Small Business and Taxes

By :: May 22nd, 2011

 We’ve all heard the allegation: President Obama wants to raise taxes on “small business.”  But buried in that claim is a massive amount of confusion about just what businesses we are talking about, what they do, and how they operate. Fortunately, we may soon get some new information to help sort it out.

 My Tax Policy Center colleagues have tried to clarify some of this confusion by distinguishing between “small businesses” and pass-throughfirms that report income on the individual tax returns of their owners. These can be S corporations, partnerships, sole proprietorships, or limited liability companies. Using currently available IRS data, we’ve concluded there are about 20 million people who report business income on their 1040s. Very few—only about 3 percent—are in the top two tax brackets (and even some of them would avoid higher tax rates under Obama’s budget). We’ve also concluded that this handful of firms accounts for nearly half of all business income reported on individual returns.

Yet, there is an awful lot we don’t know. For example, we don’t know how many are real businesses and how many represent a bit of side income for people otherwise employed at regular jobs (imagine, for instance, a tax economist who picks up a few bucks reviewing smartphones on the Web). At the same time we don’t know much at all about those hedge funds, law firms, and real estate partnerships that likely account for a large share of the total business income reported on individual returns.

Some of those information gaps may soon get filled in, thanks to some new data being pulled together by the Treasury Department. I got an early glimpse at a National Tax Association presentation on Thursday by Matt Knittel from Treasury’s Office of Tax Analysis.    

In some respects, Treasury’s new research, still very tentative, confirms what we thought. For instance, it verifies that only about 3 percent of the owners of these firms are in the top two brackets. At the same time, the new analysis suggests that those high-income pass-through firms may generate a smaller fraction of business income than we thought—perhaps less than one-third instead of half. That suggests that raising taxes on those high-earners would not only hit a relatively few people, it would also do less damage to the economy than we thought.   

At the same time, the new research takes a closer look at small firms. The proposed new methodology excludes those who make less than $10,000 in business income and report less than $5,000 in deductions. It also tries to screen out people who really work for an employer but are treated as consultants. Viewed through this lens, there may be many fewer small businesses than the political debate suggests. 

The new research also found that wage income is much more important to these taxpayers than many analysts thought, representing more than 40 percent of the 1040 income of business owners. That is very different than the popular image of the local dry cleaner who spends 60 hours a week at his establishment. Imagine instead an IT guy who works a regular job but moonlights for private clients as well. Or a plumber who works for a contracting firm during the day and does his own jobs at night. Or, it could simply reflect the wages of a spouse who holds down a regular job.    

Keep in mind that this analysis is a work in progress.  But Knittel and his Treasury colleagues may be developing some valuable new information about small businesses and help us better understand both how they are treated under today’s tax law and how they’d be affected by proposed changes. With luck, this important research will be finished before the tax reform debate gets serious.

31Comments

  1. Michael Bindner  ::  12:19 pm on May 22nd, 2011:

    I suspect that facts are the last thing that will be welcome in this debate, since they will further undercut the anti-tax position.

  2. Sid F  ::  2:07 pm on May 22nd, 2011:

    “With luck, this important research will be finished before the tax reform debate gets serious.”

    Not to worry, unless the research completition date is 2013 or later, and even then you can probably relax.

  3. Ralph H  ::  3:36 pm on May 22nd, 2011:

    I am a small business owner. We currently are a C corporation and are contemplating changing to an S corp. To minimize taxes as a C I take my compensation as W2 wages to avoid double taxation (as closely held the decision is basically mine). As a result our corporate tax rate is below my personal rate. Currently the majority of my income is in wages.

    Soon I can “retire” and collect SSI — hopefully while still working. At that point it is in my best interest to be taxed as an S corp and minimize W2 to avoid the 15% (employee and employer tax). The only downside of this is that the additional income I will report (basically the money that is kept in the business) increases my taxable income and nudges me further into Obama’s tax target of 250+ even though I have not increased my real income.

    As an aside, I will be following this topic closely and certainly feel that taxes are too high and would oppose any increase. Also note that if I elect S corp, an increase in tax rate would potentially result in less reinvestment into the business (inventory, expansion, additional hiring).

  4. Sid F  ::  7:19 pm on May 22nd, 2011:

    Ralph

    There are substantial tax issues in doing a conversion. Be sure you have a competent tax accountant or attorney who fully understands both the conversion issues and your specific tax attributes both personally and for your business before you convert. There is the issue of Built-In Gains Tax and reasonable or market salary for the owner/operator/shareholder of an S corporation amongst others.

    Also please note that the increase in taxes proposed by Administration would be on income over $250,000. For example, if taxable income were $300,000 and the top marginal tax rate went from 35% to 40%, the increased tax would be $2,500 (5% of $50,000). I say this not to disuade you from your opposition to a tax increase, but only to make certain you and the readers of this Forum are aware of the issues and amounts involved.

  5. Annette Nellen  ::  10:35 am on May 23rd, 2011:

    Seeing discussions of lowering the corporate tax rate move to looking at how businesses are legally structured and their size is interesting and important to reaching effective and meaningful reform. A few thoughts:

    1. What is the goal for reform? The one cited most often for lowering the corporate rate is to enable firms to better compete internationally. This is likely most relevant to very large companies of any legal form (corp or partnership). Any other goals for reform should be articulated now so that proposals can be evaluated in terms of how well they meet the goals.

    2. Should there be a separate tax structure for all businesses? There is some logic for this. But perhaps we should take a closer look at what is going on now in Michigan where they are moving to repeal the MBT that applied to all businesses and enact a corporate income tax.

    btw – I don’t think the one-time review of smartphones on the web is a business (or even a hobby) – sounds like the “other income” line.

    3. Should some large businesses be taxed as corporations? What does that mean other than for the tax rate? Or would the goal be to impose double taxation on all large entities? There are some tax rules, such as in the charitable contribution area that only apply to corporations. On the other hand, there are corporate reorganization rules that likely only apply to a business legally structured as a corporation. What about eliminating double taxation?

    4. Should reform separate small from large? Perhaps, but a challenge. Today’s tax law defines “small” in many different ways and they are all different from the criteria used by the SBA. For an overview on this topic, see http://www.cpa2biz.com/Content/media/PRODUCER_CONTENT/Newsletters/Articles_2010/CorpTax/SizesofSmall.jsp.

    5. Can corporate rate reform in a revenue neutral way be done in exclusion of other broad reforms? Probably not as we are seeing questions being raised about lowering the corporate rate while individual business owners (Schedule C and passthrough) remain with a much higher rate (particularly in 2013 perhaps). But, the data shows that only about 2% might possibly be in that high rate. How many of those businesses will convert to the corporate form to take advantage of lower corporate rates? Growth in S corps and partnerships occured after TRA86 when the individual rate dropped below the corporate rate.

    Thanks for the blog posts – always fascinating!

  6. Secondary Sources: Dollar, Tax and Small Business, Medicare Premium Support – Real Time Economics – WSJ  ::  11:01 am on May 23rd, 2011:

    […] […]

  7. Michael Bindner  ::  11:33 am on May 23rd, 2011:

    If you became an S corp, hiring people and building inventory are deductible on Schedule C of the 1040. They come off the top, decreasin your tax burden. Indeed, because of this, higher rates are actually an inducement for you to hire more people – which is proof that taxes are too low – since business owners can make the same amount with no expansion.

  8. Michael Bindner  ::  11:34 am on May 23rd, 2011:

    That is the official line, however gridlock means all taxes go up automatically.

  9. Secondary Sources: Dollar, Tax and Small Business, Medicare Premium Support – superworkweb.com  ::  2:06 pm on May 23rd, 2011:

    […] –Tax and Small Business: Howard Gleckman says we’ll soon get more information on what taxes are paid by small business. “Some of those information gaps may soon get filled in, thanks to some new data being pulled together by the Treasury Department. I got an early glimpse at a National Tax Association presentation on Thursday by Matt Knittel from Treasury’s Office of Tax Analysis. In some respects, Treasury’s new research, still very tentative, confirms what we thought. For instance, it verifies that only about 3 percent of the owners of these firms are in the top two brackets. At the same time, the new analysis suggests that those high-income pass-through firms may generate a smaller fraction of business income than we thought—perhaps less than one-third instead of half. That suggests that raising taxes on those high-earners would not only hit a relatively few people, it would also do less damage to the economy than we thought.” […]

  10. Around The Dial – May 23, 2011  ::  3:07 pm on May 23rd, 2011:

    […] lays out what is known about small business […]

  11. Sid F  ::  3:31 pm on May 23rd, 2011:

    An S corporation files on schedule 1120S and has nothing to do with Schedule C on 1040. Building inventory is not deductible.

    Let me repeat my earlier statement,

    “Be sure you have a competent tax accountant or attorney”

  12. mark simon  ::  3:48 pm on May 23rd, 2011:

    Gleckman would see three ducks walking down the road and use that as an argument for higher taxes. Tax the rich and you see money leave, no other result has ever happened. Gleckman has no other point, just a “maybe”….

  13. Ralph H  ::  8:14 am on May 24th, 2011:

    Thanks Sid, our CPA has advised me on this and we will go over it again when/if we change. It would be a lot easier to make a decision if future policy was known!

  14. Sid F  ::  12:38 pm on May 24th, 2011:

    “It would be a lot easier to make a decision if future policy was known!”

    It sure would, welcome to my world.

  15. Peri Dwyer  ::  1:08 pm on May 24th, 2011:

    These figures are going to be used to justify burdening sole proprietors even more by characterizing us falsely as moonlighters. The truth is, IRS rules favor an S corp owner paying herself a reasonable salary, avoiding self-employment tax on the salary amount. So a sizable proportion of the”wages” Treasury is busily tabulating are actually self-employment income after all. Reminds me of the old saying about three types of lies!

  16. Michael Bindner  ::  4:03 pm on May 25th, 2011:

    If taxes were simplified, you should file as a business as an individual – unless, of course, you don’t make over the individual surtax floor.

  17. Michael Bindner  ::  4:04 pm on May 25th, 2011:

    The principle is still the same, wages paid to others are a deduction.

  18. Why Raising Taxes on the Rich Is Good Economics « RecruitersNation  ::  8:47 am on August 9th, 2011:

    […] As a frame of reference, that is three times the cost of the 2009 stimulus package, TARP and all the other economic fixes adopted to combat the recession. By contrast, phasing out those breaks for the top 2 percent would save some $838 billion over 10 years without raising taxes on anyone else. That includes the vast majority of small businesses, which happen to create most of the new jobs that will be necessary to nurse the economy back to health. According to the Tax Policy Center, only 3 percent of the 20 million individuals in the U.S. who report business income fall in the top two income brackets. […]

  19. John Arensmeyer: Pushing High-Income Tax Cut Under Small Business Guise: Not Good Fiscal Policy | Political Ration  ::  5:50 pm on August 1st, 2012:

    […] vast majority of small business owners simply don’t make that much money. According to the nonpartisan Tax Policy Center, less than 2 percent of small businesses are in the top two income brackets — individuals […]

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  21. Small Business Lobbyists Fight Big Business Over Tax Rates  ::  6:39 pm on December 13th, 2012:

    […] 3 percent of those businesses have adequate income to strech a tip dual brackets, according to a Tax Policy Center.That means many of a advantage from those taxation breaks goes to other high-income taxpayers […]

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