Tax Bondage for Business Owners—Any Escape?

While the Tax Foundation reports that April 9 represents Tax Freedom Day—that day Americans as a group have worked enough thus far to pay their tax bill for the year—many small business owners are individually still in payment mode if they’re profitable. If small business owners are successful, they remain in tax bondage for more than 99 days of the year.

Small business owners, other than those with C corporations, pay income tax on their share of net business income—whether or not it’s distributed to them. For self-employed owners, their cost for Social Security and Medicare taxes that make up self-employment tax is effectively double the amount paid by employees—and it’s levied on their full share of net business income.

Longer bondage after 2010
This tax burden on small business owners will only get worse as proposed and scheduled tax changes kick in. If the Bush tax cuts are allowed to expire at the end of 2010, as the Administration seems to be in favor of for higher income taxpayers, then:

  • The top tax rates will rise to 36% and 39.6% (up from 33% and 35% respectively). Again, these rates apply to net income reported by business owners on their personal returns, so those in the highest bracket would see a nearly 5% tax hike.
  • The top rate on capital gains will rise to 20% (up from 15%). This will make it more costly to sell interests in a business.

 Down the road, some tax increases are already certain:

  • Starting in 2013, the Medicare portion of self-employment tax will increase by 0.9% on earned income over $200,000 ($250,000 for joint filers).
  • Also starting in 2013, there is a new unearned income Medicare contribution of 3.8% on investment income of those with adjusted gross income over $200,000 ($250,000 for joint filers). Think of what this added cost means when selling a business!

Loosen tax bondage
Short of reducing tax rates, something not likely given government expenditures, here are some things I would like to see to provide some relief:

  1. Reintroduce income averaging (it was repealed by the Tax Reform Act of 1986). Farmers and ranchers are currently allowed to average their income over three years so that the tax rate on income in a good year can be moderated by having less profitable years. While all types of owners hope that their businesses will grow year after year, most realize and many have experienced during this recession the fact that there may be lean years. Income averaging would help take the tax sting out of good years and alleviate to a small extent their tax bondage.
  2. Create meaningful tax incentives. The so-called incentives created by the HIRE Act and health care reform specifically for small businesses are useful but not significant; they are small and short-lived. Serious tax incentives that are permanent or long-term in the law would be helpful to enable business owners to plan ahead.
  3. Enact self-employment tax reform. Why should self-employed individuals effectively pay double the FICA rate on all net earnings? Some limitations could be helpful, such as creating a “salary” amount for the tax. Treating the self-employed as employees isn’t far-fetched; the tax law already does it for purposes of 401(k) plans when self-employed are permitted to make what amounts to salary deferral contributions.

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