The Standard Business Deduction

The Standard Business Deduction

Kathleen DeLaney Thomas*

In 2017, Congress passed the most sweeping tax reform bill[1]the country has seen in over 30 years.[2]The new legislation responded to many long-held concerns about the U.S. tax system, particularly that taxes were too high and that the corporate and international tax regimes were not competitive.[3]In response to those concerns, Congress lowered individual income tax rates, drastically reduced the corporate tax rate from 35% to 21%, and shifted away from a worldwide system of international taxation.[4]The bill also lowered taxes for pass-through businesses, such as partnerships, S-corporations, and sole proprietorships, by offering a new deduction for up to 20% of the business’s net earnings.[5]

In the months leading up to the tax reform bill, members of Congress also promised much needed simplification of the U.S. tax system, even going so far as to suggest that future tax returns would fit on a postcard.[6]In one respect, Congress delivered on this promise to simplify the tax system. The new legislation doubled the standard deduction, from roughly $6,000 to $12,000 for a single individual.[7]This means that individuals will now claim itemized deductions (e.g., charitable contributions or mortgage interest) only if, in the aggregate, those deductions exceed $12,000 ($24,000 for a married couple filing jointly). The higher standard deduction essentially means that fewer taxpayers will itemize their deductions, which saves time and simplifies tax return preparation.[8]

However, while the 2017 Tax Reform Bill simplifies personal deductions, the legislation does virtually nothing to simplify the tax rules for businesses. Small business owners will not see any reduction in complexity for reporting income, tracking expenses, or preparing tax returns. Instead, the new pass-through deduction only adds further complexity by inserting more steps into the process of calculating a business’s net income.

In short, Congress failed to deliver on its promise to provide simplification when it comes to small business owners. Congress could do more to reduce the complexity faced by these taxpayers, who must pay estimated taxes, track business expenses, and file complicated tax returns. To that end, this essay proposes a “standard business deduction.”[9]

A standard business deduction (“SBD”) would work like the regular standard deduction. The latter is a fixed amount that is claimed in lieu of itemized deductions (i.e., non-business deductions like charitable contributions, mortgage interest, or state and local taxes). The SBD would be a fixed amount claimed in lieu of deducting businessexpenses. Taxpayers claiming the SBD would report their gross business earnings, subtract the SBD, and arrive at net business income. No Schedule C would be necessary. Like claiming the standard deduction, claiming the SBD would be optional for the taxpayer. If a taxpayer’s actual business expenses exceeded the SBD, she could instead opt to claim those expenses.

The SBD could revolutionize tax return filing for small businesses. Imagine, for example, an independent contractor who, under the current system, must track numerous business expenses during the year and spend time filling out a Schedule C when she files her tax return. If that taxpayer’s gross earnings were reported on a Form 1099, she could automatically import that amount into a tax software program. The software could apply the SBD and calculate her net business income for both income and self-employment taxes within a matter of seconds. If she then claimed the regular standard deduction, her entire tax return could be prepared in minutes.

The discussion below outlines the following features of an SBD:

• Based on a fixed percentage of gross receipts (e.g., 60%);
• Offered only to individuals with gross business receipts less than $100,000 and total adjusted gross income less than $150,000;
• Offered only to individuals who earn income subject to Form 1099 reporting (i.e., not cash-based businesses);
• Not offered to labor-only businesses with little or no expenses (e.g., consulting, childcare).

 

Amount of SBD

 

The most important issues in implementing an SBD are determining the amount of the deduction and determining which taxpayers could claim the deduction. Because an SBD would be optional (like the regular standard deduction), setting the deduction too high would result in large windfalls for taxpayers and revenue loss for the government. This is because taxpayers with expenses below the SBD would claim it, while those with expenses well in excess of the SBD may continue to claim their actual expenses. On the other hand, an SBD set too low would not provide significant simplification benefits because most taxpayers would forego it.

Ideally, an SBD would roughly approximate business expenses for most taxpayers, although a slight windfall may be acceptable, as it would act as a subsidy for small businesses. The best way to approximate actual expenses would be to set the SBD as a fixed percentage of gross receipts, rather than a flat dollar amount (like the regular standard deduction). For example, an SBD of 60% would allow taxpayers to deduct 60% of their gross receipts as business expenses and report 40% as net business income. This would mean an independent contractor earning $50,000 per year would claim a $30,000 SBD (60% of $50,000) and report $20,000 of net business income on her tax return. This amount would then be subject to further reduction for itemized deductions or the regular standard deduction.

In earlier work, I proposed a 60% deduction for gig economy workers based on historic average profit ratios for small sole proprietorships.[10]Further study may reveal a more appropriate percentage.[11]Of course, different industries will have different profit ratios: some lines of business involve numerous expenses, and some involve very few expenses. Although developing separate SBDs for each industry would be more accurate, it would create too much complexity and would also create more opportunities for taxpayers to “game” the system by trying to characterize themselves as part of a more favorable industry.

Notwithstanding the simplicity of a single SBD, another good alternative would be two SBDs. Certain businesses that rely heavily on services and generally do not involve significant expenses, such as childcare, could be identified and given a very low SBD between zero and 10%. Or, these labor-only businesses could be made ineligible for the SBD altogether. Businesses with significant expenses (e.g., an Uber driver who incurs gasoline and car maintenance expenses) would be given a higher SBD (e.g., 60%). The rate of the SBD could be set by Congress, or it could be delegated to Treasury to determine and adjust the percentage as necessary.

 

Scope of the SBD

 

At a certain level of earnings, taxpayers presumably have better capacity to efficiently track and manage their business expenses. The SBD should therefore be limited to taxpayers with gross business receipts below a certain threshold, for example $100,000. This income cap would also mitigate potential revenue loss, making implementation of the SBD less costly: only taxpayers earning relatively low amounts of income and claiming relatively low expenses would be eligible. A cap on total adjusted gross income may also be desirable, such as a $150,000 maximum. This would prevent a high-income wage earner with a small side job (e.g., a professional earning a large salary who also takes on a small consulting project) from claiming the SBD and ensure that it is targeted only at truly “small” business owners.

Further, the SBD should be limited to those situations where taxpayers are likely reporting their gross receipts accurately. It would be undesirable, for example, to offer a 60% SBD to a cash business[12]that was reporting only half of its gross receipts to the government and was fraudulently concealing the rest. To limit the SBD to highly compliant taxpayers, it should be available only when taxpayers’ business income is reported on a Form 1099. Studies show that the vast majority of income reported on a Form 1099 is reported accurately,[13]and thus limiting the SBD to 1099 earnings would be an effective way to target compliant taxpayers.[14]

Limiting the SBD to workers who receive a Form 1099 also has the effect of limiting it to individual taxpayers and not corporations, since the 1099 rules exempt corporations.[15]This limitation makes sense. Individual business owners are most likely to have a difficult time managing their tax obligations and are more likely to have to spend resources on tax compliance that are disproportionate to their income. This group would most benefit from the SBD. Businesses operating as corporations, or in another entity form, are presumably more sophisticated because forming those entities entails legal requirements (e.g., articles of incorporation) not required of sole proprietors.[16]

An SBD would work well with gig economy workers who are paid by online platform companies (e.g., Uber, Task Rabbit, Etsy) and who, studies show, would greatly benefit from tax simplification.[17]However, the deduction could also apply to other independent contractors who otherwise fall under the income threshold and receive a Form 1099.[18]

 

Potential Costs         

 

One concern policymakers may have in implementing an SBD is potential revenue loss, since many taxpayers who claim it will deduct a higher amount than their actual expenses. There are several reasons, however, that this potential cost does not detract from the desirability of an SBD. First, limiting the SBD to taxpayers below a certain earnings threshold will minimize revenue loss. Second, not all taxpayers claiming the SBD will receive a windfall. Some taxpayers will opt to claim the SBD even when their actual expenses are more than the SBD, simply to avoid the hassle of tracking and reporting expenses.[19]Even an SBD that generated net revenue loss may be justified because it would reduce the wasteful social cost of taxpayers tracking and reporting business expenses when relatively minor amounts of tax revenue are at stake.

Further, an SBD implemented in conjunction with 1099 reporting should result in better voluntary tax compliance and less evasion overall. Taxpayers accurately report 1099 income the vast majority of the time,[20]and requiring 1099 reporting as a condition of claiming the SBD may encourage taxpayers to demand more information reporting from payers. An SBD should also reduce the over claiming of expenses,[21]further improving compliance with the tax law.An SBD would also reduce IRS enforcement costs, since the IRS would not have to monitor taxpayers with 1099 income who claim the SBD.

Potential behavioral distortions must also be considered and weighed against the SBD’s benefits. If taxpayers engage in gaming techniques, the cost of an SBD may be higher than anticipated. For example, taxpayers may bargain to share deductible costs with another party, thereby reducing their actual business expenses while still maintaining the same SBD.

Consider a housepainter who typically is paid $1,000 per job, $200 of which is spent on paint and $400 of which is spent paying an assistant. Since his expenses would normally be $600 per job, a 60% SBD would be appropriate. Under normal circumstances, the painter should net $400 per job. But if the painter knew he could claim the 60% SBD no matter what, he might instead ask the homeowner to buy the paint directly and agree to reduce his $1000 fee to $800 to compensate. In that case, the painter would earn $800 in gross receipts, and claim $480 (60% of $800) as his SBD. With no change in the economics of the arrangement, he would have reduced his taxable income from $400 to $320 ($800 gross receipts minus $480 SBD).

Much of this gaming potential should be eliminated by the 1099 requirement. For example, a painter who paints residences and who doesn’t accept credit cards or online payments would not receive a 1099 and therefore wouldn’t qualify for the SBD.

What about workers who get paid by large platform companies, who do receive 1099s and would qualify for the SBD? Cost-sharing techniques are less likely to occur in that setting, because the more costs the payer takes on, the more the payer would look like an employer for tax purposes.[22]Generally, platform companies want to avoid employer characterization because it brings with it a number of costs and legal obligations that are avoided through independent contractor classification, such as labor and employment law protections and employment taxes. Thus, if Uber wants to continue to treat its drivers as independent contractors rather than employees for tax law purposes, it is unlikely to start paying for gas and car maintenance expenses for its drivers.

This still leaves the issue of the housepainter who accepts credit card payments and therefore receives a 1099-K, but who could also engage in cost-sharing with his customers to game the SBD. The number of taxpayers who fit into this group may be insignificant. If not, one solution might be to offer the SBD only to taxpayers who receive 1099s from large payers (like internet platform companies), who would be less willing to enter into these cost-sharing arrangements. For example, the SBD could be limited to gig economy workers only.

The SBD would also make independent contractor work more attractive from a tax perspective than employment (since employees would not be offered an SBD), which may have undesired consequences. However, independent contractor status has always offered tax advantages over employment status, such as the ability to deduct business expenses in full[23]and greater ease in concealing earnings from the IRS. The recent tax reform bill has made independent contractor status even more favorable, particularly by bestowing the section 199A deduction[24]upon independent contractors but not employees, and by repealing the deductibility of employee business expenses. With these differences already embedded in the tax law, it is unclear how much influence—if any—the SBD would have on taxpayers’ employment decisions. There are also many non-tax benefits that come with employment that influence taxpayers’ decisions, such as the right to overtime, minimum wage, and health benefits.

 

Important Caveats

 

There is currently a major gap in the information reporting rules,[25]which must be fixed in conjunction with implementing an SBD. Specifically, the Form 1099-K rules provide that certain online intermediaries (e.g., platform companies like Uber, Etsy, or TaskRabbit) need not report payments to a worker until a threshold of $20,000 and 200 transactions is reached.[26]This threshold is far too high, as a significant number of gig economy workers do not earn enough to reach it and therefore do not receive 1099s.[27]Any proposal to offer these workers an SBD must also require that workers earning over $600 receive a Form 1099, which is consistent with the reporting threshold for independent contractors under the Form 1099-MISC rules.[28]

Although not mandatory for an SBD, Congress would also be well advised to consider implementing non-employee withholding in conjunction with these proposals. A withholding regime would eliminate the need for independent contractors to make quarterly estimated payments and would also reduce taxpayers’ concerns about properly budgeting for taxes. If small business owners could avoid having to remit tax themselves and avoid tracking expenses, their interactions with the tax system would be vastly simpler. Withholding would also have the added benefit of promoting better compliance and enhancing revenue collection for the government.[29]

 

***

In sum, an SBD would greatly simplify the tax system for small business owners. Taxpayers who chose to claim it could be relieved of the burden of tracking business expenses during the year and could self-prepare their tax returns without the need for expensive tax preparation assistance. Not only would the SBD reduce socially wasteful taxpayer compliance costs, it would also reduce IRS enforcement costs. Such simplification should be attractive to policymakers on both sides of the aisle and would benefit the government and taxpayers alike.

^* George R. Ward Term Professor of Law, University of North Carolina School of Law. B.S., The College of William & Mary, 2001; J.D., New York University School of Law, 2005; LL.M. (Taxation), New York University School of Law, 2010.  The author is grateful to David Walker and participants at a tax workshop at Columbia Law School for helpful discussions about this essay.

[1] Tax Cuts and Jobs Act, Pub. L. No. 115-97, 131 Stat. 2054 (2017).

[2] William G. Gale et al., Tax Policy Ctr., Effects of the Tax Cuts and Jobs Act: A Preliminary AnalysisII (2018), https://www.brookings.edu/wp-content/uploads/2018/06/ES_20180608_tcja_summary_paper_final.pdf [https://perma.cc/YWJ4-FE3M].

[3] See, e.g.,U.S. Dep’t of Treasury, Unified Framework for Fixing Our Broken Tax Code 2 (2017), https://www.treasury.gov/press-center/press-releases/documents/tax-framework.pdf[https://perma.cc/JNK3-Q2CC];Task Force on Poverty, Opportunity, and Upward Mobility, A Better Way: Our Vision for a Confident America 9-10 (2016), https://www.heartland.org/_template-assets/documents/publications/abetterway-poverty-policypaper.pdf[https://perma.cc/CJW4-ZXSK].

[4] Gale et. al., supranote 2, at 1–2, 5–6.

[5] See id. at 4; I.R.C. § 199A (2018).

[6] See, e.g.,Task Force on Poverty, Opportunity, and Upward Mobility, supra note 3, at 16.

[7] Gale et al., supranote 2, at 3.

[8] See id. The tax reform bill also reduced or eliminated some itemized deductions. Id.

[9] The Hillary Clinton campaign similarly proposed a “standard business deduction” in 2016, though it does not appear that any details about how the deduction would work were ever released. See Office of Hillary Rodham Clinton, https://www.hillaryclinton.com/issues/small-business/[https://perma.cc/B87F-G3E3].

[10] Kathleen DeLaney Thomas, Taxing the Gig Economy, 166 U. Pa. L. Rev. 1415, 1464 (2018).

[11] See, e.g.,Alastair Fitzpayne et al., Tax Simplification for Independent Workers, The Aspen Institute 4 (2018), https://assets.aspeninstitute.org/content/uploads/2018/09/Tax-Simplification-for-Independent-Workers_September-2018_Aspen-Institute-Future-of-Work-Initiative.pdf?_ga=2.113571655.1732760245.1563945034-138726258.1563945034[https://perma.cc/VM2D-JKNN] (suggesting 20%).

[12] Cash economy businesses are notoriously noncompliant. I use the term “cash” here to mean not just businesses that operate all in cash, but businesses that earn income that largely goes unreported to the IRS.  For example, a plumber may take checks from customers but still not report that income to the IRS. But if a plumber primarily uses credit cards, he may receive a Form 1099-K from the credit card company, and would therefore not be a cash economy business.

[13] See, e.g., Internal Revenue Serv., Tax Gap Estimates for Years 2008-2010 5(2016) https://www.irs.gov/pub/newsroom/tax%20gap%20estimates%20for%202008%20through%202010.pdf[https://perma.cc/MHM9-FGFD] (reporting a 93 percent compliance rate when “substantial information reporting” is present).

[14] One issue is how to treat taxpayers who earn multiple types of income, some of which is reported on a Form 1099 and some of which is not. One approach would be to allow the taxpayer to claim the SBD as long as more than half of his gross business receipts are reported on a Form 1099. Although this would encourage some taxpayers to underreport cash to ensure that the 1099 threshold is met, underreporting cash is already such a pervasive problem that this is unlikely to move the needle. Under the current system without an SBD, taxpayers already have a large incentive to report their 1099 earnings but not report some (or all) of their non-1099 earnings.

[15] The 1099-MISC rules generally do not require reporting of payments to C corporations and S corporations, however there is no exception for payments made to LLCs taxed as partnerships. See, e.g., Instructions Form 1099-MISC (2019), Internal Revenue Serv. (Nov. 28, 2018)https://www.irs.gov/instructions/i1099msc [https://perma.cc/6W2B-YGLS]. Although this essay generally advocates offering an SBD only to those businesses operating as individuals (not multiple-member entities), in theory, members of an LLC taxed as a partnership could each claim the SBD on their share of the business’s income.

[16] Single-member entities could be allowed to opt in. However, it’s likely that most low-earning small businesses do not operate in entity form.

[17] See, e.g.,Caroline Bruckner, Kogod Tax Pol’y Ctr, Shortchanged: The Tax Compliance Challenges of Small Business Operators Driving the On-Demand Platform Economy3 (May 23, 2016), https://www.american.edu/kogod/research/upload/shortchanged.pdf [https://perma.cc/CE3L-2G5K].

[18] However, as mentioned above, independent contractors in labor-only industries, who incur little to no business expenses, should either be excluded from the SBD or permitted to take only a small SBD.

[19] There is evidence that taxpayers do this when it comes to claiming the regular standard deduction instead of itemizing. See, e.g.,Mark M. Pitt & Joel Slemrod, The Compliance Cost of Itemizing Deductions: Evidence from Individual Tax Returns, 79 Am. Econ. Rev. 1224 (1989); Youssef Benzarti, How Taxing is Tax Filing? Leaving Money on the Table Because of Compliance Costs (Mar. 2015),https://site.stanford.edu/sites/default/files/how_taxing_is_tax_filing_benzarti_v7.pdf [https://perma.cc/E3ZD-ZMWQ].

[20] See supra note 14.

[21] See, e.g.,Joel Slemrod et al., Nat’l Bureau of Economic Res., Does Credit-Card Information Reporting Improve Small-Business Tax Compliance? 21412 (2015), https://www.nber.org/papers/w21412.pdf[https://perma.cc/8SXE-TJSL](discussing the over-claiming of expenses in response to 1099-K reporting).

[22] See Rev. Rul. 87-41, 1987-1 C.B. 296 (“If the person or persons for whom the services are performed ordinarily pay the worker’s business and/or traveling expenses, the worker is ordinarily an employee.”). However, determining whether a worker is an employee or an independent contractor for tax purposes depends upon the application of numerous factors, as developed by the common law, no one of which is controlling.

[23] Prior to the recent tax reform bill, employee business expenses were “miscellaneous itemized deductions,” which meant they were subject to an income floor and only available to taxpayers who itemized their deductions. Under the new rules, employee business deductions are entirely nondeductible through the end of 2025. Tax Cuts and Jobs Act, Pub. L. No. 115-97, §11045, 131 Stat. 2054, 2088 (2017).

[24] Taxpayers could be offered boththe SBD (an above line deduction that reduces gross income) and the section 199A deduction (a below the line deduction that reduces adjusted gross income in arriving at taxable income). Although the combination of the two could result in significant tax benefits for eligible taxpayers, it is important to remember that the SBD would only be offered to workers earning less than $100,000 in gross receipts, many of whom would not be able to deduct the full 20 percent under section 199A. In a sense, offering an SBD to truly small businesses in addition to section 199A would put these workers on a more level playing field with larger businesses that likely benefit much more from the 199A deduction.

[25] See, e.g.,Thomas, supra note 10, at 1426–28; Shu-Yi Oei & Diane Ring, Can Sharing Be Taxed?,93 Wash. U. L. Rev. 989, 1037 (2016); Kelly Phillips Erb, Credit Cards, the IRS, Form 1099-K and the $19,399 Reporting Hole, Forbes (Aug. 29, 2014, 11:13 AM), http://www.forbes.com/sites/kellyphillipserb/2014/08/29/credit-cards-the-irs-form-1099-k-and-the-19399-reporting-hole/#3c532d86c37b [https://perma.cc/V9EZ-3PC3].

[26] See I.R.C. § 6050W(a), (e) (2018).

[27] For further discussion, see Thomas, supra note 10, at 1427–28.

[28] See I.R.C. § 6041(a) (2018).

[29] See Kathleen DeLaney Thomas, The Modern Case for Withholding, 53 U.C. Davis L. Rev. (forthcoming 2019).