Tuesday, November 1, 2011

Martyrs to the S corporation

It's a safe bet that no one of ample means has ever doubted they fully deserved every penny of their income. In fact, it's a rule of human nature that the less one is responsible for one's enviable qualities, the prouder one is of them (beauty, distinguished ancestry, innate athletic or mental gifts). All of those upper class twits in Jane Austen novels whose incomes are fixed by nothing but the accident of birth that determined how much land they inherited are absolutely convinced that the size of a man's income is directly proportional to his virtue and merit on earth.

So I suppose it is no surprise at all that the rich of America are no different, and that the many  business owners with $1 million+ incomes quoted in yesterday's New York Times look upon their wealth as a mark of virtue that should be rewarded (and not "destroyed" by raising their taxes).

Trying to persuade any that their fortune owes something to fortune (certainly true in the case of those who inherited a family enterprise) or social investments (true of everyone in a society that employs tax dollars to build roads and bridges, educate the workforce, and maintain the rule of law that protects property rights) is a psychological near-impossibilty.

But why we would give these guys a pass on the utter nonsense they tell themselves — and the rest of us — about the factual consequences of the tax structure is another matter entirely. Again and again in recent months, the Republican proponents of flat taxes and other reverse Robin Hood schemes in such favor with the party have asserted with boundless chutzpah that if marginal rates are raised even ever so slightly on the top brackets, the consequences will be "disastrous" for small businesses.

Here is what one said yesterday in the Times:

"If Congress increases the tax rate, we would have to take more cash out of the business to pay taxes — money that we would otherwise reinvest in the company, to buy equipment or to hire more employees.”

Two not-so-little problems with this fairy tale:

First, all of those complaining about proposals to raise the top personal rate are owners of businesses organized as S corporations under the tax code, whose business profits are treated as personal income. In recent coverage this has often been reported as if it were a penalty imposed upon them by the way small businesses are inherently treated by the tax code. Representative John "How Can I Feed My Family on $200,000 a Year" Fleming (R-La.) made this assertion in bemoaning the "job killing" effects of the top personal income tax rates: "Most small businesses in this country today are taxed at the individual level as Corporation LLC. So whatever is cut out of those earnings is money taken out of capital for reinvestment for creating more jobs and opening up more locations," he said.

But in fact the decision to organize as an S corporation or an LLC is a deliberate choice made by these owners — and made precisely in order to take as much money as they can out of their businesses, at the lowest tax rate. (Anything an owner wants to pay himself out of the profits of a regularly organized C corporation is treated as a dividend, taxed both as a corporate profit at the corporate rate of 35 percent and then at the personal dividend rate of 15 percent; but in an S corporation, all of the profits are treated as regular personal income, taxed now at a top rate of 35 percent.)

The fact is, too, that if personal tax rates were raised above 35 percent, any owner of an S corporation or LLC who truly wanted to reinvest his profits could avoid the new higher personal rate by reorganizing his business as a C corporation, and continue to pay the lower corporate tax rate on 100% of all reinvested profits.

The guys who are crying about the prospect of higher personal rates in fact have no intention of doing that: the only advantage of the S corporation structure is if you want to milk your business for personal gain.

Second, and more important, in either case these are taxes on net profits — i.e., profit after deducting all of those investments made in salaries, equipment, plant, and every other business expense incurred in generating those profits. And every penny of those profits that is reinvested and which goes to pay for business expenses (salaries, equipment, etc) is going to be deductible off next year's taxes, too.

It makes as much sense for business owners to whine that paying taxes leaves them with less to reinvest in their businesses as it would for them to whine that it leaves them less to buy stocks on the stock market or bonds on the bond market. For that matter, it makes as much sense for them to complain about this as it does for any employee who pays taxes to complain that taxes leave him less to invest in stocks or bonds.

That's what taxes do to everyone: What makes you so special?