Would Ending Bush's Tax Cuts Hurt Small Business?

Senate Republican leader Mitch McConnell has thrust small business to the center of the political fracas over extending the Bush era tax cuts. He says President Barack Obama's plan to limit future tax breaks to couples earning less than $250,000 would subject 50 percent of small business income to a tax increase, stalling the job creation engine. McConnell would renew all the cuts, even those for the highest-income U.S. households. The tax cuts expire on Dec. 31 unless Congress acts.

If McConnell has his way, Obama, billionaire investor George Soros, and many film stars would be among the "small business owners" to benefit. Obama last year earned more than 10 times as much from his work as an author as he did from his $400,000 Presidential salary and reported that business income on his personal tax return, the same as a shareholder in a 50-employee machine shop might.

The debate pitting Obama's "no tax cuts for the rich" position against McConnell's "job-killer tax-increases" argument could play out on the Senate floor the week of Sept. 27, although a resolution is not likely until Congress returns for a lame duck session after the election. Which side is right? Recent studies by two nonpartisan groups suggest that McConnell, of Kentucky, is exaggerating. Yet the IRS doesn't collect the information needed to pinpoint who would pay the higher taxes, a data gap that allows both sides to claim the rhetorical high ground.

McConnell's 50-percent-of-income figure is based on a July 12 finding by the Joint Committee on Taxation, a House-Senate panel that analyzes tax issues, that half of about $1 trillion of business income in 2011 will be reported on some 750,000 personal tax returns filed by people who pay the top marginal rates. He calls those small businesses. Yet the report says the data "do not imply that all of the income is from entities that might be considered 'small.' " Almost 20,000 of those businesses, for example, had receipts of more than $50 million, it says.

Besides Obama, McConnell's 50 percent figure includes authors, actors, athletes, and others who employ few if any workers, as well as hedge fund firms and major law partnerships most people wouldn't consider small. "We are being over-inclusive in our use of small business income," says Edward D. Kleinbard, a former staff director of the Joint Committee on Taxation who is now a University of Southern California law professor.

Obama doesn't address the effect of his plan on small business income. Instead, he says his plan would hit only about 3 percent of all small businesses, also a joint tax committee number. Republicans counter that those 3 percent generate most of the real small business activity. "The last thing you would want to do is raise taxes in the middle of a recession on our most productive small businesses," McConnell said in a Sept. 15 Fox News (NWS) interview.

The confusion stems from the IRS's inability to determine if the income on a tax return comes from a small or large business. The dispute revolves around three types of businesses—partnerships, sole proprietorships, and so-called S corporations, which often have one or two shareholders. These structures are popular because they allow profits to be reported on business owners' personal tax returns without first going through a layer of corporate tax.

The nonpartisan Congressional Research Service, which analyzes issues for lawmakers, largely agreed with Obama in a Sept. 3 report that considered only taxpayers with employees. Its conclusion: Small businesses with actual workers would pay only about 12 percent of the higher taxes. "Across-the-board tax cuts for high-income individuals are not efficiently targeted to small businesses," wrote author Jane G. Gravelle.

The bottom line: Some small business income would be subject to higher taxes under Obama's plan, though not the 50 percent the GOP claims.

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