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The Tax Dance

What could proposed tax overhauls mean for your business?

While one goal of a bipartisan panel tasked with overhauling the U.S. tax code was simplification for small businesses, the panel's proposals could prove costly for business and have unintended consequences for the U.S. economy.

Indeed, the housing industry is already bracing for potential fallout from a proposed repeal of the popular mortgage interest deduction, which would be replaced with a credit worth 15 percent of interest paid during the year. "The housing market drives about 12 percent of the economy," says Martin Regalia, chief economist and vice president of economic policy for the U.S. Chamber of Commerce. "There's a tremendous section of the economy involved--housing, home building and home furnishing--and they could be significantly hurt when the immediate adjustments would take place."

The proposal is among several the Treasury Department is weighing as it evaluates two comprehensive tax reform plans from the Tax Advisory Panel appointed by President Bush. The first plan, the Growth and Investment Tax Plan, taxes income from dividends, capital gains and interest at a flat rate of 15 percent, and it taxes businesses that are not sole proprietorships at a flat rate of 30 percent. The other recommended option, the Simplified Income Tax Plan, would set the top tax rate at 33 percent and allow exclusions for dividends and capital gains from U.S. firms, though it would tax interest at regular income-tax rates.

Both plans allow businesses to write off their investments immediately. Also, Sen. John Kerry (D-MA) and Sen. Gordon Smith (R-OR) have introduced a bipartisan bill that would give the Treasury Department authority to modify or create class lives for capital assets that could be used to establish more practical depreciation allowances. Additionally, the bill would ensure that the current law permitting small businesses to immediately write off the cost of equipment and other qualifying capital expenditures up to $100,000 each year would not expire in 2007.

Simplicity for small businesses was an overriding concern, says Tax Advisory Panel member Elizabeth Garrett, a law professor at the University of Southern California in Los Angeles. "A lot of [small businesses'] cost of taxes is not actually what they send to the government, but rather the record-keeping and compliance burdens that fall very heavily on small businesses," she explains.

Second, the panel was concerned that entrepreneurs often choose a business structure, such as an LLC or S corporation, on the basis of taxes rather than "what organization is best to deliver the goods and services that you want to deliver," Garrett says. "And if you make the wrong decision, it can have disastrous tax consequences."

Despite simplification efforts, Regalia says the panel's proposals miss their mark. His biggest complaint: the lack of transition rules. "They specify some fairly dramatic changes in the tax code and treat them as if they have no dislocation effects at all, like people are going to instantaneously adjust and everyone [will be] all right," Regalia says. "In fact, you've got some significant adjustment costs to these types of fundamental changes in the tax code."

Regalia predicts real reform is still a long way off and will only happen incrementally. Along those lines, business owners would like to see a permanent repeal of the estate tax and a permanent extension of the Section 179 expensing deduction, which allows businesses to fully deduct qualified capital expenditures for the year. Says Regalia, "I think the biggest thing businesses would like to see is real, fundamental tax reform rather than a grandiose approach to tax reform."

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This article was originally published in the April 2006 print edition of Entrepreneur with the headline: The Tax Dance.

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