Statement of Richard M. Lipton on the Subject of Tax Simplification
April 26, 2001

3.  Business Tax Provisions

1. Expand the Use of the Cash Method of Accounting

   Current law requires businesses that purchase, sell, or produce merchandise to apply the inventory accounting rules and use the accrual method of accounting. Although taxpayers and the IRS have spent considerable resources contesting whether particular items constitute merchandise, the issue has never been consistently resolved. The result is some businesses cannot easily determine if they have merchandise inventory that requires them to use the accrual method of accounting. Additional issues continue to arise as taxpayers provide new products and services.

   The Treasury Department issued Revenue Procedure 2000-22, 2000-20 I.R.B. 1008, permitting businesses with gross receipts of $1 million or less to use the cash method of accounting. Subsequent modifications made by Revenue Procedure 2001-10, 2001-2 I.R.B. 1 simplified some of the requirements in Revenue Procedure 2000-22. Although we applaud the Treasury Department for taking these steps, we do not believe $1 million in gross receipts provides sufficient relief from the complexity the accrual method of accounting creates.

   Considerable simplification could be achieved by amending sections 446 and 448 to allow small businesses to elect to use the cash method of accounting even when the purchase, production, or sale of merchandise is an income-producing factor. We suggest that utilization of the $5 million gross receipts test already included in section 448 to identify small businesses eligible for this election would provide simplification for more taxpayers, minimize the confusion likely to result from different dollar thresholds, and reduce controversy that is similarly likely to result from applying different dollar thresholds for different types of businesses. A gross receipts threshold at least equal to the threshold provided for service businesses in section 448 is appropriate because the profit margin often is lower for businesses selling merchandise than for businesses providing services.

2. Inventory Accounting

   Further simplification could be achieved by amending section 471 to allow small businesses with gross receipts of $5 million or less to elect not to maintain inventories even if the purchase, production, or sale of merchandise is an income-producing factor. Although allowing a small business to deduct in the current year the cost of goods to be sold in a future year would result in some mismatch of income and expense, we believe the mismatch would be minimal for the simple reason that small businesses generally cannot afford to maintain large quantities of inventories. Although we expect there will be concern expressed over the possibilities for abuse such a proposal entails, we do not believe this should be a significant concern because we do not believe it will result in small businesses purchasing additional inventory to manipulate taxable income. Inventory purchases entail carrying costs and risks of ownership. The result is that small businesses seeking to manipulate taxable income would incur in excess of $1.00 in costs to save 35 cents in tax. We do not believe most small businesses will adopt such a course of conduct. In addition, case law provides that sham inventory purchases or purchases not for use in the ordinary course of a taxpayer's business are to be disregarded. Thus, the courts have made it clear that the IRS can address abusive situations.

   If small businesses are allowed to elect not to maintain inventories, such businesses should also be permitted to elect to deduct materials and supplies as purchased to avoid the complexity and controversy likely to result from assertions that amounts previously viewed as merchandise must be capitalized as materials and supplies under section 1.162-3 of the regulations.

   While small businesses that predominantly provide services have been involved in many of the litigated cases regarding the definition of merchandise, other small businesses with gross receipts of $5 million or less that do not primarily perform services may have relatively more significant inventory levels. Our proposal would allow these small businesses to elect not to maintain inventories as well. We believe this approach achieves maximum simplification. Should the Committee find this approach unacceptable, a different test should be developed to determine whether inventories must be maintained by taxpayers with gross receipts of $5 million or less. For example, rather than requiring inventories only if gross receipts exceed $5 million, inventories could be required if the taxpayer's total purchases of merchandise, materials, and supplies during the year exceeded a stated percentage, perhaps twenty percent, of its total gross receipts. Alternatively, inventories could be required if the taxpayer either (i) keeps a record of consumption or (ii) takes physical inventories. These alternatives, while more complicated than a $5 million gross receipts test, would nevertheless represent substantial simplification for many taxpayers.

3. Eliminate the Half-Year Age Conventions

   Section 401(a)(9) provides that retirement plan benefits must commence, with respect to certain employees, by April 1 of the calendar year following the calendar year in which the employee attains 70½. Section 401(k) states that plan benefits may not be distributed before certain stated events occur, including attainment of age 59½. Further, section 72(t) provides that premature distributions from a qualified retirement plan, including most in-service distributions occurring before an employee attains age 59½, are subject to an additional ten percent tax. The half-year age conventions complicate retirement plan operation because they require employers to track dates other than birth dates. Changing the age requirements to 70 from 70-1/2 and to 59 from 59-1/2 would have a significant simplifying effect.

4. Repeal or Modify the Top Heavy Rules

   Congress enacted section 416 to limit the ability of a plan sponsor to maintain a qualified retirement plan benefiting primarily the highly paid. Section 416 is both administratively complex and difficult to understand. Furthermore, current law includes (i) limitations on the compensation with respect to which qualified retirement plan benefits can be provided, (ii) overall limitations on qualified retirement plan benefits, and (iii) non-discrimination rules that limit the ability of sponsors to adopt benefit formulas favoring the highly paid. Given the other limitations in the Code, section 416 adds an unnecessary layer of complexity to employee plan administration.

   If section 416 is retained, the rule attributing to a participant stock owned by a member of the participant’s family for purposes of determining whether or not the participant is a key employee should be eliminated. This change would be consistent with the recent repeal of the family aggregation rules under sections 401(a)(17) and 414(q).

5. Replace the Affiliated Service Group and Employee Leasing Rules

   Sections 414(b) and 414(c) treat businesses under common control as a single employer for purposes of determining whether a retirement plan maintained by one or more of these businesses qualifies under section 401. Two other Code provisions also adopt an aggregation concept. Specifically, section 414(m) generally treats all employees of members of an affiliated service group as though they were employed by a single employer, and section 414(n) states that, under certain circumstances, a so-called leased employee will be deemed to be employed by the person for whom the employee performs services. No regulations have been finalized under these provisions. They are difficult to comprehend and to apply.

   Sections 414(m) and 414(n) should be replaced with provisions explicitly describing and limiting the circumstances under which employees of businesses that are not under common control must be taken into account for purposes of determining the qualified status of a sponsor’s retirement plan, and the discretion granted under section 414(o) to develop different rules should be repealed.