It's Time To Discuss Subchapter S, In Relation to Obama's Income Tax Proposals

Once upon a time, most entrepreneurs organized their business as what is called a C-Corporation.  Most of the publicly traded corporations you can think of, from Avon to Zenith, are essentially C-Corporations.   Such corporations had any number of advantages, but they had (and still have) one big, big disadvantage.  C-Corporations paid federal income taxes at the corporate tax rates.  And then, if after-tax profits were dividended to owners, those dividends would be taxed again.  This double taxation of earnings is something Congress talks about all the time, but never does much about.  And the implicit government tax subsidy for debt over equity does a lot to explain various waves of merger and LBO activity we have seen since the 1980's.

Now, entrepreneurs were not stupid.  No one wants their hard-earned income taxed twice.   So, entrepreneurs who owned C-corps would do one of two things.  One approach was to have the owner pay himself a large salary, thus reducing corporate income and converting the dividends to more tax-advantaged wages.  The other approach was to have the company issue the owner loans rather than dividends.  I have seen many closely-held C-corps with huge accumulated corporate loans to their owners, which may only be unwound years or decades later when the company is sold or liquidated and profits can be taken out a lower capital gains rates.

Over the last 20 years or so, a new corporate vehicle called the sub-chapter S or S-corp has become popular.  With a few limitations, the S-corp offers all the same liability protections as a C-corp, with a big tax advantage:  S-corps are not subject to corporate taxes -- corporate profits of the owners flow straight through the corporation to the owners' 1040 personal returns, eliminating any double taxation  (Limited Liability Corps or LLC's operate roughly the same, but with slightly different rules).  For this reason they are also sometimes called pass-through entities.

It is interesting to note something I never hear mentioned when discussing aggregate personal income data, which is that the switch over time from entrepreneurs using the C-corp to the S-corp creates something of a discontinuity in the income data.  Thirty years ago, much of the annual corporate earnings, and all of the retained earnings, of business owners would not show up in the IRS personal income data  -- it shows up as corporate income, but not personal income.  Today, nearly all of that corporate income of small business owners shows up as regular income on personal tax returns.  Absent any other changes in income trends, business owners as a group will appear to have large increases in taxable income, when in fact economically nothing may have changed save the corporate structures of their businesses.

But the real point I want to make is that all of the retained income and potential investment capital of a small business using S-corps or LLCs (which is nearly everyone nowadays)  shows up on the owner's personal income tax returns.  Let's hypothesize an entrepreneur whose S-corp earns $250,000 in profits after-tax.  Let's say he typically puts $150,000 of that to savings and living expenses, and the other $100,000 is reinvested in the growth and/or productivity of the business.  Now let's look at proposed increases in upper income tax brackets.  With these higher proposed rates, the business owner will have less than $250,000 in after tax income.  Let's say it goes down to $220,000.  Odds are that the owner will retain his lifestyle (he will as a minimum still have the same size mortgage and school and other payments).  The slack, then, comes out of the retained earnings.  Essentially, higher taxes result in less investment capital.  In fact, we can see an increased tax rate on wealthier entrepreneurs and business owners could easily result in a dollar for dollar reduction in business investment among small businesses, acknowledged to be the place where most all new jobs are created.

I think readers know that I don't fully accept the Obama administration's analysis of this recession.  However, let's take them at face value for a moment.  They are concerned that savings of average people won't currently translate into more business investment, as they fear the credit crisis causes banks to hold the savings rather than re-lend it.  If this were the case, then it would mean that as a policy, we would want to preferentially route tax savings to entrepreneurs and business owners who invest their own money directly, because their is no intermediary of a bank to interfere with the process.  But in fact, this is exactly opposite of what the Obama administration is doing through tax policy, instead taking away the investment capital and retained earnings of entrepreneurs through higher taxes.

This is the European-style corporate state in a nutshell.  In Europe, entrepreneurship is made extraordinarily difficult.  This is part of the deal that the political elite have with the largest companies in their countries -- we will protect you from potential new competitors, we will bail you out when times get tough, and you in turn will support us politicians.  One only has to look at the turnover of the top 30 companies in the US since 1970 vs. the top 30 in Germany or France to see this at work.  Political turnover is even slower, as an elite group of ministers run the country, almost no matter the party voted in office.  The economy as a whole suffers, but for the top 1000 or so men in power, the system works to protect their position, be it in government or in the largest industries.

And now we bring this system to the US.  Small business owners and entrepreneurs are punished with higher taxes in order to bail out politically powerful but failing companies like GM or Citicorp.  Welcome to America, the new corporate state.

Postscript: A lot of folks erroneously associate corporate states with right-wing governments, and certainly that was the case in Mussolini's Italy.  But the closest brush the US has ever had with such a system (prior to today) was implemented by leftish FDR via the National Industrial Recovery Act, and governments of both left and right have supported the corporate state approach of France and Germany.  In Britain, it was the left that built the corporate state and the right, under Thatcher, who tore it down.

  • http://http//www.tinyvital.com/blog John Moore

    A few years back a friend sold his Sub-S. At the time he had 80 employees and was probably doing over $10 million/year gross.

    Increasing the personal rates would directly have impacted the company's finances.

  • Kit

    Mussolini was no right-winger!

  • Mike C

    Kit:

    You are absolutely right. Read "Liberal Fascism" if you have any doubts that Mussolini was a socialist.

  • Link

    I've been trying to build a tech-oriented business that's people intensive. So when we raise outside financing, it mostly goes out as salaries. We're a start-up ... and not yet cash-flow positive ... but a big chunk of our equity goes to government even now. Unlike Tony Soprano as a business partner ... government wants its cut up front, and then again if and when we make real money.

    This gave me greater insight into why venture-financed companies were so big on stock options. You paid key employees in stock option wampum to avoid these upfront taxes. It also creates a bias to hiring people who can live on less cash -- single folks. You don't want people who even ask about your benefit plans.

    One of the best things you can do for a stranger is to give them a job they don't hate, that pays decently.

    My experience has taught me to avoid hiring people as much as possible.

    Like a lot of people with small businesses ... I'm spending too much time right now thinking about how to cut my future taxes. If I don't find a way, the joke is on me.

  • http://www.escapetradition.com Dan Evans

    The article was interesting, but it seems to sidestep the fact that investment back into the growth of the business is tax deductible. (which is why the income being discussed is called "retained income" as seen in paragraph 5 above) So, to change perspective a little, couldn't it be argued that more taxes on retained income above $250k in the given scenario would actually be incentive for the business owner to re-invest and grow the business?

    Higher taxes on retained income isn't a tax on investment capital, as argued above. It's actually an incentive to keep retained income low, (meaning profits and dividends low) and re-investment back into the business growth high - it would mean hiring more workers, investing in more assets and buying more supplies.

    Side note: Dividends and profits that are too high are classic indicators that the business executives aren't re-investing properly back into their business for growth and further development. As a business owner and a share holder, I'd much rather have my share price increase exponentially because of business growth and development than take out dividends and profits in cash because the managers don't know what else to do with it.

  • Link

    Not everything is deductible. Some "investments" have to be capitalized ... so they can only be deducted over time.

    Which raises the bigger point. If the return on investment is lowered, because it'll get taxed more ... you'll see less investment ... especially for riskier investments. Riskier investments don't make sense, if the government demands too much of the return. In that case investment flows to less risk, small but surer returns ... or to present consumption ...or goes "dark" to avoid the taxman.

    As I write, Obama just likened the stock market to a tracking poll ... and said he doesn't look to its day-to-day gyrations.

    So here's a pop quiz:

    Is Obama

    A) just a sh*thead who doesn't know any better, or

    B) purposefully creating chaos to bring the world crashing down.

    There is no "C."

  • Mike

    The answer is "B".

    See, at first I thought Obama was an idiot. But I've realized he's not, he knows what he's doing.

    Ever argue with someone, and ended up being wrong? Even try to make yourself right by sabotaging what ever the argument was about to make the other guy wrong?

    Capitalism works, but Obama wants it to be broken, so he can replace it with Socialism. He complains that Rush Limbaugh wants him to fail. But Obama wants Capitalism to fail, and he's doing all that he can to make it happen.

  • Jacadasag

    My business partner and I are in a similar situation where the company's net is passed to the partners but much of the net is returned as investment. With a high payroll, enough cash must be available for the January payroll plus many other expenses. We are aggressive on growth so little cash cushion. Just today we've started discussion on changing the organizations to lessen the impact of President Obama's upcoming policies. I'm looking forward to reading creative ideas and solutions from others on this subject.

  • Link

    One of the things we're looking at is to apply for a couple of patents. Even if the patents have little "free standing" value, we may be able to get future distributions to the founders paid out as royalties at capital gains rates.

  • http://www.escapetradition.com Dan Evans

    Link,

    The capitalization of some expenses as capital investments (since they're assets) that you describe - those that must be deducted over time - are still tax-deductible (assuming you're going to be in business for more than a couple years). In addition, the first $100k or so (I can't remember the exact number off the top of my head) of those investments have an allowance to be taken as immediate expenses and don't have to deducted over time. So, I feel comfortable with my assessment that the scenario originally given in the article is a bit misleading.

    I'm not sure why you have investments in quotes...

    I watched the same interview of Obama yesterday. The quote about the stock market has a much broader context than what you posted. I found that overall his interview was extremely thoughtful and well informed. You and I may disagree with some of his strategies - which I can understand and gladly accept - but to discount him as stupid or malicious reeks of willful ignorance or simply un-managed, illogical, anger. I try to avoid both if at all possible, since they help no-one and can be detrimental to many.

  • David

    To solve the double taxation of dividends problem---why not do this?
    Let corporations write off dividends as an expense---like they were paying their shareholders a salary basically. Then just tax dividends at the personal level as if they were ordinary income, just as interest from bank accounts is taxed.

  • Link

    Response to Dan:

    I'm convinced that Obama's priority is to use the crisis to push his agenda, not to fix the crisis. Fixing the banks, etc should be dealt with first ... instead it's been pushed off, which is weighing down the market.

    As another example, his energy plan is a joke. Wind and solar are incapable of being more than 10% of the mix, which is only half of what our existing antiquated nuclear reactors are already putting out. Hybrids make no sense in a world of $2.00 gas ...

    I'd have some respect for Obama if he were a true Robin Hood, instead of a hustling "playa." He took a Rezko bribe to buy a mansion, took a pay-off through Michelle's salary ... I'd bet there was more. You'd think that after funneling millions of state money to Rezko for his failed slums, Obama would have shame ... or at least have learned a lesson about the limited effectiveness of government spending. Instead ... he wants to piss away hundreds of billions.

  • Link

    ... and furthermore.

    Many of us wouldn't be so worked up if all we thought was that top rates would go to 39% ordinary and 20% capital gains. But the numbers don't add up. We're looking at huge future spending commitments that have to be paid for eventually. That means rates will get jacked and brackets lowered, significantly. We may be skating to the edge of hyperinflation.

    So with that as backdrop, I don't know how you can't conclude that Obama is either a sh*thead about these things, diabolical ... or both.

  • Junior Samples

    Link,

    I voted for Obama, but you do make a good point about his approach to the banking problem. Paul Krugman (hardly a right wing apologist) has been critical of Geithner's hesitance to get into the shorts of the banks to understand just how bad their balance sheets really are and nationalize the truly sick ones. Obama even getting pounded by Maureen Dowd of all people about the level of pork in the stimulus and Obama's seeming hesitation push back on it despite his campaign promises (see her most recent column). I do disagree with McCain that spending on Astronomy research is not germane to the ordinary American (astronomy research is very hardware intensive - lots of concrete, rebar, machine tools, etc)

    I also agree that higher taxes on upper income earners only makes sense if it doesn't discourage business investment. I am all for closing the loophoole on hedge fund managers paying themselves in stock so that their marginal rate on billion dollar incomes made manipulating markets is only 15%, but I don't want to do that if it means that real business owners (i.e. not quasi-criminal enterprises) are discouraged from re-investing in their enterprises.

    The fact that the failure to police Wall Street seems to a bi-partisan effort doesn't give me much reason for hope. For F$%s sake the SEC had a guy waving mathematical proof that Madoff was a con-man for years and they did absolutely nothing. And Freddie Mac/Fannie Mae has a giant army of government bureacrats watching them (forget the name of that agency) who sole purpose is to police them, yet they couldn't figure out what was obvious to guys like Robert Schiller, et al.

    I also agree that Obama's association with various slumlords like Rezko (and his close adviser Valerie Jarret is disturbing). These folks were clearly feeding at the public trough under the guise of helping the poor and he was encouraging it.

    I am beginning to worry that we've replaced one brand of scumbag crooks with another brand of scumbag crooks.

    /JS

  • Link

    To Junior Samples,

    I know a lot about banks, but can't figure out where we are ... because of the lack of good information ... which is telling.

    I want to say that we have a severe problem ... not catastrophic ... think Category 3, maybe 4 ... but not yet 5. We've had these storms in my lifetime ... just not since 1990-1991. I lived with a decade of Cat 4's as a kid in the 1970s.

    Until recently, Obama likened this to the Great Depression .. a Cat 5 ... but ... after scaring us into supporting his Stimulus Plan ... his recent budget assumes a strong recovery in 2010 ... a Cat 3 ... go figure.

    As my mother would have said, "He's a lying sack of shit."

    Our immediate problem is concentrated with a few big banks ... and it seems addressable. We have a larger problem in the need to find a substitute for the consumer securitization market. Until this is fixed, troubled companies like GM are sailing into a 30 mph head wind ... as if their predicament didn't suck enough.

    That Obama hasn't made fixing this his #1 priority, and instead wants to require "cap and trade" ... is telling.

  • http://small-business-counts.blogspot.com/ Barb

    I don't anticipate a rush to terminate S elections, but I do anticipate greater spending on assets eligible for the section 179 write off. The initial effect of this may be to stimulate the economy, but there will also be a pernicious side effect: business owners will be likely to spend money in ways they would not have in the absence of the tax increase on individual income. Prior to the tax increase, a business owner might have made a decision to save a portion of the money earmarked for reinvestment in the business, perhaps to purchase a building. After the tax increase, the business owner's decision will be skewed toward making immediate purchases of tangible personal property (personal in this context meaning tangibles other than real property). This skewing of the decision making process away from what would ultimately have been best for the business is bound to have a negative effect in the long run.