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4 tax reforms that can reinvigorate Main Street — and boost the economy

Cripple Creek, Colorado
John Greim | LightRocket | Getty Images
Cripple Creek, Colorado

President Trump and congressional Republicans have vowed to cut taxes, simplify returns and stimulate business growth. With many details to be fleshed out and negotiated, entrepreneurs are hoping for tax changes to encourage business start-ups, which have been sluggish.

The Bureau of Labor Statistics says creation of new businesses hit about 679,000 in 2015, up from the Great Recession low of 561,000 in 2010 but still shy of the record 716,000 in 2006. Even worse, jobs created by businesses less than one year old, though rising in recent years, have lagged, hitting about 3 million in 2015 compared to more than 4.7 million a year in 1998 and 1999.

In fact, many "new businesses" created in recent years are really just one-person shops set up by individuals who have lost their jobs, says Enrolled Agent Steven J. Weil, president of RMS Accounting in Fort Lauderdale, Florida. With no employees, they're not helping to build employment.

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"While these independent contractors are, in effect, in business for themselves, they are not truly in (a growing) business, since their primary interest is merely replacing the employment income they can't seem to find in a job," Weil says.

Many factors account for sagging new-business formation — from slow economic growth, to a widespread belief that starting a new company is just too difficult, to regulations and tight lending standards. But tax policies are culprits, too, according to start-up experts.

So what's on their tax wish list?

All sorts of things, of course, ranging from eliminating the alternative minimum tax and estate tax that hit many small-business owners, to offering tax credits for new hires, to eliminating the IRS's ability to judge whether executive compensation is appropriate. But here are the four broad categories that come up most.

Tax cuts

Most start-up experts endorse Trump's campaign proposal to cut the business tax rate to 15 percent. Currently, corporations face a top rate of 35 percent, while owners of many small businesses — typically set up as sole proprietorships, limited liability companies, partnerships or S corporations — pay income-tax rates topping out at 39.6 percent, plus a 3.8 percent Medicare surtax to fund Obamacare.

Slashing business taxes could spur start-ups by raising after-tax earnings, making it worthwhile for prospective entrepreneurs to give up regular salaries to strike out on their own, says accountant Dominique Molina, founder of the American Institute of Certified Tax Planners.

The self-employment tax is another obstacle to start-ups, since an entrepreneur has to pay both the employer and employee's share, says Tom Wheelwright, CEO of ProVision Wealth of Tempe, Arizona.

"An employee pays 7.65 percent in Social Security tax. As soon as she becomes self-employed, that rate doubles to 15.3 percent, and when she starts earning real income, Obamacare raises that rate to 16.2 percent," he says. "Reducing or eliminating that extra self-employment tax would be huge for new entrepreneurs."

Faster deductions

Molina and others interviewed would also like businesses large and small to be able to deduct the cost of new assets, like equipment in the year they are purchased instead of spreading them over decades through depreciation allowances.

The tax code, she says, is not kind to start-up costs, like feasibility studies and expenses for things like professional advice.

"Under the current guidelines, just $5,000 of (this type of ) expense can be deducted in the year incurred, while the remainder is deducted over a 15-year period," she says. "In the event costs exceed $50,000, taxpayers may not even be able to deduct the entire $5,000 of first-year expenses."

Equal treatment for equity and debt

Start-ups typically have little or no track record and may lose money for years, making it hard to borrow significant sums. So many raise money instead by selling stock. The tax code allows deductions for interest paid on debt but nothing comparable for stock, putting the stock-dependent start-up at a disadvantage.

The Tax Policy Center, a think tank devoted to tax issues, has found that partnerships, S corporations and other tax structures commonly used by start-ups face an effective marginal tax rate of 20 percent on stock, while a corporation using debt has a rate of –6 percent, meaning the tax code effectively subsidizes companies using debt.

A level playing field

Currently, deductions for investments and losses are not all treated equally. The tax code "favors investments in equipment, software and intellectual property over those in structures and inventories," according to the Ewing Marion Kauffman Foundation, which studies entrepreneurship and business start-ups.

R&D expenses are deductible in the year incurred, for example, while spending on equipment and structures is deducted over many years through depreciation.

This makes it harder, for example, for wholesale or retail start-ups that have little to write off. In fact, the Tax Policy Center found that a retail business faces an effective tax rate of 31 percent, while a chemical or pharmaceutical company would pay 9 percent to 11 percent. The higher rate is a stiff headwind for someone trying to open a store on Main Street.

Also, the Tax Policy Center says that a start-up that has yet to book profits doesn't get as much tax benefit from its losses and other write-offs as an established firm. Losses can be "carried forward" to offset future profits, but that doesn't provide much relief for a start-up struggling in the present.

"Such carry-forwards provide less value than immediate tax savings because of the time value of money, as well as the possibility that the firm will never report sufficient income to take advantage of them," the Tax Foundation says.

No one expects tax reform to be easy, given entrenched interest groups and the government's enormous appetite for tax revenue, but start-up advocates feel reform would pay off through more business and job creation.

"Our results illustrate the need for thoughtful tax reform," the Kauffman Foundation says. "There is no reason to favor debt over equity, for example, and many differences across assets and industries appear difficult to justify. In addition, the inconsistent value of tax incentives for investment and R&D, especially among start-ups and fast-growing young firms, deserves a close look."

— By Jeff Brown, special to CNBC.com

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