This isn’t meant to be political post. But as a CPA, I had a reaction to the coverage of the proposed tax increase and decided to write about it.
Joe the Plumber has brought to light small business owner’s troubled reaction to Mr. Barack Obama’s desire to raise taxes for anyone making over $250,000. However, I haven’t seen anyone in the media take the time to explain the full implications of this on small businesses.
Most small businesses are either S-Corps or LLC’s. The advantage of these organizational structures is that the owner pays taxes on income based on their personal tax rate, as opposed to the corporate tax rate. For 2008, the personal tax rate for an income of $250,000 is 35% and the corporate tax rate is 39%. So in its simplest form, the proposed tax structure will cost an individual making $250,000 an additional $10,000 a year in taxes.
With a LLC or S-Corp, the owner must pay income on the businesses net income, regardless of whether they pull any money out of the company for personal use or not. So if a company makes $250,000 in net income and the owner draws out $50,000, the owner still has to pay taxes on the company’s net income of $250,000 (and not just on the $50,000 he drew out for personal use). This is probably the most common unwanted surprise new S-Corp and LLC owners have in their first profitable tax year.
But there is more to this than that.
When a business buys an asset, the cost is not expensed at the time of purchase, but rather depreciated over the life of the asset. Depreciation is an accounting means of matching the expense of an asset with the use of the asset over the assets useful life. For instance, computers are 5-year assets. So if you purchase a $10,000 in computer equipment today, you would pay $10,000 in cash today and would only be able to take a depreciation expense of $2,000 in the current year (I’m leaving accelerated depreciation and Section 179 out of this for simplicity sake). This means that $8,000 of the purchase price of the computer is counted as income for the business in the year of the purchase, even though the cash was spent for an asset the company needs. Therefore, the owner must pay taxes on the $8,000 that was used to purchase assets for his business.
If taxes are raised, small business owners will be taking this into account in their business and personal tax planning. It is likely that they will choose to lower the investments they make in their companies in order to pay the higher tax on their income.
This is why the proposed tax increase would have a negative effect on small business growth.