Entrepreneurs generally don’t give taxes much thought as they contemplate launching a new business. But the U.S. tax code presents a number of challenges for start-ups – challenges that can amount to the difference between survival and failure. Specifically, the current tax code penalizes businesses with substantial, early-years losses, discourages investors from backing risky new businesses, and impedes successful new companies from expanding.
Tax rates are important to start-ups because capital is the lifeblood of any new business. As one entrepreneur explained to us: “People talk about access to capital in the context of investors. But it’s also about holding onto the money you generate internally through sales. Young businesses barely scrape by in the early years, and yet the government takes a third of any profit in taxes – money that could have been invested back into the business.”
Nearly 95 percent of U.S. businesses, 85 percent of small businesses, and virtually all new businesses are organized as S corporations, partnerships, limited liability companies (LLCs), or sole proprietorships. Such businesses are referred to as “pass-through” businesses because their profits are passed through to owners and investors who pay taxes on those distributions by way of their individual returns.
Entrepreneurs who choose to organize their new business as a pass-through currently face a higher federal tax rate – 44.6 percent – than at any point since 1986, and 10 percentage points higher than C corporations. A recent Tax Foundation report showed that the all-in tax rate on pass-through business income can exceed 50 percent when state and local taxes are included.
New businesses that organize as C corporations are taxed at 35 percent – the highest statutory business tax rate in the industrialized world. Meanwhile, the top tax rate on capital gains – 25 percent – is the highest since 1997, and the top tax rate on dividends – also 25 percent – is the highest since 2002.
Tax complexity and uncertainty exacerbate the burden of high tax rates. Unlike larger or more established firms, start-ups typically don’t have the resources to hire a chief financial or tax officer to navigate a complex and ever-changing tax code – they do it themselves. And uncertainty regarding future tax obligations can discourage or even punish calculated risk-taking. Entrepreneurs distracted with tax compliance rather than focused on their product, service, and the marketplace are much more likely to make mistakes, miss opportunities, or even fail.
CAE supports comprehensive tax reform that would significantly reduce tax rates by simplifying the tax code and broadening the tax base through major reductions in existing expenditures, exemptions, preferences, and other loopholes. According to the Joint Committee on Taxation, revenue lost due to tax expenditures hit a record high in 2017 of $1.6 trillion, or nearly 80 percent of combined corporate and individual tax revenue. If counted as part of the annual budget, expenditures would amount to over a quarter of total government spending. Reducing the number and/or size of expenditures, exemptions, and other loopholes would enable policymakers to lower statutory rates without a significant loss of net revenue.
More favorable and predictable tax treatment would help cultivate new business formation, survival, and growth by allowing new businesses to retain and reinvest more of what they earn, preserving critical cash flow, and minimizing the distraction and burden of tax complexity and uncertainty.
Current law generally permits businesses with gross receipts of $10 million or less to use the cash method of accounting. The cash method is simpler, less costly, and easier for new businesses to understand than accrual accounting or other more complex accounting methods, and simplifies tax accounting. CAE recommends that all new businesses, regardless of revenue levels, be permitted to use the cash method of accounting, if they choose to, for the first five years of operation.
A particularly counterproductive and anti-innovation aspect of the current U.S. tax code is that the United States is the only major industrial nation that applies income tax to the worldwide earnings of U.S.-based businesses. Most other nations maintain a “territorial” framework whereby taxes are paid only to the governments of the countries in which foreign profits are earned. The Germany-generated earnings of France-headquartered companies, for example, are taxed by Germany but not also by France.
Though the U.S. code applies to worldwide earnings, business income earned overseas is taxed only if it is transferred home. As long as foreign-earned profits remain abroad, U.S. taxes are indefinitely deferred. The system of assessing taxes on income earned anywhere in the world, together with the deferral of taxation until earnings are repatriated, creates a powerful incentive for U.S.-based businesses to keep their foreign earnings overseas – and to reinvest those funds anywhere but back in the United States.
U.S. corporations currently hold as much as $3 trillion overseas, with hundreds of billions added every year. Moody’s has noted that the practice is particularly common among technology companies, which depend on high rates of innovation and continuous research and development and are, therefore, particularly sensitive to repatriation taxes. According to a recent analysis by Bloomberg, the top eight technology companies alone account for a fifth of all U.S. corporate earnings held overseas – nearly $500 billion.
CAE urges policymakers to shift to a territorial tax system. To be sure, overseas investment by U.S. corporations should not be discouraged or penalized. U.S. companies earn a large and growing share of their total earnings overseas, and foreign operations create additional value for shareholders and promote economic growth and job creation back home. But the global allocation of companies’ resources should not be artificially driven by powerful and illogical tax-related incentives. A shift to a territorial system of taxation would result in the repatriation of hundreds of billions or even trillions of dollars, a significant portion of which would fund research and innovation that would likely spawn thousands of new American start-ups over time.
Because capital is the lifeblood of any new business – and because holding onto as much capital as possible can be the difference between success or failure – CAE also recommends that start-ups be permitted to defer any tax liability incurred during the critical first five years, and to apply that tax liability at any time over the ensuing 20 years. Because money has a time value – future tax payments are worth less than immediate payments – deferred tax payments should be assessed a reasonable rate of interest, perhaps a real (inflation-adjusted) rate of 2 percent. The interest adjustment would also provide an incentive for start-ups to discharge of any deferred tax liability as quickly as possible once profitable.
The current tax code entails a fundamental asymmetry between the tax treatment of operating profits and losses – an asymmetry that significantly disadvantages new businesses. If an existing business sustains a net operating loss in a given year, it is often eligible to “carry back” and deduct the loss from income earned in previous years, or to “carry-forward” the loss to be deducted from future income. Current law permits businesses to carry forward operating losses for a period of 20 years.
Most new businesses lose money in their initial years – sometimes for many years – before hopefully becoming profitable. Such losses are often due to substantial research and development (R&D) investments, salaries, and other expenses that exceed earnings. For many start-ups, R&D and salaries can be the primary expenses of the new company in its early years. Whatever the cause, start-ups, because they are new, have no previous income against which to apply current operating losses. Moreover, income against which losses can eventually be deducted might not materialize for years. Such circumstances are not only problematic from the standpoint of minimizing start-ups’ tax liability, but can also discourage investment in new ideas, since the cost of new investment is not recoverable in a tax context.
Even more problematic, two aspects of the current tax code that restrict loss and credit carry-forwards – Sections 382 and 383 – can have the effect of virtually eliminating any carry-forward tax benefit for start-ups. Sections 382 and 383 were written in the mid-1980s to prevent “loss trafficking” – companies acquiring failing firms with large losses solely to use the acquired company’s tax losses to offset other unrelated income. Section 383 pertains to tax credits, while Section 382 pertains to net operating losses. The rules can virtually eliminate the use of net operating losses and credits following transactions perceived as a change in ownership.
Start-ups often depend on outside investments, from venture capital firms or other sources, to finance R&D and other expenses, sometimes for many years. Such investments are critical for the survival and growth of new firms – but often trigger 382 and 383 change-of-ownership restrictions, potentially nullifying net operating loss carry-forward tax benefits, including for R&D investments. In other words, Section 382 and 383 carry-forward restrictions actually punish start-ups for incurring the very kinds of investments that federal tax policy explicitly encourages for older established firms.
With this policy inconsistency in mind, CAE recommends that net operating losses and R&D credit carry-forwards for start-ups be exempt from the limitation rules of Sections 382 and 383.
Once a new business has been successfully launched and has established the viability of its product or service in the marketplace, entrepreneurs seek to grow, or “scale,” their new business as rapidly as possible. Scaling is important to solidifying the long-term viability of a new business and to job, wealth, and opportunity creation. Successful scaling of a new business often requires significant capital investment in equipment, additional office space, and machinery.
Rapidly growing start-ups are disadvantaged by the current tax code, which requires businesses to deduct the cost of capital investment over long periods of time according to more than two dozen complex depreciation schedules. Because immediate deductions are more valuable than future deductions, the longer that businesses have to wait to write off the full cost of capital investment, the less likely they are to make critical investments necessary to expand.
The Small Business Tax Revision Act of 1958 created for the first time a special first-year depreciation allowance whereby small businesses could deduct or “expense” from taxable earnings a portion of their total cost of capital and equipment investment, pursuant to section 179 of the Internal Revenue Code. Expensing is the most accelerated form of depreciation, allowing businesses to write off the cost of business investment immediately rather than over time. The purpose of the provision was to reduce the tax burden on small businesses, stimulate small business investment, and simplify tax accounting for smaller firms. The original deduction was limited to $2,000 of the cost of new and used business machines and equipment.
Since 1958, the limits and details of the special expensing allowance have changed many times – most typically to raise the expensing limit as a means of stimulating economic growth by incentivizing business investment. In the midst of the accelerating economic downturn in 2008, Congress raised the allowance to $250,000 as part of the Economic Stimulus Act of 2008, and then to $500,000 as part of the Small Business Jobs Act of 2010. The American Taxpayer Relief Act of 2012, signed by President Obama to avoid the “fiscal cliff,” preserved the $500,000 allowance for 2013.
CAE recommends that start-ups be allowed 100 percent first-year expensing of all business-related capital, equipment, and real estate. According to an analysis by the Treasury Department, 100 percent expensing lowers the average cost of capital on new investments by more than 75 percent. Such savings are enormously significant, especially for new businesses for whom access to sufficient capital at reasonable terms remains a principal challenge.
Together with the ability to carry forward losses, explained immediately above, 100 percent expensing of all business-related investment – which would contribute to losses – would dramatically improve start-ups’ financial and tax-related circumstances.
The Research and Experimentation Tax Credit – commonly known as the research and development (R&D) tax credit – was created as part of the Economic Recovery and Tax Act of 1981 to incentivize technological progress and innovation by allowing businesses to deduct a portion of the cost of research and product development from their taxable earnings. The United States was one of the first countries to incentivize R&D by way of the tax code and claimed the world’s most generous tax treatment of R&D into the early 1990s.
Since its introduction, the R&D tax credit has been shown to be a powerful driver of innovation and economic growth. A large and growing body of research indicates that R&D investment is associated with future gains in profitability and market value at the firm level, and with increased productivity at the firm, industry, and broader economy levels. R&D also has significant “spill-over” benefits, as research conducted by one firm can lead to progress that increases the productivity, profitability, and market value of other firms in related fields.
The credit is particularly relevant for start-ups, which often incur substantial losses in their early years due to research and development of new products and services, methodologies, and techniques – and for whom preservation of cash flow and operating capital is crucial to survival. And yet, until recently, start-ups were largely shut out of any benefit associated with the credit because it could only be applied against taxable earnings.
The Protecting Americans from Tax Hikes (“PATH”) Act of 2015 made a number of improvements to the application of the R&D tax credit, perhaps most notably finally making the credit permanent after numerous extensions and expirations since its creation in 1981. Now certain of the credit’s availability, businesses can make investment decisions more effectively and efficiently. In addition, the PATH Act addressed the disconnect between the policy intention of the R&D credit and start-ups by allowing new businesses to apply the credit against payroll taxes, rather than income taxes, up to $250,000 annually. To qualify, companies must have had gross receipts for five years or less and gross receipts of less than $5 million for the tax year the credit is applied.
CAE recommends enhancing the PATH Act’s payroll tax provision by expanding the eligibility definition to be consistent with the current definition of “qualified small businesses” (i.e., young companies with under $50 million in gross assets), and to raise the payroll tax deduction limit to $1 million annually.
Early-stage or “seed” financing is critical to the formation, survival, and growth of new businesses. “Angel” investors – wealthy individuals who invest in new companies – have emerged as the principal source of such funding, providing 90 percent of outside seed capital, once entrepreneurs have exhausted their own resources and those of family and friends. Each year, angels invest about $25 billion in more than 70,000 new companies. For every new company that receives venture capital, 15 others receive angel capital. Amazon, Home Depot, and Uber are just a few examples of the many companies launched with angel capital.
According to the Center for Venture Research (CVR), which has analyzed the angel market since 1980, there are about 300,000 active angel investors in the United States. Angel investing has also become more organized in recent years, with more angels participating in groups, which facilitate more rigorous analysis of potential ventures, and, occasionally, help spread risk by syndicating investments. They also help entrepreneurs identify and connect with active angel investors. According to the Angel Capital Association, the number of angel groups across the country has tripled since 1999 to more than 400.
Angel investors are similar to venture capitalists in a number of ways. Like VCs, angels invest in new, high potential companies in exchange for an equity stake in the business. Many angel investors – particularly those who are current or former entrepreneurs – also provide advice, mentoring, and other support to the management teams of the new businesses they invest in. As with venture capital, angel capital is recovered and any returns realized when financed firms either go public or are bought by another company.
And, like venture investing, angel investing is very risky. According to the Angel Capital Association, half of all angel investments fail and just 7 percent of investments generate 75 percent of total returns.
Angel investors also differ from venture capitalists in significant ways. Unlike VCs, who invest institutionally-raised capital in amounts of $1 million or more, angels invest their own money, typically in amounts between $25,000 and $500,000. Despite smaller individual investments, aggregate angel capital invested rivals that of venture capital.
Given the critical importance of early-stage seed capital to start-ups, the formation and commitment of angel capital should be incentivized. Section 1202 of the tax code was enacted in 1993 to incentivize investment in “qualified small business” by excluding a portion of any capital gains on investments held for at least five years from federal income tax. Section 1202 originally excluded 50 percent of capital gains from gross income.
The PATH Act of 2015 made permanent a 100 percent exclusion from capital gains tax for any gains on long-term investments in qualified small businesses, up to $10 million or ten times the original investment, whichever is greater. Previously, the American Recovery and Reinvestment or “Stimulus” Act of 2009 raised the excluded portion from 50 percent to 75 percent, and exempted any gains from the Alternative Minimum Tax (AMT). Subsequent legislation raised the exclusion to 100 percent and extended the AMT exclusion temporarily. CAE recommends that this full exclusion from federal income tax of any gains on angel investments in start-ups held for at least five years be retained in order to maximize the pay-off on any successful investments.
At present, the Section 1202 exclusion only applies to companies organized as C corporations. Because most new businesses are launched as S corporations, partnerships, or limited liability companies (LLCs) – “pass-throughs” (see first recommendation above) – CAE also recommends that the 1202 exclusion be applied to any start-up that converts to a C corporation within five years – and that the period of time spent as a pass-through count toward the five-year holding period required by Section 1202. In other words, angel investors would not have to hold the investment for five years beyond conversion to a C corporation, but only five years beyond the original investment in the company.
Total capital gains tax revenues have historically represented less than 5 percent of federal tax revenues, so exempting gains on angel investments would have almost no impact on federal tax revenue. And since most angel investors reinvest most or all of their returns into the next generation of innovative new companies, exempting such gains from federal taxes would have the further benefit of increasing the amount of seed capital available to start-ups.
As a counterpart to the Section 1202 tax treatment of angel investment gains, Section 1244 of the tax code allows investors in qualified small businesses to deduct losses on such investments as an ordinary loss (deducted from ordinary income) rather than as a capital loss. Normally, the tax code treats equity investments as capital assets and, therefore, losses are deducted as capital losses to offset capital gains. If capital losses exceed gains in a particular year, remaining losses are deductible up to a limit of $3,000 annually, with any additional remaining losses carried forward to subsequent years. By contrast, a loss on a Section 1244 investment is deductible from ordinary income up to $50,000 for individuals and $100,000 for couples filing jointly.
To qualify for Section 1244 treatment, the issuing company’s aggregate equity capital must not exceed $1 million at the time of issuance, the company must have derived more than 50 percent of its income from business operations rather than passive investments for the previous five years, and the shareholder must have purchased the stock directly from the company and not received it as compensation. Start-ups generally don’t issue stock for years after launch, if ever – nor have they been in existence for five years – and, therefore, currently don’t meet the requirements of qualifying small businesses.
To further incentivize seed-stage investments in start-ups, CAE recommends expanding Section 1244 to permit losses sustained by angel investors on investments in new companies held for at least 5 years to be deductible from ordinary income up to $100,000 annually.