The House and Senate have both put out proposals that would increase taxes on the highest-income Minnesotans. I’ve heard legislators ask how many small businesses would be affected – good question! First, let’s walk through a few basic facts about how small businesses are taxed.
There is no agreed upon definition of “small business” – but for tax purposes, it means that the business is taxed at the owner or shareholder level, as opposed to corporations or C-Corps that are taxed at the corporate level and are subject to the corporate income tax.
A small business can organize itself, in terms of ownership structure, as a partnership, sole proprietorship, subchapter S Corporation (S-Corp) or a Limited Liability Company (LLC). Each year, the business fills out a statement of profit and loss that shows the business’ net profit, if any. The profit is then reported to the owners/shareholders. The owners, in turn, have to report the “passthrough” income they received on their federal and state income tax returns. (There is one exception – an LLC can choose to pay taxes on its profits as a corporation, though they seldom do.)
Example: John Q. Public is a marketing consultant organized as sole proprietorship. His business brings in a gross profit of $200,000. He pays all of his business expenses – car expenses, fees, contract labor, depreciation, mortgage paid, office expenses, pension plan, any rent paid, repairs, travel, business meals and entertainment, utilities, etc. The net profit after expenses – say, $50,000 – “passes through” to John. He pays individual income tax on that $50,000 (less credits and deductions), just as a salaried worker would on their income. Or, if he has other taxable income, the $50,000 is lumped in with that.
Now to the question of how many small businesses would be impacted by increases in the top income tax rates. In 2007, House Research ran the numbers on several proposals that increased the income tax on the highest-income Minnesotans. It found that fewer than 10% of households with small business income would see a tax increase under those scenarios. For example:
- A proposal to raise income taxes on household income above $250,000 would have effected an estimated 9.1% of residents with small business income, or about 29,800 Minnesota households. Remember, only income above $250,000 would be taxed at the 9.1% higher rate – the first $250,000 would be taxed at existing rates.
- A proposal to raise income taxes on household income above $400,000 would have impacted an estimated 2.9% of residents with small business income, or 9,500 households.
Note: The above two figures were calculated when the economy was still chugging along – I’d assume fewer small business owners would be impacted by a similar tax increase, as profits are down and income is down.
Concern about the tax impact on businesses seems to assume that state taxes represent a large cost of doing business and can hurt job creation. However, research on the connection between state taxation and business activity is much less conclusive. For example, a study commissioned by the Small Business Association found that state tax policy, including both tax rates and the type of taxes in a state’s portfolio, has only a modest effect on business creation.
The world is complex and the economy is complex. Many factors impact the decisions of small business owners: their own personal situation, health of the economy, regulations, etc. Taxes are just one factor. In fact, health care costs regularly are listed higher than taxes as a barrier to business growth. A Robert Wood Johnson Foundation survey of small businesses this past December found that health care costs are the top concern of small business owners. Bottom line: as policymakers consider tax proposals, they should remember that taxes are just one piece of the “business climate” puzzle.
Remember, the debate on taxes is just getting started. With the House and Senate Omnibus Tax bills out, it’s likely that we’ll get updated estimates on how small businesses will be impacted by tax proposals – and I’ll be sure to blog on it.