How the Tax Code Impedes Entrepreneurial Growth

Though not new information, testimony before the Committee on Small Business in Congress has in the past few years shed light on how the tax code complicates the startup and growth of entrepreneurial venturesⁱ. The main reason for bringing these points to light again is the recent change in the political power at the federal level. With Democratic control of all three branches of government, the recent improvements in these areas are likely to be reversed and even make the situation worse for entrepreneurial business ventures.

There are three areas in which entrepreneurial ventures are unique in the business world, and all three result in problems due to the tax structure and regulations. While each of these three characteristics are common to the entrepreneur startup and growth, the business is disadvantaged by current tax codes:

Many entrepreneurs operate at a loss for significant periods of time. Many do not survive this negative cash flow situation, but there is no significant help in the tax codeⁱⁱ.
The risk of early failure due to extended periods of loss makes possible investors wary of funding entrepreneurial businessesⁱⁱⁱ.
When the entrepreneur’s business does begin to show success, their goal is usually to rapidly expand their scale and operations^iv. Again, funding resources are difficult to attract.

These characteristics are common to the entrepreneurial venture, and the success of the venture is disadvantaged by the tax structure.

Operating Losses Tax Treatment

While a business that turns a profit is subject to an immediate tax liability for that profit, the business that produces a loss is often not entitled to an immediate tax benefit from the loss. Check details with a licensed tax preparer, but the general rule is that when a business’s loss exceeds recent profits, there is little or no recent tax benefit from the loss, as it must be carried over to future tax years when there is a profit. An entrepreneurial business with successive years of operating losses is getting no current tax relief and may not survive long enough to take advantage.

Investors and Capital Losses

Many entrepreneurs rely upon outside investors for financial capital to get from startup to profit. These are risky ventures, and many investors shy away due to the risk. Compounding the problem is the inability in most cases for the investors to take advantage of the capital losses immediately, making them wait until there are capital gains to offset. While capital gains are subject to an immediate tax liability, capital losses often are not able to receive any tax benefit.

Scaling Up and Business Growth Investment

Once an entrepreneurial venture begins to show a profit, the immediate goal is often to scale up for rapid growth. This usually requires significant investment, often in equipment and infrastructure. Current depreciation rules penalize the investors who fund these large expenditures, as they often must depreciate them over many years.

High Marginal Business Tax Rates

The 2020 elections and change in political power have introduced the likelihood of reversing recent business tax reductions and increasing taxes on businesses across the board.

All considered, it is tough to be an entrepreneur in today’s business world. However, as it has always been, there is no better way to achieve financial success in the U.S.

i The Tax Code as a Barrier to Entrepreneurship, TaxFoundation.org

ii Entrepreneurship and the U.S. Economy, Bureau of Labor Statistics

iii Venture outcomes are even more skewed than you think, Seth Levine

iv The Five Stages of Small Business Growth, Harvard Business Review