The Skinny on Fat Taxes Affecting Small-Business Owners

We’ve all heard politicians talk about the importance of a vibrant small-business community to the American economy. Their sound bites exude enthusiasm and support for our entrepreneurial efforts, but what happens after the cameras stop rolling?

Do their votes actually reflect your best interests as a small-business owner, or do they favor big-donor special interests?

Business owners will be able to size up the loyalty of their lawmakers in upcoming debates on personal taxes. Popular rhetoric holds that increasing taxes on dividends, capital gains and estates will force ultra-rich Americans to pay their fair share. The bipartisan reality is that pending changes to our nation’s tax policy are going to take their toll on small-business owners. Here are the hot points:

Dividends

Since 1997, the S corporation designation has been the most popular form of corporate tax return filed with the IRS. One of the nifty benefits of an S corporation is that it allows shareholders who work in the business to minimize taxes by taking income out of the business in two ways. The first form of compensation is a modest, but reasonable, “market” salary in which employment and income taxes are collected. The second form is through corporate dividend payments, which are taxed at lower rates. Obviously, the more compensation that S corporation business owners direct toward dividends, the more money they save.

Unless Congress acts before the end of the year, the top tax rate for individuals who receive qualified dividends from investments held more than two months is scheduled to rise to 39.6 percent. That’s a big jump from the current figure of 15 percent.

Capital gains

Currently, individuals pay capital gains taxes on the sale of profit-making investments. For individuals in top tax brackets, the rate is 15 percent. For individuals in lower tax brackets, the rate is a neat 5 percent. Washington, D.C., is currently mulling over changes to capital gains tax rates.

Low or no capital gains tax obligations make it easier for startup entrepreneurs and main-street business owners to attract expansion capital. Individual investors, often referred to as angels, provided more than $19 billion in high-risk funding to small businesses in 2008 and may represent as much as 90 percent of funding for business owners who have exhausted personal savings or can’t yet qualify for bank loans or venture capital funding.

Individual investors have a choice in where they allocate their funds. If Congress reduces the profitability associated with investing in small businesses by boosting capital gains tax obligations, investors will simply shift their dollars to other more secure savings opportunities. That’s not good for small-business owners.

Low capital gains taxes, plus preferences for the sale of qualified small-business stock, also reward business owners. Like private investors, when startup entrepreneurs invest their personal savings in their companies, they hope to one day sell their businesses at a handsome profit.

When it’s time for you to sell your business, wouldn’t you like to keep more of your profits?

Estate taxes

OK, OK, I get it. Estate planning seems like a hot topic for retired individuals, not big, goal-seeking business owners who only see growth and opportunity ahead.

But estate tax law is just one more issue where silence hurts small-business owners. Again, if Congress doesn’t act before the end of the year, federal estate taxes are expected to jump to a top tax rate of 55 percent for non-spouse asset transfers. That’s right: Up to 55 percent of everything you’ve worked for and saved may be gone.

Adding to the tax pain is the dramatic decrease in the exclusion — from $3.5 million down to just $1 million. This change in exclusion is a real killer for average Americans who own just enough to be taxed heavily but don’t have so much money that they can tap lawyers and accountants to help them bypass estate tax obligations.

There are a few different rules for estates that include family-owned businesses. The tax-free exclusion for business-owner estates is $1.3 million, provided the business is inherited by the owner’s children and they remain active in the business for a considerable period. This sounds like a lot of money, but not for businesses that own real estate as part of their business operations.

Having an exclusion from taxes on the first $3.5 million of assets certainly gave Americans more flexibility to keep the rewards of their hard work within their families. Another reason for my concern about estate tax legislation is it tends to hang around for a while. The last time Congress paid serious attention to estate taxes was in 2001.

I’m not a tea party member, just an entrepreneurial builder, investor, educator and advocate. Americans who put the most on the line to start companies and create the lion’s share of our nation’s new jobs deserve a bigger voice in Washington. But that happens only if small-business owners speak up and monitor how their representatives vote on these important issues.

Susan Schreter is a 20-year veteran of the venture finance community and a university educator in entrepreneurship. She is the founder of TakeCommand, a community service organization that offers the largest centralized database of venture capital funds, angel investment clubs, incubators and microfinance lenders in the U.S. Ask her your questions at susan@takecommand.org.

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