Every small business has a very demanding partner -- one who contributes no up-front money, takes no risk, and plays no part in starting or running the company. Yet this partner demands his share of profits the moment any are earned, and he takes his share whether or not other partners take theirs.

Sound irrational? It is.

Even when all the other partners -- the founder and the stockholders -- want to reinvest their share of the profits in the company's growth, the federal government, that irrational partner, demands its portion immediately. It extracts its money when income is earned, regardless of the company's cash-flow requirements and growth plans. Consequently, the company frequently must borrow to pay the tax, and either postpone growth or borrow again to keep growth on track. This loss of cash to taxes has serious effects on the company's operating condition and contributes mightily to the high small-business failure rates. The economic consequences are fewer jobs and a slowdown in the creation of new goods and services.

One solution -- eliminating the corporate income tax altogether -- has already been advocated by many people, including Jack Albertine, president of the American Business Conference (See INC., March, page 15). While this idea is compelling' it would require a complete overhaul of the Internal Revenue Code, which is not likely to happen. A less radical approach, and one more likely to secure legislative action and support, would be a limited replacement of the income tax imposed on small businesses. Such a replacement can be found in a proposal known as the small business consumed-income tax.

Under this proposal, small companies meeting certain conditions could elect a 10-year exclusion from corporate income tax. During that time, income from the business would be taxed to shareholders personally, but only when the income is distributed to them or invested by the company in nonbusiness assets. As long as profits are used to finance plant, equipment, inventory, expansion, employment, research and development--in short, business operations -- no tax would be imposed.

Such a system would let emerging companies retain the income they need to grow while still providing the government with its share of profits. But the change would make the government a more rational investor, deferring collection of its share of profits until the business no longer needs the money to finance operations -- when income is distributed to shareholders. At that moment, the government would collect its share on an equal footing with other partners.

Companies would qualify under the system if their gross receipts were less than $20 million, their net assets less than $5 million, and their net pretax income less than $1 million. They would also have to be domestic corporations engaged in active trade or business, have only one class of stock, and have 35 or fewer stockholders.

A qualifying company electing the 10-year exclusion from corporate income tax would be phased-in over 4 years. Twenty-five percent of its income would be excluded from tax in the first year, 50% in the second, and 75% in the third year. In the fourth and subsequent years, all income would be excluded. During the exclusion period, no tax would be imposed on income used to finance operations. After the 10-year term, the company would regain its taxable status.

The net effect of this system would be a controlled integration of corporate and individual taxes. It would allow companies to retain their income to finance operations, thereby improving their cash flow. This would reduce their dependence on borrowed capital and improve their ability to repay whatever loans they still needed.

In addition to improving cash flow and strengthening operating conditions, such a system would have far-reaching consequences for small business owners. Although this is not the immediate purpose of the proposal, a consumed-income system would eliminate many long-standing tax problems faced by entrepreneurs:

* Reasonable compensation. Under the present tax code, companies may claim a deduction for compensation paid to executives who are also shareholders, but they may not claim a deduction for dividend payments. So a company realizes a significant tax saving by adopting generous compensation packages for these executives rather than paying them dividends. The Internal Revenue Service, not surprisingly, frequently challenges these compensation plans.

A consumed-income tax system would render this issue moot. The corporate earnings accumulated during the election period, which would eventually become subject to tax, would be equally reduced by compensation or dividends.

Put simply, the tax ultimately paid under the system is the same regardless of how distributions are made.

* Debt/equity. Under the present tax system, companies receive a deduction for interest payments. As a result, many choose to treat permanent shareholder investments as interest-bearing loans rather than as dividend-generating equity. Again, companies are frequently challenged on the debt/equity issue. A consumed-income tax system would eliminate the incentive to treat investments as loans.

* Double taxation. Under the present tax code, corporate income is subject to a double tax: once when it is earned and again when it is distributed to investors. A consumed-income tax would partially eliminate double taxation, since no corporate income tax would be imposed during the 10-year election period.

But how much would such a reform cost?

Total federal revenues last year were $601 billion. The corporate income tax, paid by companies of all sizes, accounted for only $37 billion, or about 6% of the total, and only about $6 billion of that came from small companies.

So even if all small-business income were excluded from the corporate income tax, federal revenues would decline by only 1%. But the real consequences would be significantly less -- because of the four-year phase-in period, because some companies would elect not to participate, and because other small companies would continue paying dividends that are taxable to the recipients, just as they are doing now.

Most important, though, this new system would help small companies retain the capital they need to hire more workers, develop more new products, and expand into new markets. All of this activity would contribute to federal revenues. New workers alone are both new taxpayers and more vigorous consumers, and the new jobs might reduce public support rolls. The economic activity caused by expansion of markets and product lines would have a positive ripple effect on the national economy. Added together, these factors probably would offset any initial revenue drain created by the small business consumed-income tax.

If small companies' contributions to national economic growth are to continue, as they must, government must adopt a more responsible attitude toward collecting its share of small business income. Fortunately, interest in small business and interest in tax reform seem to be coinciding on Capitol Hill and within the Administration. A small-business consumed-income tax offers a rational way of dealing with small business income, and it could point the way toward broader tax reform for all business groups.

Published on: Nov 1, 1984