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Taxes and Small Business, a View from the Cheap Seats

July 31, 2012

Chris Garlasco, Owner & Managing Partner – Founders Insurance Group

I thought about this blog for a long time before making the decision to bring this blog entry to the Founder’s Forum. The Forum isn’t designed to be a political blog but often times politics intersect with our business. The goal has been to offer a point of view without gravitating to one side of the political spectrum or the other. My conversations about the health insurance changes have been focused on the “insurance” perspective rather than pointing to a particular political ideology. It is with that same focus in mind in bringing up the discussion of taxes and small business.

The coming elections have increased the intensity of the tax discussion in America. It is often said that increases in taxes will be damaging to small businesses. However, the reasons why they can be an obstacle to small business are seldom mentioned. The goal of this entry is to shed some light on the subject from ground level of this issue through the eyes of a business owner.

More than 900,000 American small businesses are “Sub-Chapter S” corporations and more than another million small businesses are LLC’s or sole proprietorships. It isn’t necessary to understand the differences between each of these for the purpose of this article. What is important to know is that in each of these cases, the profits from these businesses flow directly to the personal income tax return of the business owner(s). So, if in a given year a business shows a $200,000 profit, that amount must be added to the amount the business owner took home in base salary. So a business owner that makes $100,000 per year would have to report on his/her personal tax filing an income of $300,000 and pay tax on that amount.

Here is where the problem comes in; the additional amount in our example may not have actually made it to the business owner as personal income, leaving the business owner with a tax bill on money that was never retained. Typically, a business owner will then take a bonus from the business to cover the additional tax due. What if the cash flow doesn’t permit it? The best case scenario would be an additional strain on the business; the worst case scenario could be the need to shed a job or two.

So, where did this money go? Often times that money may have been used to pay back small business loans. A small business that is expanding and creating new jobs will often need a small business loan to finance that expansion. Those loan payments are not tax deductible (although the interest on the loan is tax deductible). It is important to note that many of these small business loans are short term, generally less than 5 years and almost always less than 7 years. This creates sizable monthly payments. Keeping with our example, if the small business owner took out a $500,000 loan on a five year note, the payments will be $100,000 plus interest. So in our example, the business owner will pay taxes on $300,000 while only $200,000 was retained as personal income.

Increasing personal income taxes will force a small business owner to think twice before seeking to expand the business with a needed small business loan as the burden of paying taxes on money not received has now become an ever greater risk. That is the first part of the problem. In addition to that issue, the amount of money that must come out of the business coffers to cover that additional tax also becomes a greater challenge. The end result of those two things has a direct effect on small business expansion and hiring as money needed to create jobs has been decreased.

Considering that as much as 70% of America’s job creation comes from small business owners, one can see the importance of this issue. It can really discourage small businesses from hiring. The increased regulations and other mandates that kick in when a business reaches 50 employees further create obstacles to hiring.

This is our current system, not a political agenda. Each person will have to decide for themselves whether or not this is harmful or not harmful to small business and job creation.

Have a great day!

Chris Garlasco

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