I hear many astute bloggers and commentators remark that raising the top income tax rate is no big deal; the rich can afford to pay a more. I gnash my teeth, waiting for someone to point out the fallacy of this proposition.
There is a small problem with that thinking. It’s called a Subchapter S corporation. An S corporation is a C corporation that has filed an election to be taxed as a "pass through" entity. This means that instead of being taxed on its income, it passes the income through to the shareholders, who are then taxed on it. An S corporation avoids the double taxation that faces C corporations. Profits are "passed through" to the shareholders without being taxed in the corporation.
S Corporation is widely used by small businesses, partnerships, service firms, accounting and law LLC’s. The most robust portion of the economy and the largest employer is small business. Small business is dominated by families and women.
Let’s create an example, shall we?
Joan and Nancy are friends and skillful cooks, they are both divorced and have two children each and a mortgage. They are mid-level management making enough to get by, but they know they will not be advanced to the next level. They decide to start a catering business on the weekends to supplement their income. They have a partnership agreement drawn up, using their credit cards they rent a kitchen, a van and begin to network for clients. They have a talent for event planning and soon they are sought after. They hire four full time employees in the kitchen, 3 hourly wait staff and contract a florist. They begin to make enough money to quit their jobs and Nancy’s famous chocolate truffles are a monster hit. A local gourmet distributor wants them in quantity. They need to expand operations to do so. They decide it is time to incorporate and apply for a loan to finance their expansion.
They are advised to form a S corporation, J&N Inc., which allows the profits to “pass through” to shareholders ( Joan and Nancy in this case) and taxed at their personal tax rates, which may be a much lower rate. J& N obtain a contract for production to secure the loan and startup their wholesale operation and the truffles sell like hot cakes. Soon the entire enterprise is cranking out truffles by the hundreds of thousands, but it’s not all ganache at J&N Inc.
Rising costs of imported raw materials, electricity and gas eat into their margin. California increases employer contributions and sales taxes, Oakland raises the city inventory tax, their staff unionizes and more is sliced off the net cake. J&N Inc. is in a very competitive industry, they cannot increase wholesale prices. J&N now face the classic small business dilemma; growing costs that cannot be passed on to customers.
Add a federal income tax increase and they have no choice but to refinance, downsize, close or sell to their competitor Bigge Candy International, who owns the gourmet distributor and made them a very attractive offer. Joan and Nancy gave it a good try, they had a boffo product, worked hard, but they have little incentive to continue. So they sell to Bigge, who promptly closes J&N’s operations and produces the truffles in their Mexico factory.
This is of course a very simplistic view and many of you can think of various ways that J&N could offset expenses, grow their business and continue, but it reaches a point of scale where you are working only to break even, to keep loyal people employed. Eventually most small business owners walk away exhausted and discouraged, those who do not often end in bankruptcy court. Increasing taxes and fees are a back-breaking reality for hundreds of thousands of small businesses, the dry cleaners, the florist, the car wash, the copy shop, restaurants, bakeries, and the myriad of small businesses that provide our daily services and goods.
Next time you're out running errands think about each small merchant you do business with, look at the faces. They are the "rich" Kerry plans to tax along with his wife and country club friends. The only difference is that the dry cleaner can't afford a top-5 accountancy firm to find a loophole; he hocks the family home or closes.
This is a dirty little secret the Dems won’t tell you and the Repubs are too dim counter effectively. The tax increase will hit the middle class where it can least absorb the cost; small businesses, family farms and mom & pop operations.
Still think only the rich will pay the Kerry tax roll back?
I still don't understand this "S corporation" thing. They're still making an income in the upper bracket (wherever it's from), so what's the big deal? Still a rich person, to me.
That said, I think you are right in one respect: much better to tax wealth (money doing nothing), than tax income...
Posted by: sam at April 14, 2004 11:41 AMI agree, the S corporation has nothing to do with the rate at which one taxes "the rich." If anything, I'd expect someone in the highest bracket to be less inclined to use the S corporation, as income that stays in the corporation would otherwise be taxed at the lower, corporate rate.
Also, S corporations don't work for partnerships or LLCs. They are an alternative to partnerships and LLCs, which are not subject to the corporate income tax either. [An LLC may be taxed in some jurisdictions, if it's structured wrong.]
Posted by: Xrlq at April 14, 2004 02:33 PMXRLQ: You are right, the third paragaph is badly written, it should read that S corps are an alternative to partnerships and LLC's, they provide tax benefits but also have offset/loss drawbacks as well. IMHO-Partnerships are too risky in our litigenous society to even consider.
In my example I clearly stated that J&N replaced their partnership with an S.
Do the math, raise taxes on small business and they will employ fewer, purchase less...the local econmy rachets down in the proportion of the tax increase. You are removing capital from a sector of economy that can least sustain the loss. So who have you really punished? The local Crispy Creme franchisee or Donald Trump?
Sam: Money that's doing nothing? Anyone who has money that is doing nothing is a stone-cold fool and will soon have none.
Posted by: feste at April 14, 2004 04:20 PM