Tax Hike on the Wealthy: Bad for Small Business?

Editor's Note: This is the first in a three-part series by Washington bureau chief Kent Hoover looking at pressing tax issues for American small businesses. On Tuesday, read about the debate over what to do with the estate tax. And on Wednesday, find out more on how Congress may change tax rates on capital gains and dividends.

Small businesses will play a key role in Congress' decision on whether to allow tax rates to increase next year for higher-income Americans.

If Congress does nothing, all of the reductions in income-tax rates enacted during President George W. Bush's administration will expire at the end of this year. That would result in higher taxes for middle-income Americans, as well as the wealthy.

While the federal government could use the revenue from such a sweeping tax increase, most economists think that would further weaken the U.S. economy. Plus, there's an election looming, and a middle-class tax hike could be political suicide.

So the debate in Congress likely will focus on what to do with the rates for the top two income brackets. President Obama has proposed allowing income-tax rates to increase next year for individuals making more than $200,000 and couples making more than $250,000, while extending lower tax rates for everyone else

Business groups contend, however, that all of the Bush-era tax cuts should be extended, at least temporarily, given the shaky state of the economy.

"In one bold, swift move, this would substantially boost investor, business, and consumer confidence and would infuse our economy with fresh momentum," the U.S. Chamber of Commerce wrote in an open letter to Congress and the president.

The National Federation of Independent Business would like Congress to make all the tax cuts permanent—an unlikely outcome.

NFIB contends small-business owners are worried about higher taxes even if they aren't in the tax brackets that Obama has targeted for increases.

"We haven't dealt with any of these rates yet—that's a major concern for small businesses," said NFIB tax counsel Bill Rys.

Unless Congress acts, a major tax hike is less than five months away. This uncertainty makes small businesses less willing to spend money on growing their businesses, Rys said.

Individual income-tax rates matter to small businesses because most are organized in such a way that their profits pass through to their individual owners for tax purposes.

If Congress limits tax hikes to high earners, most small-business owners would be spared. Only 3 percent of individuals with business income would face higher taxes if the top two current rates of 33 percent and 35 percent revert to their previous levels of 36 percent and 39.6 percent.

"Ninety-seven percent of small businesses in this country would not pay a penny more due to letting these upper-income tax rates expire," said Treasury Secretary Timothy Geithner.

Extending tax cuts for high-income Americans would cost the federal government $700 billion over the next decade, "adding significantly to an already unsustainable level of debt," he said.

It also wouldn't do much to stimulate the economy because wealthy Americans "are the least likely to spend those tax cuts." The argument that raising taxes on high-income Americans would hurt small businesses is a "myth," Geithner said, "a political argument masquerading as substance."

Rys disagrees, however. Congress needs to consider which small businesses would face higher taxes, not just how many would be affected, he said. Small businesses that employ 20 to 250 workers are the most likely to be hit by an increase in the top two tax rates, according to NFIB research. Businesses of this size employ more than 25 percent of the U.S. workforce.

"If you want to put a face on the rich Americans that everyone likes to talk about, the top 1 to 2 percent, it's the small businesses, it's the S corporations," said Craig Fritsche, president of Tart Lumber Co. in Sterling, Virginia.

In good years, Fritsche said his business might make $400,000 or $500,000—money that he puts "back into the business."

"We buy trucks, we hire more people," he said.

The past two years have not been good years because of the construction industry's decline, and he expects he'll probably lose money this year. But he's optimistic business eventually will pick up.

"If we get back to making money again, I'll be paying 39.6 percent," he said

That's a higher tax rate than the 35 percent corporate tax rate imposed on large businesses like Intel, he said.

"The tax increases that are coming don't make a lot of sense, especially for small business," he said.

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Kent Hoover is the Washington bureau chief for bizjournals.