Q&A: Looming small business tax hike explained
- Tax cuts are due to expire Dec. 31 It's not clear whether Congress will act to keep them Result: Businesses have delayed plans to hire and expand
NEW YORK (AP) — Taxes and uncertainty.
Those words sum up one of the biggest worries facing small business owners. With the scheduled expiration on Dec. 31 of tax cuts enacted during the Bush administration, many people who run small companies don't know how much they'll be paying in tax in 2013. And many say that's why they have put off plans to hire and expand.
The uncertainty is complicated because the outcome of the presidential and congressional elections is far from clear. President Barack Obama and challenger Mitt Romney have different ideas about tax policy and it's hard to say whether Congress will act to stop the tax cuts from expiring.
Here are some questions and answers about the tax cuts and how their expiration may affect small businesses:
Q. Which scheduled tax increases are small business owners concerned about for the tax year that ends Dec. 31, 2013?
A. The change that's expected to affect owners the most is an increase in personal tax rates. The top rate will rise to 39.6% from 35%. That would affect single taxpayers with income of $200,000 or more and households with income of $250,000 or more.
Also expiring is the 15% rate on dividends. They will be taxed as ordinary income, which means business owners who receive dividends from their companies will likely be paying much more tax on this income than they have since 2003.
Q. How do personal tax rate increases affect small business owners?
A. Most small businesses are what's known as "pass-through" or "flow-through" companies. That means the company itself doesn't pay taxes on what it makes. Owners report the income on their personal tax returns. These companies include sole proprietorships, partnerships and what are called S corporations (named for a provision of the federal tax code). The income is taxed according to the owner's tax rate. So single business owners with income of $200,000 or more and those whose households have income of $250,000 or more will see their taxes rise next year. There are no exact numbers on how many small businesses are pass-through companies, but the National Federation of Independent Business estimates that 75% of small businesses pay taxes that way.
Q. How many small business owners would be subject to the highest rate?
A. Again, no one has exact figures, but the number appears to be in the mid-single percentages. The staff of the congressional Joint Committee on Taxation estimates that next year, 940,000 taxpayers with profitable businesses will have tax rates of 36% of 39.6%. That represents 3.5% of the total number of taxpayers with profitable businesses.
Another estimate comes from a survey by the lobbying group Small Business Majority. Five percent of small business owners who participated in the survey said their household income was $250,000 or more.
Q. What about large companies?
A. Large companies pay their own income taxes, and owners then pay tax on any dividends they receive. This form of taxation is used by what are called C corporations. Those companies include large companies, like General Motors and Apple, but they also include small businesses. The top tax rate on C corporations is scheduled to drop to 28% next year from 35% in 2012.
Q. So if a company can avoid the higher personal tax rate by organizing as a C corporation, why not do that?
A. It's important to remember that C corporations have "double taxation" — on the company's income and the dividends paid to the owners. And corporations are subject to more regulation than other types of companies. Owners need to comply with the laws of the states where a company is incorporated. Turning a company into any type of corporation means legal fees. And over the long run it might make sense not to change a company's structure.
"Tax rates can change year after year," says Charles Massimo, CEO of CJM Wealth Management, a financial advisory firm based in Melville, N.Y. He says owners need to choose a
structure for their company based on their long-term needs.
Q. Can Congress do something about this?
A. In theory, yes. Congress is in recess until after the election. When lawmakers reconvene they can consider stopping the increase or approving a smaller tax hike. However, there's a wide division between the political parties. GOP Presidential nominee Mitt Romney and the Republicans who control the House oppose the higher tax rates and say a higher tax bill will prevent small business owners from hiring. President Barack Obama and the Democrats who control the Senate believe a higher tax on the wealthiest people will help reduce the government's soaring budget deficit.
Congress doesn't have to act by Dec. 31. Lawmakers can pass legislation at any point during 2013 — or even after the year ends. For example, on Feb. 18 of this year, Congress approved an extension of a 2% payroll tax deduction for all of 2012. However, a prolonged debate in Congress would extend the uncertainty for business owners.
Q. How is this uncertainty affecting business owners' decisions?
A. Uncertainty about taxes has been one reason why some owners have been reluctant to take on new employees, according to surveys by the National Federation of Independent Business. "It's a major reason why people are not hiring now," says Jim Moniz, CEO of Northeast Wealth Management, a Braintree, Mass.-based financial advisory firm that counts small business owners among its clients.
Moniz says many of his clients who operate small companies have called him seeking advice about how to plan amid the uncertainty over taxes.
"It ultimately affects how many people we hire and whether we expand," says Darin Feinstein, whose businesses include five Fatburger fast-food franchises in Las Vegas.
Feinstein says higher taxes would come on top of other rising expenses, including what he pays for food and employee salaries.
"My margins are shrinking to a number that would make me reconsider how many employees I'm going to have," he says.
Dan Biederman, who has an urban planning consulting firm based in New York, says he's expecting taxes to rise next year, and because of that he's holding back on hiring.
"I was going to hire someone for a project in New Jersey, and now I'm not going to do it," he says.
Q. Should owners make business decisions based on tax policy?
A. Financial advisers are sticking to the advice they have long given small business clients: Taxes should be just one consideration in a business decision.
"Don't let the tax tail wag the dog," says Jeffrey Berdahl, a certified public accountant with RLB Accountants, an Allentown, Pa. accounting firm whose clients include small businesses. "If you need to hire someone for your business, you need to do it."
Owners should talk to accountants and financial advisers before making big decisions, says Massimo, of CJM management. "A business owner should base decisions on the company's ability to make profits and revenue and the needs of their business," he says.
Not all small business owners are focusing on what's going to happen to their taxes. David Rosenbaum says higher taxes won't change his plans for his New York-based company, Real-Time Computer Services Inc.
"I have never delayed or accelerated a decision based on what my taxes were going to be in a given year," he says.
Q. If nothing is done to stop the expiration, what can a small business owner do to prepare for higher taxes?
A. Owners need to determine if there are ways to improve their profits, says Moniz of Northeast Wealth Management. Although higher taxes will hurt, having a higher income will mean there's money available to help the business grow.
"Businesses need to become much more efficient and make sure that the people they have are as productive as possible," Moniz says.
Rosenbaum agreed that companies need to focus on improving their profits.
"If your margins are so small that taxes make the different between making and losing money, there may be a need to evaluate your business model," he says.
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