Tax Law considerations

originally appeared on npr.org:

Every time President Obama explains why he wants to increase taxes on the richest 2 percent, Republicans have a ready answer: Most small business owners file their taxes as individuals, and a rate hike would discourage them from hiring new workers.

So when Obama visited the K'NEX factory in Pennsylvania recently to push for his tax plan, House Republicans countered with a campaign-style video, also featuring a Pennsylvania business.

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In it, Gorski Engineering's owner explains how his company is set up as a "subchapter S" corporation under the tax code. So, however good or bad we do is my income, he says.

But how does that back up the fundamental Republican argument, that a higher tax rate would make it harder for him to hire new workers?

Actually, it doesn't. Which is why, Gorski's owner told NPR in an interview, he specifically avoided saying that in the video. He didn't know that that would be true for his business or a different business unless we understood the complete situation.

Some of these situations, said other business owners, are such that the higher tax rate could actually act as an incentive to hire more employees or invest in new equipment.

Because that would then lower your potential tax rate, according to the owner of Hobby Works, a group of toy stores in the Washington, D.C., area.

If this seems counterintuitive, the answer lies in the way businesses calculate their taxes. Obama's proposal would increase the tax rate, but only for income that exceeds a quarter-million dollars per household.

For some 97 percent of small business owners, that higher rate is irrelevant. They make less than $250,000 a year.

And for those whose income works out to be just over that threshold, one way out of paying that higher tax rate could be to hire one more person — or finally replace that 10-year-old car. These investments would pull net income back under that quarter-million-dollar mark, out of range of that higher rate.

The owner of Paloma Clothing in Portland, Ore., thinks if you're a person who hates paying taxes, hiring another employee for thirty- or forty-thousand a year is a great way to stay below the new so-called marginal rate.

There are situations, though, where Obama's proposed higher rates would make it tougher for particular small businesses to expand.

Owners of franchise restaurants, for example, who need to save up tens of thousands of dollars in cash so they can open up a new eatery, would have a harder time. Such savings are treated as business profit and, therefore, in the case of most small businesses, personal income prior to the reinvestment.

If that money is taxed at 35 percent instead of 31 percent, it would take somewhat longer to get to the necessary goal, according to the CEO of Florida-based Firehouse Subs.

Gorski Engineering's owner similarly faces that higher tax rate when he saves up for a number of years to hire a highly paid employee or a piece of earth-moving equipment.

Gorski Engineering's owner indicated that if he started to build a nest egg again, if I start to invest in equipment and things but I don't have as much to do that, or invest in people, which is our biggest resource, I don't have as much to do that, that's going to be difficult.

Of course, when Gorski finally does hire that expensive employee or buys that pricey backhoe, he will have a large, new expense he can write off — potentially offsetting some or most of the extra taxes he had to pay earlier.

The owner of Hobby Works, says there's really nothing new or unusual about taking the tax code into account when making business decisions.

He indicated the fact of the matter is, businesses, all businesses, large and small, do this all the time.

One business strategy is to continually plow extra profit back into the business to avoid those higher tax rates. Eventually, the owner can sell the business or take it public, and convert those years of deferred income into a big cash payout.

And depending on how it's handled, selling a business can be considered capital gains, taxed at a lower rate right now, a much lower rate.