OVERVIEW OF PRESENT LAW AND SELECTED PROPOSALS

REGARDING THE FEDERAL INCOME TAXATION OF

SMALL BUSINESS AND AGRICULTURE

Scheduled for a Public Hearing

Before the

SENATE COMMITTEE ON FINANCE

on June 4, 2002

Prepared by the Staff

of the

JOINT COMMITTEE ON TAXATION

May 31, 2002

JCX-45-02
i

CONTENTS

Page

INTRODUCTION .......................................................................................................................... 1

I. OVERVIEW................................................................................................................................ 2

A. Federal Income Tax Rates..................................................................................................... 2

B. Definition of “Small Business”.............................................................................................. 2

C. Choice of Entity ..................................................................................................................... 3

II. ECONOMIC ANALYSIS.......................................................................................................... 9

A. Data on Small Business and Agriculture ............................................................................ 9

B. Background and Discussion of Issues Related to the Federal Minimum Wage ............... 26

1. History of the Federal Minimum Wage ........................................................................ 26

2. The Minimum Wage and Employment......................................................................... 33

3. The Minimum Wage and Poverty................................................................................. 34

III. SELECTED PROVISIONS THAT AFFECT SMALL BUSINESS AND

AGRICULTURE .................................................................................................................... 36

A. Expensing Depreciable Business Assets........................................................................... 36

B. Accounting Methods......................................................................................................... 37

1. In general ...................................................................................................................... 37

2. Cash and accrual methods............................................................................................. 37

3. Uniform capitalization of inventory costs..................................................................... 38

IV. SUMMARY OF SELECTED PROPOSALS RELATIVE TO AGRICULTURE AND

SMALL BUSINESS ............................................................................................................... 40

A. Summary of S. 312, the “Tax Empowerment and Relief for Farmers and Fisherman

Act”................................................................................................................................... 40

1. Farm, Fish and Ranch Risk Management Accounts (“FFARRM”) ............................. 40

2. Exclusion of rental income from SECA tax ................................................................. 41

3. Exclusion of conservation reserve program payments from SECA tax........................ 42

4. Exemption of agricultural bonds from private activity bond volume limits................. 42

5. Modifications to section 512(b)(13) ............................................................................. 42

6. Charitable deduction for contributions of food inventory ............................................ 43

7. Coordinate farmers and fisherman income averaging and the alternative minimum

tax................................................................................................................................ 44

8. Modify cooperative marketing to include value added processing through animals.... 45

9. Extend declaratory judgment procedures to farmers’ cooperative organizations......... 45

10. Small ethanol producer credit ..................................................................................... 46

11. Payment of dividends on stock of cooperatives without reducing patronage

dividends..................................................................................................................... 47

B. Qualified Small Business Stock........................................................................................ 48

C. Proposals Relating to S Corporations ............................................................................... 49

APPENDIX................................................................................................................................... 51
1

INTRODUCTION

The Senate Committee on Finance has scheduled a public hearing on June 4, 2002, on 

issues relating to the Federal Income Taxation of Small Business and Agriculture. This 

document,1 prepared by the staff of the Joint Committee on Taxation, describes selected Federal 

income tax provisions that affect these activities, as well as proposals in the Senate that would 

affect small business and agriculture.

 

1

 This document may be cited as follows: Joint Committee on Taxation, Overview of 

Present Law and Selected Proposals Regarding the Federal Income Taxation of Small Business 

and Agriculture (JCX-45-02), May 31, 2002. 
2

I. OVERVIEW

A. Federal Income Tax Rates

U.S. individuals (citizens and residents) are taxed at graduated statutory rates ranging 

from 10 percent (for taxable income of married joint filers or surviving spouses up to $12,000) to 

38.6 percent (for taxable income of married joint filers or surviving spouses over $307,050) for 

2002. The intermediate rates are 15 percent, 27 percent, 30 percent, and 35 percent. The 

maximum tax rate on net long-term capital gains generally is 20 percent.2

Corporations are taxed at statutory rates ranging from 15 percent (for taxable income up 

to $50,000) to 35 percent (for taxable income over $10,000,000). The intermediate rates are 25 

percent and 34 percent. The benefit of graduated rates below 34 percent is phased out for 

corporations with taxable income between $100,000 and $335,000, and the benefit of the 34 

percent rate is phased out for corporations with taxable income in excess of $15,000,000. The 

maximum tax rate for corporate net long-term capital gains is 35 percent.

In addition, present law imposes a minimum tax on individuals and corporations to the 

extent their minimum tax liability exceeds their regular tax liability.3 This alternative minimum 

tax ("AMT") is imposed on corporations at the rate of 20 percent on the alternative minimum 

taxable income ("AMTI") in excess of a $40,000 phased-out exemption amount, and on 

individuals at a rate of 26 percent for the first $175,000 of AMTI in excess of a phased-out 

exemption amount and 28 percent in excess of such amount.4 AMTI is the taxpayer's regular 

taxable income increased by certain preference items and adjusted by determining the tax 

treatment of certain items in a manner that negates the deferral of income resulting from the 

regular tax treatment of those items. In general, the AMT applies a lower tax rate to a broader 

tax base. Specifically, the regular tax base is increased for AMT purposes by adding back 

certain items treated as tax preferences, and disallowing certain deductions and credits.

B. Definition of “Small Business”

The Code does not contain a uniform definition of a “small business.” Rather, there are 

numerous definitions throughout the Code that are applied in specific contexts. Moreover, there 

is no single criterion used to determine whether a business is “small.” Examples of the different 

 

2

 Net gain from the sale of collectibles is taxed at a 28 percent rate, while certain gain 

from the sale or exchange of certain depreciable real estate (i.e., “unrecaptured section 1250 

property”) is taxed at a 25 percent rate.

3

 A corporation with average gross receipts of less than $7.5 million for the prior three 

taxable years is exempt from the corporate minimum tax. The $7.5 million threshold is reduced 

to $5 million for the corporation’s first 3-taxable year period.

4

 The exemption amount is $49,000 in the case of married individuals filing a joint return 

(for taxable years beginning in 2002, 2003, and 2004). The exemption amount is completely 

phased out for married individuals filing a joint return with AMTI in excess of $346,000 and for 

a corporation with AMTI in excess of $310,000.
3

criteria used in the Code include a business’s gross assets,5 gross receipts,6 number of 

shareholders7, or a combination of factors.8

The range of definitions with respect to quantitative limits also is significant. For 

example, a small producer for purposes of certain excise taxes is defined as having gross receipts 

in the previous year of less than $500,000.9 In contrast, the definition of a “small business” for 

purposes of the 50-percent exclusion for gain from the sale of stock in certain small business 

stock is one that at the time of the stock issuance had aggregate gross assets of not more than $50 

million.10

C. Choice of Entity

In general

Owners of a business may conduct their activities as "sole proprietorships," which do not 

involve legal entities separate from the owner. However, for a variety of business or other

reasons, a separate entity may be used to conduct the business. One common reason to use a 

separate entity is the limited liability protection provided by State law to qualifying entities (but 

not sole proprietorships). The choice of entity affects the tax treatment of the entity as well as of 

the investors. As described in detail below, some entities ("C corporations") involve tax at the 

entity and the owner level; other entities ("pass-through entities") generally involve a single level 

of tax at the owner level. 

Corporations 

A corporation is a business entity organized under a Federal or State statute, or under a 

statute of a federally recognized Indian tribe, if the statute describes or refers to the entity as 

incorporated or as a corporation.11 Subchapter C of the Code taxes a corporation as an entity 

separate from its shareholders. Thus, a C corporation's income generally is taxed when earned at 

 

5

 Section 1202(d)(1).

6

 Section 474(c).

7

 Section 1361(b)(1)(A).

8

 Section 44(b) defines an “eligible small business” as any person if either (a) the gross 

receipts for the preceding year did not exceed $1 million or (b) the business did not employ more 

than 30 full-time employees during the preceding year.

9

 Sections 5081(b)(1) and 5801(b)(1).

10 Section 1202(d)(1).

11 Treas. Reg. sec. 301.7701-2(b)(1).
4

the corporate level, and is taxed again when distributed as dividends12 to its shareholders. 

Corporate deductions and credits reduce only corporate income and are not passed through to 

shareholders.

Corporate income that is not distributed to shareholders is subject to current tax at the 

corporate level only. To the extent that income retained at the corporate level is reflected in an 

increased share value, the shareholder may be taxed at favorable capital gains rates upon sale or 

exchange (including certain redemptions) of the stock or upon liquidation of the corporation.13 

Because of the preferential tax treatment of capital gains, certain investors may prefer not to 

receive dividends from a C corporation, but instead may prefer retention of earnings at the 

corporate level so that the value attributable to those earnings may be realized as capital gains on 

the sale or disposition of stock. In addition, foreign investors may be exempt from tax on certain 

capital gains, but are subject to withholding tax on dividends.

An "accumulated earnings tax" can be imposed on certain earnings in excess of $250,000 

($150,000 for certain service corporations in certain fields) accumulated beyond the reasonable 

needs of the business.14 A "personal holding company tax" is imposed on certain undistributed 

personal holding company income, generally where the corporation meets certain closely held 

stock requirements and more than 60 percent of the adjusted ordinary gross income (as defined) 

consists of certain passive-type income such as dividends, interest, and similar items.15

Amounts paid as reasonable compensation to shareholders who are also employees are 

deductible by the corporation, and thus are taxed as ordinary income compensation at the 

individual level. On the other hand, amounts paid as dividends to shareholders generally are not 

deductible by the corporation and are taxed as ordinary income to the shareholders. Thus, there 

is an incentive to pay compensation or other deductible amounts (e.g., rents or royalties) to 

shareholders who also provide services or property to the corporation to reduce or eliminate 

corporate-level tax. To the extent a C corporation is able to establish that amounts paid to 

shareholder-employees do not exceed reasonable compensation for services provided, the 

deduction is permitted. Otherwise, the portion in excess of the amount determined to be 

reasonable compensation is not deductible to the corporation and is treated as a dividend to the 

shareholder. 

 

12 Distributions with respect to stock that exceed corporate earnings and profits are not 

taxed as dividend income to shareholders but are treated as a tax-free return of capital that 

reduces the shareholder’s basis in the stock. Distributions in excess of corporate earnings and 

profits that exceed a shareholder’s basis in the stock are treated as amounts received in exchange 

for the stock and in general are taxed to the shareholder at capital gains rates.

13 If an individual shareholder retains stock until death, the appreciation can pass to the 

heirs free of income tax (sec. 1014).

14 Sections 531-537.

15 Sections 541-547.
5

In general, interest is deductible by a C corporation but dividends are not. Subject to 

non-tax business considerations, this creates a tax incentive favoring debt over equity in a capital 

structure. A common issue in the closely held corporate context is whether instruments 

denominated as debt and issued to persons who are also equity owners (or to other persons) 

should be respected as debt or should be recharacterized as equity. This determination requires 

an examination of the substance of the instrument.

A C corporation may be the entity of choice if a corporation anticipates "going public," 

since publicly traded partnerships are generally taxed as corporations, and S corporations 

(discussed below) are not permitted to have more than 75 shareholders and thus are not suitable 

public offering vehicles.

Partnerships

In general

Partnerships generally are treated for Federal income tax purposes as pass-through 

entities, not subject to tax at the entity level.16 Items of income (including tax-exempt income), 

loss, deduction and credit of the partnership are taken into account in computing the tax of the 

partners (based on the partnership’s method of accounting and regardless of whether the income 

is distributed to the partners). Each partner takes into income his "distributive share" of the 

partnership's taxable income and the separately allocable items of income, gain, loss, deduction, 

and credit.17 A partner's deduction for partnership losses is limited to the amount of the partner's 

adjusted basis in his partnership interest.18 To the extent a loss is not allowed due to a 

limitation, it generally is carried forward to the next year. A partner's basis in his partnership 

interest generally equals the sum of his capital contribution to the partnership, his distributive 

share of partnership income, and his share of partnership liabilities, less his distributive share of 

losses allowed as a deduction and any partnership distributions.19

Partnerships provide partners a significant amount of flexibility to vary their respective 

shares of partnership income. Unlike some other types of pass-through entities, such as an S 

corporation (discussed below), partnerships generally permit a significant amount of flexibility in 

allocating specific tax consequences to particular partners; for example, depreciation deductions 

can be allocated disproportionately to one partner while taxable income (but not current cash 

flow) can be allocated disproportionately to another partner. The Code permits such allocations 

only to the extent they have "substantial economic effect." In general, an allocation is permitted 

 

16 Section 701.

17 Section 702(a).

18 Section 704(d). In addition, “passive loss” and “at-risk” limitations limit the extent to 

which certain types of income can be offset by partnership deductions. These limitations do not 

apply to corporate partners (except certain closely held corporations) and may not be important 

to individual partners who have partner level “passive income” from other investments.

19 Section 705.
6

to the extent the partner to whom the allocation is made receives the economic benefit or bears 

the economic burden of such allocation and the allocation substantially impacts the dollar 

amounts to be received by the partners from the partnership independent of tax consequences. 

Limited liability companies

In recent years, another form of entity--the limited liability company ("LLC")--has 

emerged that provides corporate-like treatment for local law purposes and partnership treatment 

for Federal income tax purposes.20 LLCs are entities organized under State law. They are 

neither partnerships nor corporations under applicable State law, but they generally provide 

limited liability to their owners. An LLC generally affords income tax treatment similar to that 

of a partnership. Under regulations promulgated in 1996, any domestic non-publicly traded 

unincorporated entity with two or more members generally may elect to be treated as either a 

partnership or a corporation for Federal income tax purposes; while any single-member 

unincorporated entity may be disregarded for Federal income tax purposes (i.e., treated as not 

separate from its owner).21 These regulations, known as the "check-the-box" regulations, were a 

response, in part, to the growth of LLCs. The regulations permit a multiple-member LLC to 

elect to be treated as a partnership, and a single-member LLC to be disregarded (or to be taxed as 

a corporation).

S corporations

In many instances, owners of business enterprises may wish to incorporate for nontax 

reasons (e.g., to obtain limited liability or easier access to capital markets), but would prefer not 

to have C corporation tax treatment. Noncorporate tax treatment may be preferred because: (i) 

owners may not wish business earnings to be subject to two levels of tax (once when earned and 

again when distributed); (ii) the average or marginal tax rates for the individual shareholders may 

be lower than that of the corporation; (iii) owners may wish to use losses generated by the 

business to offset income from other sources; and (iv) the owners may not wish tax to be 

imposed under the corporate tax base (which may include items not applicable to individuals). 

Subchapter S of the Code allows certain qualified corporations to elect essentially to be 

relieved from corporate-level taxation and to pass the corporate items of taxable income and loss 

through to the shareholders of the corporation. Thus, a corporation and its shareholders that elect 

subchapter S status (an "S corporation") are generally treated more like a partnership and its 

partners than a C corporation and its shareholders, respectively. In order to make an election to 

be treated as an S corporation, a corporation must meet certain requirements primarily regarding 

its capital structure and the identity of its shareholders.

To be eligible to elect S corporation status, a corporation may not have more than 75 

shareholders and may not have more than one class of stock. Only individuals (other than 

 

20 The first LLC statute was enacted in Wyoming in 1977. All States (and the District of 

Columbia) now have an LLC statute, though their tax treatment for State tax purposes may 

differ.

21 Treas. Reg. sec. 301.7701-3.
7

nonresident aliens), certain tax-exempt organizations, and certain trusts and estates are permitted 

shareholders. A corporation may elect S corporation status only with the consent of all its 

shareholders, and may terminate its election with the consent of shareholders holding more than 

50 percent of the stock.22 Although there are limitations on the types of shareholders and stock 

structure an S corporation may have, there is no limit on the asset size of such a corporation (as 

there is no limit on the size of a C corporation or partnership).

S corporations generally are treated for Federal income tax purposes as pass-through 

entities, not subject to tax at the corporate level.23 Items of income (including tax-exempt 

income), gain, loss, deduction and credit of the corporation are taken into account in computing 

the tax of the shareholders (under the corporation’s method of accounting and regardless of 

whether the income is distributed to the shareholders). A shareholder's deduction for corporate 

losses is limited to the sum of amount of the shareholder's adjusted basis in his stock and in the 

indebtedness of the corporation to such shareholder. To the extent a loss is not allowed due to 

this limitation, the loss generally is carried forward to the next year. The shareholder's basis in 

the S corporation stock (and debt) is reduced by his share of losses and (in the case of stock) by 

distributions; whereas the shareholder's basis in the S corporation stock is increased by his share 

of the corporation's income.24

There are two principal exceptions to the general pass-through treatment of S 

corporations. Both are applicable only if the corporation was previously a C corporation and are 

generally intended to prevent avoidance of otherwise applicable C corporation tax consequences. 

First, an S corporation is subject to tax on excess net passive investment income (but not in 

excess of its taxable income, subject to certain adjustments), if (for less than three consecutive 

years25) the corporation has subchapter C earnings and profits, and has gross receipts more than 

25 percent of which are passive investment income for the year.26 Second, for the first 10 years 

after a corporation that was previously a regular C corporation elects to be an S corporation, 

certain net "built-in" capital gains of the corporation attributable to the period in which it was a C 

corporation are subject to tax at the corporate level.27

In general, a shareholder is not subject to tax on distributions unless the distributions 

exceed the shareholder's basis in the stock of the corporation or the corporation was formerly a C 

 

22 Section 1362. 

23 Sections 1363 and 1366.

24 Section 1367.

25 If the S corporation continues to have C corporation earnings and profits and has gross 

receipts more than 25 percent of which are passive investment income in each year for three 

consecutive years, the S corporation election is automatically terminated.

26 Section 1375.

27 Section 1374.
8

corporation and has undistributed earnings and profits.28 To the extent of such earnings and 

profits, corporate distributions are treated as dividends of C corporations and generally are 

subject to tax as ordinary income in the hands of the shareholders.

Notwithstanding that they both provide for pass-through treatment, there are significant 

Federal tax differences between S corporations and partnerships. For example, corporate 

liabilities (other than those owed to its shareholders) are not included in a shareholder's basis for 

his interest in an S corporation. Thus, unlike a limited partner who can take deductions 

supported by certain partnership indebtedness, S corporation shareholders who wish to obtain 

similar types of deductions are required to individually borrow and contribute or re-lend such 

amounts to the S corporation. Also, S corporations generally may have only one class of stock, 

and thus do not offer the same flexibility as partnerships to allocate income or losses to different 

investors.

 

28 Section 1368.
9

II. ECONOMIC ANALYSIS

A. Data on Small Business and Agriculture

 Figure 1 and Table 1 show data from the Internal Revenue Service's Statistics of Income 

("SOI") regarding the number of tax returns filed by different forms of business organizations 

from 1978 to 1999.29 In these data, farms are measured solely by reference to those taxpayers 

who report income (or loss) on Schedule F of Form 1040. Other taxpayers engaged in 

agricultural enterprises may use a separate entity. When this occurs, the data reported below 

report that entity among the totals of C corporations, S corporations, or partnerships.

Throughout the period 1978 to 1999, nonfarm sole proprietorships made up the vast 

majority of businesses. In 1999, they constituted 66.3 percent of all business entities; over the 22 

years, they were never lower than 58 percent of the total. 

 

29 These data are based upon returns filed by individuals and entities. The numbers 

reported for nonfarm sole proprietorships and for farm returns are based upon the number of 

taxpayers who file a business return as a sole proprietor (Schedule C to Form 1040) and who file 

a farm income return (Schedule F to Form 1040). One taxpayer may report more than one 

business organized as a sole proprietorship; the data reported here count only one sole 

proprietorship. On the other hand, the data for C corporations, S corporations, and partnerships 

count the number of tax returns and information returns filed by C corporations, S corporations, 

and partnerships. One taxpayer may own more than one corporation. When this occurs, unlike 

the case in sole proprietorships, the data reported here count each corporation as a separate 

entity. Thus, the data are not perfectly comparable across entity classification.
10

Figure 1.–Number of Different Types of Business Returns, 1978-1999

0

2,000,000

4,000,000

6,000,000

8,000,000

10,000,000

12,000,000

14,000,000

16,000,000

18,000,000

20,000,000

1978197919801981198219831984198519861987198819891990199119921993199419951996199719981999

Year

Number of Business Entities

Nonfarm sole props

C Corps

S Corps

Partnerships

Farms (Schedule F)
11

Table 1.–Number of Different Types of Business Returns Relative to

All Business Returns, 1978-1999

Year

Sole

Proprietorships

C

Corporations

S

Corporations Partnerships Farms Total

1978 8,908,289 1,898,100 478,679 1,234,157 2,704,794 15,224,019

1979 9,343,603 2,041,887 545,389 1,299,593 2,605,684 15,805,674

1980 9,730,019 2,165,149 545,389 1,379,654 2,608,430 16,428,641

1981 9,584,790 2,270,931 541,489 1,460,502 2,641,254 16,498,966

1982 10,105,515 2,361,714 564,219 1,514,212 2,689,237 17,234,897

1983 10,703,921 2,350,804 648,267 1,541,539 2,710,044 17,954,575

1984 11,262,390 2,469,404 701,339 1,643,581 2,694,420 18,771,134

1985 11,928,573 2,552,470 724,749 1,713,603 2,620,861 19,540,256

1986 12,393,700 2,602,301 826,214 1,702,952 2,524,331 20,049,498

1987 13,091,132 2,484,228 1,127,905 1,648,035 2,420,186 20,771,486

1988 13,679,302 2,305,598 1,257,191 1,654,245 2,367,527 21,263,863

1989 14,297,558 2,204,896 1,422,967 1,635,164 2,359,718 21,920,303

1990 14,782,738 2,141,558 1,575,092 1,553,529 2,321,153 22,374,070

1991 15,180,722 2,105,200 1,696,927 1,515,345 2,290,908 22,789,102

1992 15,495,419 2,083,652 1,785,371 1,484,752 2,288,218 23,137,412

1993 15,848,119 2,063,124 1,901,505 1,467,567 2,272,407 23,552,722

1994 16,153,871 2,318,614 2,023,754 1,493,963 2,242,324 24,232,526

1995 16,423,872 2,321,048 2,153,119 1,580,900 2,219,244 24,698,183

1996 16,955,023 2,326,954 2,304,416 1,654,256 2,188,025 25,428,674

1997 17,176,486 2,257,829 2,452,254 1,758,627 2,160,954 25,806,150

1998 17,398,440 2,260,757 2,588,081 1,855,348 2,091,845 26,194,471

1999 17,575,643 2,210,129 2,725,775 1,936,919 2,067,883 26,516,349

Source: Internal Revenue Service, Statistics of Income, published and unpublished data.
12

Table 2 reports the rate of growth in the number of different types of business entities. 

The growth rate of all entities was greater for the period 1978 to 1988 than for the period 1988 to 

1999. The number of farm returns generally declined through the 22-year period. While the 

relative share of nonfarm sole proprietorships increased after 1986, the growth rate in their 

numbers did not rise from that of earlier periods and has in fact slowed in the 1990s. The 

increase in the relative share of nonfarm sole proprietorships is an artifact of the decline in the 

absolute number of partnerships and C corporations following the Tax Reform Act of 1986. The 

number of each of those forms has declined in each year from 1987 through 1993. At the same 

time, the number of S corporations increased threefold between 1986 and 1999. The growth in 

the number of S corporations was most dramatic immediately following 1986; in the past few 

years, growth rates have returned to the range of pre-1986 growth rates. The number of S 

corporations also grew rapidly following the Subchapter S Revision Act of 1982.30

Table 2.–Average Annual Rate of Growth in Business Entities

(percent)

Business 1978-1988 1988-1999 1978-1999

Nonfarm sole proprietorship 4.4 2.3 3.3

C corporation 4.1 -4.2 0.7

S corporation 10.1 7.3 8.6

Partnerships 3.0 1.4 2.2

Farms (Schedule F) -1.3 -1.2 -1.3

Total 3.7 1.5 2.7

Source: Joint Committee on Taxation staff calculations.

 

30 For details on the changes in S corporation law over the 1980's, see Part II.C. of Joint 

Committee on Taxation, Present Law and Proposals Relating to Subchapter S Corporations and 

Home Office Deductions (JCS-16-95), May 24, 1995. For a description of the changes made in S 

corporation law part of the Small Business Job Protection Act of 1996 see, Joint Committee on 

Taxation, General Explanation of Tax Legislation Enacted in the 104th Congress (JCS-12-96), 

December 18, 1996.
13

As a consequence of the changing rates of growth of different forms of business entities, 

the distribution of different types of business has changed since 1978, with sole proprietorships 

and S corporations growing in relative shares of business entities and farms and C corporations 

declining in relative shares. Figure 2, Figure 3, and Figure 4 below, display the percentage 

distribution of different types of business returns for 1978, 1988, and 1999.

Figure 2.–Percentage Distribution of Different

Types of Business Returns, 1978

Nonfarm sole props

59%

Farms (Schedule F)

18%

Partnerships

8%

S Corps

3%

C Corps

12%
14

Figure 3.–Percentage Distribution of Different Types of

Business Returns, 1988

Nonfarm sole props

64%

Partnerships

8%

Farms (Schedule F)

11%

C Corps

11%

S Corps

6%
15

Figure 4.–Percentage Distribution of Different Types of

Business Returns, 1999

Nonfarm sole props

67%

Partnerships

7%

Farms (Schedule F)

8%

C Corps

8%

S Corps

10%
16

The use of the limited liability company (“LLC”) as an entity is a development of the past 

several years. Most LLCs filed the partnership reporting form for Federal reporting purposes 

and their numbers, assets, and gross receipts are counted among the partnership data reported in 

Table 1 and Table 2 and Figure 1, Figure 2, Figure 3, and Figure 4, above. Table 3 and Figure 5, 

below, decompose the number of partnerships for the period 1989 through 1999 into general 

partnerships, limited partnerships, and LLCs.31 Figure 5 documents the rapid growth of LLCs 

relative to other partnership forms over the past several years.

Table 3.–Number of Partnership Returns by Type, 1989-1999

Type of Partnership

Year

General

Partnerships

(thousands)

Limited

Partnerships

(thousands)

Limited Liability

Companies

(thousands)

1989 1,341 294 n.a.

1990 1,267 285 n.a.

1991 1,245 271 n.a.

1992 1,214 271 n.a.

1993 1,176 275 17

1994 1,163 283 48

1995 1,167 295 119

1996 1,116 311 221

1997 1,069 329 349

1998 945 343 470

1999 898 354 589

n.a. - not available.

Source: Alan Zempel and Tim Wheeler, “Partnership Returns, 1999,” SOI Bulletin, 21, Fall 2001.

 

31 The data in Table 3 may not sum to the total number of partnerships reported in Table 

1 because of rounding and because, for 1996 through 1999, Table 3 does not include those 

businesses that checked either the “limited liability partnership” box or the “other” box on Form 

1065, Schedule B, line 1. See, Alan Zempel and Tim Wheeler, “Partnership Returns, 1999,” SOI 

Bulletin, 21, Fall 2001.
17

Figure 5.–Partnership Returns by Type of Partnership, 1990-1998

It is important to recognize that in any given year a substantial number of business 

enterprises report a loss. Figure 6, below, reports for 1997 the percentage of businesses by type 

of entity that reported net income.

0

200

400

600

800

1000

1200

1400

1990 1991 1992 1993 1994 1995 1996 1997 1998

Year

Thousands

General Partnership

Limited Partnership

Limited Liability

Companies
18

Figure 6.–Percentage of Businesses with Net Income, 1997

Sole

Proreitorships

C

Corporations

S

Corporations Partnerships Farms

All

Business

Entities

0.0%

10.0%

20.0%

30.0%

40.0%

50.0%

60.0%

70.0%

80.0%

Source: IRS Statistics of Income data Appendix Table A-1.

74.0%

48.4%

63.4% 62.1%

33.4%

66.5%
19

While one may often associate small businesses with organization in the form of a sole 

proprietorship, a partnership, or an S corporation, there is not an ironclad correspondence 

between the size of the business and the form of organization. While many small businesses are 

arranged as a sole proprietorship, a partnership, or an S corporation, not all businesses organized 

in those forms are small and not all businesses organized as C corporations are large. One can 

use SOI data on assets and gross receipts to measure the size of businesses in order to sort out 

how small businesses are arrayed across the different forms of organization.

Table 4, Table 5, Table 6, and Table 7 display 1999 SOI data on C corporations, S 

corporations, partnerships, and nonfarm sole proprietorships. For the first three forms of

organization, the tables classify all taxpayers using that form of organization both by the size of 

assets and gross receipts. For sole proprietorships (Table 7), there is no tax data on assets, so the 

table uses only gross receipts as a classifier. When businesses are classified by asset size, one 

can see that there are a significant number of C corporations of small size. More than 700,000 

corporations have assets under $50,000, approximately 40 percent of the total number of C 

corporations. For both S corporations and partnerships, approximately one half have assets 

under $50,000. 

The concentration of assets differs among the three forms. C corporations have the 

largest disparity in asset holding. Firms with over $100 million in assets, which represent eight 

tenths of one percent of all C corporations, hold 95 percent of the assets in C corporations. By 

comparison, a nearly similar share of partnership returns (those with assets over $50 million) 

holds just under 68 percent of the assets in partnerships and a similar share of S corporation 

returns (those with assets over $10 million) hold 48 percent of S corporations assets.

When businesses are classified by gross receipts, a picture emerges that is similar to that 

seen in the asset data. There are a substantial number of quite small C corporations (more than 

400,000 corporations with gross receipts less than $25,000, nearly 22 percent of the number of C 

corporations). But across the other forms of organization there are higher percentages of 

businesses with small amounts of gross receipts. For nonfarm sole proprietorships, two thirds 

have gross receipts under $25,000, while for partnerships there are 71 percent, and for S 

corporations there are 26 percent.

As with assets, the dispersion of gross receipts across the classifrications is more skewed 

for C corporations and partnerships than for S corporations. C corporations with over $50 

million in gross receipts, which represent approximately eight tenths of one percent of all C 

corporations, collect over 80 percent of gross receipts of all C corporations. For partnerships, 

approximately the eight tenths of one percent of partnership returns with gross receipts in excess 

of $10 million report nearly 78 percent of all partnership gross receipts. On the other hand, the 

two percent of S corporation returns reporting gross receipts in excess of $10 million account for 

55 percent of all S corporation gross receipts. For nonfarm sole proprietorships, the 1.5 percent 

of returns reporting gross receipts in excess of $500,000 account for 36 percent of all nonfarm 

sole proprietorship gross receipts.
20

Table 4.–Distribution of C Corporations, 1999

Firms classified by Number of Total assets Total

assets less than returns (millions) Returns Assets

$0 130,728 0 5.91% 0.00%

$25,000 506,544 4,547 28.83% 0.01%

$50,000 239,523 8,750 39.67% 0.03%

$100,000 273,421 19,871 52.04% 0.08%

$250,000 372,024 60,877 68.88% 0.24%

$500,000 243,238 86,506 79.88% 0.45%

$1,000,000 171,648 120,366 87.65% 0.76%

$10,000,000 217,748 596,493 97.50% 2.25%

$50,000,000 30,039 662,085 98.86% 3.91%

$100,000,000 7,562 539,995 99.20% 5.27%

Over $100,000,000 17,654 37,735,971 100.00% 100.00%

 Total 2,210,129 39,835,461

Firms classified by Number of Gross receipts Gross

revenues less than returns (millions) Returns receipts

$0 230,559 0 10.43% 0.00%

$2,500 60,228 53 13.16% 0.00%

$5,000 32,082 120 14.61% 0.00%

$10,000 47,010 339 16.74% 0.00%

$25,000 107,488 1,846 21.60% 0.02%

$50,000 124,999 4,607 27.25% 0.05%

$100,000 195,495 14,439 36.10% 0.15%

$250,000 343,413 56,654 51.64% 0.55%

$500,000 305,191 110,787 65.45% 1.32%

$1,000,000 264,560 189,018 77.42% 2.64%

$10,000,000 429,038 1,222,229 96.83% 11.18%

$50,000,000 52,889 1,083,944 99.22% 18.75%

Over $50,000,000 17,177 11,631,533 100.00% 100.00%

 Total 2,210,129 14,315,569

Source: JCT calculation from Statistics of Income data.

Cummulative percent

Cummulative percent

All returns

All returns
21

Table 5.–Distribution of S Corporation, 1999

Firms classified by Number of Total assets Total

assets less than returns (millions) Returns Assets

$0 182,275 0 6.69% 0.00%

$25,000 857,446 7,604 38.14% 0.47%

$50,000 330,062 12,111 50.25% 1.21%

$100,000 325,702 23,235 62.20% 2.64%

$250,000 419,501 68,141 77.59% 6.82%

$500,000 234,689 82,614 86.20% 11.89%

$1,000,000 159,112 110,655 92.04% 18.69%

$10,000,000 195,555 539,704 99.21% 51.82%

$50,000,000 18,541 355,498 99.89% 73.65%

$100,000,000 1,717 118,143 99.96% 80.91%

Over $100,000,000 1,175 310,987 100.00% 100.00%

 Total 2,725,775 1,628,692

Firms classified by Number of Gross receipts Gross

revenues less than returns (millions) Returns receipts

$0 393,817 0 14.45% 0.00%

$2,500 70,789 76 17.04% 0.00%

$5,000 52,032 196 18.95% 0.01%

$10,000 66,795 490 21.40% 0.02%

$25,000 133,120 2,243 26.29% 0.09%

$50,000 170,284 6,315 32.54% 0.29%

$100,000 289,867 21,377 43.17% 0.94%

$250,000 480,583 79,755 60.80% 3.40%

$500,000 371,065 132,347 74.41% 7.47%

$1,000,000 281,359 198,730 84.74% 13.58%

$10,000,000 362,855 1,004,270 98.05% 44.47%

$50,000,000 45,750 929,214 99.73% 73.05%

Over $50,000,000 7,459 876,377 100.00% 100.00%

 Total 2,725,775 3,251,390

Source: JCT calculation from Statistics of Income data.

Cummulative percent

All returns

Cummulative percent

All returns
22

Table 6.–Distribution of Partnerships, 1999

Firms classified by Number of Total assets Total

assets less than returns (millions) Returns Assets

$0 572,760 0 29.57% 0.00%

$25,000 220,530 2,014 40.96% 0.03%

$50,000 93,307 3,413 45.77% 0.09%

$100,000 135,420 9,829 52.77% 0.25%

$250,000 216,364 35,725 63.94% 0.84%

$500,000 175,806 63,755 73.01% 1.90%

$1,000,000 175,188 124,118 82.06% 3.95%

$10,000,000 296,271 865,193 97.35% 18.25%

$50,000,000 38,943 793,572 99.36% 31.37%

$100,000,000 5,646 393,886 99.65% 37.88%

Over $100,000,000 6,684 3,758,112 100.00% 100.00%

 Total 1,936,919 6,049,617

Firms classified by Number of Gross receipts Gross

revenues less than returns (millions) Returns receipts

$0 0 0 0.00% 0.00%

$2,500 1,258,080 45 64.95% 0.00%

$5,000 27,495 98 66.37% 0.01%

$10,000 34,206 251 68.14% 0.02%

$25,000 57,058 968 71.08% 0.08%

$50,000 66,280 2,469 74.51% 0.23%

$100,000 91,326 6,777 79.22% 0.65%

$250,000 137,109 22,216 86.30% 2.00%

$500,000 92,558 33,296 91.08% 4.03%

$1,000,000 67,362 47,564 94.56% 6.93%

$10,000,000 90,228 249,379 99.21% 22.15%

$50,000,000 11,597 242,561 99.81% 36.94%

Over $50,000,000 3,620 1,033,752 100.00% 100.00%

 Total 1,936,919 1,639,376

Source: JCT calculation from Statistics of Income data.

Cummulative percent

All returns

Cummulative percent

All returns
23

Table 7.–Distribution of NonFarm Sole Proprietorships, 1999

An alternative way of characterizing business size is by the number of employees. The 

Small Business Administration (“SBA”) utilizes Department of Labor employment data to 

classify business entities by size. The SBA defines a firm as a small business if it employs fewer 

than 500 employees. Table 8 and Table 9 below present data compiled by the SBA from surveys 

in 1999 by the Bureau of the Census. The SBA estimates that in 1999 there were approximately 

5.6 million firms in the United States employing 111 million persons.32 The SBA estimates that 

more than 99 percent of the firms in the United States are small business and that these small 

businesses employ slightly more than 50 percent of the individuals employed in the private 

sector. Thus, oppositely, a relatively small number of businesses (the large businesses) employ a 

large percentage of the private sector workforce. This finding is consistent with the data reported 

in Table 4, Table 5, Table 6, and Table 7 that show that a large percentage of assets are held 

(gross receipts are received) by a relatively small number of businesses characterized by a high 

level of gross assets (gross receipts).

The majority of small business and the majority of small business employment are in the 

retail trade and service sectors. In 1999, these two sectors accounted for 61.5 percent of the 

small businesses in the United States and 59.8 percent of the small business employment. Table 

 

32 U.S. Small Business Administration, Office of Advocacy, “Statistics of U.S. 

Businesses: Firm Size Data,” http://www.sba.gov/advo/stats/data.html, May 2002.

Firms classified by Number of Gross receipts Gross

revenues less than returns (millions) Returns receipts

$0 0 0 0.00% 0.00%

$2,500 4,437,464 4,244 25.25% 0.44%

$5,000 1,957,465 7,091 36.39% 1.18%

$10,000 2,323,041 16,852 49.60% 2.94%

$25,000 3,177,383 51,392 67.68% 8.31%

$50,000 2,191,093 77,987 80.15% 16.45%

$100,000 1,540,835 109,075 88.91% 27.84%

$250,000 1,231,961 190,032 95.92% 47.68%

$500,000 450,758 155,378 98.49% 63.91%

$1,000,000 181,039 122,461 99.52% 76.69%

$10,000,000 83,139 157,901 99.99% 93.18%

$50,000,000 1,285 23,811 100.00% 95.67%

Over $50,000,000 180 41,488 100.00% 100.00%

 Total 17,575,643 957,712

Source: JCT calculation from Statistics of Income data.

Cummulative percent

All returns
24

8 below presents the percentage distribution of small business firms and the percentage 

distribution of small business employment across various sectors of the United States’s economy 

for 1999. 

Table 8.–Percentage Distribution of Small Business Firms

and Employment by Sector, 1999

Percent of all small 

business firms

Percent of all small 

business employees

Agriculture, Forestry, Fishing, and Hunting 0.5 0.3

Mining................................................ 0.3 0.4

Utilities and Information................................ 1.5 1.8

Construction................................................... 12.4 9.7

Manufacturing................................................ 5.5 12.3

Wholesale Trade ............................................ 6.4 6.9

Retail Trade.................................................... 13.0 11.5

Transportation and Warehousing................... 2.8 2.7

Finance and Insurance.................................... 4.0 3.4

Real Estate and Rental and Leasing............... 4.0 2.4

Services.......................................................... 48.5 48.3

Other .............................................................. 1.8 0.3

Source: U.S. Small Business Administration, Office of Advocacy, “Statistics of U.S. Businesses: Firm Size Data,” 

http://www.sba.gov/advo/stats/data.html, May 2002.

Table 9 reports within each sector the percentage distribution of firms and employment 

distributed by firm size. These data show the majority of employment is provided by small 

businesses in the agriculture, forestry, fishing, and hunting, construction; public utilities and 

information technology; wholesale trade; real estate, rental and leasing; and service sectors. 

Large firms provide the majority of employment in the mining, manufacturing; transportation, 

retail trade; and finance and insurance sectors. In every sector except agriculture, construction, 

and services, firms employing 100 or more employees provide a majority of the employment.

The data in Table 8 and Table 9 are not comparable to the tax return data reported 

previously. These data are drawn from employment reports for one week in March 1999. They 

do not include any farming enterprises. They do not include any enterprise that routinely has no 

employees. Hence, the majority of nonfarm sole proprietorships are not included. Similarly, 

partnerships with no employees would not be included. Table 9 does, however, report a 

significant number of firms with no employees. These data may arise from firms for which 

employment is seasonal, firms that are in the process of starting business operations, or firms that 

are in the process of ceasing business operations. 
25

Table 9.–Percentage Distribution of Number of Firms and Employment

by Size of Firm and Industry, 1999

Percentage Distribution by Firm Size

Industry Total

Employing

0

Employing

1-19

Employing

20-99

Employing

100-499

Employing

500 or more

Agriculture Forestry, and Fishing, and Hunting

Firms

Employees

26,259

192,155

16.8%

0.0%

76.8%

46.6%

5.1%

24.4%

0.9%

13.9%

0.4%

15.2%

Mining

Firms

Employees

18,828

456,645

10.6%

0.0%

74.3%

14.0%

10.9%

16.3%

2.4%

12.6%

1.8%

57.1%

Utilities and Information

Firms

Employees

83,715

3,901,592

0.6%

0.0%

5.8%

0.5%

1.0%

1.0%

0.3%

1.1%

0.3%

14.5%

Construction

Firms

Employees

691,490

6,201,626

14.5%

0.0%

76.9%

39.8%

7.6%

31.9%

0.9%

15.9%

0.1%

12.5%

Manufacturing

Firms

Employees

311,902

16,659,930

7.4%

0.0%

65.2%

7.7%

20.7%

16.0%

5.2%

17.4%

1.5%

58.9%

Transportation and Warehousing

Firms

Employees

155,170

3,627,057

14.1%

0.0%

73.8%

14.2%

9.6%

15.7%

1.8%

12.1%

0.7%

58.0%

Wholesale Trade

Firms

Employees

358,564

5,972,022

9.9%

0.0%

75.5%

22.9%

11.5%

25.0%

2.2%

16.2%

0.9%

35.8%

Retail Trade

Firms

Employees

730,303

14,476,628

10.5%

0.0%

79.7%

20.1%

8.3%

15.4%

1.2%

8.6%

0.3%

55.9%

Finance and Insurance

Firms

Employee

223,535

5,965,174

10.8%

0.0%

79.9%

11.5%

6.9%

10.3%

1.6%

10.3%

0.7%

67.9%

Real Estate and Rental and Leasing

Firms

Employee

242,838

1,873,792

13.6%

0.0%

80.6%

36.9%

4.3%

19.5%

0.9%

14.2%

0.5%

29.4%

Services

Firms

Employee

2,729,181

50,313,454

3.5%

0.0%

18.9%

4.0%

1.3%

2.6%

0.2%

1.7%

0.1%

4.5%

Other

Firms

Employee

103,473

1,065,586

56.2%

0.0%

38.3%

n.a.

0.2%

0.6%

0.0%

n.a.

0.0%

0.0%

Source: U.S. Small Business Administration, Office of Advocacy, “Statistics of U.S. Businesses: Firm Size Data,” 

http://www.sba.gov/advo/stats/data.html, May 2002.
26

B. Background and Discussion of Issues Related to the Federal Minimum Wage

1. History of the Federal Minimum Wage

The present Federal minimum wage is $5.15 cents per hour.33 In general, the Federal 

minimum wage applies to employees of enterprises that have at least $500,000 worth of sales per 

year. It also applies to employees of smaller firms if the employees are engaged in interstate 

commerce or in the production of goods for commerce, such as employees who work in 

transportation or communications or who regularly use the mail or telephones for interstate 

communications. It also applies to employees of Federal, State, and local government agencies, 

hospitals and schools, and it generally applies to domestic workers.

Congress first established a minimum wage in 1938 as part of the Fair Labor Standards 

Act of 1938 (“FLSA”). When enacted in 1938, the Federal minimum wage applied to a smaller 

universe of employees than it does today. At its inception, the Federal minimum wage applied 

only to employees engaged in interstate commerce or in the production of goods for interstate 

commerce. In 1949, Congress expanded the scope of coverage to include employees in the air 

transport industry. Amendments to the FLSA in 1961 brought employees in the retail trade 

sector within the ambit of the Federal minimum wage. Amendments in 1966 extended coverage 

to public schools, nursing homes, laundries and dry cleaners, the construction industry, large 

hotels, motels, and restaurants, and certain farm employees. In 1974, Congress included all nonsupervisory employees of Federal, State, and local governments and many domestic workers.

The FLSA set a minimum wage of $0.25 per hour for 1938 with a scheduled increase to 

$0.30 for 1939. The Congress has increased the Federal minimum wage numerous times over 

the past 63 years. Figure 7, below, shows how the value of the Federal minimum wage has 

changed since 1938. Figure 7 also shows the value of the minimum wage in the past in terms of 

2001 dollars. Since 1997, the real, inflation adjusted, value of the minimum wage has eroded as 

there has been modest inflation and no change in the minimum wage. The real value of the 

current minimum wage is greater than that which prevailed from 1938 through 1955 and that 

which prevailed from 1988 through 1995, but less than that which prevailed from 1956 through 

1987.34

 

33 For newly hired employees under age 20, a youth sub-minimum wage of $4.25 per 

hour prevails during the employee’s first 90 calendar days of employment. In addition, certain 

other employees whose employer is otherwise subject to the Federal minimum wage may be paid 

less than $5.15 per hour. Among these employees are student-learners (e.g., vocational 

education students) and full-time students in retail or service establishments, agriculture, or 

institutions of higher education. An employer may consider tips as part of wages for “tipped 

employees” and pay tipped employees no less than $2.13 per hour in direct wages. “Tipped 

employees” are employees who regularly receive more than $30 per month in tips.

34 Since these data do not take into account non-wage compensation, such as health 

benefits, these data do not necessarily reflect the relative value of total compensation for 

minimum wage workers over time. 
27

Figure 7.–Minimum Wage in Current and Constant Dollars

Source: Department of Labor, Bureau of Labor Statistics, and calculations of the Staff of the Joint Committee on 

Taxation.

$0.0

$1.0

$2.0

$3.0

$4.0

$5.0

$6.0

$7.0

$8.0

$9.0

193819401942194419461948195019521954195619581960196219641966196819701972197419761978198019821984198619881990199219941996199820002002

Year

Dollars Per Hour

Federal Minimum Wage

(current dollars)

Federal Minimum Wage 

(2001 dollars)
28

The 2001 value of past levels of the minimum wage assesses the purchasing power of the 

minimum wage. An alternative assessment of the value of the minimum wage is to compare the 

level of the minimum wage to the average value of other wages in the economy. Figure 8, 

below, plots the value of the minimum wage and the value of the average hourly earnings of 

production workers annually for the period 1947 through 2001. For 2001, the value of the 

minimum wage was 36 percent of average hourly earnings. Between 1974 and 2001, the value 

of the minimum wage compared to average hourly earnings of production workers has varied 

between 31 and 56 percent. While showing the relative rates of pay of employees receiving the 

minimum wage and average hourly earnings of production workers, may not accurately reflect 

the relative total compensation of employees receiving the minimum wage and average hourly 

earnings of production workers. Employees receiving the minimum wage are less likely to 

receive other forms of compensation such as pension coverage or employer provided medical 

benefits. In general, non-wage compensation constitutes a large and growing share of total 

compensation in the United States. Thus, while showing the relative value of cash wages 

between an employee receiving the minimum wage and the average production worker, will not 

accurately reflect the relative economic well being of an employee receiving the minimum wage 

and the average production worker. 
29

Figure 8.–Federal Minimum Wage Versus Average Hourly

Earnings of Production Workers

Source: Department of Labor, Bureau of Labor Statistics.

The Bureau of Labor Statistics has estimated that approximately 72.5 million employees 

were paid at hourly rates in 2001. Approximately 2.2 million, or 3.1 percent, of these employees 

0

2

4

6

8

10

12

14

16

1938194119441947195019531956195919621965196819711974197719801983198619891992199519982001

Year

Dollars Per Hour

Average Hourly Earnings of

Production Workers

Federal Minimum 

Wage
30

were paid at or below35 the prevailing Federal minimum wage. Table 10, below, reproduces 

Bureau of Labor Statistics estimates of the number of employees paid at hourly rates in 2001 by 

age, sex, race, and by whether the employee was full-time or part-time. The data reveal that 

while 23 percent of workers paid at hourly rates were age 24 or younger, 54 percent of 

employees paid the minimum wage were age 24 or younger. A higher percentage of hourly 

female employees were paid the minimum wage compared to male employees (4.0 percent for 

women, 2.2 percent for men). The incidence of employees paid the minimum wage was nearly 

identical by race. Among whites, 3.1 of hourly paid employees were paid the minimum wage. 

The comparable percentages were 3.0 percent for black hourly paid employees and 3.0 percent 

for Hispanic hourly paid employees. 

Table 10 also documents that while 24 percent of all workers paid at hourly rates were 

part-time workers in 2001, 62 percent of those workers paid the minimum wage were part-time 

workers. The predominance of part-time workers among all employees paid at the minimum 

wage does not mean that part-time work most often leads to minimum wage employment. 

Indeed, part-time workers paid at the minimum wage comprised 8.0 percent of all part-time 

workers. Among part-time workers, men were somewhat more likely to be paid at the minimum 

wage than were women. Of all male part-time workers, 8.3 percent were paid at the minimum 

wage compared to 7.9 percent for women.

 

35 The data reported here and in Table 10 and Table 11, below, are from the U.S. 

Department of Labor, Bureau of Labor Statistics. These data are for wage workers, excluding 

the incorporated self-employed. The Bureau of Labor Statistics prepared the estimates from 

surveys. The data refer to a person’s earnings on their sole or principal job, and pertain only to 

workers who are paid hourly rates. Salaried workers and other non-hourly workers are not 

included. The presence of workers with hourly earnings below the minimum wage does not 

necessarily indicate violations of the FLSA as there are exceptions to the minimum wage 

provisions of the law. In addition, some survey respondents might have rounded hourly earnings 

to the nearest dollar, and, as a result, reported hourly earnings below the minimum wage even 

though they earned the minimum wage or higher.
31

Table 10.–Wage and Salary Workers Paid Hourly Rates with Earnings at or Below

the Prevailing Federal Minimum Wage by Selected Characteristics

(numbers in thousands)

2001

Workers paid hourly rates

Total at or below prevailing 

Federal minimum wage

Characteristic Total Number

Percent of 

hourly-paid 

workers

SEX AND AGE

Total, 16 years and over ................................................................. 72,486 2,238 3.1

16 to 24 years.......................................................................... 16,602 1,206 7.3

25 years and over .................................................................... 55,884 1,032 1.8

Men, 16 years and over .................................................................. 36,029 784 2.2

16 to 24 years.......................................................................... 8,491 473 5.6

25 years and over .................................................................... 27,538 311 1.1

Women, 16 years and over............................................................. 36,457 1,454 4.0

16 to 24 years.......................................................................... 8,111 733 9.0

25 years and over .................................................................... 28,346 721 2.5

RACE, HISPANIC ORIGIN

White, 16 years and over................................................................ 59,152 1,861 3.1

Black, 16 years and over ................................................................ 10,014 297 3.0

Hispanic origin, 16 years and over................................................. 10,030 302 3.0

FULL- AND PART-TIME STATUS

Full-time workers........................................................................... 55,232 853 1.5

Part-time workers........................................................................... 17,124 1,378 8.0

Source: Department of Labor, Bureau of Statistics.

Table 11, below, reproduces Bureau of Labor Statistics estimates of the number of 

employees paid at hourly rates in 2001 by industry. Of the 2.2 million employees paid at the 

minimum wage in 2001, approximately 1.1 million (48 percent) are employed in eating and 

drinking establishments. Workers paid at the minimum wage constitute 20 percent of all hourly 

paid workers in eating and drinking establishments. Among other retail trades approximately 2.6 

percent of employees are paid at the minimum wage. These other retail employees paid at the 

minimum wage account for nearly 12 percent of all employees paid at the minimum wage. After 

retailing, service industries account for the largest percentage of employees paid at the minimum 
32

wage, as nearly 24 percent of all employees paid at the minimum wage are in service industries. 

However, these employees comprise only 2.7 percent of all service industry employees.

Table 11.–Wage and Salary Workers Paid Hourly Rates with Earnings at or Below

the Prevailing Federal Minimum Wage by Industry

(numbers in thousands)

2001

Workers paid hourly rates

Total at or below prevailing 

Federal minimum wage

Characteristic

Total Number

Percent of 

hourly-paid 

workers

INDUSTRY

Private wage and salary workers.................................................... 63,520 2,100 3.3

Agriculture.............................................................................. 1,107 44 4.0

Nonagricultural industries....................................................... 62,413 2,056 3.3

Mining ............................................................................. 317 1 .2

Construction..................................................................... 5,066 28 .6

Manufacturing ................................................................. 12,006 84 .7

Durable goods........................................................... 7,384 31 .4

Nondurable goods..................................................... 4,623 52 1.1

Transportation and public utilities................................... 4,211 32 .8

Transportation .......................................................... 2,618 21 .8

Communications and other public utilities............... 1,593 11 .7

Wholesale and retail trade ............................................... 17,941 1,356 7.6

Wholesale trade........................................................ 2,250 16 .7

Retail trade ............................................................... 15,691 1,340 8.5

Eating and drinking places................................ 5,384 1,077 20.0

Finance, insurance, and real estate .................................. 2,988 23 .8

Services............................................................................ 19,883 532 2.7

Private households.................................................... 421 70 16.6

Other service industries............................................ 19,462 462 2.4

Personal services, except private households.... 1,848 101 5.5

Entertainment and recreation services .............. 1,288 87 6.8

Government workers...................................................................... 8,966 138 1.5

Federal.................................................................................... 1,823 17 .9

State ........................................................................................ 2,391 45 1.9

Local....................................................................................... 4,752 76 1.6

Source: Department of Labor, Bureau of Statistics.
33

2. The Minimum Wage and Employment

Economists have long argued that the imposition of a minimum wage above the 

prevailing wage rate paid in the market place will reduce employment, particularly among young 

and unskilled workers. This conclusion rests on the observation that the market for lower-wage 

jobs is competitive. That is, there are many potential employers and employees and lower-wage 

jobs are generally homogeneous. Under these conditions employers seeking to maximize their 

profits demand more low-skilled workers when wages are low than when wages are high. That 

is, the demand curve for low-skilled labor is downward sloping. Individuals are more willing to 

offer themselves to potential employers, or are willing to work more hours, if wages are high 

than if wages are low. That is, the supply curve for low-skilled labor is upward sloping. A 

minimum wage imposed above the market equilibrium wage level determined by the intersection 

of demand and supply creates “unemployment” by two effects. First, because the minimum 

wage is higher than the market equilibrium wage, employers will reduce their demand for 

workers in response to the wage increase. Second, because the minimum wage is higher than the 

market equilibrium wage, more individuals will offer themselves to potential employers, that is, 

the supply of labor increases. As the supply of labor increases while the demand for labor 

decreases, unemployment results. The “unemployment” can manifest itself in several ways. 

Some of those who were employed at the prevailing market wage prior to the imposition of the 

higher minimum wage could lose their jobs. Alternatively, workers paid the minimum wage 

may remain employed but work fewer hours. In a growing economy, new jobs may not be 

created.36

Economists also have undertaken many empirical studies attempting to measure whether, 

and to what extent, changes in the minimum wage lead to unemployment. Until the last ten 

years, one could summarize the empirical analyses as concluding that a 10 percent increase in the 

minimum wage resulted in a one to three percent reduction in employment among low-skilled 

workers, such as teenagers.37 Aggregate data generally were the basis for these conclusions. A 

widely cited 1994 study restricted its analysis to 410 fast food restaurants in New Jersey and 

Pennsylvania to assess the effects of an increase in New Jersey’s minimum wage. That study 

found that employment increased after the imposition of the higher minimum wage.38 However, 

 

36 In theory, if the labor market for unskilled labor is not competitive, an increase in the 

minimum wage could lead to an increase in employment. Madeline Zavodny, “Why Minimum 

Wage Hikes May Not Reduce Employment,” Economic Review, Second Quarter 1998, Federal 

Reserve Bank of Atlanta, provides a clear exposition of the case of a monopsonistic (one buyer) 

labor market. 

37 For critical reviews of the empirical literature relating to minimum wages see David 

Card and Alan B. Krueger, Myth and Measurement: The New Economics of the Minimum Wage, 

(Princeton, N.J.: Princeton University Press), 1995, and David Neumark, Mark Schweitzer, and 

William Wascher, “The Effects of Minimum Wages Throughout the Wage Distribution,” 

National Bureau of Economic Research working paper #7519, February, 2000.

38 David Card and Alan B. Krueger, “Minimum Wages and Employment: A Case Study 

of the Fast-Food Industry in New Jersey and Pennsylvania,” American Economic Review, 84, 

September 1994, pp. 772-793. Card and Krueger also summarize the results of several other 
34

others have criticized that study’s methodology and results. A recent study using payroll data, 

rather than a survey approach, covering many, but not all, of the establishments of the original 

study found that an increase in New Jersey’s minimum wage resulted in a decrease in 

employment at the fast food establishments in the range of 1.0 to 2.5 percent for each 10 percent 

of the increase in the minimum wage.39 Yet further re-examination of Pennsylvania and New 

Jersey fast food restaurants utilizing a third data source suggests no negative employment 

effects.40 In short, the academic battle rages.

The reason why it may be difficult to disentangle the employment effects of a change in 

the minimum wage is that a change in the minimum wage may have effects beyond those 

employees whose wages are directly affected. If employers initially respond to an increase in the 

minimum wage by reducing employment it will likely result in reductions in the production of 

goods and services. A reduction in the supply of goods generally causes prices to rise. An 

increase in prices ameliorates the decline in employment, but would be unlikely to completely 

counteract it. 

An increase in the price of low-skilled labor could lead to a change in the composition of 

firms’ labor force, increasing the demand and employment of more skilled workers while 

reducing the employment of less skilled workers. An increase in the minimum wage would 

make the cost of low-skilled labor rise compared to higher-skilled labor. To maintain production 

while keeping costs from rising, firms may make greater use of higher-skilled labor. Such a 

possibility could result in an indeterminate change in total employment, although low-skilled 

employees would lose their employment or be employed for fewer hours.

3. The Minimum Wage and Poverty

Advocates of increasing the minimum wage see the minimum wage as an anti-poverty 

tool. While a family of five with two workers working full time at the minimum wage would 

have an income sufficient to exceed the poverty level by a few hundred dollars, a family with 

two children and with a full time minimum wage worker and a half-time minimum wage worker 

would have an income that was almost two thousand dollars below the poverty level. Increased 

income from a higher wage would benefit such a family. However, the minimum wage may not 

be a very efficient anti-poverty tool. As discussed above, increases in the minimum wage may 

 

studies that likewise compared affected establishments with unaffected establishments and failed 

to detect negative employment effects from increases in the applicable minimum wage.

39 David Neumark and William Wascher, “Minimum Wages and Employment: A Case 

Study of the Fast-Food Industry in New Jersey and Pennsylvania: Comment,” American 

Economic Review, 90, December 2000, pp. 1362-1396. 

40 David Card and Alan B. Krueger, “Minimum Wages and Employment: A Case Study 

of the Fast-Food Industry in New Jersey and Pennsylvania: Reply,” American Economic 

Review, 90, December 2000, pp. 1397-1420. In this study, Card and Krueger suggest that certain 

non-randomness in the compilation of Neumark and Wascher’s data may have biased their 

findings towards a negative employment effect.
35

result in some low-wage workers losing their jobs or working reduced hours. With such an 

outcome, the gains against poverty of some come at the expense of lower incomes of others. 

Furthermore, as discussed above, an increase in the minimum wage could raise the cost of goods 

and services. Any such inflation in the price of consumer goods and services would erode the 

economic position of those below the poverty line.

In addition, increasing the minimum wage targets the earnings of low-wage workers and 

does not specifically target low-income families. The data presented above showed that more 

than 50 percent of minimum wage workers were age 24 or younger. Those workers include the 

teenage sons and daughters of middle class families working as cooks at fast food 

establishments. While some researchers have calculated that more than one third of the earnings 

gains from an increase in the minimum wage goes to families in the lowest family income 

decile,41 others have concluded that less than 20 percent of the earnings gains from an increase in 

the minimum wage goes to families below the poverty line.42

Recent research has suggested that the earned income tax credit (“EITC”) may be a better 

anti-poverty tool than the minimum wage.43 The reason for this is that the EITC is primarily 

targeted to low-income families with children. Thus, the teenage minimum wage worker from a 

middle class family is not helped by the EITC. Additionally, since the EITC increases after-tax 

wages through the tax code, rather than by mandating a specific minimum pre-tax wage, 

employers’ employment costs do not rise as a result of the EITC. To the extent that the EITC 

increases labor supply that would drive down the market clearing pre-tax wage, employers’ 

employment costs may even fall.44 Because employers’ employment costs do not rise as a result 

of increases in the EITC, any negative employment effects of increasing the minimum wage 

itself are avoided.

 

41 Card and Krueger, Myth and Measurement. 

42 Kenneth A. Couch, “Distribution and Employment Impacts of Raising the Minimum 

Wage,” FRBSF Economic Letter, February 19, 1999, Federal Reserve Bank of San Francisco. 

43 David Neumark and William Wascher, “Using the EITC to Help Poor Families: New 

Evidence and a Comparison with the Minimum Wage,” National Bureau of Economic Research 

Working Paper No. 7599, March 2000.

44 Employers’ employment costs with respect to the wages of workers at the minimum 

wage would not fall as a result of the EITC because they must still pay the minimum wage. 

Their employment costs could fall if they cut back fringe benefits in response to the EITC.
36

III. SELECTED PROVISIONS THAT AFFECT

SMALL BUSINESS AND AGRICULTURE

A. Expensing Depreciable Business Assets

A taxpayer generally must capitalize the cost of property used in a trade or business and 

recover such cost over time through allowances for depreciation or amortization. Tangible 

property generally is depreciated under a modified Accelerated Cost Recovery System, which 

determines depreciation by applying specific recovery periods, placed-in-service conventions, 

and depreciation methods to the cost of various types of depreciable property (sec. 168).

To relieve some taxpayers of the requirement to calculate depreciation, section 179 

permits taxpayers with a sufficiently small amount of annual investment to elect to expense and 

deduct up to $24,000 (in 2002) of the cost of qualifying property placed in service for the taxable 

year. In general, qualifying property is defined as depreciable tangible personal property that is 

purchased for use in the active conduct of a trade or business. The $24,000 amount is reduced 

(but not below zero) by the amount by which the cost of qualifying property placed in service 

during the taxable year exceeds $200,000. In addition, the amount eligible to be expensed for a 

taxable year may not exceed the taxable income of the taxpayer for the year that is derived from 

the active conduct of a trade or business (determined without regard to this provision). Any 

amount that is not allowed as a deduction because of the taxable income limitation may be 

carried forward to succeeding taxable years (subject to similar limitations). In the case of a 

partnership (or S corporation), the $24,000, $200,000, and taxable income limitations are applied 

at the partnership (or corporate) and partner (or shareholder) levels.

In addition, for qualifying property above the amounts eligible for immediate expensing 

the Job Creation and Worker Assistance Act of 2002 allows an additional first-year depreciation 

deduction equal to 30 percent of the adjusted basis of certain depreciable property acquired after 

September 11, 2001, and before September 10, 2004. The additional first-year depreciation 

deduction is allowed for both regular tax and alternative minimum tax purposes for the taxable 

year in which the property is placed in service. The basis of the property and the depreciation 

allowances in the year of purchase and later years are appropriately adjusted to reflect the 

additional first-year depreciation deduction. In general, depreciable property qualifies for the 

additional depreciation if the original use begins with the taxpayer and general rules of MACRS 

apply with (1) an applicable recovery period of 20 years or less, (2) water utility property (as 

defined in section 168(e)(5)), (3) computer software other than computer software covered by 

section 197, or (4) qualified leasehold improvement property. 
37

B. Accounting Methods

1. In general

A taxpayer must compute its taxable income under a method of accounting on the basis 

of which the taxpayer regularly keeps its books so long as, in the opinion of the Secretary of the 

Treasury, such method clearly reflects the taxpayer's income (sec. 446). Among the permissible 

methods of accounting are the cash receipts and disbursement method ("cash method"), an 

accrual method, any other method permitted or required under the Code, or any hybrid method 

allowed under regulations. A taxpayer may change its method of accounting with the consent of 

the Secretary.

Special statutory rules allow farmers and small businesses to use accounting methods that 

are unavailable to larger taxpayers. Many of these rules are designed to alleviate the tax 

accounting burdens of small businesses, while other rules are designed to provide a tax incentive. 

Some of these special rules are described below.

2. Cash and accrual methods

Under the cash method of accounting, income is recognized and deductions are allowed 

when the taxpayer receives or remits cash or cash equivalents. The cash method is 

administratively easy and provides the taxpayer flexibility in the timing of income. It is the 

method generally used by most individual taxpayers.

Under an accrual method of accounting, income generally is recognized in the year in 

which all the events have occurred that establish the taxpayer's right to receive the income and 

the amount of the income can be determined with reasonable accuracy. A deduction is allowed 

for an expense in the year in which (i) all events have occurred that establish the liability of the 

taxpayer for the expense, (ii) the amount of the liability can be determined with reasonable 

accuracy, and (iii) economic performance has occurred with respect to the item of expense. 

Accrual methods of accounting generally result in a more accurate measure of economic income 

than does the cash method and conform to generally accepted accounting principles. The accrual 

method is used by most businesses for financial accounting purposes.

In general, a taxpayer must use an accrual method of accounting for Federal income tax 

purposes when the production, purchase, or sale of merchandise is an income-producing factor in 

the taxpayer's business. A taxpayer must use an accrual method of accounting for Federal 

income tax purposes if the taxpayer's average annual gross receipts for all prior taxable years 

exceed $5 million (sec. 448). Individuals, partnerships (other than partnerships having a C 

corporation as a partner), farming businesses, S corporations, and "qualified personal service 

corporations" are exempt from the rule requiring the use of an accrual method. 

However, the IRS has provided that, as a matter of administrative convenience, a 

qualifying taxpayer with average annual gross receipts of $1 million or less will be permitted to 

use the cash method of accounting and will not be required to use an accrual method of 
38

accounting for purchases and sales of merchandise.45 Subsequently, the IRS expanded the class 

of small businesses eligible to use the cash method of accounting to qualified taxpayers with 

average annual gross receipts of $10 million or less unless the taxpayer’s principal business 

activity consists of mining, manufacturing, wholesale trade, retail trade, or a listed information 

industry.46

Special rules are provided for corporations engaged in farming. A corporation (or a 

partnership with a corporate partner) engaged in the trade or business of farming must use an 

accrual method of accounting for such activities unless such corporation (or partnership), for 

each prior taxable year beginning after December 31, 1975, did not have gross receipts 

exceeding $1 million. A family corporation (or a partnership with a family corporation as a 

partner) must use an accrual method of accounting for its farming business unless, for each prior 

taxable year beginning after December 31, 1985, such corporation did not have gross receipts 

exceeding $25 million. A family corporation is defined as a corporation in which at least 50

percent of the stock of the corporation is held by one family (or in some limited cases, two or 

three families.)

3. Uniform capitalization of inventory costs

A taxpayer that sells goods in the active conduct of its trade or business generally must 

maintain inventory records in order to determine the cost of goods it sold during the taxable 

period. The cost of goods sold generally is determined by adding the taxpayer's inventory at the 

beginning of the period to purchases made during the period and subtracting from that sum the 

taxpayer's inventory at the end of the period.

In general, the uniform cost capitalization rules (sec. 263A) require taxpayers that are 

engaged in the production of real or tangible personal property or in the purchase and holding of 

property for resale to capitalize or include in inventory the direct costs of the property and the 

indirect costs that are allocable to the property. Direct costs generally are the costs directly 

associated with the production of a good; i.e., the materials and labor applied in the production of 

the good. Indirect costs are costs associated with functions removed from the direct production 

of the good; e.g., overhead and administrative costs. In determining whether indirect costs are 

allocable to production or resale activities, taxpayers are allowed to use various methods so long 

as the method employed reasonably allocates indirect costs to production and resale activities.

However, the uniform capitalization rules do not apply to property acquired by a taxpayer 

during the taxable year for resale if the average annual gross receipts of the taxpayer for each of 

the preceding three taxable years did not exceed $10,000,000. Similarly, the uniform 

 

45 Rev. Proc. 2001-10, 2001-2 I.R.B. 272, modifying Rev. Proc. 2000-22, 2000-20, 

I.R.B. 1008.

46 Rev. Proc. 2002-28, 2002-18 I.R.B. 815. 
39

capitalization rules do not apply to taxpayers in certain farming businesses (unless the taxpayer is 

required to use an accrual method of accounting under sec. 447 or 448(a)(3)).47

 

47 Sec. 263A(d).
40

IV. SUMMARY OF SELECTED PROPOSALS RELATIVE

TO AGRICULTURE AND SMALL BUSINESS

A. Summary of S. 312, the “Tax Empowerment and Relief

 for Farmers and Fisherman Act”

1. Farm, Fish and Ranch Risk Management Accounts (“FFARRM”) 

The proposal would allow taxpayers engaged in an eligible business to establish 

FFARRM accounts. An eligible business would be any trade or business of farming in which the 

taxpayer actively participates, including the operation of a nursery or sod farm or the raising or 

harvesting of crop-bearing or ornamental trees.48 An eligible business would also include the 

trade or business of commercial fishing in which the taxpayer actively participates. The term 

“commercial fishing” has the meaning given such term by section (3) of the Magnuson-Stevens 

Fishery Conservation and Management Act (16 U.S.C. 1802) and includes the trade or business 

of catching, taking or harvesting fish that are intended to enter commerce through sale, barter or 

trade.

Contributions to a FFARRM account would be deductible and would be limited to 20 

percent of the taxable income that is attributable to the eligible business. The deduction would 

be taken into account in determining adjusted gross income and would reduce income 

attributable to the eligible business for all income tax purposes other than the determination of 

the 20 percent of eligible income limitation on contributions to a FFARRM account. Under the 

proposal, contributions made on or before the due date (without regard to extensions) of the 

taxpayer’s return for a taxable year would be deemed to have been made on the last day of such 

year. 

A FFARRM account would be taxed as a grantor trust and any earnings would be 

required to be distributed currently. Thus, any income earned in the FFARRM account would be 

taxed currently to the farmer or fisherman who established the account.

Contributions to a FFARRM account would not reduce earnings from self-employment. 

Accordingly, distributions would not be included in self-employment income. 

Amounts may remain on deposit in a FFARRM account for up to five years. Any 

amount that has not been distributed by the close of the fourth year following the year of deposit 

would be deemed to be distributed and includible in the gross income of the account owner. 

Distributions for the year would be considered to first be made from the earnings that are 

required to be distributed. Additional amounts distributed for the year would be considered to be 

made from the oldest deposits.

Distributions from a FFARRM account may not be used to purchase, lease, or finance 

any new fishing vessel, add capacity to any fishery, or otherwise contribute to the 

 

48 An evergreen tree that is more than 6 years old when severed from the roots (and thus 

eligible for capital gains treatment on cutting) would not be considered an ornamental tree for 

this purpose.
41

overcapitalization of any fishery. The Secretary of Commerce shall implement regulations 

enforcing this restriction.

A taxpayer who has ceased to engage in an eligible business may not maintain a 

FFARRM account. If the taxpayer does not engage in an eligible business during two 

consecutive taxable years, the balance in the FFARRM account would be deemed to be 

distributed to the taxpayer on the last day of such two-year period.

If the taxpayer who established the FFARRM account dies, and the taxpayer’s surviving 

spouse acquires the taxpayer’s interest in the FFARRM account by reason of being designated as 

the beneficiary of the account at the death of the taxpayer, the surviving spouse would “step into 

the shoes” of the deceased taxpayer with respect to the FFARRM account. In other cases, the 

account would cease to be a FFARRM account on the date of the taxpayer’s death and the 

balance in the account would generally be deemed distributed to the taxpayer on the date of 

death. 

A FFARRM account would be a trust that is created or organized in the United States for 

the exclusive benefit of the taxpayer who establishes it. The trustee must be a bank or other 

person who demonstrates to the satisfaction of the Secretary that it will administer the trust in a 

manner consistent with the requirements of the section. At all times, the assets of the trust must 

consist entirely of cash and obligations which have adequate stated interest (as defined in section 

1274(c)(2)) and which pay such adequate interest not less often than annually. The trust must 

distribute all income currently, and its assets may not be commingled except in a common trust 

fund or common investment fund. Additional protections, including rules preventing the trust 

from engaging in prohibited transactions or from being pledged as security for a loan, are 

provided.

Penalties would apply in the case of excess contributions and failures to make required 

distributions.

2. Exclusion of rental income from SECA tax 

Generally, Self-Employment Contributions Act (“SECA”) taxes are imposed on an 

individual’s net earnings from self-employment. Net earnings from self-employment generally 

means gross income (including the individual’s net distributive share of partnership income) 

derived by an individual from any trade or business carried on by the individual less applicable 

deductions. An exclusion from net earnings from self-employment is allowed for certain real 

estate rentals. Under this present-law rule, net earnings from self-employment for an owner or 

tenant of land do not include income from the rental of real estate and from personal property 

leased with the real estate unless: (A) the rental income is received under an arrangement 

between the owner or tenant of the land and another individual that provides: (1) such other 

individual shall produce agricultural or horticultural commodities on such land; and (2) there 

shall be material participation by the owner or tenant with respect to any such agricultural or 

horticultural commodities; and (B) there is material participation by the owner or tenant with 

respect to any such agricultural or horticultural commodities. Other rules apply to rental 

payments received by an individual in the course of the individual’s trade or business as a real 

estate dealer.
42

The proposal would provide that net earnings from self-employment for an owner or 

tenant of land do not include income from the rental of real estate except under certain lease 

agreements (rather than an arrangement) between the owner or tenant of land and another 

individual. Under this proposal, an owner or tenant of land would have self-employment income 

only where (A) the rental income is received under a lease agreement between the owner or 

tenant of land and another individual which provides: (1) such other individual shall produce 

agricultural or horticultural commodities on such land; and (2) there shall be material 

participation by the owner or tenant in the production or management of the production of such 

agricultural or horticultural commodities; and (B) there is material participation by the owner or 

tenant with respect to any such agricultural or horticultural commodities.

3. Exclusion of conservation reserve program payments from SECA tax

Generally, SECA tax is imposed on an individual’s self-employment income within the

Social Security wage base. Net earnings from self-employment generally means gross income 

(including the individual’s net distributive share of partnership income) derived by an individual 

from any trade or business carried on by the individual less applicable deductions. A recent 

court decision found that payments made under the Department of Agriculture’s conservation 

reserve program are includible in an individual’s self-employment income for purposes of SECA 

tax.

The proposal would provide for purposes of the SECA tax that net earnings from selfemployment do not include conservation reserve program payments. 

4. Exemption of agricultural bonds from private activity bond volume limits

Interest on bonds issued by States and local governments is excluded from income if the 

proceeds of the bonds are used to finance activities conducted or paid for by the governmental 

units (sec. 103). Interest on bonds issued by these governmental units to finance activities 

carried out and paid for by private persons (“private activity bonds”) is taxable unless the 

activities are specified in the Internal Revenue Code. Private activity bonds on which interest 

may be tax-exempt include bonds issued to finance loans to first-time farmers for the acquisition 

of land and certain equipment (“aggie bonds”).

The volume of tax-exempt private activity bonds that States and local governments may 

issue in each calendar year (including aggie bonds) is limited by State-wide volume limits. For 

2002, the volume limits are the greater of: (1) $75 per resident of the State; or (2) $225 million. 

The volume limits do not apply to private activity bonds to finance airports, docks and wharves, 

certain governmentally owned, but privately operated solid waste disposal facilities, certain high 

speed rail facilities, and to certain types of private activity tax-exempt bonds that are subject to 

other limits on their volume (qualified veterans’ mortgage bonds and certain empowerment zone 

and enterprise community bonds).

The proposal would exempt “aggie bonds” from the private activity bond volume limits. 

5. Modifications to section 512(b)(13)
43

While generally exempt from Federal income tax, charitable, educational, religious, and 

certain other organizations described in Code section 501(a) are subject to tax on any unrelated 

trade or business income (secs. 511-514). The tax applies to gross income derived by an exempt 

organization from any unrelated trade or business regularly carried on by it, less allowable 

deductions directly connected with the carrying on of such trade or business, both subject to 

certain modifications. An unrelated trade or business is defined as any trade or business of a taxexempt organization the conduct of which is not substantially related (aside from the need of 

such organization for income or funds or the use it makes of the profits derived) to the exercise 

or performance by such organization of the charitable, educational, religious, or other nonprofit 

purpose and function constituting the basis for its exemption (sec. 513(a)).

In general, interest, rents, royalties and annuities are excluded from the unrelated 

business income (“UBI”) of tax-exempt organizations. However, section 512(b)(13) treats 

otherwise excluded rent, royalty, annuity, and interest income as UBI if such income is received 

from a taxable or tax-exempt subsidiary that is 50 percent controlled by the parent tax-exempt 

organization. In the case of a stock subsidiary, “control” means ownership by vote or value of 

more than 50 percent of the stock. In the case of a partnership or other entity, control means 

ownership of more than 50 percent of the profits, capital or beneficial interests. In addition, 

present law applies the constructive ownership rules of section 318 for purposes of section 

512(b)(13). Thus, a parent exempt organization is deemed to control any subsidiary in which it 

holds more than 50 percent of the voting power or value, directly (as in the case of a first-tier 

subsidiary) or indirectly (as in the case of a second-tier subsidiary).

Under present law, interest, rent, annuity, or royalty payments made by a controlled 

entity to a tax-exempt organization are includible in the latter organization's UBI and are subject 

to the unrelated business income tax to the extent the payment reduces the net unrelated income 

(or increases any net unrelated loss) of the controlled entity.

The Taxpayer Relief Act of 1997 (the “1997 Act”) made several modifications, as 

described above, to the control requirement of section 512(b)(13). In order to provide 

transitional relief, the changes made by the 1997 Act do not apply to any payment received or 

accrued during the first two taxable years beginning on or after the date of enactment of the 1997 

Act (August 5, 1997) if such payment is received or accrued pursuant to a binding written 

contract in effect on June 8, 1997, and at all times thereafter before such payment (but not 

pursuant to any contract provision that permits optional accelerated payments).

The proposal would provide that interest, rent, annuity, or royalty payments made by a 

controlled subsidiary to a tax-exempt parent is not UBI except to the extent that such payments 

exceed arm’s length values, as determined under sec. 482 principles.

6. Charitable deduction for contributions of food inventory

Under present law, the maximum charitable contribution deduction that may be claimed 

by a corporation for any one taxable year is limited to 10 percent of the corporation's taxable 

income for that year (disregarding charitable contributions and with certain other modifications) 

(sec. 170(b)(2)). 
44

Corporations also are subject to certain limitations based on the type of property 

contributed. In the case of a charitable contribution of short-term gain property, inventory, or 

other ordinary income property, the amount of the deduction generally is limited to the taxpayer's 

basis (generally, cost) in the property. However, special rules in the Code provide an augmented 

deduction for certain corporate contributions. Under these special rules, the amount of the 

augmented deduction is equal to the lesser of (1) the basis of the donated property plus one-half 

of the amount of ordinary income that would have been realized if the property had been sold, or 

(2) twice the basis of the donated property. To be eligible for the enhanced deduction, the 

taxpayer must establish that the fair market value of the donated item exceeds basis. S 

corporations, personal holding companies, and service organizations are not eligible donors. The 

valuation of food inventory contributed by corporations has been the subject of ongoing disputes 

between taxpayers and the IRS.

The proposal49 would amend section 170 to expand the augmented deduction such that 

any taxpayer, rather than only a C corporation, engaged in a trade or business would be eligible 

to claim an enhanced deduction for donations of food inventory under section 170(e)(3).

The value of the enhanced deduction could be no greater than twice the taxpayer’s basis 

in the donated property. The proposal would provide in the case of a cash method taxpayer, that 

the taxpayer’s basis in the donated food equal half of the fair market value of the donated food.

The proposal would modify and clarify the determination of fair market value for the 

donation of food inventory. Under the proposal, the fair market value of donated food which 

cannot or will not be sold solely due to internal standards of the taxpayer, lack of market, or 

similar circumstances would be determined without regard to such factors and, if applicable, by 

taking into account the price at which the same or similar food items would be sold by the 

taxpayer at the time of the contribution or in the recent past.

7. Coordinate farmers and fisherman income averaging and the alternative minimum tax

An individual taxpayer engaged in a farming business as defined by section 263A(e)(4) 

may elect to compute his or her current year tax liability by averaging, over the prior three-year 

period, all or portion of his or her taxable income from the trade or business of farming. The 

averaging election is not coordinated with the alternative minimum tax. Thus, some farmers may 

become subject to the alternative minimum tax solely as a result of the averaging election.

The proposal would extend to individuals engaged in the trade or business of fishing the 

election that is available to individual farmers to use income averaging. It would also coordinate 

farmers and fishermen income averaging with the alternative minimum tax. As a result, a farmer 

 

49 H.R. 7, the “Community Solutions Act of 2001,” as passed by the House of 

Representatives on July 19, 2001, includes a similar provision, except that H.R. 7 does not 

change the present-law calculation of the enhanced deduction, does not provide a special basis 

rule for cash method taxpayers, and provides that the enhanced deduction would be available 

only for food that qualifies as “apparently wholesome food.” In addition, H.R. 7 provides a 

slightly different definition of fair market value.
45

or fisherman would owe alternative minimum tax only to the extent he or she would owe 

alternative minimum tax had averaging not been elected. This result is achieved by excluding 

the impact of the election to average farm or fishing income from the calculation of both regular 

tax and tentative minimum tax, solely for the purpose of determining alternative minimum tax.

8. Modify cooperative marketing to include value added processing through animals

Under present law, taxable cooperatives in essence are treated as pass-through entities in 

that the cooperative is not subject to corporate income tax to the extent the cooperative timely 

pays patronage dividends. Tax-exempt cooperatives (sec. 521) include cooperatives of farmers, 

fruit growers, and like organizations organized and operated on a cooperative basis for the 

purpose of marketing the products of members or other producers and remitting to the members 

or other producers the proceeds of sales, less necessary marketing expenses, on the basis of 

either the quantity or the value of products furnished by them.

The IRS takes the position that a cooperative is not marketing the products of members or 

other producers where the cooperative adds value through the use of animals (e.g., farmers sell 

corn to a cooperative which it feeds to chickens that produce eggs).

The proposal would provide that marketing products of members or other producers 

includes feeding products of members or other producers to cattle, hogs, fish, chickens, or other 

animals and selling such animals or the resulting animal products.

9. Extend declaratory judgment procedures to farmers’ cooperative organizations 

Cooperatives may deduct from their taxable income amounts distributed to patrons in the 

form of patronage dividends, and certain other amounts paid or allocated to patrons, to the extent 

of the net earnings of the cooperative from business done with or for patrons, provided that there 

is a pre-existing obligation to distribute such amounts (sec. 1382). Cooperatives that qualify as 

farmers’ cooperatives under section 521 may claim additional deductions for dividends on 

capital stock and patronage-based distributions of nonpatronage income.

Under present law, there is limited access to judicial review of disputes regarding the 

initial or continuing qualification of a farmer’s cooperative described in section 521. The only 

remedies available to such an organization are to file a petition in the U.S. Tax Court for relief 

following the issuance of a notice of deficiency or to pay tax and sue for a refund in a U.S. 

District Court or the U.S. Court of Federal Claims.

In other limited contexts, declaratory judgment procedures are available, which generally 

permit a taxpayer to seek judicial review of an IRS determination prior to the issuance of a notice 

of deficiency and prior to payment of tax. Examples of declaratory judgment procedures that are 

available include disputes involving the initial or continuing classification of a tax-exempt 

organization exempt from tax described in section 501(c)(3), a private foundation described in 

section 509(a), or a private operating foundation described in section 4942(j)(3), the qualification 

of retirement plans, the value of gifts, the status of certain governmental obligations, or 
46

eligibility of an estate to pay tax in installments under section 6166.50 In such cases, taxpayers 

may challenge adverse determinations by commencing a declaratory judgment action. For 

example, where the IRS denies an organization’s application for recognition of exemption under 

section 501(c)(3) or fails to act on such application, or where the IRS informs a section 501(c)(3) 

organization that it is considering revoking or adversely modifying its tax-exempt status, present 

law authorizes the organization to seek a declaratory judgment regarding its tax exempt status.

Declaratory judgment procedures are not available under present law to a cooperative 

with respect to an IRS determination regarding its status as a farmers’ cooperative under section 

521.

The proposal would extend the declaratory judgment procedures to cooperatives. Such a 

case could be commenced in the U.S. Tax Court, the U.S. District Court for the District of 

Columbia, or the U.S. Court of Federal Claims, and such court would have jurisdiction to 

determine a cooperative’s initial or continuing qualification as a farmers’ cooperative described 

in sec. 521.

10. Small ethanol producer credit

 “Small ethanol producers” are allowed a 10-cents-per-gallon production income tax 

credit on up to 15 million gallons of production annually. This credit is in addition to the 53-

cents-per-gallon benefit that is generally available for ethanol production.

Under present law, cooperatives in essence are treated as pass-through entities in that a 

cooperative is not subject to corporate income tax to the extent the cooperative timely pays 

patronage dividends. Under present law, the only credits that may be flowed-through to 

cooperative to its patrons are the rehabilitation credit (sec. 47), the energy property credit (sec. 

48(a)), and the reforestation credit (sec. 48(b)).

The proposal51 would: (1) provide that the small ethanol producer credit is not a “passive 

credit”; (2) allow the credit to be claimed against the alternative minimum tax; (3) repeal the 

present-law rule that the amount of the credit is included in income; and (4) define a small 

ethanol producer to include a person who, at all times during the taxable year, has a productive 

capacity for alcohol not in excess of 60,000,000 gallons.

The proposal also would allow cooperatives to elect to pass an amount equal to the small 

ethanol producer credit through to their patrons. The credit would be allowed to a patron in an 

 

50 For disputes involving the initial or continuing qualification of an organization 

described in sections 501(c)(3), 509(a), or 4942(j)(3), declaratory judgment actions may be 

brought in the U.S. Tax Court, the U.S. District Court for the District of Columbia, or the U.S. 

Court of Federal Claims. For all other Federal tax declaratory judgment actions, proceedings 

may be brought only in the U.S. Tax Court.

51 On April 25, 2002, the Senate passed H.R. 4, as amended by the Senate. Division H 

of the bill, the “Energy Tax Policy Act of 2002”, contains several energy tax incentives, 

including some that are similar to incentives contained in S. 312.
47

amount equal to the credit that the cooperative elects to pass through for that year, multiplied by 

the proportion that the amount of patronage of that patron for that year bears to total patronage of 

all patrons for that year.

11. Payment of dividends on stock of cooperatives without reducing patronage dividends

Cooperatives, including tax-exempt farmers' cooperatives, are treated like a conduit for 

Federal income tax purposes in that a cooperative may deduct patronage dividends paid from its 

taxable income. In general, patronage dividends are amounts paid to patrons (1) on the basis of 

the quantity or value of business done by the cooperative with or for its patrons, (2) under a valid 

enforceable written obligation to the patrons to pay such amount, which obligation existed before 

the cooperative received such amounts, and (3) which are determined by reference to the net 

earnings of the cooperative from business done with or for its patrons.

Treasury Regulations provide that net earnings of a cooperative are reduced by dividends 

paid on capital stock or other proprietary capital interests. The effect of this rule is to reduce the 

amount of earnings that a cooperative can treat as patronage earnings, which reduces the amount 

that a cooperative can deduct as patronage dividends.

The proposal would allow cooperatives to pay dividends on capital stock without such 

dividends reducing the amount of deductible patronage-sourced income, to the extent that the 

cooperative’s organizational documents provide that the dividends do not reduce amounts owed 

to patrons from patronage.
48

B. Qualified Small Business Stock

Under present law, individuals may exclude 50-percent (60-percent for certain 

empowerment zone businesses) of the gain from the sale of certain small business stock acquired 

at original issue and held for at least five years. The taxable portion of the gain is taxed at a 

maximum rate of 28 percent. Forty-two percent of the excluded gain is a minimum tax 

preference. The amount of gain eligible for the exclusion by an individual with respect to any 

corporation is the greater of (1) ten times the taxpayer's basis in the stock or (2) $10 million. In 

order to qualify as a small business, when the stock is issued, the gross assets of the corporation 

may not exceed $50 million. The corporation also must meet certain active trade or business 

requirements.

Under present law, individuals may rollover gain from qualified small business stock to 

other qualified small business stock where the replacement stock is purchased during the 60-day 

period beginning on the date of sale of the original stock.

Various proposals52 have been made to modify the small business stock provisions. 

These proposals include:

• The percentage of excluded gain would be increased to a higher percentage.

• The 5-year holding period requirement would be reduced.

• The minimum tax preference for small business stock would be repealed.

• The $10 million maximum exclusion amount would be increased or eliminated.

• The capital gains tax rate on the taxable portion of the gain would be made the 

same as for other taxable capital gain.

• The exclusion would be made available to corporate shareholders.

• The $50 million gross asset amount would be increased.

• The working capital limitation would be modified.

• The rules relating to redemptions of small business stock would be modified.

• The 60-day period to make a rollover would be increased to 180 days

 

52 These proposals are found in S. 455 (introduced by Sen. Collins and others); S. 1134 

(introduced by Sens. Lieberman and Hatch); S. 1676 (introduced by Sen. Kerry); and S. 1823 

(introduced by Sens. Collins and Carper).
49

C. Proposals Relating to S Corporations

S. 120153, the “Subchapter S Modernization Act of 2001” would make the following 

amendments to the provisions of subchapter S, which are summarized in Part I.C, above:

• The maximum number of eligible shareholders would be increased from 75 to 150.

• Certain family members could elect to be treated as one shareholder for purposes of 

determining the number of shareholders.

• Nonresident aliens would be allowed to be eligible shareholders.

• IRAs could continue to hold bank stock when the bank elects subchapter S status.

• An S corporation could issue nonpartipating preferred stock that would be treated 

similarly to debt.

• “Straight debt” could include convertible debt.

• Excess passive income would no longer be a terminating event, but instead would be 

subject to the tax on excess passive income.

• The tax on excess passive income would only apply if the passive income exceeded 60 

percent of gross receipts, and capital gain would not be treated as passive income

• The basis in S corporation stock would not be reduced by the amount of the appreciation 

in charitable contributions made by the corporation.

• Certain losses on the liquidation of subchapter S stock would be treated as an ordinary 

loss.

• Passive loss deductions would be allowed to an S corporation to the extent generally 

allowed on a complete disposition of a passive activity.

• Suspended S corporation losses could be transferred where the stock is transferred 

incident to a divorce.

• Qualified subchapter S corporation trust income beneficiaries would be allowed to treat 

certain dispositions by the trust as dispositions for purposes of the at-risk rules and the 

passive loss rules.

• Interest on indebtedness incurred to acquire S corporation stock would be deductible by 

an electing small business trust.

 

53 S. 1201 was introduced on July 19, 2001, by Senators Hatch, Breaux, Lincoln, Allard, 

Thompson, and Gramm.
50

• Unexercised power of appointments would be disregarded in determining potential 

current income beneficiaries of an electing small business trust.

• The electing small business trust distribution rules would be clarified.

• Excluded cancellation of indebtedness income would not increase the shareholder’s basis 

in its stock (this provision has since been enacted into law.)

• Certain back-to-back loans would be treated as indebtedness.

• Investment securities income of a bank would not be treated as passive income.

• Qualifying director shares in a bank would not be treated as a second class of stock.

• Bad debt reserves of a bank could be recaptured on the making of an S corporation 

election.

• Inadvertent invalid qualified subchapter S subsidiary elections could be validated.

• Information returns for qualified subchapter S subsidiaries could be made by the 

subsidiary.

• A sale of an interest in a qualified subchapter S subsidiary would be treated as a sale of 

the subsidiary’s assets.

• The “step transaction” doctrine would not apply to restructurings in connection with the 

making of a qualified subchapter S subsidiary election.

• All earnings and profits attributable to pre-1983 taxable years would be eliminated.

• No gain or loss on deferred intercompany transactions under the consolidated return 

regulations would result from a conversion to an S corporation or a qualified S 

corporation subsidiary.

• Charitable contribution deductions and foreign tax credit carryforwards could offset the 

tax on built-in gains of former C corporations.

• An S corporation could pay deductible dividends to an ESOP.

• A former S corporation could reelect to be an S corporation upon the enactment of the 

bill.
51

APPENDIX

Data for Figure 6

Table A-1.–All Business Returns and Business Returns

With Net Income, 1997, by Entity Type

Business

Total

number

Number with

net income

Percentage with

net income

Nonfarm sole proprietorship returns 17,176,486 12,702,663 74.0

C corporation returns 2,257,829 1,092,078 48.4

S corporation returns 2,452,254 1,555,396 63.4

Partnership returns 1,758,627 1,091,826 62.1

Farms (Schedule F) 2,160,954 721,466 33.4

All business entities 28,258,404 18,718,825 66.2

Source: IRS Statistics of Income 
52