Congress and the administration have some work ahead of them
We hear a fair amount about the upcoming fiscal cliff that will be upon us Jan.1, 2013. On that date, the Bush-era individual tax cuts expire, as well as other significant tax provisions. In addition, the social security payroll tax holiday also expires. No doubt we will survive in some measure — but at what cost? Will we need to buy shovels to dig out of another recession?
The impending tax rate increases impact every taxpayer as tax rates, deductions and credits are all impacted by the expiration of the Bush-era tax cuts. The current political consensus appears to be that, for most taxpayers, the tax rates should not be allowed to expire. The bigger debate is whether higher income taxpayers should receive any extension at all.
In connection with the entire tax debate is the discussion of the impact of a tax increase on small business and what an increase will do to these businesses and the jobs they create. Years ago, small businesses overtook the Fortune 500 as the engine of job creation. Recently, I took a few minutes and tried to determine the magnitude of small businesses in the tax base. One can look at the Internal Revenue Service statistics on tax returns to try to identify the potential universe of the small business tax base.
The IRS provides, in its statistics, the number of taxpayers filing specific tax forms or schedules in their respective Form 1040. The latest available IRS tax return statistics are for the 2009 tax-filing year. For purposes of the definition of small business, I am ignoring any C corporation filers (although we know many fall in the small business category) and focusing on businesses where the profit and loss activity is reported in a Form 1040. The Joint Committee on Taxation also issued a report in late July using the IRS statistics as the basis for its analysis on business taxpayers in a report it presented to Congress. My comments below are based on this information.
In 2009, nearly 4.1 million of the 5.8 million corporate tax returns filed with the IRS were filed by S corporations. The S corporation taxable income activity is reported on the returns of the individual S corporation shareholders. The IRS indicated there were more than 7 million S corporation shareholders in 2009. Nearly 85 percent of S corporations reported gross receipts of $1M or less in 2009.
S corporation returns are not the only small business returns that report business activity on Form 1040. The most common form of doing business these days is the use of a limited liability company. Also there is the still the use of a partnership to conduct business. Both of these types of entities file a federal partnership return if there are two or more owners of the LLC or partnership. Once again, this business activity is reported on the individual member’s or partner’s tax return (Form 1040). More than 3 million partnership returns were filed in 2009. Most of these entities had individuals as the partners or members.
In addition to S corporations and LLCs, many individuals conduct business through a sole proprietorship format. Sole proprietorship activity is also reported on Form 1040s (Schedule C). Schedule C activity was reported on more than 22 million returns in 2009. This includes LLCs that have one member (owner). In addition, more than 1.9 million from 1040 tax returns included Schedule F for farming activity. This form is similar to Schedule C but specific to farmers.
Also, many other individual tax returns included business activity from rental properties or mineral interests. More than 10 million individual tax returns included either income from rents or royalty activity.
The point in reviewing all these statistics is that there are a large number of tax returns with business activities impacted by any change in individual federal income tax rates. It is only logical to expect that a change in marginal federal income tax rates may impact business decisions on capital expenditure, hiring and overall business expansion and growth. Granted, many of the taxpayers who own a small business or an interest in a small business may not currently be at the maximum tax rate, but one can likely assume that most would like to be generating income that would place them in the highest tax rate bracket. And as their businesses are more profitable, the marginal tax rate increases on the additional income earned. Recalling my college economics class, the law of diminishing returns fits in here somewhere.
We all remember the interaction between the President (when a candidate in 2008) and Joe the Plumber. Joe had concerns of where tax rates were going and what the impact would be on his business. Many believe this concern still exists given some of the uncertainty about the economy, the direction of tax rates and the implementation of the health care legislation and other regulatory reforms.
The uncertainty related to tax rates is having some assurance of what will be the enacted tax rates for this year, next year and the years after that. Many view the proposed extension of Bush-era cuts for another year or so to be no more than just kicking the can down the road without making an actual decision on where tax rates should ultimately be set. And of course, there is the debate on who should receive or not receive the benefit of any extension of those cuts. There is also the consideration of whether meaningful tax reform should be done to allow for the streamlining of the tax code and its regulations as well as having a competitive tax system in place for businesses dealing in a global marketplace. Perhaps someone in Washington will think about the millions of small businesses as they debate tax policy and legislation.
It is interesting to note that Japan recently reduced its corporate tax rates. When Japan’s enacted tax rates are fully effective, it appears the U.S. will now be the champion of the highest corporate marginal tax rate (federal and state corporate income tax rates combined) of any major industrialized country. That’s one gold medal the U.S. may prefer not to win.
It is fair to say that taxes impact business decisions. We see the evidence of this with the competition and movement of business activities between the states here in the U.S. as the states offer incentives to attract business. Many countries have adopted business-friendly research incentives and reduced corporate tax rates on income from patents and other intellectual property to attract high-value business activity. Meanwhile, in the U.S., the research tax credit expired Jan. 1. As a result, U.S. businesses are currently operating with no ability to claim research tax credits.
Congress and the administration appear to have some work ahead of them.
Bill Roth is a tax partner with the local office of international accounting firm BDO LLP. The views expressed are those of the author and are not necessarily those of BDO. The comments are general in nature and not to be considered specific tax or accounting advice and cannot be relied upon for the purposes of avoiding penalties.