A Case of Mistaken Identity

At last week’s Pittsburgh Business Times Biz-Mix event an unsuspecting entrepreneur was trapped into listening to my advice on why she should structure her new business as a pass-through entity.  I’m sure it was just what she wanted to talk about over cocktails at the Savoy.  In addition to vowing to be a more effective networker, this experience also made me think differently about tax reform.  If it's supposed to help small business, that would mean everyone is clear on what tax policies really benefit small companies and that's not the case. 

Even the IRS is getting that more clarity is needed in terms of defining what a business taxpayer looks like.  Tax Vox did a piece on the IRS overhaul of their small business count.  Using criteria that say a small business has combined income or deductions of at least $10,000 but no more than $10 million and operates in a businesslike manner, the number of small businesses in the US is now pegged at 20 million.  (Prior to the study it was 35 million).  This isn’t a story about the recession closing down businesses, it’s just cutting out businesses that are so small that they’re not really supporting anyone and also taking out businesses with small numbers of employees but lots of income.  Both those types of businesses don’t really care about things like health care tax credits or bonus depreciation.

One other item that came out of the research is only 27% of small businesses pay any wages at all.  This does bring up a recession related story.  According to a new Kaufman Foundation  study the truism about small business being the main job creator in the U.S. is true -- and that's not necessarily good news. When you net out businesses that don’t employ workers beyond the boss, the US has a decline in new business creation. According to the report new businesses in the US have historically contributed 3 million new jobs a year to the economy.  Starting in 2009, that number has fallen to 2.7 million per year.  Worse yet, the average start up staff in the 1990s was 7.5 people.  Today that same number is 4.9 jobs.  So fewer start ups and fewer jobs per business.  

My takeaway from all this is that tax reform for small business could really make a difference in helping the economy improve.  The key is paying attention to what helps businesses that grow into job creators and can scale to the point they make a difference.  This isn’t an impossible task given the available data, but it does require paying attention to more than just good sound bites. 

Location, Location, Taxation

As the talk about tax reform increases in Washington, the actions of businesses are moving that one step faster.  Even with the current real estate relocation challenges businesses are making the effort to locate in a way that mitigates their tax burden.  One big example appeared in this week’s Wall Street Journal  where they detailed how many US based companies that have the opportunity to incorporate offshore prior to an IPO (lots of restrictions on this, but it can be done) are making sure to do so.  Another area that’s getting plenty of attention now is state taxation.  Certainly the buzz I hear is that companies are doing the tax math in terms of both their initial location and how they grow the business.

The Small Business & Entrepreneurship Council just released their Business Tax Index of 2011 ranking the 50 states in terms of tax friendliness.   The top five friendly states are:  South Dakota, Texas, Nevada, Wyoming and Washington.  The five worst:  California, Maine, Iowa, New York, New Jersey, Minnesota and Washington DC.  (I don’t know if that last one is supported by data or emotion.)  Speaking from my own limited experience I would say that New York, California and New Jersey don’t make it easy for small business owners in terms of taxes.  In particular, they have a thicket of fees for corporations located outside of the state who do business in the state that make the airlines look like they have transparent pricing. 

Of course, the issue is more nuanced than just thinking about income taxes.   For example states that have no income tax like Texas and Florida have other “fees”  that impact the bottom line of a business the same way a tax does.  A recent Ernst & Young study on the topic noted that income taxes from businesses make up a relatively small portion of state budgets, but that in 2009 property taxes collected from businesses by states  went up.  In the midst a huge commercial real estate crisis, business property taxes collected are going up?!  The other direct tax issue to consider is personal vs. corporate tax rates.  Many small business owners pay taxes on their profits via their personal returns, so that’s an important factor to consider. 

Like everything else involving taxes it’s not straightforward, but doing the math during your tax planning time rather than at filing time is worth the effort.