The $250,000 Small Business Tax Question

New data released by the bipartisan Tax Policy Center show that most small business owners won't be taxed at higher rates under Obama's proposed budget

By Karen E. Klein

New data released by the bipartisan Tax Policy Center show that most small business owners won't be taxed at higher rates under Obama's proposed budget

In the weeks since President Obama proposed rolling back federal income tax rates on the nation's top two marginal tax rates as part of his federal budget, the term "small business owner" has turned into a political football.

Proponents of the budget proposal claim that less than 3% of small business owners have net household income above $250,000, the threshold over which tax rates go up under Obama's plan. Budget opponents, on the other hand, claim that 15% or more of small business owners will be negatively affected, and at a time when many small companies are struggling.
What's the reality, and why is it so tough to parse? Confusion reigns for a number of reasons, among them the definition of "small business owner" and various methods for calculating taxable income. Wrap all that up with the charged language of politics and it's not surprising that conflicting claims are put forward, experts say.
Mom-and-Pop Misperception?

But tax analyses show that the percentage is likely to be on the lower side, and those taxed at higher rates—if the budget is approved as presented—are unlikely to be those most people think of when they hear "small business owner."

"Most small business owners aren't in the top two marginal tax rates. In my opinion, there's some misunderstanding in these political debates that the people who'll be affected are middle-income Americans who run mom-and-pop stores," says Benjamin Harris, senior research associate at the Tax Policy Center, a bipartisan venture of the Urban Institute and the Brookings Institution that aims to provide independent analyses of current and longer-term tax issues.

Mike Schenk, senior economist for the Credit Union National Assn., predicts that the tax increases will have a large negative impact, but only on a small number of small business owners. "I would ultimately conclude, as an economist, that on balance there are some real positives to come out of [the proposed budget]. The negatives will be apparent to a small sliver of the universe," he says.
Why only a small sliver? Because individuals who file IRS Schedules C, E, and F (which is how tax calculations are made about "small businesses") and are taxed at the two highest rates are likely to be investors and wealthy wage-earners, some of whom have income from small businesses, rental properties, or royalties, Harris says.

Projecting the Impact in 2012

So why invoke the "small business owner" in the debate? "It's easier to say these people who are getting hit by the proposed tax policy are small business owners," Harris says, than to fully describe the range of people in the category.

An analysis done by the Tax Policy Center shows that 8.9% of individuals who report small business income or loss (including self-employment income; income from S-corps, partnerships, and limited liability companies; farm income; and income from rental property and royalties), have household income greater than $250,000. But fewer than 2% of those filers fall into the top two tax brackets, according to the center's analysis.

New data the center released this week goes a step further, to show the projected impact in 2012 on individuals who report small business income and whose rates would be raised if Obama's budget is enacted as proposed. President George W. Bush reduced the top two tax rates, along with two lower rates, in 2001 and 2003. The rate reduction is scheduled to expire, and rates revert back to the higher figures of the 1990s, at the end of 2010. Obama’s budget proposes allowing the tax cuts to expire as scheduled, but only for families earning more than $250,000 per year or single filers earning more than $200,000 per year.
Under the Obama proposal, those currently taxed at 33% would be taxed at 36% and those taxed now at 35% would be taxed at 39.6%.

By 2012, individuals filing Schedules C, E, and F with "cash income" between $200,000 and $500,000 who are taxed at the top rates would face a -0.1% impact on their after-tax income, the data shows. The percent change in after-tax income would be -0.9% for those with cash income from $500,000 to $1 million, the center's projections show.

Those with small business income who have $1 million or more in "cash income" in 2012 would experience a 2.4% decrease in after-tax income if the tax hikes go through, according to the projections. "That would be considered a moderate or significant impact from one change in policy," but the changes on the lower two income groups would be considered small or negligible by tax experts, Harris says.
(The Tax Policy Center uses the "cash income" figure, which is similar to that used by the U.S. Treasury Dept. in its calculations. It includes wages and salaries, employee contributions to tax-deferred retirement savings plans business income or loss, farm income or loss, Schedule E income, interest income, taxable dividends, realized net capital gains, Social Security benefits received, unemployment compensation, energy assistance, temporary assistance to needy families, worker's compensation, veteran's benefits, SSI, child support, disability benefits, taxable IRA distributions, total pension income, alimony received, and other income, including foreign-earned income.)

Reinvestment Could Be Discouraged

The Tax Policy Center's projections also show that in 2012, 88.2% of filers with small business income or loss will report cash income of less than $200,000. Those who report cash income greater than $200,000 would be 11.8% of the total, according to the projections.

However, although the impact on what most people think of as small business owners may be small, tax hikes still have a disproportionately negative impact, says Olivier Garret. Garret is the CEO of Casey Research, an independent research organization whose main publication, The Casey Report, provides financial analysis for 25,000 mostly high-net-worth individuals, including small business owners.

He worries that higher tax rates on the country's most successful small business owners will discourage them from building cash reserves and reinvesting in their companies. "People think that someone making a million dollars is rich. But I know a lot of business owners who have reported income that is very high but they reinvest most of it and don't take that much home personally. They will be weakened dramatically by this change," he says.

Chas Roy-Chowdhury, head of taxation at the Assn. of Chartered Certified Accountants, questioned the timing of planning tax increases during a recession. "On the one hand, you're giving out stimulus packages and pumping money into the system, and then on the other hand doing tax rises," he says. "Are those the kind of messages we want to put out now?"

It's likely that the poor performance of many small businesses in recent months means that fewer entrepreneurs would be impacted by the tax increases. "Profits are a lagging indicator of the health of a business. It may take a while for many of them to be brought into the higher tax brackets," Roy-Chowdhury acknowledges. However, "I think it is just giving out the wrong message, in a climate where we're trying to get businesses to spend. If they know that over the horizon they'll be paying more tax, why would they spend as much?"

Adding to an Already High Tax Burden?

The proposed tax rate increases would go into effect in calendar year 2011 and show up on tax returns filed in 2012, Harris says. "There's a several-year lag before they'd be raised," he says. He notes that wealthier taxpayers tend to be savvier on issues like timing of income to minimize tax liability. "An announced tax increase in the future has an effect today," he says, "but if in 2010 we're still in a rough patch with the economy, the increases would likely be revisited."

Brad Hall, a CPA based in Newport Beach, Calif., whose clients include many successful small business owners, says he objects to the disproportionate tax burden in general. In 2006, the most recent year for which tax statistics have been released by the IRS, 3.8% of the total individual tax returns filed reported adjusted gross income of $200,000 or greater, he says. "That same 3.8% paid 50.6% of the total taxes that the government brought in that year. Those making over $500,000 AGI are less than 1% of the population, yet they contribute 35% of the total U.S. tax," he says. "That burden they're already carrying is quite high. To raise the tax on that 3.8% of the population or that 1% doesn't seem fair."

Hall shares the concerns about small business reinvestment being discouraged by higher tax rates. "People think that if small business owners make more than $250,000 they're actually taking that much out of the company, when in reality they are putting a good chunk of their income back into the business as additional working capital," he says.

A larger objection to the new tax policy is that it represents yet another complicated change that small businesses must keep track of. Rudy Penner, an institute fellow of the Tax Policy Center, says now is the time to reform the U.S. taxation system, making it more efficient and equitable. "There's never been a more propitious time to do that, considering that we have to do something about the [alternative minimum tax], we're reconsidering the Bush tax cuts, and we have a corporate tax that is really in extreme trouble," he says.

Karen E. Klein is a Los Angeles-based writer who covers entrepreneurship and small-business issues

Startups in a Downturn

Entrepreneurs who helped build their startups into tech stalwarts—companies like Cisco, Oracle, and Google—share lessons on how to thrive during tough times

By Spencer E. Ante

December 1987 was no time to be raising money for a startup. Computer engineer Len Bosack was trying to attract funding for a young enterprise called Cisco Systems (CSCO). But the stock market had just crashed and the Dow Jones industrial average had plummeted 40% since October. Gun-shy venture capitalists either didn't get the newfangled technology or deemed it too risky.

Making matters worse, Bosack was running low on the savings he had used to bootstrap the business, and competition was gaining steam. It wasn't until this 75th meeting that he found a receptive audience. The willing financier was Donald Valentine of Sequoia Capital, a venture capital firm in Silicon Valley. On Dec. 14, two months after Black Monday, Sequoia invested $2.5 million in Cisco. "Valentine's reasoning was pretty simple," Bosack recalls. "It doesn't matter what they are. They are selling stuff in a bad market. With a little bit of capital and more experienced help they should be able to do better."
Better is just what Cisco did. By the time of its initial share sale three years later, in February 1990—during a recession—the maker of telecom networking equipment was worth $224 million. Within a decade, Cisco Systems had become one of the world's most valuable companies.

Greatness Can Emerge from a Slump

Today, some of America's sharpest financiers and entrepreneurs say Cisco's story holds a profound lesson easily forgotten amid financial turmoil: Great companies can be built during tough times. "For us, Cisco is always the company we think of when we think about bad times," says Michael Moritz, a general partner with Sequoia Capital who was a young associate when the firm made its investment.

Cisco is just one example. In the history of technology, many other great companies either were founded during downturns or forged business models during bad times. In 1939, at the tail end of the Great Depression, two engineers started Hewlett-Packard (HPQ) in a garage in northern California. During the recession of 1957, Digital Equipment, the first computer company to challenge IBM (IBM), set up shop in a Civil War-era wool mill, sparking a high-tech boom in Massachusetts. "It makes sense to do research and development counter-cyclically," says Tom Nicholas, associate professor in the Entrepreneurial Management Group of Harvard Business School. "Recessions can be really useful strategic opportunities."

Entrepreneurs, financiers, and historians point to several reasons for this phenomenon. For starters, everything is cheaper during a downturn, including the cost of labor, materials, and office space. There's less competition, both from incumbents that are trying to put out their own fires and from startups that find it harder to raise money. And the tough times force entrepreneurs to work on their business models earlier, so they end up reaching profitability more quickly than when money comes cheap. "The companies are tougher because they were tested during a tougher time," says Carl Schramm, president of the Kauffman Foundation, an organization that promotes entrepreneurship.

In fact, Silicon Valley itself was largely created during the nasty recession of the mid-1970s. During that decade, entrepreneurs and financiers built companies that pioneered three entirely new industries: video games through Atari, personal computers with Apple (AAPL), and biotechnology thanks to Genentech (DNA).

Find Your Passion

Talk to the entrepreneurs who built great companies during bad times, and they'll tell you there are a number of lessons that help explain their success. Atop the list: Founders of the most successful companies are motivated less by the lure of riches than the dream to solve an important problem and benefit the world. As a young, self-taught computer engineer, Mitch Kapor saw an opportunity in the early 1980s, another recessionary period, to create software tools for personal computers that would help businesses be more productive. So in 1982 he founded his own software company called Lotus.

The startup was an immediate hit because it was the first software program to demonstrate the value of a personal computer to the business world. During an October 1982 conference, Kapor showed off his initial product, Lotus 1-2-3, the first software tool to integrate spreadsheets and graphing programs. After taking $900,000 in orders during the conference, he had to tear up all of his sales forecasts. "It was one of the biggest shocks of my life," he recalls. "It turned out there was an enormous latent demand for what we did."
Kapor also noticed that market leaders such as Microsoft (MSFT) had taken their eyes off the ball. In 1981, IBM had introduced its first PC with a 16-bit microprocessor. Microsoft, contracted to provide the operating system for IBM, was also building a spreadsheet, but it was based on code built for machines with slower, 8-bit processors. Kapor realized Microsoft had left him an opening. He set about creating spreadsheet software tailored to the new chips. In 1983, its first full year of business, Lotus sold an astonishing $53 million in software. "If a product meets an unmet need, it doesn't matter if the economy is bad," Kapor says.
Cater to Your Market

Another key lesson is to pick markets strategically, says Umang Gupta, who joined database maker Oracle (ORCL) in 1980 as employee No. 17 and wrote its first business plan. Ultimately, the company wanted to build a database program that would work with multiple types of computers, from minicomputers to PCs to mainframes, those hulking machines that crunched massive amounts of data. But Oracle couldn't do it all at once. It started out creating a database that worked on minicomputers such as Digital Equipment's PDP-11. Then Oracle methodically went upstream, pursuing mainframes next, rather than going for mainframes and PCs at the same time. "We concentrated our bets," Gupta says. "We built a culture of an extremely focused, aggressive company."

For some companies, it may be tempting to slough off belt-tightening customers loath to place new orders amid a slump. Bad move, financiers say. The best companies go the extra mile during a cold spell, engendering goodwill that pays off when the economy bounces back and companies have more money to spend.
At Cisco, Bosack launched a customer advocacy group, one of whose jobs was to help customers design their computer networks before they spent even one penny with the company. Employees would spend weeks holed up in the basements of customer offices fixing the glitches that popped up. "We were happy to help," Bosack says. "We didn't expect a big order… People sell products today and abandon their customers. It's bad business."

Embrace Frugality

Almost all great companies built during bad times also learn how to run extremely efficiently. Workers wear multiple hats, buy used furniture, and look for any way to cut costs. Tales of frugality are legendary in the tech industry. At the headquarters of Digital Equipment, the company's founders didn't even go to a garage sale. They appropriated desks that had been left by the previous tenants, and they didn't install doors, even in bathrooms, because they cost too much.

But while companies need to watch their bottom line, downturns also present an excellent opportunity to hire high-quality labor on the cheap. A lot of good talent gets laid off during downturns, and workers are more open to joining new companies since there are fewer jobs to be had in big corporations.

After the dot-com bust early this decade, Google (GOOG) took huge advantage of the surfeit of talent. At the end of 2001, Google had 281 full-time employees. By the end of 2004, the number had swelled to more than 3,000. Those employees, many of whom Google poached from big rivals such as IBM and Microsoft, allowed Google to handle and generate explosive growth. In 2001, Google earned $7 million on $86 million in sales; by the end of 2004, Google reaped $399 million in profit from $3.2 billion in sales. "When I joined Google we were the only place hiring," says Sheryl Sandberg, a former executive at Google who is now the chief operating officer of Facebook.

There's Room for Optimism

Today, when venture capitalist Moritz surveys the economy, he admits times are sobering. It was his venture capital firm that spooked the entire tech industry with a presentation, leaked on the Web, that was titled "RIP: Good Times" and detailed for startups the gloomy state of the economy. As he and others have noted, selling anything in this economy is more of a challenge. And it's harder than ever to raise money because the IPO market is dead and mergers have dried up.

Moritz nevertheless sees a lot of opportunity, and says great companies will emerge from this downturn, just as they have in the past. "Things get overblown in the Valley," he says. "As the obituaries are currently being penned, those are overstated, too. Good ideas and brilliant people will find us very willing to step out into the cold with them. It's as easy for me to be excited today by the unknown 23-year-olds as I was in the past."

Six Companies Born During Downturns

By Emily Maltby, CNNMoney.com staff writer

Think a recession is a bad time to start a company? Imagine if the founders of these major corporations had thought the same...

Rising above inflation

Company: Procter & Gamble

Ticker: PG

Industry: Household productsFounded during: The Panic of 1837

Candle maker William Procter and soap maker James Gamble joined forces to start a small household-goods business in Cincinnati. It was a risky move for the brothers-in-law: The shaky economy had a full six years of financial crisis ahead. Massive migration to the West caused land prices to rise, and inflation soon followed. Under President Martin Van Buren, bank failures and concerns about the paper economy spurred the greatest economic decline since the birth of the country. But P&G survived and went on to score lucrative contracts to supply necessities to the Union Army during the Civil War.
Status today: With $83.5 billion in revenue in 2008, Procter & Gamble has built a portfolio of some of the most recognizable brands in the U.S., including Tide, Pampers, Oral-B, Iams, Pantene, Duracell and Pringles. The company's shares took a hit this past year, but it has held steady against smaller competitors such as Johnson & Johnson and Colgate-Palmolive, and its earnings remain strong: P&G had net earnings last year of $12.1 billion. Because consumers rely on P&G products in good times and bad, it is considered a titan even in a rough economy.

Outliving a long depression

Company: IBM

Ticker: IBM

Industry: ComputerFounded during: The Long Depression, 1873-1896

Aptly named, this era comprised a series of unfortunate events. The Vienna Stock Exchange fell. The Coinage Act of 1873 demonetized silver, pushing investors away from making long-term loans. U.S. banks collapsed twice, causing the Panic of 1873 and the Panic of 1893.
But three startups - the Tabulating Machine Company, the International Time Recording Company and the Computing Scale Corporation - developed technologies during this 23-year period that were in demand despite the sour economy. A time clock for recording workers' hours, for example, was needed as industrial production at the end of the century surged. Also, a tabulating machine was vital during the immigration wave, to tally up the expanding population. These three companies merged in 1911 as the Computing-Tabulating-Recording Company, which changed its name to IBM several years later.
Status today: If it's true that what doesn't kill you makes you stronger, IBM came into this recession well-fortified: Big Blue is a veteran of near-death experiences.
IBM's wild success in the 1960s led to antitrust action by the U.S. Department of Justice. The fallout from U.S. v. IBM took its toll over the next decade and radically reshaped IBM's business operations. IBM eyed oblivion again in the early 1990s, as its traditional hardware and mainframe computing business dried up. Under Lou Gerstner's leadership, IBM overhauled its business model, shifting the emphasis from products to services. Although consumers are spending less on technology in the current economy, IBM recently posted a strong quarter, which it attributed to an increased demand for its outsourcing services. Last year, the company had record revenue of $103.6 billion. However, thousands of layoffs are reportedly underway in IBM's sales and software units.

A bright idea in a financial crisis

Company: General Electric

Ticker: GEI

ndustry: Energy and otherFounded during: Panic of 1873

Kicking off the Long Depression was the Panic of 1873, which began when major investment firm Jay Cooke & Co. collapsed, causing the NYSE to shut down for days. The ensuing financial crisis lasted six years.
Sound like an ideal time to open a laboratory? That's what Thomas Edison thought as he set up a facility in Menlo Park, N.J., in 1876. There, he produced the first light bulb in 1879 - the same year the panic officially ended. Although economic conditions would remain poor until 1896, Edison had gained enough momentum to start a company he called Edison General Electric Company. In 1896, Edison's GE landed a spot on the first-ever Dow Jones Industrial Average. Today, it is the only remaining company of the original twelve. Status today: GE posted $183 billion in revenues in 2008, but its earnings were down 19%. Profits from GE's consumer and industrial segment dropped 65% during the year, and GE Capital's profits fell almost 30%. While GE's energy sector saw a modest growth in profits, the company is bracing for a rough 2009

Smooth riding through a panic

Company: General Motors

Ticker: GMIndustry:

AutomobilesFounded during: The Panic of 1907

Back in the days of President Theodore Roosevelt, before a central bank had been established, lending institutions were dependent on their own currency resources. This became a problem in 1907 when numerous large banks made a bid for controlling shares of United Copper Company. When the attempt failed, the public pulled their money from the banks, causing runs that led to the failure of many trusts and lending institutions.
These events didn't deter William Durant, a leading manufacturer of horse-drawn vehicles, from trying his luck on a new technology called the automobile. He founded GM on Sept. 16, 1908 in Flint, Mich. That year, it became a holding company for Buick and Oldsmobile, which had been established several years. Historians consider the Panic of 1907, also known as the Banker's Panic, to have ended in June 1908, even though the market didn't reach pre-1907 levels until 1909. That was perfectly timed for GM, which went on to acquire many more companies in that rebound year.
Status today: Hit with a double whammy in 2008 from sky-high fuel prices and a terrible market, GM has seen its stock price fall 85% in a year. Its competitors aren't faring much better - in December, GM went to Washington with Chrysler and Ford to seek $34 billion in government loans. The company is currently under scrutiny: Iit must prove it can cut costs enough to be a viable recipient of the billions it needs to stave off bankruptcy.