Small Business and Taxes: Not What You Think

By :: September 27th, 2011

In the politics of taxation, nothing may be more controversial than the hot-button issue of small business. But important new research by career staffers at the Treasury Department concludes that there are lots fewer of these firms than many think, they account for only about 17 percent of total business income, and  hire many fewer workers than the political rhetoric would have you to believe.

Using newly available tax data, the Treasury staff has refined its definition of small business and found there are no more than about 20 million owners of these firms in the U.S.-- far fewer than the 35 million they previously figured. And only about five million have any employees.

Small businesses take on an outsized importance in the tax policy debate for two reasons: These firms play into the great American entrepreneurial narrative and, in the current political debate, they are the “job creators.” Raise their taxes, goes the argument, and you further wreck an already-weak economy by discouraging these firms from hiring and investing.

Well, it turns out most of the firms those pols define as small businesses don’t hire or invest very much at all. There is no question that other companies whose income is reported on individual tax returns do hire and invest (quite a lot in some cases), but they are not small businesses, at least not according to this new definition.

So what is a small business? The Treasury team, led by Matthew Knittel at the Office of Tax Analysis, defined one as a firm that has combined income or deductions of at least $10,000 but no more than $10 million and one that operates in a businesslike manner. In other words, it has expenses such as wages, office supplies, rent, and the like.

This is very different than the Small Business Administration, which uses multiple definitions but can include firms with sales of as much as $35.5 million with as many as 1,500 employees. It also is an effort to distinguish between those who report business income on their individual returns and actual small businesses. Treasury finds that many partnerships, S corporations, and others who file on an individual return don’t meet the small business test—either because they make too much money to be “small” or too little to be a real business.

Those distinctions are extremely important since many politicians love nothing more than to happily label all firms whose owners report income on their individual returns as iconic small businesses. If nothing else, the Treasury staff analysis shows how bogus that exercise is.

For example, using tax year 2007 data, Treasury found that of the 23.2 million people who reported income on Schedule C, fewer than half met its small business test—nearly all because they were too small. On average, the excluded firms reported just $7,000 of total income and $4,600 of net income.

About small business as job creators: Treasury found that only about 5.4 million small businesses paid any wages at all. Of the more than 10 million with income of less than $100,000, only about 10 percent paid any wages, and about half that compensation went to owners and other officers.

This picture of small businesses is vastly different from the image presented by many politicians—and casts the debate over how these firms are taxed in a very different light. Knittel and his colleagues acknowledge there are other ways to measure these businesses, but conclude that most competing definitions tell roughly the same story they do.

Congress would do well to get its facts right. But unfortunately, when it comes to rhetoric about small business, lawmakers seem to prefer their own version of don’t-ask-don’t-tell.

11Comments

  1. Michael Bindner  ::  7:11 pm on September 27th, 2011:

    How did the OTA study treat franchises? As independent businesses or units of the parent company? If included, what happens to the numbers when franchises are excluded? Of course, talking about this subject brings in the question of whether such firms are truly independent or a dodge to hide inventory from the balance sheet and workers from unionization and the payment of decent benefits.

  2. Becky Hargrove  ::  8:18 pm on September 27th, 2011:

    Unfortunately, the dialogue about saving small business serves as a cover to hide the lack of access for small business at local levels. By pointing a finger at Washington, many think the problem resides there, when the reality is that local insiders don’t want the small business person to get a foothold in countless communities across the country.

  3. Vivian Darkbloom  ::  6:48 am on September 28th, 2011:

    “In the politics of taxation, nothing may be more controversial than the hot-button issue of small business. But important new research by career staffers at the Treasury Department concludes that there are lots fewer of these firms than many think, they account for only about 17 percent of total business income, and hire many fewer workers than the political rhetoric would have you to believe.”

    There’s no question about it, this is a hot-button political issue. However, it appears that Mr. Gleckman is simply playing politics on one side of that issue. So, the SBA defines a “small business” as one that has no more than $35 million in revenues; whereas the Treasury Department revised that downward to $10 million. Is this downward revision the result of Treasury Department “research” as Mr. Gleckman would have us believe, or is it merely another arbitrary cutoff? It seems to me that what is “small” is a relative concept and generally a firm with less than $35 million in gross revenues would be “small” in my relative judgement. Feel free to disagree, but don’t claim this distinction is based on “research”. Here, Mr. Gleckman would do well to get *his* facts right, or at least to stop pretending that these rather subjective definitions of what constitutes a “small business” constitute “facts” in the first place.

    As far as excluding those that are merely passive activities, I have no qualms with that. But, excluding those with no persons yet on the wage payroll (aside from the proprietor or partners) misses the point completely. All businesses that are currently “big businesses” started out small. Presumably, Mr. Gleckman would have excluded Steve Jobs and Steve Woziniak from the definition of a “small business” when they started that little business some 40 years ago. It is not solely relevant that these small businesses are not yet hiring or are not currently hiring. Rather, the point is that unless the conditions allowing them to inclubate and grow exist, they will never reach the hiring stage of development.

    And, fostering a good environment for small businesses is not merely about job creation. It allows those small businesses, with or without employees, to challenge the “big business” status quo. That’s important if you want to foster innovation and competition with the existing big business oligarchy.

  4. Joe Barnett  ::  11:21 am on September 28th, 2011:

    Thanks for ridiculing those who are concerned about small business and relied on previous SBA definitions, etc. I find it boorish, but then again, I don’t write for the Huffington Post.

    Joe Barnett
    Director of Policy Research
    National Center for Policy Analysis

  5. Ralph H  ::  12:22 pm on September 28th, 2011:

    My wife and I have 3 small businesses with distinctly different taxations; a factory (c corp), real estate (LLC) and a 1 person consulting firm (reported on Sched C). Each presents it own problems, but there are several comonalities. 1)We pay MUCH HIGHER effective tax rates than big companies like GE, Google, etc. 2)We have MUCH MORE at risk than people who work for a salary as we can lose all work or be sued at any time. 3)We have no voice with politicians. In my view we are completely overtaxed and forced to fill in way too many federal and state forms. The factory in particular is hit by two states, two municipalitys, a county school district and the Feds, with a proliferation of “nickle and dime” taxes such as BPT. In short any group who wants to increase my tax burden is an enemy, especially if they increase entitlements for people sitting on their butt at home.

  6. “Small” Is In the Eye Of The Beholder | South By North Strategies, Ltd.  ::  10:10 am on October 4th, 2011:

    […] TaxVox  summarizes new research into small businesses and taxes. Small businesses take on an outsized importance in the tax policy debate for two reasons: These firms play into the great American entrepreneurial narrative and, in the current political debate, they are the “job creators.” Raise their taxes, goes the argument, and you further wreck an already-weak economy by discouraging these firms from hiring and investing. … Well, it turns out most of the firms those pols define as small businesses don’t hire or invest very much at all. There is no question that other companies whose income is reported on individual tax returns do hire and invest (quite a lot in some cases), but they are not small businesses, at least not according to this new definition. … So what is a small business? The Treasury team, led by Matthew Knittel at the Office of Tax Analysis, defined one as a firm that has combined income or deductions of at least $10,000 but no more than $10 million and one that operates in a businesslike manner. In other words, it has expenses such as wages, office supplies, rent, and the like. […]

  7. Hire CPA Firm  ::  1:39 am on October 12th, 2011:

    This is a wonderful article, I have found some valuable points in it.Accounting is necessary to assess the financial position of a company and accordingly engage in future planning for finances.

  8. tax  ::  11:43 am on December 13th, 2011:

    There is no hiding from the fact that small tax allowance and perks help small businesses, it really does fall under the fundamenals. But as other comments have said, why are small businesses paying more tax than larger companies (some of which dont even create much employment)

  9. Electronic Cigarette San Antonio  ::  3:24 pm on June 23rd, 2013:

    Great post.Thanks Again. Much obliged.

  10. Beverly Hills Real Estate agent  ::  3:16 pm on October 17th, 2013:

    I needed to thank you for this wonderful read!!
    I certainly enjoyed every bit of it. I’ve got you book marked to check
    out new things you post…

  11. Tax Accountants in Southampton  ::  3:04 am on October 20th, 2014:

    Many small businesses and start-ups give less priority for the accountancy & Taxation factors. But giving more importance and hiring an expert Tax Accountants will be beneficial for long run.