating resources through short tax deferrals.
Under current law only C corporations may elect any tax year of their choosing. However, S corporations and entities treated as partnerships—including most limited liability companies, general partnerships, and limited partnerships—(collectively, "flow-through entities") generally must adopt a December 31 calendar year-end or the year-end of the flow-through entity’s majority owners, which is often December 31 4 unless a business purpose test 5 is met or unless a section 444 election 6 is made.
Reasons for Change
Requiring calendar year-ends for most passthrough entity start-ups creates an unintended problem for businesses passing their financial results through to their owners for inclusion in the owners' annual tax calculation. Applied to virtually every start-up small business in the country, these rules result in disruptive and unproductive demands on those businesses and their advisors during the same few months every year, and create an unnecessary pressure on start-up survivability. The substantial workload is compressed into the period from December through April. This "workload compression" often negatively impacts those who can least afford it: most small business start-ups that form a solid foundation for the American economy.
A high number of small business start-ups that will have less than $5 million of average annual revenues, and their advisors, are disproportionately burdened by this compression, especially in comparison with the very modest amount of the nation’s taxable business income they generate.
In particular, start-up businesses need extra time and attention that is invariably scarce and that commands a premium during the so-called "busy season" from December through April. The first year of a business involves making critical decisions that have a significant influence on their ability to survive. These decisions include determining countless first year elections among the various available tax and accounting policies as well as establishing sound, compliant and correct business, accounting and tax procedures. In addition to other unavoidable calendar year-end responsibilities, start-ups must, for the first time, close their books, produce annual financial statements for their banks, conclude financial statement audits or reviews, and prepare tax returns and tax information for their owners well before April 15. 7
Giving small business start-ups the flexibility to choose their fiscal year-ends will also facilitate their success in the following ways.
- Allowing small business start-ups to spread their workloads and ease recordkeeping burdens by adopting a normal operating cycle year-end. Most federal and state information and payroll reporting requirements must be satisfied on a calendar year basis—filing Forms 1099 and W-2, and their state equivalents—because these reporting requirements principally relate to nonowner calendar year taxpayers. Requiring entities to close their books, and where applicable, count inventory at the same time of year creates an additional and unnecessary burden on small businesses. Permitting start-ups to adopt a year-end coinciding with the low point of a business’s normal operating cycle would allow their paperwork to be spread throughout the year and the new entrepreneurs to more closely focus on the success of the business, rather than its paper trail.
- Maximizing their access to professional advisors. Small, start-up businesses should be able to freely choose their advisors from the broadest possible spectrum of qualified advisors. H.R. 3225 helps spread out the workload for the advisors, such as CPAs, supporting these small business by providing critically needed advice, especially to new business operators who are generally less familiar with the full spectrum of business and tax responsibilities.
- Providing marginal amounts of operating resources. Adoption of a fiscal year would generally encourage capital formation through a modest postponement of tax liability for new, growing, successful businesses.
Expanding fiscal year options would also offer advantages to the government:
- System processing efficiencies. Our tax system must be efficient. Wasted efforts are a drag on the economy. Allowing small business start-ups to elect fiscal years would begin to spread the IRS’s workload out as well by staggering the dates returns must be processed by the service centers. Further, requiring a huge number of passthrough entities to close their annual accounts at December 31 means that return preparers cannot physically complete a significant number of Forms 1065 or 1120S before the business' owners are required to file their individual returns on April 15. The result is an ever-growing number of Forms 1040 that must be extended each year, solely for lack of information from a passthrough entity. H. R. 3225 would reduce the need to extend the April 15 deadline for filing individual income tax returns because Schedule K-1 information returns from fiscal year partnerships and S corporations would be received earlier in the recipient’s tax year. A start-up business (and therefore its owners) almost universally obtains a filing extension to September or October to use all available time to manage the new businesses first year tax filings. Staggered workloads would also allow tax professionals who play a critical role in the nation’s self-assessment system to operate more efficiently.
- Modest budgetary impact. H.R. 3225 only affects a modest number of small entities and has a relatively small budgetary impact because the affected entities report only a small amount of taxable income to their owners. 8
- Focusing on consistency with other small business provisions. Both Congress and Treasury have recognized the burden the tax laws place on small businesses and adopted Code and administrative provisions designed to ease this burden. H. R. 3225 is relatively simple and based on existing Internal Revenue Code rules and precedents. For example, section 448 permits entities with average gross receipts of less than $5 million to use the cash method of accounting, and section 179 permits small businesses to immediately write off the cost of some equipment. More recently, Treasury exempted entities with gross receipts under $1 million from the complex inventory rules, and there have been legislative proposals to increase this exemption to $5 million. 9
Fiscal year conformity causes an unnecessary burden to small business start-ups that can be alleviated with modest changes to the tax system. Once relieved of these extra pressures, sound new businesses will have a greater chance of survivability and for success.
Explanation of Proposal
H.R. 3225 amends the Code by permitting a "qualified small business" to elect any fiscal year ending on the last day of April through November (or at the end of an equivalent annual period (varying from 52 to 53 weeks)). Only a new business entity can be a "qualified small business" and it must elect its fiscal year in its year of formation. Specifically, a "qualified small business" is any entity that:
- Is a newly formed S corporation or a newly formed entity treated as a partnership for federal income tax purposes;
- Conducts an active trade or business;
- Is a "start-up business"; and
- Meets a gross receipts test.
An entity would qualify as a "start-up business" only if no more than 75% of the entity is owned by any person who previously conducted the same trade or business any time within the previous 12 months. For attribution of ownership purposes, husbands, wives and minor children (under age 21) are considered one owner.
An entity would meet the gross receipts test if its average gross receipts do not exceed $5 million. Existing rules under section 448(c) (3–year test) would be used to determine an entity’s average gross receipts. Accordingly, when an entity’s life is less than 3 years, the number of years of existence would be used. In the case of the sale of a capital or section 1231 asset, the gain on the sale (not gross proceeds) would be used in determining average gross receipts. Multiple businesses and complex ownership structures would be aggregated into a single "qualified small business" using the anti-abuse rules of sections 448(c)(2) and 267 (b) and (e).
Entities that are not "qualified small businesses" or that cease to qualify (trusts, personal service corporations and flow-through entities that are small businesses owned by large partnerships, S corporations, or C corporations) would determine their fiscal years under existing rules—a "required" taxable year; a "natural" business year; or a "permitted" fiscal year as elected under section 444.
When the average gross receipts of an otherwise "qualified small business" exceed $5 million, it must either elect to maintain a deposit under section 444 or convert to a permitted year-end under existing rules. The entity would report items resulting in net profits from its last fiscal year-end to December 31 ratably over the shorter of either the number of years its fiscal year was in effect, or four years. Net losses would be deducted in the year of change. This would mirror existing transition rules under sections 448 and 481, and Rev. Proc. 2002–13. Appropriate conforming amendments would also need to be made to sections 444, 706, and 1378.
Under this legislation, each "qualified small business" would have only one automatic opportunity to adopt a fiscal year. A qualifying entity would have to elect a fiscal year for its first year of operation on the entity’s first filed return of income or default to a year allowable under current law.
1. FY 2001-2006 SBA Strategic Plan.
2. "The Estimated Revenue Effect of H.R. 3225, the Small Business Tax Flexibility Act of 2003," PricewaterhouseCoopers LLP, October 2003.
3. Financial Difficulties of Small Businesses and Reasons for Their Failure, SBA-95-0403, 9/98.
4. Section 806 of The Tax Reform Act of 1986 required S corporations, personal service corporations and trusts to adopt calendar years. The 1954 Code already required all new partnerships to use December 31 year-ends.
5. Partnerships or S corporations satisfying the business purpose tests under reg. sections 1.706(b)(1)(B)(i) and 1.1378(b)(2) may apply to use a "natural business year." However, the IRS grants few requests under the current, restrictive rules.
6. The Omnibus Budget Reconciliation Act of 1987 provided some relief from fiscal year conformity but further rate changes (from the then-28% highest rate to the now–35% highest rate) in the tax law soon thereafter made this relief impractical. Section 444 permits businesses to elect fiscal years, but requires electing entities to maintain a deposit with the Treasury Department equal to the amount of deferred income tax, calculated by multiplying the income deferred by the highest marginal individual income tax rate plus one percentage point. Few entities can utilize the election now because of the high cost and the limited deferral time permitted.
7. The IRS has acknowledged the special needs of the small business constituency, including start-ups, by creating the Small Business/Self-Employed Division. The SB/SE will place a greater emphasis on pre-filing activities, such as education, and generally ensure that small businesses find tax compliance easier.
8. IRS 1992 Statistics of Income (SOI) data indicated that 77.03 percent of S Corporation returns with positive income report net income below $50,000, representing, cumulatively, only 11.66 percent of the total positive net income reported on Forms 1120S. 1992 SOI data also indicated that 69.63 percent of partnership returns with positive income report net income below $50,000, representing, cumulatively, only 5.63% of the total positive net income reported on Forms 1065. New businesses represent a small fraction of this income.
9. For example, see H.R. 1037, the Small Employer Tax Relief Act of 2001.