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 March 28, 2001

Prepared by the Staff

of the

JOINT COMMITTEE ON TAXATION

March 27, 2001

JCX-19-01
i

CONTENTS

Page

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

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

A. Federal Income Tax Rates -- Summary of Certain Provisions Affecting

Small Business.................................................................................................. 2

B. Definition of "Small Business".......................................................................... 2

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

1. In general..................................................................................................... 3

2. Corporations................................................................................................ 3

3. Partnerships................................................................................................. 5

4. S Corporations ............................................................................................ 6

II. DATA ON SMALL BUSINESS AND AGRICULTURE....................................... 9

III. SELECTED PROVISIONS THAT AFFECT SMALL BUSINESS AND 

AGRICULTURE...................................................................................................... 25

A. Expensing Depreciable Business Assets ........................................................... 25

B. Accounting Methods.......................................................................................... 25

 1. In general..................................................................................................... 25

 2. Cash and accrual methods........................................................................... 26

3. Uniform capitalization of inventory costs.................................................... 27

IV. SUMMARY OF SELECTED PROPOSALS RELATING TO SMALL

BUSINESS................................................................................................................. 28

A. Taxpayer Relief Act of 2000............................................................................. 28

1. Increase in expensing of depreciable business assets.................................. 28

2. Increase deduction for business meals......................................................... 28

3. Increased deduction for business meals while operating under

Department of Transportation hours of service limitation........................... 29

4. Repeal special occupational taxes on producers and marketers of

Alcoholic beverages.................................................................................... 29

5. Clarification of cash accounting rules for small businesses........................ 30
Page

ii

B. Proposals Relating to S Corporations ............................................................... 31

1. Shareholder and corporate eligibility.......................................................... 31

2. Elections and terminations........................................................................... 32

3. Computation of taxable income ................................................................... 33

4. Transition rule for elections after termination............................................. 35

5. Information returns for qualified subchapter S subsidiaries........................ 35

V. SUMMARY OF SELECTED PROPOSALS RELATING TO

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

1. Farm, Fish and Ranch Risk Management Accounts ("FFARRM")........................ 36

2. Exclusion of rental income from SECA tax.......................................................... 37

3. Exclusion of conservation reserve program payments from SECA tax................. 38

4. Exemption of agricultural bonds from private activity bond volume limits.......... 38

5. Modifications to section 512(b)(13) .................................................................... 39

6. Charitable deduction for contributions of food inventory..................................... 40

7. Coordinate farmers and fisherman income averaging and the alternative

minimum tax......................................................................................................... 40

8. Cooperative marketing to include value added processing through animals......... 41

9. Extend declaratory judgment procedures to farmers' cooperative

organizations ........................................................................................................ 41

10. Small ethanol producer credit .............................................................................. 42

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

dividends.............................................................................................................. 43

APPENDIX: Data for Figure 6.......................................................................................... 44
1

INTRODUCTION

The Senate Committee on Finance has scheduled a public hearing on March 28, 2001, on 

issuing 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-19-01), March 27, 2001.
2

I. OVERVIEW

A. Federal Income Tax Rates -- Summary of Certain

Provisions Affecting Small Business

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

from 15 percent (for taxable income of married joint filers or surviving spouses up to $45,200) to 

39.6 percent (for taxable income of married joint filers or surviving spouses over $297,350) for 

2001. The intermediate rates are 28 percent, 31 percent, and 36 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. Thus, a corporation with 

taxable income between $335,000 and $10,000,000 is effectively subject to a flat rate of 34 

percent. 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

 

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 that $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 $45,000 in the case of married individuals filing a joint return. 

The exemption amount is completely phased out for married individuals filing a joint return with 

AMTI in excess of $330,000 and for a corporation with AMTI in excess of $310,000.
3

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

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 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 issuance of the stock had aggregate gross assets of not more than $50 million.10 One 

commonly-used measure is whether the entity’s average annual gross receipts for the threetaxable year period ending with the prior year exceeds $5 million.11

C. Choice of Entity

 1. 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") involve a single level of tax at 

the owner level. 

 2. 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 

 

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 Sections 448(c), 474(c), and 172(b)(1)(F)(iii).
4

incorporated or as a corporation.12 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 

the corporate level, and is taxed again when distributed as dividends13 to individual shareholders. 

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

individual 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.14 

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. (Any appreciation in the stock that has not been realized at the 

time of death is exempt from capital gains tax, due to the step-up of basis to fair market value at 

death). 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 (secs. 531-537). 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 

(secs. 541-547).

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

deductible by the corporation, and thus are taxed only 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 sufficient 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 

 

12 Treas. Reg. sec. 301.7701-2(b)(1).

13 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.

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

heirs free of income tax (sec. 1014).
5

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. 

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 the 

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 additional equity. This determination 

requires an examination of the economic 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.

 3. Partnerships

In general

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

entities, not subject to tax at the entity level (sec. 701). 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 (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, deduction, and credit (sec. 702(a)). A partner's deduction for 

partnership losses is limited to the amount of the partner's adjusted basis in his partnership 

interest (sec. 704(d)).15 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 (sec. 705).

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 

 

15 In addition, "passive loss" and “at-risk” limitations limit the extent to which certain 

types of limited partner 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.
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 treatment for local law purposes and partnership treatment for 

Federal income tax purpose.16 LLCs are entities organized under State law. They are neither 

partnership nor corporations under applicable State law, but they generally provide limited 

liability to their owners. An LLC generally affords local law and 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; while any single-member unincorporated entity may be disregarded 

for Federal income tax purposes (i.e., treated as not separate from its owner).17 These 

regulations, known as the "check-the-box" regulations, were a response, in part, to the growth of 

LLCs. The regulations permit an LLC simply to elect to be treated as a partnership.

 4. 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 layers 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 that elects subchapter S 

status (an "S corporation") and its shareholders 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. These requirements are 

discussed in detail below.

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 

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

 

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

Columbia) now have an LLC statute.

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

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 (sec. 1362). 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 (secs. 1363 and 1366). Items of income 

(including tax-exempt income), loss, deduction and credit of the corporation are taken into 

account in computing the tax of the shareholders (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 allowed as a deduction 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 (sec. 1367).

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 

years18) 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 (sec. 1375). 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 (sec. 1374).

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 

corporation and has remaining earnings and profits (sec. 1368). To the extent of such earnings 

and profits, corporate distributions are treated like 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 

differences between S corporations and partnerships. For example, corporate liabilities 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 

 

18 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.
8

have only one class of stock, and thus do not offer the same flexibility as partnerships to allocate 

income or losses to different investors. 
9

 II. 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 1998.19 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 1998, nonfarm sole proprietorships made up the vast 

majority of businesses. In 1998, they constituted 66.4 percent of all business entities; over the 20 

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

 

19 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, 1978-1998

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

1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998

Year

Number of Business Entities

Nonfarm sole props

C Corps

S Corps

Partnerships

Farms (Schedule F)
11

Sole C S

Year Proprietorships Corporations 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

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

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

All Business Returns, 1978-1998
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 

1998. The number of farm returns generally declined through the 20-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 1998. 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 1982.20

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

(percent)

Business 1978-1988 1988-1998 1978-1998

Nonfarm sole proprietorship 4.4 2.4 3.4

C corporation 4.1 -4.4 0.9

S corporation 10.1 7.5 8.8

Partnerships 3.0 1.2 2.1

Farms (Schedule F) -1.3 -1.2 -1.3

Total 3.7 1.5 2.8

Source: Joint Committee on Taxation staff calculations

 

20 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. Figures 2, 3, and 4, below, display the percentage distribution of 

different types of business returns for 1978, 1988, and 1998.

Figure 2.--Percentage Distribution of Different Types of

Buisness Returns, 1978

Nonfarm sole props

59%

C Corps

12%

S Corps

3%

Partnerships

8%

Farms (Schedule F)

18%
14

Figure 3.--Percentage Distribution of Different Types of

Business Returns, 1988

Nonfarm sole props

64%

C Corps

11%

S Corps

6%

Partnerships

8%

Farms (Schedule F)

11%

Figure 4.--Percentage Distribution of Different Types of

Business Returns, 1998

Nonfarm sole props

66%

C Corps

9%

S Corps

10%

Partnerships

7%

Farms (Schedule F)

8%
15

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 

Tables 1 and 2 and Figures 1-4 above. Table 3 and Figure 5, below, decompose the number of 

partnerships for the period 1990 through 1998 into general partnerships, limited partnerships, and 

LLCs.21 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, 1990-1998

Type of Partnership

Year

General

Partnerships

(thousands)

Limited

Partnerships

(thousands)

Limited Liability

Companies

(thousands)

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

n.a. - not available.

Source: Alan Zempel, “Partnership Returns, 1998,” SOI Bulletin, 20, Fall 2000.

 

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

1 because of rounding. Also, for 1998, the IRS has excluded from this decomposition those 

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

1065, Schedule B, line 1. See, Alan Zempel, “Partnership Returns, 1998,” SOI Bulletin, 20, Fall 

2000.
16

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

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

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.
17

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%
18

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.

Tables 4 through 7 display 1998 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 900,000 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 threequarters of one percent of all C corporations, hold 96 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 45 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 18 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 36 percent, and for S 

corporations there are 21 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 three quarters of one percent of all C 

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

approximately the one percent of partnership returns with gross receipts in excess of $10 million 

report nearly 70 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 one third of all nonfarm sole 

proprietorship gross receipts.
19

Firms classified by Number of Total assets Total

assets less than returns (millions) Returns Assets

$0 0 0 0.00% 0.00%

$25,000 665,363 4,786 29.43% 0.01%

$50,000 247,999 9,082 40.40% 0.04%

$100,000 279,177 20,083 52.75% 0.09%

$250,000 380,371 62,174 69.57% 0.27%

$500,000 244,581 86,657 80.39% 0.51%

$1,000,000 174,352 122,695 88.10% 0.85%

$10,000,000 215,263 587,502 97.63% 2.49%

$50,000,000 29,379 647,379 98.92% 4.29%

$100,000,000 7,396 526,262 99.25% 5.76%

Over $100,000,000 16,882 33,825,312 100.00% 100.00%

 Total 2,260,797 35,891,796

Firms classified by Number of Gross receipts Gross

assets less than returns (millions) Returns receipts

$0 94,123 0 4.16% 0.00%

$2,500 90,382 79 8.16% 0.00%

$5,000 40,559 148 9.96% 0.00%

$10,000 60,124 447 12.61% 0.00%

$25,000 121,346 2,057 17.98% 0.02%

$50,000 142,881 5,282 24.30% 0.06%

$100,000 208,289 15,415 33.52% 0.16%

$250,000 373,163 61,955 50.02% 0.60%

$500,000 326,090 117,626 64.45% 1.42%

$1,000,000 287,600 204,290 77.17% 2.86%

$10,000,000 443,074 1,255,010 96.77% 11.65%

$50,000,000 55,768 1,127,372 99.23% 19.56%

Over $50,000,000 17,355 11,474,079 100.00% 100.00%

 Total 2,260,757 14,263,763

Source: JCT calculation from Statistics of Income data.

Cumulative percent

Table 4.--Distribution of C Corporations, 1998

Cumulative percent

All returns

All returns
20

Firms classified by Number of Total assets Total

assets less than returns (millions) Returns Assets

$0 0 0 0.00% 0.00%

$25,000 1,001,604 7,367 38.70% 0.51%

$50,000 299,276 10,895 50.26% 1.25%

$100,000 320,240 23,006 62.64% 2.84%

$250,000 396,195 64,242 77.95% 7.25%

$500,000 218,852 77,157 86.40% 12.55%

$1,000,000 148,379 104,176 92.14% 19.71%

$10,000,000 184,549 507,382 99.27% 54.57%

$50,000,000 16,551 314,283 99.91% 76.16%

$100,000,000 1,456 100,563 99.96% 83.07%

Over $100,000,000 981 246,412 100.00% 100.00%

 Total 2,588,084 1,455,484

Firms classified by Number of Gross receipts Gross

assets less than returns (millions) Returns receipts

$0 145,434 0 5.62% 0.00%

$2,500 105,342 103 9.69% 0.00%

$5,000 53,762 197 11.77% 0.01%

$10,000 75,309 550 14.68% 0.03%

$25,000 164,823 2,832 21.05% 0.12%

$50,000 193,838 7,278 28.53% 0.35%

$100,000 296,237 21,753 39.98% 1.04%

$250,000 516,610 84,918 59.94% 3.74%

$500,000 347,309 122,019 73.36% 7.61%

$1,000,000 288,333 201,470 84.50% 14.02%

$10,000,000 349,083 966,513 97.99% 44.73%

$50,000,000 45,033 915,396 99.73% 73.81%

Over $50,000,000 6,968 824,250 100.00% 100.00%

 Total 2,588,081 3,147,278

Source: JCT calculation from Statistics of Income data.

Cumulative percent

Table 5.--Distribution of S Corporations, 1998

All returns

Cumulative percent

All returns
21

Firms classified by Number of Total assets Total

assets less than returns (millions) Returns Assets

$0 581,788 0 31.36% 0.00%

$25,000 212,577 1,857 42.81% 0.04%

$50,000 92,560 3,374 47.80% 0.10%

$100,000 122,319 9,007 54.40% 0.28%

$250,000 210,660 34,307 65.75% 0.94%

$500,000 162,055 59,030 74.49% 2.08%

$1,000,000 162,868 115,883 83.26% 4.32%

$10,000,000 266,082 769,048 97.60% 19.20%

$50,000,000 34,319 691,157 99.45% 32.57%

$100,000,000 4,723 328,395 99.71% 38.93%

Over $100,000,000 5,399 3,156,571 100.00% 100.00%

 Total 1,855,348 5,168,628

Firms classified by Number of Gross receipts Gross

assets less than returns (millions) Returns receipts

$0 169,561 0 9.14% 0.00%

$2,500 169,840 128 18.29% 0.01%

$5,000 62,614 237 21.67% 0.02%

$10,000 95,524 708 26.82% 0.05%

$25,000 184,234 3,095 36.75% 0.21%

$50,000 200,121 7,322 47.53% 0.58%

$100,000 223,534 16,176 59.58% 1.40%

$250,000 293,988 47,672 75.43% 3.82%

$500,000 171,998 60,423 84.70% 6.88%

$1,000,000 121,315 85,362 91.24% 11.21%

$10,000,000 142,390 381,165 98.91% 30.53%

$50,000,000 15,884 329,091 99.77% 47.21%

Over $50,000,000 4,345 1,041,400 100.00% 100.00%

 Total 1,855,348 1,972,782

Source: JCT calculation from Statistics of Income data.

Cumulative percent

Table 6.--Distribution of Partnerships, 1998

All returns

Cumulative percent

All returns
22

Firms classified by Number of Gross receipts Gross

assets less than returns (millions) Returns receipts

$0 481,950 0 2.77% 0.00%

$2,500 3,796,610 4,422 24.59% 0.48%

$5,000 2,052,015 7,525 36.39% 1.30%

$10,000 2,404,495 17,639 50.21% 3.22%

$25,000 3,035,564 49,644 67.65% 8.64%

$50,000 2,111,469 75,435 79.79% 16.86%

$100,000 1,584,188 112,558 88.89% 29.12%

$250,000 1,227,428 189,890 95.95% 49.82%

$500,000 451,608 154,345 98.55% 66.64%

$1,000,000 175,063 118,354 99.55% 79.54%

$10,000,000 76,807 145,831 99.99% 95.43%

$50,000,000 1,141 20,747 100.00% 97.70%

Over $50,000,000 101 21,139 100.00% 100.00%

 Total 17,398,440 917,529

Source: JCT calculation from Statistics of Income data.

Cumulative percent

Table 7.--Distribution of Nonfarm Sole Proprietorships, 1998

All returns

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. Tables 8 and 9 below present data compiled by the SBA from surveys in 

1996 by the Bureau of the Census. The SBA estimates that in 1996 there were approximately 

5.5 million firms in the United States employing 102 million persons.22 The SBA estimates that 

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

businesses employ 52 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 

Tables 4 through 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 1996, these two sectors accounted for 59.8 percent of the 

small businesses in the United States and 58.0 percent of the small business employment. Table 

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

 

22 U.S. Small Business Administration, The State of Small Business: A Report of the President, 

1998, Table A.5. 
23

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

for 1996. 

Table 8. --Percentage Distribution of Small Business Firms

and Employment by Sector, 1996

Percent of all small 

business firms

Percent of all small 

business employees

Agriculture services, forestry and 

fishing.................. 2.0 1.1

Mining................................................. 0.4 0.4

Construction.......................................... 11.9 8.8

Manufacturing........................................ 6.0 13.4

Transportation, communication and public

 utilities.......................................... 4.0 4.1

Wholesale trade..................................... 7.6 8.3

Retail trade............................................ 20.1 20.7

Finance, insurance, and real estate................ 8.2 5.8

Services............................................... 39.7 37.3

Other................................................... 0.5 0.1

Source: U.S. Small Business Administration, The State of Small Business: A Report of the President, 1998, Table 

A. 5.

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; construction, communication, and public utility; wholesale trade; 

retail trade; and service sectors. Large firms provide the majority of employment in the mining, 

manufacturing; transportation, communication, and public utility sectors. In every sector except 

agriculture and construction firms, employing 100 or more employees provide a majority of the 

employment.

The data in Tables 8 and 9 are not comparable to the tax return data reported previously. 

These data are drawn from employment reports for the week of March 12, 1996. 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. 
24

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

by Size of Firm and Industry, 1996

Percentage Distribution by Firm Size

Industry Total

Employing

0

Employing

1-19

Employing

20-99

Employing

100-499

Employing

500 or more

Agriculture Services, Forestry, and Fishing

Firms

Employees

111,513

664,356

22.4%

0.0%

95.3%

56.4%

4.2%

23.9%

0.3%

8.1%

0.1%

11.7%

Mining

Firms

Employees

21,102

574,328

11.4%

0.0%

84.5%

12.7%

11.0%

15.0%

2.6%

13.6%

1.8%

58.7%

Construction

Firms

Employees

651,915

5,207,460

16.4%

0.0%

92.3%

43.5%

6.9%

31.6%

0.7%

14.4%

0.1%

10.5%

Manufacturing

Firms

Employees

332,565

18,558,485

8.7%

0.0%

73.4%

7.3%

20.2%

15.0%

5.0%

16.2%

1.5%

61.5%

Transportation, Communication, and Public Utilities

Firms

Employees

217,710

6,057,265

14.3%

0.0%

87.9%

13.4%

9.6%

13.2%

1.8%

10.5%

0.8%

64.0%

Wholesale Trade

Firms

Employees

416,958

6,664,886

10.4%

0.0%

85.9%

24.6%

11.3%

25.7%

2.0%

15.7%

0.8%

43.1%

Retail trade

Firms

Employees

1,103,549

21,487,341

12.5%

0.0%

88.0%

20.6%

10.5%

20.3%

1.2%

10.3%

0.3%

48.8%

Finance, Insurance, and Real Estate

Firms

Employee

453,319

7,185,291

12.8%

0.0%

90.8%

21.4%

7.3%

17.2%

1.5%

16.9%

0.7%

57.3%

Service

Firms

Employee

2,175,597

35,747,905

12.3%

0.0%

90.8%

21.4%

7.3%

17.2%

1.5%

16.9%

0.4%

44.5%

Other

Firms

Employee

29,013

39,980

57.0%

0.0%

99.3%

85.0%

0.7%

15.0%

0.0%

0.0%

0.0%

0.0%

Source: U.S. Small Business Administration, The State of Small Business: A Report of the President, 1998, Table A-5.
25

III. SELECTED PROVISIONS THAT AFFECT

SMALL BUSINESS AND AGRICULTURE

The previous discussion on the tax rate structure and choice of entity highlights two 

fundamental aspects of the tax laws that affect businesses (regardless of size) in all sectors of the 

economy. Small businesses and farmers are particularly sensitive to these considerations. The

tax laws also include provisions that are more specifically targeted to small business and farmers. 

In some instances, the provisions are designed to provide additional economic incentives; in 

other cases, they are designed to alleviate some of the complicated aspects of business taxation. 

The discussion below focuses on selected areas of the tax laws where special rules are provided 

for 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 2001) 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.

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.
26

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. 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 accounting for purchases and sales of merchandise.23

Additionally, 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 required use of an accrual method.

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 

 

23 Rev. Proc. 2001-10, 2001-2 I.R.B. 272, modifying Rev. Proc. 2000-22, 2000-20, I.R.B. 

1008.
27

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 cost. 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 

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)).24

The special rules discussed above highlight congressional and administrative efforts to 

alleviate the burdens of complying with the tax code for small business and agriculture. The 

following discussion summarizes legislative proposals that would affect small business and 

agriculture.

 

24 Sec. 263A(d).
28

IV. SUMMARY OF SELECTED PROPOSALS

RELATING TO SMALL BUSINESS

A. Taxpayer Relief Act of 2000

The conference report to H.R. 5542, the Taxpayer Relief Act of 2000, which was 

incorporated by reference in the conference agreement for H.R. 2614, the Certified Development 

Company Program Improvements Act of 2000, included the following proposals that would 

affect the tax treatment of small businesses:

 1. Increase in expensing of depreciable business assets

Present law provides that, in lieu of depreciation, a taxpayer with a sufficiently small 

amount of annual investment may elect to deduct up to $24,000 (for taxable years beginning in 

2001)25 of the cost of qualifying property placed in service for the taxable year (sec. 179). 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 $20,000 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.

The proposal would increase the maximum dollar amount that may be deducted under 

section 179 from $24,000 to $35,000. 

 2. Increase deduction for business meals

Ordinary and necessary business expenses, as well as expenses incurred for the 

production of income, are generally deductible, subject to a number of restrictions and 

limitations (secs. 162 and 212). No deduction generally is allowed for personal, living, or family 

expenses (sec. 262). Meal and entertainment expenses incurred for business reasons or for the 

production of income are deductible if certain legal and substantiation requirements are met. 

Generally, the amount allowable as a deduction for business meal and entertainment expenses is 

limited to 50 percent of the otherwise deductible amount (sec. 274(n)). Exceptions to this 50-

percent rule are provided for food and beverages provided to crew members of certain vessels 

and off-shore oil or gas platforms or drilling rigs, as well as to individuals subject to the hours of 

service limitations of the Department of Transportation. 

An expense for food or beverages is not deductible unless the taxpayer establishes that 

the item was directly related to the “active conduct” of the taxpayer’s trade or business or, in the 

case of an item directly preceding or following a substantial and bona fide business discussion, 

that the item was “associated with” the active conduct of the taxpayer’s trade or business (sec. 

274(a)(1)(A)). Accordingly, a business meal expense generally is not deductible unless there is a 

substantial and bona fide business discussion during, directly preceding, or directly following the 

meal. Also, the taxpayer or an employee of the taxpayer must be present at the meal (sec. 

274(k)(1)(B)).

 

25 The amount is increased to $25,000 for taxable years beginning in 2003 and thereafter.
29

The proposal would increase the business meals deduction from the present-law 50 

percent to 70 percent.

3. Increased deduction for business meals while operating under Department of 

Transportation hours of service limitation

The Taxpayer Relief Act of 1997 increased to 80 percent the deductible percentage of the 

cost of food and beverages consumed while away from home by an individual during, or incident 

to, a period of duty subject to the hours of service limitations of the Department of 

Transportation. Individuals subject to the hours of service limitations of the Department of 

Transportation include:

(1) certain air transportation employees such as pilots, crew, dispatchers, mechanics, and 

control tower operators pursuant to Federal Aviation Administration regulations,

(2) interstate truck operators and interstate bus drivers pursuant to Department of 

Transportation regulations,

(3) certain railroad employees such as engineers, conductors, train crews, dispatchers and 

control operations personnel pursuant to Federal Railroad Administration regulations, and

(4) certain merchant mariners pursuant to Coast Guard regulations.

The increase in the deductible percentage is phased in according to the following schedule:

Taxable years beginning in: Deductible percentage:

1998, 1999 55 percent

2000, 2001 60 percent

2002, 2003 65 percent

2004, 2005 70 percent

2006, 2007 75 percent

2008 and thereafter 80 percent

The proposal would accelerate the increase in the deduction for business meals while 

operating under Department of Transportation hours of service limitations so that it becomes 80 

percent sooner.

 4. Repeal special occupational taxes on producers and marketers of alcoholic beverages

Under present law, special occupational taxes are imposed on producers and others 

engaged in the marketing of distilled spirits, wine, and beer. These excise taxes are imposed as 

part of a broader Federal tax and regulatory engine governing the production and marketing of 

alcoholic beverages. The special occupational taxes are payable annually, on July 1 of each year. 
30

The present tax rates are as follows:

Producers:

Distilled spirits and wines (sec. 5081) $1,000 per year, per premise

Brewers (sec. 5091) $1,000 per year, per premise

Wholesale dealers (sec. 5111):

Liquors, wines, or beer $500 per year per location

Retail dealers (sec. 5121):

Liquors, wines, or beer $250 per year per location

Nonbeverage use of distilled spirits (sec. 5131) $500 per year

Industrial use of distilled spirits (sec. 5276) $250 per year

The proposal would repeal the special occupational taxes on producers and marketers of 

alcoholic beverages.

 5. Clarification of cash accounting rules for small businesses

The proposal would provide that a taxpayer is not required to use an accrual method of 

accounting if the average annual gross receipts26 of the taxpayer (or any predecessor) do not 

exceed $2.5 million for all prior taxable years beginning after October 31, 1999 (including the 

prior taxable years of any predecessor).27 Thus, even if the production, purchase, or sale of 

merchandise is an income-producing factor in the taxpayer's business, the taxpayer is not 

required to use an accrual method of accounting with regard to such purchases and sales if the 

average annual gross receipts of the taxpayer do not exceed $2.5 million.

The proposal would also provide that a taxpayer meeting the average annual gross 

receipts test is not required to account for inventories under section 471. If a taxpayer elects not 

to account for inventory under section 471, the taxpayer would be required to treat such 

inventory in the same manner as a material or supply that is not incidental. Thus, a taxpayer that 

elects to treat inventory as a material or supply would include in expense the charges for 

materials and supplies only in the amount that they are actually consumed and used in operation 

during the taxable year for which the return is made. If a taxpayer elects this treatment, direct 

 

26 Average annual gross receipts would be determined by averaging the gross receipts of 

the three taxable year period ending with such prior taxable year.

27 Similar proposals have been introduced in the 107th Congress, but permitting the use of 

the cash method of accounting if the average annual gross receipts of the taxpayer does not 

exceed $5 million. See, S. 189 introduced by Senator Bond for himself and Senator Enzi, and S. 

336 introduced by Senator Bond. 
31

and indirect labor costs, production costs, and other costs that would normally be required to be 

capitalized under either section 471 or section 263A would not be required to be capitalized.

B. Proposals Relating to S Corporations

The following is a description of selected proposals introduced in the 106th Congress28

that would affect the tax treatment of S corporations and their shareholders.

 1. Shareholder and corporate eligibility

(a) Number of eligible shareholders

Under present law, a small business corporation may elect to be treated as an S 

corporation. A "small business corporation" is defined as a domestic corporation which is not an 

ineligible corporation and which does not have (1) more than 75-shareholders; (2) as a 

shareholder, a person (other than certain trusts, estates, charities, or ESOPs) who is not an 

individual; (3) a nonresident alien as a shareholder; and (4) more than one class of stock. For 

purposes of the 75-shareholder limitation, a husband and wife are treated as one shareholder. An 

"ineligible corporation" means any corporation which is a member of an affiliated group, certain 

financial institutions which use the reserve method of accounting for bad debts, certain insurance 

companies, a section 936 corporation, or a DISC or former DISC.

S. 1415 would provide that all family members owning stock could elect to be treated as 

one shareholder. A family would be defined as the lineal descendants of a common ancestor (and 

their spouses and former spouses). The common ancestor could not be more than six generations 

removed from the youngest generation of shareholder at the time the S election is made (or the 

effective date of the provision, if later). The election would be made available to only one family 

per corporation.

 S. 875 would provide that the maximum number of eligible shareholders would be 

increased from 75 to 150.

(b) Individual Retirement Arrangements (“IRAs”) allowed as shareholders

S. 875 would permit IRAs to be shareholders in small business corporations. In addition, 

an IRA could sell stock to the individual beneficiary pursuant to an election by the corporation to 

be an S corporation.

(c) Nonresident aliens allowed as shareholders

S. 1415 would permit a nonresident alien to be a shareholder in a small business 

corporation. Any effectively connected U.S. income allocable to the nonresident alien would be 

 

28 S. 1415 was introduced by Senator Hatch, and S. 875 was introduced by Senator Allard 

and others.
32

subject to a withholding tax in a manner similar to the treatment of such income allocable to 

nonresident aliens that are partners in U.S. partnerships under present law.

(d) Family partnerships allowed as shareholders

S. 875 would provide that partnerships all of whose members are of one family could 

hold stock in an S corporation.

(e) Requirement that an S corporation have one class of stock

Under present law, a small business corporation eligible to be an S corporation may not 

have more than one class of stock. Certain debt ("straight debt") is not treated as a second class 

of stock so long as such debt is an unconditional promise to pay on demand or on a specified 

date a sum certain in money if: (1) the interest rate (and interest payment dates) are not 

contingent on profits, the borrower's discretion, or similar factors; (2) there is no convertibility 

(directly or indirectly) into stock, and (3) the creditor is an individual (other than a nonresident 

alien), an estate, certain qualified trusts or person engaged in the lending business.

Under both S. 875 and S. 1415, a small business corporation would be permitted to issue 

certain preferred stock. In general, such preferred stock would be stock that is not convertible 

and does not participate in corporate growth to any significant extent. Only eligible S 

corporation shareholders would be allowed to own preferred stock. Payments made on the 

preferred stock would be treated as interest.

Under S. 1415, the definition of "straight debt" would be expanded to include debt that is 

convertible into the stock of the corporation under terms that are substantially the same as the 

terms that could have been obtained from an unrelated person.

Under S. 875, shares held by reason of being a bank director and which are subject to an 

agreement pursuant to which the holder is required to dispose of the shares upon termination of 

the holder’s status as a director at the same price the individual acquired such shares would be 

eligible stock of an S corporation. Distributions would be treated like interest payments.

 2. Elections and terminations

(a) Election to be an S corporation

Under present law, a corporation may elect to be an S corporation only if all the 

shareholders consent to such election.

S. 875 would provide that an election could be made if shareholders holding 90 percent 

or more of the stock consent. The portion of the corporation represented by shares that did not 

consent would continue to be taxed as a C corporation.
33

(b) Termination of election and additions to tax due to passive investment income

Under present law, an S corporation is subject to corporate-level tax, at the highest 

marginal corporate tax rate, on its net passive income if the corporation has (1) subchapter C 

earnings and profits at the close of the taxable year and (2) gross receipts more than 25 percent of 

which are passive investment income. In addition, an S corporation election is terminated 

whenever the corporation has subchapter C earnings and profits at the close of three consecutive 

taxable years and has gross receipts for each of such years more than 25 percent of which are 

passive investment income. For these purposes, "passive investment income" generally means 

gross receipts derived from royalties, rents, dividends, interest, annuities, and sales or exchanges 

of stock or securities (to the extent of gains). 

S. 1415 would repeal capital gain as a category of passive income. S. 1415 also would 

eliminate the rule that terminates an S corporation election whenever the corporation has 

excessive passive income for three consecutive years. Rather, the tax on excess passive income 

would apply.

S. 875 would provide that, in the case of a bank, passive income does not include interest 

or dividends on assets required to be held by the bank.29

 3. Computation of taxable income

(a) Treatment of charitable contributions of certain property

Under present law, taxpayers generally are allowed to deduct the fair market value of 

property contributed to a charitable organization. In the case of business property contributed to 

a charity and used in the tax-exempt function of the charity, donors must reduce the amount of 

the deduction by the amount of gain that would not have been long-term capital gain had the 

property been sold by the donor (sec. 170(e)(1)(A)). However, the amount of the reduction is 

capped in the case of a corporation (other than an S corporation) that contributes (1) certain 

inventory used by the donee solely for the care of the ill, needy, or infants (sec. 170(e)(3)(B)) or 

(2) certain scientific property used for research (sec. 170(e)(4)). In such cases, the amount of the 

reduction is limited to the sum of (1) one-half of the amount of gain that would not have been 

long-term capital gain had the property been sold and (2) the amount (if any) by which the 

charitable contribution (determined by taking into account the amount described in (1)) exceeds 

twice the basis of the property.

If an S corporation contributes appreciated property to a charity, the shareholders of the 

corporation must reduce their basis in their S corporation stock by the amount of the contribution 

that flows through to them.

 

29 This proposal is in response to competing concerns of the passive investment income 

limitations and bank regulations regarding adequate capital requirements. Bank regulators want 

to ensure that banks have sufficient liquidity for safety and soundness reasons. Report by the 

General Accounting Office, Banking Taxation, Implications of Proposed Revisions Governing SCorporations on Community Banks (GAO/GGD-00-159), at Appendix V, (June 23, 2000).
34

S. 1415 would provide that S corporations would be treated the same as C corporations 

with respect to charitable contributions of (1) certain inventory used by the donee solely for the 

care of the ill, needy, or infants and (2) certain scientific property used for research.

S. 1415 also would allow an increase in the basis of S corporation stock for the excess of 

the deduction for charitable contribution over the basis of the property contributed by the 

corporation.

(b) Treatment of certain fringe benefits

Under present law, for fringe benefit purposes, an individual that owns two percent or 

more of the stock of the S corporation at any time during the year is treated the same as a partner 

in a partnership. Self-employed individuals may deduct up to 60 percent (70 percent in taxable 

years beginning in 2002; 100 percent thereafter) of the amount paid during the year for medical 

insurance that covers the individual and his or her spouse and dependents. An individual that 

owns two percent or more of an S corporation at any time during the year is treated as a selfemployed individual.

Under S. 875 and S. 1415, for fringe benefit purposes, an S corporation would be treated 

as a C corporation rather than as a partnership. However, two-percent shareholders would be 

treated as self-employed individuals for purposes of the deduction for medical insurance (i.e., 

their deductions for medical insurance would be limited to the applicable percent of their cost).

(c) Treatment of losses on liquidation of S corporation

Under present law, if an S corporation is liquidated, gain or loss on the property 

distributed in liquidation is measured at the corporate level (by comparing the fair market value 

of the property to its adjusted basis in the hands of the corporation) and flowed through to the 

shareholders. The character of such gain or loss also is determined at the corporate level and 

may flow through to shareholders as ordinary gain or loss. The gain increases the shareholders' 

adjusted bases in their stock. The shareholders then have gain or loss with respect to the 

property received (measured by comparing the fair market value of the property to the 

shareholders' adjusted bases in their stock). Such gain or loss generally is capital gain or loss. 

Under S. 1415, loss recognized by a shareholder in complete liquidation of an S 

corporation would be treated as ordinary loss to the extent the shareholder's adjusted basis in the 

S corporation stock is attributable to ordinary income that was recognized as a result of the 

liquidation. In addition, years for which the corporation is an S corporation would be 

disregarded in determining the number of years an item may be carried over by a C corporation. 

A passive loss deduction on the disposition of an activity would be allowed to an S corporation 

after the election.

(d) Interest on certain tax-exempt obligations

Under present law, a financial institution which is a C corporation or, for its first three 

years after an election, is an S corporation is subject to a 20 percent reduction on the interest that 

is allocable to certain tax-exempt obligations issued after 1982 and before August 8, 1986.
35

S. 875 would alter the application of this rule in the case of financial institutions that are 

S corporations.

(e) Bad debt charge off

Under present law, a C corporation electing to be an S corporation is subject to tax on its 

net built-in-gain for the first 10 years after the election to the extent net gains are recognized.

S. 875 would require the Treasury Department to modify its regulations with respect to 

bad debt deductions to treat the deductions as a built-in-loss during the period the built-in-gains 

are recognized from changing its accounting method for recognizing bad debts.

 4. Transition rule for elections after termination

Under present law, a small business corporation that terminates its subchapter S election 

(whether by revocation or otherwise) may not make another election to be an S corporation for 

five taxable years unless the Secretary of the Treasury consents to such election.

Under S. 1415, for purposes of the 5-year rule, any termination of subchapter S status in 

effect immediately before the date of enactment of the bill would not be taken into account. 

Thus, any corporation that had terminated its S corporation election within the 5-year period 

before the date of enactment may re-elect subchapter S status without the consent of the 

Secretary of the Treasury.

 5. Information returns for qualified subchapter S subsidiaries

Under present law, a wholly owned subsidiary of an S corporation may elect to be treated 

a part of the S corporation in computing its taxable income.

S. 875 would provide authority to the Secretary of the Treasury regarding information 

returns of subchapter S subsidiaries.
36

V. SUMMARY OF SELECTED PROPOSALS

RELATING TO AGRICULTURE

The conference report to H.R. 5542, the Taxpayer Relief Act of 2000, also included the 

following proposals that would affect the tax treatment of taxpayers in the agriculture industry:30

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 trees31. 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 

 

30 Variations of these proposals also were considered and passed by the Senate in the 

106th Congress as part of the Senate’s consideration of H.R. 8, the Death Tax Elimination Act of 

2000. These proposals are also included in S. 312, the Tax Empowerment and Relief for 

Farmers and Fisherman Act,” introduced in the 107th Congress by Senators Grassley, Baucus and 

others. 

31 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.
37

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 

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, SECA taxes are imposed on an individual’s net earnings from selfemployment. 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) 
38

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.

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 arrangements) 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 will be 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 
39

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)

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).
40

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)). 

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. The 

valuation of food inventory has been the subject of ongoing disputes between taxpayers and the 

IRS. S corporations, personal holding companies, and service organizations are not eligible 

donors.

The proposal 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.
41

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 

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 income from the calculation of both regular tax and tentative minimum 

tax, solely for the purpose of determining alternative minimum tax.

8. 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) are 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 turning back 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 cooperative which is feed to chickens which 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 the resulting animals or 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 

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 limited circumstances, 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 an 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 
42

plans, the value of gifts, the status of certain governmental obligations, or eligibility of an estate 

to pay tax in installments under section 6166.32 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 may be commenced in the U.S. Tax Court, a U.S. district court, or the U.S. Court of Federal 

Claims, and such court would have jurisdiction to determine a cooperative’s initial or continuing 

qualification of 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 available for ethanol generally.

Under present law, 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. Under present law, the only credits that may be flowed-through to 

cooperative patrons are the rehabilitation credit (sec. 47), the energy property credit (sec. 48(a)), 

and the reforestation credit (sec. 48(b)), but not the small ethanol producer credit.

The proposal would: (1) provide that the small 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 small ethanol producer to 

be 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 would also allow cooperatives to elect to pass-through small ethanol 

producer credits to its patrons. The credit would be allowed to a patron in that proportion of the 

credit the cooperative elects to pass-through for that year as the amount of patronage of that 

patron for that year bears to total patronage of all patrons for that year.

 

32 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, a U.S. district court, 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.
43

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 since 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 with or for its patrons, (2) under a valid enforceable 

written obligation to the patron to pay such amount, which obligation existed before the 

cooperative received such amounts, and (3) which is determined by reference to the net earnings 

of the cooperative from business done with or for its patrons.

Treasury Regulations provide that net earnings 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 the cooperative can treat as patronage earnings. That reduces the amount that 

cooperative can deduct as patronage dividends.

The proposal would allow cooperatives to pay dividends on capital stock without those 

dividends reducing excludable 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. 
44

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