Tax Rate Debate

Due to concerns about President Barack Obama's intentions to raise taxes on our wealthiest citizens, there has been a lot of discussion in the media, on blogs and on talk radio about how such tax increases would affect small businesses. Today the Washington Post website had an example (see here) from which I intend to lift this quote:

Other business owners are also nervous. Jim Murphy, president of EST Analytical in Fairfield, Ohio, which sells analytical instruments to environmental testing labs and pharmaceuticals, said his company is struggling in the sluggish economy. But if profit returns to pre-recession levels -- about $455,000 -- Murphy said his accountant estimates that Obama's proposals could add $60,000 to his $120,000 tax bill.

"The misconception is that guys like me take [our profits] and put it into our pockets," said Murphy, who employs 47 people. "But the money the company earns in a given year is used to buy additional inventory so we can grow and hire." A 50 percent tax increase, he said, would be "really painful."

The above serves as an example where small business owners sometimes try to mislead the public when discussing this issue. I have to think that this must be deliberate. Surely Mr Murphy is not so ill informed about how the profits of his company are figured and how the bottom line is arrived at that he must pay taxes on.

Mr Murphy is not paying taxes on his companies gross profits, at least not to the feds (he may be paying local taxes on gross receipts, but that is not a federal tax). The money that is "used to buy additional inventory so we can grow and hire" is deducted from his gross profits and he and/or his company (it depends on how his business is organized which entity pays the taxes) would only pay taxes on net profits. Thus if Mr Murphy's company plows 100% of his gross profits back into the company, he would end up with a federal tax bill of zero. That's right, he would not owe a dime in taxes so he would have completely escaped Barack Obama's proposed tax increases.

Mr Murphy attempts to call this into question by directly stating: "The misconception is that guys like me take [our profits] and put it into our pockets." But the only profits he pays taxes on are those he puts into his pocket. Anything reinvested in the company is an allowed business expense which is deducted from the gross before taxes are paid.

Now there are some genuine arguments that can be made for why increasing taxes on small businesses would be undesirable. (The strength of these arguments could be debated as well.) However fabricating outright false arguments in an attempt to mislead those who do not know any better does nothing to win the debate.

Actually, it could be argued that increasing taxes on net profits could motivate additional reinvestment of gross profits back into the company in order to escape the tax increase. Perhaps Mr Murphy is not smart enough to figure out how this might be so, but if he seeks the advice of a competent tax accountant he might come to understand how it works. A good accountant can also offer him advice on how to structure his company so as to minimize his tax exposure.

I am self employed (a small business) and I know that I enjoy many tax advantages that most average citizens are unable to take advantage of. Perhaps I just have a better tax accountant.