Businesses that survived the Great Recession and the sluggish economy, are now reckoning with the fiscal cliff — more than $600 billion in spending cuts and tax increases coming January 2 if Congress doesn’t strike a deal.
The Congressional stalemate over the two top individual tax rates and rates on dividends and capital gains have been central to the dispute because many business owners (including those with S-Corps., partnerships, limited liability companies and sole proprietorships) pay taxes on their business profits through their individual tax returns.
These types of businesses employ about 54 percent of the private sector workforce and pay 44 percent of federal business income taxes, according to an Ernst & Young study. It’s not only small businesses that are impacted: more than 20 million workers are employed by larger businesses (those with more than 100 employees) that pay individual income tax, the study found.
Tax hikes aimed at Americans making over $250K would also impact successful small business owners, says Dennis Hoffman, a professor of economics at the W.P. Carey School of Business at Arizona State University. “This would hit well-to-do individuals, but it would also hit small business owners who file individual taxes,” Hoffman says. They also will face tax hikes on investment income and new taxes tied to the Affordable Care Act.
The potential changes have many small business owners feeling anxious. According to a new Gallop poll, small business owners expect to add fewer jobs in the coming year than they have since late 2008 when the country was in the midst of the recession. A National Federation of Small Business (NFIB) report on Tuesday also found that the Small Business Optimism Index dropped 5.6 points in November. “Between the looming fiscal cliff, the promise of higher health care costs and the endless onslaught of new regulations, owners have found themselves in a state of pessimism,” chief economist Bill Dunkelberg said in the report.
Here are 6 ways the fiscal cliff could affect small businesses:
Federal Income Tax Hikes
If Congress doesn’t extend the Bush-era tax cuts, earners in almost all tax brackets would pay higher taxes. The top two federal income brackets would rise from 33 percent to 36 percent and from 35 percent to 39.6 percent. "Raising taxes on small businesses is only going to make it harder for our economy to grow," said House Speaker John Boehner recently. "And if our economy doesn't grow, Americans don't get new jobs."
But according to the nonpartisan Joint Committee on Taxation, just 3 percent of more than 30 million Americans who report business income on their tax returns will pay at the top marginal rates next year. "Ninety-seven percent of small businesses would not see any increases in their income taxes," Obama said on December 6. "And even folks who make more than $250,000 would still have a tax break for their incomes up to $250,000."
Alternative Minimum Tax
Many taxpayers with incomes between $200,000 and $1 million also would owe alternative minimum tax. Economists and tax experts describe the little-known AMT as a parallel tax system. Taxpayers who owe more under the AMT code than under the regular tax code pay AMT.
In its basic form, it’s a flat tax with only a low and a high rate: 26 percent and 28 percent of income, respectively. Instead of itemizing deductions for dependents, medical expenses and state and local taxes, taxpayers get a single AMT deduction. But, since the AMT deduction isn’t indexed for inflation, Congress has increased the exemption amount each year with a short-term patch.
Without another exemption hike, the Tax Policy Center estimates the number of Americans (many of them small business owners) paying AMT would rise from 4 million to 30 million.
Affordable Care Act
To help pay for the Affordable Care Act, wealthier Americans and many business owners also will face an extra 3.8 percent Medicare tax on net investment income above $200,000. Beginning in 2013, the income cap on wages subject to the Medicare portion of FICA taxes also will be removed. Individual employees or business owners with incomes over $200,000 will pay 1.45 percent on the first $200,000 and 2.35 percent on anything earned after that. According to the Joint Committee on Taxation, only 4.1 percent of small businesses would be affected by the health care surcharge.
Many business owners depend on income from capital gains and stock dividends. Both taxes are slated to take a hefty hike if the Bush-era tax cuts aren’t extended.
Long-term capital gains — the tax paid on the difference between the price of an asset when it’s sold and its original cost, would rise from 15 percent to 20 percent, or 23.8 percent for high-income taxpayers, which includes a 3.8 percent tax on net investments that’s part of the Affordable Care Act. The tax hike is even heftier for stock dividends: Rates would soar from 15 percent to a maximum of 39.6 percent, or 43.4 for the wealthiest Americans. That’s because qualified dividends would be taxed at the same rates as ordinary income in 2013.
All workers pay this tax to fund Social Security. The last two years, employees paid 4.2 percent, instead of 6.2 percent, but in 2013, the rate would revert to the 6.2 percent tax rate. “That increase alone would result in a significant tax increase for all working families,” says Howard Gleckman, editor of the TaxVox blog at the Tax Policy Center. The center estimates the average payroll tax liability would go up about $700 per household.
Self-employed taxpayers, including many small business owners, also pay Social Security and Medicare taxes on their business profit, but they pay a higher combined rate of 13.3 percent (10.4 percent for Social Security and 2.9 percent for Medicare). That’s because they contribute both the employer and employee portion of the payroll taxes. In 2013, that combined rate would rise to 15.3 percent.
Limits on Deductions
High income taxpayers, and many business owners that pay under individual taxes, also would be eligible for fewer deductions, which would increase the tax rate on ordinary income, dividends and capital gains.
According to the NFIB, the eliminated deductions would include the following: businesses would not be able to expense more than $25,000 (real estate property is not included); the start up deduction would revert to $5,000 from $10,000; companies would no longer be able to claim a 50 percent bonus depreciation on qualified capital investments; and the holding period for gains on appreciated S corporation assets would be reduced from 10 years to 5 years.
Patricia Soldano, western region chairman for GenSpring Family Offices, says the tax unpredictability and lack of certainty is crippling to small business owners and large corporations alike. “There is no way to plan,” she says. “It’s a huge issue for families and businesses.”