Tax Expenditures Taken by Small Businesses in the Federal Tax Code

August 5, 2019

Like individuals, businesses take advantage of tax expenditures such as exclusions, exemptions, deductions, and credits, when calculating federal tax liability. The composition of the tax expenditures taken by firms may vary depending on their size. Small firms may, for example, be less likely to take advantage of tax expenditures related to foreign profits if they are less exposed to international markets.

A study commissioned by the Small Business Administration (SBA) in 2013 measured the benefit of federal tax expenditures used by small businesses. In the study, small businesses are defined as pass-through entities with less than $10 million in gross receipts or C-corporations with less than $10 million in assets.

Using tax expenditure estimates from the Joint Committee on Taxation (JCT), the authors estimate that about $57.5 billion in tax expenditures were used by small businesses in fiscal year 2013. Of the largest tax expenditures taken by businesses in fiscal year 2013, about $40.2 billion is taken by small businesses out of $161.2 billion in total business tax expenditures.

The relative size of a tax expenditure does not necessarily convey the importance of the expenditure to small businesses. For example, certain tax expenditures may simplify tax compliance for small firms even if they do not confer a large reduction in tax liability. 

Table 1. Largest Tax Expenditures Used by Small Businesses, Fiscal Year 2013
Expenditure Fiscal Year 2013 Cost (billions of dollars)
Source: John O’Hare, Mary Schmitt, and Judy Xanthopoulos, ”Measuring the Benefit of Federal Tax Expenditures Used by Small Business,” Small Business Administration Office of Advocacy, November 2013

Retirement plans (Keogh Plans)

$10.53

Exclusion of interest on state and local private activity bonds

$6.01

Deduction for health insurance premiums and long-run care insurance premiums by the self-employed

$5.19

Expensing under section 179 of depreciable business property

$4.62

Deduction for income attributable for domestic production activities

$3.93

Depreciation for equipment in excess of the alternative depreciation system

$3.83

Exclusion of interest on public purposes State and local government bonds

$3.63

Depreciation of rental housing in excess of the alternative depreciation system

$3.27

Exclusion of investment income on life insurance and annuity contracts

$2.96

Deferral of gain on like-kind exchanges

$2.41

The SBA study authors estimate that about 73 percent of all small business tax expenditures in 2013 were realized by partnerships and S corporations, accounting for about $42.2 billion of the $57.5 billion in tax expenditures benefiting small businesses.

Many tax expenditures available to businesses are not used by small firms. For example, prior to the Tax Cuts and Jobs Act (TCJA), firms benefited from the deferral of active income from controlled foreign corporations (CFCs), a tax expenditure worth $42.4 billion in FY 2013. Similarly, tax expenditures such as the deferral of active financing income.

Like all businesses, small firms benefit from tax expenditures like the deduction for health insurance premiums paid by employers, the tax treatment of retirement plans, and expensing provisions under section 179 of the tax code. Many of these tax expenditures are intended for self-employed individuals and may mirror the tax treatment of employees. For example, small businesses may deduct income used for health insurance premiums when calculating their individual income tax liability.

Like with tax expenditures used for all firms, the expenditures offered to small businesses are not created equal.  For example, while JCT considers depreciation for business investment in excess of the alternative deprecation system (ADS) to be a tax expenditure, full expensing better reflects the economic costs of investment through the time value of money. Each tax expenditure should be evaluated on its own merits to determine if it is consistent with sound tax policy.

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