By William Brown
Today I prepared the 2012 tax return for one of my clients who owns a successful Iowa small business. The taxes for the year were substantial, but fortunately the client had paid significant amounts in to the government as estimated tax and withholding, so this client has paid in about the same amount as he owes in tax for the year. That amount is substantial, but when it is broken into more manageable chunks with wage withholding and estimated tax, it just doesn’t seem as much.
As a lark, I decided to figure out how much his federal tax bill would be in 2013 if his income and expenditures were exactly the same as in 2012. While I knew that the tax increase would be more than the rate increase at the top marginal rate because of other tax changes effective this year, including tax changes in Obamacare, I was floored by the increase in his 2013 taxes as compared to 2012. Amazingly, his total federal tax bill for 2013 increased by 12 percent over his actual tax bill for 2012 based on the same income and expenditures as in 2012.
Is this really just “a little bit more”, as President Obama asserts? Since this person runs a successful Iowa small business – exactly the type of business that creates the bulk of the high wage jobs in this country – is it really reasonable to think that this “just a little bit more” will have no substantial impact on job creation or economic growth?
Consider this hypothetical situation. Assume that Fred owns a small business that operates as an S corporation, LLC or partnership and generates $400,000 of income after salaries (most small businesses are organized in this fashion). Because of the structure of its operation, all of the net income of the business is taxed to Fred rather than to the business, regardless of whether he actually pays out all of that net income to himself or not. As a result, Fred must pay out some of the business earnings each year to cover his tax bill on those earnings. As a successful small business trying to grow the business, Fred wisely does not pay out all of the net income but instead pays out only enough to pay the taxes on the business income – typically about 40 percent of the net income, or in this case $160,000. Such an earnings distribution approach is fairly typical for such a business.
Since Fred needs all of the distributions from the business to pay taxes on the business income, lets also assume he pays himself a salary of $100,000 to cover his living expenses. For federal tax purposes, this individual has $500,000 of gross income from the business – $100,000 from salary and $400,000 of business income taxed to him. But he only receives $260,000 of cash from the business – the $160,000 of distributions to pay the tax on the business income and the $100,000 of salary paid to him. Remember, however, that Fred also pays FICA tax on his wages of $5,650 through wage withholding.
Lets also assume that Fred has been frugal and has also received an inheritance from his parents. From those savings, Fred has accumulated personal funds in dividend paying stocks which generate an additional $50,000 of dividend income each year. Fred reinvests the dividends with the companies in a dividend reinvestment plan to save for retirement since his growing business has no retirement plan. Lets also assume that this individual lives in Iowa and pays Iowa income tax on all of his income, and thus pays about $35,000 of Iowa income tax (about right for this level of income, assuming federal deductibility) and that state income tax is his only itemized deduction for federal income tax purposes. He also gets a $3,800 personal exemption from income tax, which reduces his income subject to federal income tax.
Most people would say this person is rich, since he has gross income for tax purposes of $550,000. Moreover, his federal taxable income after accounting for his itemized deductions and personal exemption still makes him rich by most accountings – Fred has a taxable income of about $511,200 – $100,000 of salary plus $400,000 of business income taxed to him plus $50,000 of dividends taxed to him less $35,000 of Iowa income tax and less a $3,800 personal exemption. Under 2012 federal tax law, this would generate a total federal income tax bill of about $145,700 – a hefty amount, but it doesn’t seem too high given his income level, does it?
However, keep in mind that this individual pays out only enough of the business income to pay the taxes on that income – at about a 40 percent rate (about $160,000) – and reinvests the rest of the earnings in the business for growth so that the business can create more quality jobs for Iowans. His cash flow makes him comfortable, but by no means rich. His cash flow consists of $100,000 of salary plus $160,000 of distributions from the business, or $260,000. However, he has substantial taxes to pay of $186,350, consisting of $145,700 of federal income taxes, $35,000 of Iowa income taxes and $5,650 of FICA taxes withheld from his wages. This leaves him with only $73,650 of net cash flow – enough to be comfortable, but surely not enough to be regarded as rich. Of course, Fred could have another $50,000 of cash flow from his reinvested dividends if he wanted, but if he does that his funds available for retirement will be diminished – so he chooses not want to tap these funds now and instead reinvests the dividends.
So Fred, who has $550,000 of gross income for tax purposes, in fact only has $73,650 to live on after taxes.
So what is Fred’s situation in 2013 if he has the same amount of income and expenses? Under the tax law in effect in 2013, his federal tax situation is very different, and not just because of (or even mostly because of) the increase in the top marginal federal income tax rates on his income.
His federal tax position is affected in a number of adverse ways. First, he loses part of his itemized deductions. Second, he loses his personal exemption. Third, his payroll taxes go up (as all of ours will). Fourth, he pays an additional Medicare tax under Obamacare on his dividend income. Fifth, he pays a higher tax rate on his dividends. Finally, he pays a higher tax rate on a portion of the income of the business which is reinvested in the business since his taxable income is in the highest marginal tax bracket.
So what will Fred’s federal income tax bill be in 2013? Fred’s taxable income, without any increase in real earnings, has now been increased by $12,800 – a $9,000 reduction in his itemized deductions and a total loss of his $3,800 personal exemption. This alone raises his federal income tax, even at the prior highest marginal rate, by $4,500.
In addition, he has an increase in his withheld FICA tax of $2,000 and an Obamacare tax on his reinvested dividends of $1,900. Also, the federal income tax on his reinvested dividends has increased by 5% due to the increased tax rate on these income sources – a $2,500 increase. And all of this occurs before accounting for the increased maximum marginal tax rate on the upper levels of his taxable income from his salary and his business. The increased marginal tax rates on this income, in fact, are only a relatively minor part of the total increased tax – in this case an income tax increase of $2,800 – perhaps by itself “just a little bit more” but not so when combined with his other federal tax increases.
The net effect of this is a total increase in Fred’s federal taxes of $13,700 – consisting of an increase in federal income taxes of $9,800, an increase in his withheld FICA tax of $2,000 and imposition of a new Medicare tax on his reinvested dividends under Obamacare of $1,900. His total federal and state tax bill is now $200,050 – consisting of $155,500 of federal income tax, $7,650 of withheld FICA tax on his salary, a new Obamacare tax on his reinvested dividends of $1,900, and $35,000 of state income tax.
Fred’s net disposable income will then be reduced to $59,950. His cash flow will consist of $100,000 salary plus $160,000 business distributions less $155,500 of federal income tax, less $7,650 of withheld FICA and $1,900 Obamacare tax on dividends and $35,000 of state income taxes, netting $59,950 of cash flow. Fred could start tapping his dividends rather than reinvesting them to supplement his cash flow, but that will short his retirement. So what will Fred do?
Fred has three choices: 1) stop reinvesting all or part of his dividends and instead begin using all or part of those funds for his support, 2) reduce his standard of living substantially (a 19% reduction), or 3) increase his distributions from his business to pay the increased taxes. The first choice shorts his accumulation of funds to pay for his retirement. The second choice is a major hit to his lifestyle. Since the first two choices dramatically alter his personal financial plan, Fred is likely to instead make the third choice. This choice, however, reduces the reinvestment of earnings in his business and will affect the future growth of the business. As a result of increasing the distributions from the business to pay the increased federal tax burden, he may need to cut employment or reduce hours of existing employees to maintain the profitability of the business.
So, is all of this having the rich pay “just a little bit more”? Fred’s federal taxes have increased by 9% with no change in his earnings. If Fred does not increase his distributions from his business to pay these increased taxes, his disposable income will decrease by 19%. Might these increased taxes have no substantial impact on the prospects of his small business and its employees? Not a chance.
And to think that President Obama wants further tax increases on the “wealthy” as part of the solution to avoid the sequester. His solutions are a recipe for damage to the successful small businesses that are the engines of job growth and economic prosperity in this country. These solutions will likely guarantee continued economic stagnation for America because of their affect on successful small businesses.
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