“Small business owners” are part of the tax reform conversation that is underway, but what does this term mean? The Treasury’s Office of Tax Analysis (OTA) has traditionally defined these individuals as owners receiving flow-through income from sole proprietorships (Schedules C and F filers), partnerships (including limited liability companies), S corporations, and those reporting rental activities on Schedule E of Form 1040. OTA now believes this definition to be overly broad and has released a technical paper on Methodology to Identify Small Businesses, which will be posted here soon.
OTA developed tests based on income and deductions reported on the businesses tax returns under the previous definition of small business owners as well as Form 1120 used by C corporations to separate business from non-business activities. For purposes of being treated as a business, OTA did not take into account de minimis activities, such as an individual reporting only modest rental income for a vacation home, and hobby activities. De minimis for this purpose means total income or deductions exceeding $10,000 or their sum exceeding $15,000. Thus, only activities that generate, or have the potential to generate, income that is non-negligible are taken into account. So too are only businesslike activities that generate deductions exceeding $5,000.
Applying these tests to the 2010 tax year, of the 23 million individuals who filed Schedule C, 43% qualified as “businesses.” For Schedule E filers reporting rental income and expenses that year, 49% were deemed to be “businesses.”
But which of these “businesses” are classified as “small businesses”? The OTA used a total income threshold for this purpose. More specifically it set a threshold of $10 million of income or deductions to identify “small” businesses. Using this criterion, 53% of taxpayers filing any of these forms are small businesses (for the 2010 tax year used in the paper).
The OTA also clarified its definition of “employer.” An entity is an employer if direct labor deductions (wage and salary expenses) exceed $5,000. For sole proprietors, contract labor is taken into account. Of these, 20% conform to the OTA’s definition of an employer.
Impact on tax reform
Steven Mnuchin, who has been been named as Treasury Secretary, pending confirmation, wants to slash taxes across the board. As the corporate rate is cut from the current top of 35% (39% when combined with the average state corporate tax rate) to 15% (as Trump wants) or something else (e.g., 20% under the Ways and Means Blueprint), rates on small business owners will also have to decrease. The Blueprint, for example, would cap the tax rate on pass-through business income at 25%.
So definitions become meaningful. Would the Treasury’s revised definition be taken into account in the tax reform process? If so, then hobby activity income would be taxed at up to the highest individual income tax rate, whatever that may be, while other pass-through income could be capped at some lower rate.
I’m delighted that the government is taking a good look at the definition of “small businesses.” In J.K. Lasser’s Small Business Taxes 2017, I list 27 different definitions of small business for purposes of various tax rules. Some of the definitions are based on gross receipts, some on the number of employees, some on the amount of capital investments for the year, and some on equity in the business. All of this leads to confusion.
It is my hope that pending tax reform will not only lower the tax rates on small business owners, but also adopt a more rational definition of small business that can be applied consistently throughout the Tax Code and simplify things for small business owners.