Small Business Taxation - Assignment Example

SMALL BUSINESS TAXATION [Inset al Affiliation What is the key structural question which is discussed in this chapter and why is this question important? The chapter discusses the structural question of the different ways that some sub-category of incorporated firms and incorporated firms are treated for taxation purposes. Moreover, the differential tax treatment of normal returns to financial capital and labour income are unequivocally discussed as they basically have a great impact on working incentives and economic growth. While many economists have proposed the creation of an equal or standard tax system, the above questions are multifaceted and encompass the design of the whole tax system, a factor that makes it necessary to take them into consideration (Murphy, 2007). For the government to design a sensible corporate or personal tax system, these questions must be addressed, and the surfacing differences need to be steamrolled. Overtime, the realisms and substance of taxation have been varying ominously with a group of full-time, permanent employees on one side of the spectrum and shareholders of the incorporated business at the other end. This groups are taxed differently, a practice that many perceive to be bigoted and flouting economic and social progress. Similarly, some activities by unincorporated and incorporated businesses might appear economically similar, but upon further exploration, there is the revelation that the activities are based on dissimilar legal obligations, rights, and relationships. While similar taxation treatment of these employees and corporations might be unfair to some employees and corporations, the differential treatment creates mayhem in the tax system (Murphy, 2007). Considering the canons of taxation, employees and businesses in the small-businesses spectrum should be subjected to the same tax rate (Meade, 1978). While this might be lasting solution that will not only increase the effectiveness and efficiency of the operations of the tax system, but also spur investment, it cannot be accomplished straightforwardly. The difficulty of attaining a standard tax rate mushrooms from the natural variation in receipts and the differences in legal forms of businesses. In considering the nature of receipts, the authors assert that rules guiding the derivation of a profit figure must be applied since an employee’s wage cannot be paralleled with business receipts, and even after obtaining the profit figure, the law might require that the profits be paid out as dividends or wages (Meade, 1978). This requires the analysis of tax paid on corporate and personal levels, a factor that further creates controversy in taxation. Similarly, attaining neutrality in taxation of varying types of businesses has been made difficult owing from the current trend of taxing labour income, income from entrepreneurial activities, at a percentage that is greater than that imposed on income from capital. This has brought the incentive to convert income from labour to capital income so as to circumvent the high taxes. Consequently, government loses tax revenues, and people are discouraged from working, a factor that can further derail economic progress (McNulty, 1992). To spur investments and the entrepreneurial spirit, therefore, the government must upsurge the inducements for risk-taking by implementing a tax rate that is attracting and economically viable. Accommodation of the aforementioned structural problems requires designing a tax system where taxes levied on capital income or labour income will not detriment capital income earners or labour income earners (MacKie-Mason & Gordon, 1997). However, this should not be attained by reclassification labour income as capital income. For the system to be equitable and practical, the system should explicitly elucidate and incorporate the mechanism of ascertaining the nature of the return. This issue is quite imperative since failure to address it will lead an increase in number of incorporated firms and self-employed individuals, which will disintegrate the U.K’s reputation in the international arena. A tax system that is differential only discriminates on legal forms, and there is need to consider income redistribution and acquisition by formulating and implementing a more effective tax rate system (Loutzenhiser, 2007). The U.K is concerned with this structural issues particularly due to the recent increase in rates of social security contributions (NICs) and the introduction, reduction, and removal of the corporation tax commonly termed as ‘starting rate’. Noteworthy, it is important to safeguard investments since they grow the economy and create more jobs to accommodate the continuously increasing U.K job seekers and eventually eliminate the problem of unemployment, poverty and social insecurity (Murphy, 2007). The questions addressed are fundamental in reaching an effective tax system in the U.K. 2. What approaches have been tried or proposed to address the tax implication of the differential tax treatment? Some approaches have been proposed to reduce the vice concerning the effectiveness of the tax rates that is applied to incorporated small businesses and unincorporated business that have an implication on different tax treatment (KPMG, 2006). The following are the approaches that have been anticipated. Optional pass-through treatment approach A number of analysts have argued over the option partnership treatment to be readily available to the small companies in the United Kingdom as it is successfully done in United States. The fame of this approach in United States is an outcome of the tax system in the US which is different from that of UK and aptitude to escape some social security and labour. The approach provides vital opportunities to gain tax advantages by using one of the forms. A scenario in a tax system where the corporate tax is lower than the income tax rate, the pass-through treatment would be a beautiful option for companies if anticipate making loss. In practice, some businesses in UK can opt to set up as a limited liability with capability of setting off business losses alongside other personal income; however, the number of business doing so are small. Mandatory pass-through treatment approach In this approach, whole or part of the income of an owner managed companies is treated as labour earnings, not putting into consideration whether out in salary means or not. This aligns tax rates on capital gains and labour. This is the approach that is working in United Kingdom MSC and PSC provisions, though since NIC’s are not at the moment aligned for self- employees and employees. The treatment of either PSC or MSC income as employment income causes the owners to suffer then they would have benefited if they had to operate as unincorporated firms. The UK provisions currently apply to finding the relevant companies that the approach applies though it is somehow impossible if not difficult. The mandatory pass-through treatment approach does not give a significant impact on small business taxation. The effect of the legislation is taxation of profits of small enterprises because labour earnings are not considered in the capital investment. Deterring or preventing incorporation approach This is an approach that curb taxation problem by preventing small businesses from incorporating and consequently increases the minimum capital requirement. According to this approach, small businesses remain unincorporated and are taxed under personal tax system hence eliminating re-characterization of income opportunities. Despite the fact, that there is some difficulty in the arrival of a suitable minimum capital requirement level, the approach is acceptable in United Kingdom. Special rules for companies with active owners The approach advocates for the difficulty in taxation of small businesses in United Kingdom due to the application of double income tax system combining flat rate on capital income in progressive taxation of labour earnings. To effectively deal with this critical problem, majority of businesses have put in practice special rules for the treatment of revenues. The system of treatment differs from the treatment of income under United Kingdom MSC and PSC by making allowance for investment capital. A relevant example is in Sweden where from corporations are taxed at a reducing rate to an attributed return on price acquisition of shares of which above this taxes are the same as labour. Even though the approach looks like it is more acceptable than just treating all income of small businesses as labour earnings, the problem of definition arises. Whichever categorization of active shareholders or owner managed business is chosen, it is most likely to be arbitrary hence creating horizontal inequity for companies either side of the boundary. It should be noted that there is a trade-off in the approach. This is between the simplicity of a well-defined boundary between those who the respective rules apply to and those whom the rules do not apply, and the capability of small businesses to put tax avoidance into practice by moving to the favourable side of the boundary. Rejection of definition-based approaches The approach stipulates that definitional problems of this type are demonstrated in practice by the very troubles experienced with definition of MSC and PSC in the United Kingdom. Also, reactions to the approaches weathered by some of the Nordic countries. Norway, for example, had a system that subjected income from revenue and capital from labour to mandatory division. This was similar to Sweden where there was a reduction in the percentage of companies so as the taxpayers could teach about the term “active” shareholders (Lee, 2007). The owners of small businesses have rationally reacted to arbitrary classification by seeking the most favourable tax position that favours them. In dealing with the issue of taxing the owner-managed companies (small businesses); the best solution for this problem will be the one that do not rely on the task of defining sub-categories of company or shareholders. 3. Assuming profits/income of £25,000 and £75,000 update Tables 11C.1 and 11C.2 using 2014-15 tax and NIC rates and discuss the implications of the historical trends for individuals who are employed or self-employed. From the table 11C.2, it is clear that total tax and NICs to be paid to the UK by legal form has been decreasing and increasing simultaneously for the individuals who earn £25,000 profits per annum.The tax and NIC declined from 29.2% in a financial year 1996-97 to 28.4% in 1997-98 then consequently increased to 28.5%. Tough it scaled up, its increase is insignificant. The tax and NIC then gradually to 26.6% in 2002-03 financial year where it again increased to 27.9% in 2004-05 fiscal year where they remained constant to financial year 2006-07 then decreased down to 27% in the year 2008-09. The recent tax and NIC of the fiscal year 2014-15 shows a rate of 23.93. At glance, this means that the employed class has been paying a less amount of tax in their current financial year to the government as compared to the prior fiscal year. The historical trend reveals that the tax and NICs are to continue scaling down hence the individuals who are employed are expected to pay less tax and NICs in the forthcoming financial years. For individuals who are employed and earn £75000 started by paying a tax and NICs of a relatively high value of 37.1% as compared with employed class that makes £25000. This discloses that the tax system that is used by the UK is a progressive tax system whereby the tax and NICs increase with the rise in the amount of profits per annum. The tax and NICs value decreased from 37.1% in the financial year 1996-97 to 36.5% in 1997-98 fiscal years. The tax then scaled up gradually to 37.2 in 37.2% in 1999-2000 financial year. The value increased to 37.9% in 2004-05 financial year and consequently decreased afterwards to 37.4% in 2008-09. The recent data reveals that they paid a rate of 35.20% in 2014-15 financial year. This implies that again the rates are to continue decreasing gradually hence they should anticipate a relief in the payments. For self-employed class, their initial total tax and NICs was 23.4 which dropped to 22.0% in the financial year 2002-03. The tax increased to 22.8% in during 2003-04 fiscal year that hiked to 22.9 in 2004-05 and remained constant in the following financial year. The tax and NICs decreased to 22.8% by 2006-07 financial year then fell to 21.9% then 22.4% in 2008-09 financial year. 2014-15 financial year shows 18.17% tax and NICs rate. The rates have been remaining constant after which it either increasing or continuously decreasing for at least two years. It is anticipated that self-employed individuals are going to experience a further reduction in the tax and NICs rates hence reduction in the burden. Self-employed individuals earning £75,000 profits per annum paid a tax and NICs of 31.6 in 1996-97 financial year. The tax scaled down to 31.1% in the year 1997-98 and remained constant to next fiscal year that is 1998-99. The tax and NICs decreased to 31.0% for the following two financial years then by the financial year 1999-2000, it increased to 31.1% in 2001-01 financial year then remained constant in 2002-03. It then scaled to 32.0% by 2003-04. After that, the tax and NIC remained constant for five successive financial years. It then decreased insignificantly to 31.8 in 2008-09. The rate of tax and NIC remained constant 31.8% in 2014-15 financial year. This exhibits a stepwise graph rate values. This postulates that the rates will continue behaving in this manner for the future financial year so self-employed individual should expect the same rate in the coming financial year. From the above analysis, it is noted that employees and self-employed individuals pay different tax and NICs rates taking into consideration the level of their annual profit. For instance, an individual generating £25000 per annum as the profit and he/she is employed will pay tax and NICs rate of 23.93% while a self-employed will pay 18.17%. Therefore, an employed individual stands a chance to pay more tax and NICs rate than a self-employed person for equity in taxation to prevail. Similarly, at an annual profit of £ 75000, an employed individual will have to pay 35.20% as the tax and NICs rate that is higher than that of self-employed which is at 29.54%. 4. In your opinion, is there a need to address the differential tax treatment referred to in this chapter? To be precise, differential tax treatment to individuals who are self-employed, employed and small business activity generates incentive for individuals to be self-employed than being employee and being incorporated than being self- employed. A tax incentive to include emerges due to opportunities available to convert labour income that is highly taxed on capital income that is less taxed after incorporation (Lagerberg, 2007). Additionally, tax differential influence the choice of legal form and does not always target commercial business sufficiently. They do create costs and revenue for authorities and business respectively. Rational taxpayers take advantage of the differentials, and thus revenue authorities fail head to vital structural issues. They as an alternative reacts with compound provisions that try fruitlessly to lock up the tax advantage to a sub-category. Differential tax treatment reveals that authors do not believe entrepreneurship can be incorporated into the tax system. Rather, the solution of producing neutral system does not lie in providing particular small business stipulations. The difficulty of reaching non-arbitrary and enforceable definition of small enterprises in the tax system was neutral with respect to legal form that appeared insuperable. It improves efficiency and equity and consequently reduces distortions in the system of tax making it simpler than other measures. Among the employed, incorporated and self-employed, the activities seem similar economic wise but from differential tax system point of view, they are of different legal relationships and obligations. It treats all employees in such business organisations the same way as far as tax is concerned. The tax differential treatment highlights the central problem experienced by the small businesses. This is due to lack of neutrality among legal forms that do business activities for profit making. It can clearly be seen that is the real problem in the current economic society by the small businesses. They not only make a crucial contribution to the economy but also voluble when it comes to tax policy. They can punch above and create distrust in the tax system even if small number of people feels the impact. The achievement of tax reform that is sensible, the community concerns are to be addressed effectively but the underlying tax policy. Differential tax treatment has created the way in which small businesses are to be taxed hence posing an impact on the structure of corporate taxation, as well as that of personal at large. Additionally it postulates that the total alignment of the firms has been one of the difficult tasks because of different forms even though they seem to be carrying out the same economic activities. It further makes an attempt to reduce conformity costs that can involuntarily increase to the small businesses because the reliefs bring in complexities. The proliferation of thresholds below which particular treatment can be available can time be confusing and, therefore, some of the reliefs may require significant amount of advice and calculation before it can be sure whether they are of advantage to them. For example, value added tax can be paid as a percentage of the turnover intending to reduce the accounting work for each transaction, though proper business records are needed for the purpose of income taxation in order to save time (Keatinge, 2007). The scheme is meant for revenue neutrality and time-saving. More so, differential tax treatment has tried to solve structural problems in question such as risk that are not measurable, other issues of equity and creation of incentive for the purpose of taking risks. Any proposed new tax system whereby capital income is to be taxed at a lower rate than the labour income needs to ensure that the manner in which they are achieved is exploited in any way by recharacterizing labour income as the capital income (Sørensen, 2005). It calls for the mechanism of determining the nature of returns is required to be built into the system and be made applicable to all firms in order to make it more practical and equitable (Truman, 2006). The developments, together with times low corporation tax rates have led to the increase in number of incorporated and the self-employed firms hence growth in an economy. Therefore, there is a need to address the differential tax treatment because of its merits to small businesses. Bibiliography Keatinge, R. (2007), Self-Employment Tax Issues in LLCs Taxed as Partnerships, Suffolk University Law School Research Paper No. 07-33. KPMG (2006), Administrative Burdens: HMRC Measurement Project, KPMG Publication No. 300-808. Lagerberg, F. (2007), ‘Managed Service Companies: What Next?—Section 25 and Schedule 3’, British Tax Review, 5, 459-43. Lee, N. (2007), ‘Revenue Law—Principles and Practice’, 25th edn. Haywards Heath, West Sussex: Tottel Publishing. Lindhe, T., Södersten, J., and Oberg, A. (2002), ‘Economic Effects of Taxing Closed Corporations under a Dual Income Tax’, ifo Studien, 48, 575-610. Loutzenhiser, G. (2007), ‘Income Splitting and Settlements: Further Observations on Jones v Garnett’, British Tax Review, 6, 693-716. Lindhe, T., Södersten, J., and Oberg, A. (2002), ‘Economic Effects of Taxing Closed Corporations under a Dual Income Tax’, ifoStudien, 48, 575-610. Loutzenhiser, G. (2007), ‘Income Splitting and Settlements: Further Observations on Jones v Garnett’, British Tax Review, 6, 693-716. MacKie-Mason, J., and Gordon, R. (1997), ‘How Much do Taxes Discourage Incorporation?’, Journal of Finance, 52, 477-505. McNulty, J. (1992), Federal Income Taxation of S Corporations, New York: Foundation Meade, J. (1978), The Structure and Reform of Direct Taxation: Report of a Committee Murphy, R. (2007), Small Company Taxation in the UK: A Review in the Aftermath of the ‘Arctic Systems’ Ruling, Tax Research UK. Public Finance, 12, 777-801. Sørensen, P. (2005), ‘Neutral Taxation of Shareholder Income’, International Tax and Truman, M. (2006), ‘What’s in a name?’, Taxation. Read More