Brass Taxes Is Here for All You Warrior Poets and Other Nice People Who Hate TurboTax

The top individual tax rate is scheduled to jump to 39.6% on January 1, 2011. To those of us who do private business tax returns for a living, one effect is obvious: this will raise the tax rate on LLC and S corporation income.

But now Treasury Secretary Tim Geithner says that all my small business clientsthy rich law partners and CEOs (my emphasis):

Ninety-seven percent of small businesses in this country would not pay a penny more due to letting these upper-income tax rates expire.

Now some have argued that even if only a few percent of small business owners make over $250,000, these few make up a vast amount of supposedly small business income.

This argument apparently counts anyone who receives any type of partnership or business income as if they were a small business.

By this standard, every partner in a major law firm and every principal in a major financial institution would count as a separate small business. A CEO who has board fees or speech fees would also count as a small business owner under this overly broad definition.

Well yes, Timmy, “some” have argued for that “overly broad definition” — your friends who say 97% of small businesses won’t be affected by the scheduled tax increase. A 2009 report by the Center on Budget and Policy Priorities is a source of the talking point that only a tiny fraction of businesses will be affected by the expiration of the tax increase. They define a small business 1040 as:

…any tax unit that receives any income (or loss) from a sole proprietorship, farm proprietorship, partnership, S corporation, or rental income.

So while a CEO who has board fees will count as a separate small business — as will President Obama, for that matter — so will every taxpayer that has a schedule C, schedule E or Schedule F. Your office Mary Kay girl or Shacklee dealer counts as a small business. Everybody who moonlights and reports their income is a small business. Everybody who rents out a duplex or vacation home counts, as does every taxpayer who holds, even briefly, an interest in a publicly-traded oil and gas partnership.

So how much small business economic activity will be hit by the increase in the top rate? A lot more than 3%. The center-left Tax Policy Center estimates that 44.3% of taxable income of these “small businesses” will be hit with next year’s scheduled tax increase (hat tip: Howard Gleckman). That seems low, if anything, based on what I see in practice.

It’s the successful, growing and profitable S corporations and partnerships that push their owners into the top tax brackets. Growing businesses typically distribute only enough income to owners to cover taxes — either by inclination or by agreements with lenders. Their remaining earnings go into growing the business or paying off the bank. If you increase their taxes, it either reduces growth and hiring or their ability to service their debt — neither of which does much for the economy.

When Tim Geithner says that the only people who will get hit by his tax increase are rich lawyers and director fee millionaires, it may tell us something about his social world. It tells us nothing about how the tax increase will hit business owners.