TAXING SMALL BUSINESSES TAKES ON A NEW MEANING

May 28, 2010

When the House takes up the extenders package, one of the provisions (found in Section 413, Page 282 of the amendment language) would for the first time impose the self-employment tax on S-corporation profits earned by firms with three or fewer members, and which are engaged in “personal services” (health, law, lobbying, engineering, architecture, accounting, actuarial science, performance arts, consulting, athletics, investment management, and brokerage services).

Under tax law, a corporation can elect treatment under “Subchapter S,” and become a so-called “S-corporation.”  Unlike an ordinary corporation, an S-corporation does not pay taxes on profits at the company level.  Rather, the profits flow through to the owners, who pay income taxes on them right on their personal 1040 forms.  Under current law, no self-employment taxes are owed on S-corporation profits.  Those who own more than 2% of the company’s shares and perform services for the company must, however, pay themselves a “reasonable salary.”  Like any salary, these earnings face Social Security and Medicare payroll taxation.

Because this tax structure is relatively-simple and avoids any potential for double taxation (always a problem with regular corporations), the S-corporation election has been increasingly-popular with tens of millions of small businesses since the 1950s.  Many smaller professional and manufacturing firms are organized as S-corporations.  According to the IRS, there were 4 million S-corporations in 2007, the latest year with data.  These 4 million small businesses had 6.8 million owners. Of these, ATR has estimated from IRS data that approximately 1 million S-corporations are in the areas of  “professional services.”

These 1 million S-corporations have multiple owners.  Assuming that the ratio of owners-to-companies holds up in the professional service sectors, this bill raises taxes on 1.7 million S-corporation owners.

The recent healthcare law raises the Medicare portion of the self-employment tax for most small business profits from 2.9 to 3.8 percent.  As a result of that, the House extenders bill means that the rate on most S-corporation profits will rise from 35 percent today (income tax only) to 43.4 percent by 2013 (3.8 percent Medicare payroll tax plus 39.6 percent top income tax rate that year).  This is a 24 percent increase in the marginal tax rate most S-corporation profits face.

This tax increase probably won’t hurt the S-corporation owners much at all.  Many today take a “draw” from the company to pay taxes associated with their pro-rata share of profits.  In order to pay this new tax rate, most owners will simply take more money out of their companies.  This is capital no longer available for wages, benefits, new jobs, plant and equipment, or other vital investments in our economy.  Even as a class-warfare tactic, this tax hike doesn’t make any sense.  The true incidence will be borne by workers and in the form of less economic growth.

Here is how the "Extenders Bill" will raise taxes on pensions, university endowments and charieites:

First of all, the package has a pair of tax increases on investment partnerships (Sec. 411 and 412).  Investment partnerships consist of a “general partner” who makes investment decisions for the partnership.  It also consists of “limited partners” who contribute money to the partnership.  Limited partners are usually large investors like defined-benefit pension plans, university endowments, and charities.

The two tax hikes in question each involve the general partner.  A general partner is usually compensated under a system known as “two-and-twenty,” or a similar arrangement.  Under this system, the general partner receives a taxable salary equal to two percent of the assets under management (like all salary, this is taxed at ordinary income tax rates).  He also earns a twenty percent share of the profit he can generate for the partnership.  It’s important to note that this profit share only becomes available after the limited partners have gotten a set return themselves.  The general partner can also sell his ownership interest in the partnership, and would pay capital gains tax on any profit from that sale.

The extenders bill raises the tax rate the general partner pays on capital gains (either from the sale of the ownership interest, or the sale of partnership investment assets) from 15 percent today to 38.5 percent in 2013.  This is done by requiring three-fourths of the capital gain to be taxed at ordinary income tax rates.  Both the capital gain and ordinary tax rates are scheduled to rise in 2011 under the Congressional Democrat and Obama budgets.  Additionally, Obamacare imposes an investment surtax of 3.8 percent in 2013.  Below is the tax rate on these capital gains for each of the next several years:

  Tax Rate
2010 (Pre-Hike) 15%
2010 31.3%
2011-2012 31.3%
2013 + 38.5%

What will be the result of this 157% tax hike on general partners of investment firms?  One possibility is that the general partner will demand a higher percentage of profits, in order to make himself whole on an after-tax basis.  For example, a partner with a 20 percent share of the profits today might need to be able to claim 30 or 40 percent tomorrow in order to get the same after-tax return.  This, in turn, would leave less profits available for the limited partners—defined benefit pension plans, university endowments, and charities.  This tax hike could easily become a tax hike on them, not general partners.

America’s trading competitors have no such desire to punish savings.  India has no capital gains tax, and the rate is a low 10 percent in China.  Even in the United Kingdom, the rate is only 18 percent.

The ultimate goal of Congressional Democrats is clear: piece by piece, they want to tax all capital gains at ordinary income tax rates.  If that happens, the combined federal-state rate on capital gains could easily approach 50 percent—stifling investment in jobs and growth.

We believe that the Constitution of the United States speaks for itself. There is no need to rewrite, change or reinterpret it to suit the fancies of special interest groups or protected classes.