COMMITTEE on WAYS and MEANS

Chairman Dave Camp

Print this Page The Tax Tracker

DEMOCRATS’ TICKING TAX BOMB, PART V (Small Businesses)

How the Democrats’ Year-end Tax Hike Will Affect Small Businesses

f t # e
Washington, Aug 23, 2010 | comments

Starting January 1, 2011, Washington Democrats will impose a $3.8 trillion tax hike on hard-working Americans.  This tax increase will affect every American who pays income taxes through higher tax rates on individuals, families, and small businesses. 

As described below, Washington Democrats are targeting small businesses – the engines of job creation and economic growth – for much higher taxes starting next year, at a time when they are struggling just to meet payroll and the unemployment rate remains near 10 percent.  Among the most significant small business-related tax increases that will take effect on January 1, 2011:

  • The individual income tax rates – which apply to 75% of small businesses and 56% of all business income – will increase across the board.  
  • Expensing limits will be reduced, forcing small businesses to pay higher taxes on investments in depreciable property.
  • The death tax will be reinstated at a top rate of 55% and an exemption of only $1 million – meaning the federal government could take more than half of a small business’s value before it is passed on to a family member.

Below are some further details about these looming small business-related tax increases.  For more information about the Democrats’ $3.8 billion tax hike, see Part I of this series for an overview, Part II for examples of how it will affect typical taxpayers, Part III for the specific impact on middle-class families, and Part IV for how it will affect senior citizens.

Tax Rates Increased

Preventing individual tax rates from rising is critical for the small businesses that have created nearly 70 percent of new U.S. jobs in recent years.  According to the National Federation of Independent Business (NFIB), “75 percent of small businesses are organized as pass-through entities (sole proprietors, partnerships, S Corps, etc.), meaning they pay taxes on their business income based on the individual tax rates.”1   Moreover, according to the National Association of Manufacturers (NAM), “[a]bout 68 percent of all manufacturers are organized as S-corporations or other entities that file at the individual rate.”2

These small businesses that pay at the individual tax rates earn the majority of total income earned by all businesses in America.  According to IRS data, in 2007, over 56% of total business income was earned by these sole proprietorships, partnerships, and S corporations.3 If Democrats allow the automatic tax increases to go into effect, all this small business income will be taxed at higher rates.  With small business credit in short supply and fewer customers buying their products due to the economic downturn, tax rate increases will make it even more difficult for small businesses to create jobs and pay good wages.

Some Democrats claim they intend to limit these automatic tax increases on owners of small businesses to just those earning more than $200,000 (singles) and $250,000 (joint returns), asserting that this smaller tax increase would apply to only 2 or 3 percent of small businesses.  This is a highly misleading statistic.  A more meaningful way to assess the impact of that tax increase is to examine the amount of small business income that would be affected.  According to the Joint Committee on Taxation (JCT), raising taxes “only” on those owners of small businesses with incomes above $200,000 / $250,000 would still subject approximately 50% of small business income to a tax increase.4  Looking at the small businesses hit by these higher taxes provides a clearer picture of how many jobs would be affected.  According to NFIB, “the businesses most likely to face a tax increase by raising the top two rates are businesses employing between 20 and 250 employees. According to U.S. Census data, businesses with between 20 and 299 workers employ more than 25 percent of the total workforce.”5

tax rates on small businesses

Portion of Small Business Income Taxed at Certain Marginal Rates

Rates Without Democrats'
2011 Tax Hikes

Rates With Democrats' 2011 Tax Hikes 

Approximately 50% of small
business income

 10%

15%*

 15%

 15%

 25%

 28%

 28%

 31%

Approximately 50% of small
business income

 33%

 36%

 35%

 39.6%6

* Note that 100% of owners of sole proprietorship, partnerships, and S corporations that have taxable income will face a tax increase as a result of the expiration of the 10% bracket.

Small Business Expensing Dramatically Reduced

Section 179 of the tax code allows small businesses to expense (i.e., deduct immediately, instead of depreciating over time) the full cost of a certain amount of property and equipment that they place into service each year.  This deduction makes it cheaper and simpler for small businesses to expand and modernize by purchasing more capital equipment.  Setting aside additional, temporary adjustments made over the past several years in response to the economic downturn, small businesses can generally expense up to $125,000 annually (indexed for inflation each year), with the phase-out range beginning when certain capital expenditures exceed $500,000 (also indexed for inflation).    As shown in the table below, the Democrats’ 2011 tax increase will significantly reduce these limits, leaving small businesses with much higher after-tax costs for their capital investments.  

small business expensing limits

Small Business Expensing Provision

Without Democrats'
2011 Tax Hikes
7

With Democrats'
2011 Tax Hikes

Maximum capital investment that
can be fully expensed

 $137,000
($125,000 indexed for inflation)

 $25,000

Phase-out begins when
capital spending exceeds

$542,000
($500,000 indexed for inflation)

 $200,000

Dollar amounts are based on JCT estimates of various tax parameters reflecting expected inflation adjustments for 2011.

Death Tax Reinstated

For 2010, the estate tax is completely repealed.  Unless Congress acts, however, the estate tax will return in full force next year, with a top rate of 55% on the assets of taxable estates, after subtracting an exemption of $1 million (not adjusted annually for inflation).  In many cases, this tax represents double or even triple taxation:  the taxpayer paid tax when the income was earned, paid tax again on dividends or interest when that after-tax income was later invested, and then the estate has to pay tax on the assets purchased with that previously taxed income before those assets can be passed on to the taxpayer’s heirs.

Because they are often asset-rich but cash-poor, small businesses and family farms will be hit particularly hard by the reinstatement of the estate tax, as they may be required to liquidate upon the death of the owner just to pay the tax bill.  Regrettably, jobs are lost when small businesses and family farms are sold off to pay estate taxes or when those businesses make decisions not to expand because of anticipated estate tax liabilities. 

reinstatement of the death tax

Estate Tax Provision

2010

 2011

Exemption amount

 N/A - Death Tax repealed

 $1 million

Top rate

 N/A - Death Tax repealed

 55%

While the effect of Democrats’ 2011 tax increases on any particular small business will depend on that business’s specific facts and circumstances, it is clear by any measure that this is a massive tax hike that struggling small businesses and their hard-working employees simply can’t afford.

 

 

###

1.     http://www.nfib.com/issues-elections/issues-elections-item/cmsid/253

2.     http://www.nam.org/Communications/Publications/Capital-Briefing/Archive/041510.aspx

3.     http://www.irs.gov/taxstats/bustaxstats/article/0,,id=152029,00.html

4.     http://jct.gov/publications.html?func=startdown&id=3691

5.     http://www.nfib.com/issues-elections/issues-elections-item/cmsid/253

6.     Because of the reinstatement of additional, hidden tax rates (see Part I of this series), while the top statutory rate will be 39.6% in 2011, the top effective rate will actually be 41.6%.

Assumes that the inflation-adjusted amounts set in 2006 – rather than the even higher amounts in effect for 2010 under subsequent law – would be extended through 2011.

f t # e