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The Small Business Tax Penalty

paying_taxesOur mission here at BIGG Success is to help entrepreneurs and the organizations that serve them. So we talk with a lot of small business owners as part of our work. One thing is clear:

Small businesses are still struggling. The conversations with many entrepreneurs can be pretty bleak.



Reducing the corporate tax rate won’t help small businesses

We’ve heard calls to reduce corporate taxes. We’re not here to take a position on that.

We’re just here to say it won’t help most small business owners.

Public companies are organized as C-Corporations. So they pay tax at the corporate level. Then if they distribute the profits in the form of a dividend to their stockholders, the individual stockholders pay taxes again.

So the same money gets taxed twice.

And with small businesses, the entrepreneur may be the only shareholder!

That’s why most entrepreneurs choose a pass-through entity like an S-Corporation or Limited Liability Company. Then they don’t get taxed twice on the same money!

Many politicians just don’t understand small business

But as we’ve listened to many politicians talk, it quickly becomes clear that many of them really don’t understand this aspect of small business.

And they definitely don’t understand how it impacts entrepreneurs.

This misunderstanding results in the small business tax penalty. You might be surprised at how taxing it is!

The cause of the small business tax penalty

The penalty occurs because income at the entity level and the individual level is combined forcing the small business owner into a higher tax bracket. It’s similar to the marriage tax penalty, which Congress has now largely eliminated.

But they haven’t done it for small business owners. In fact, we’ve never really heard anyone talk about it. That’s why we’re talking about it!

The large company scenario
The best way to understand it is by looking at an example. Let’s say a large company makes $100,000 in profit after paying its CEO $100,000 in salary. So there’s $200,000 of total income.
We’re making a simplifying assumption that the CEO’s entire salary is taxable income. The total taxes paid between the corporation and the CEO would pay be about $39,600 at current rates.

The small company scenario
Let’s apply the same set up and the same simplifying assumption to the entrepreneur and his or her business. The small business owner (who is also the CEO) takes out a $100,000 salary and the business clears $100,000 after paying this salary.

The entrepreneur ends up paying a little over $44,200. That’s almost 12% more in taxes than the large company and its CEO paid!

The reason is that the income of the business passes through (hence the name) to the entrepreneur’s individual taxes. This bumps the small business owner into a higher tax bracket than the large corporation and its CEO. That’s the small business tax penalty.

So why don’t more entrepreneurs choose to be a C-Corporation?

Some pass-through entities allow for more flexibility. It’s also very expensive for closely-held corporations (those with just a few owners) to take profits out as dividends because they get double taxed. And they can really get slammed when they sell their business.  

This penalty really hits growth businesses hard

So entrepreneurs pay more taxes now because their business income gets grouped with their personal income. This is particularly troublesome for fast-growing small businesses that have to reinvest to keep the growth going.

And think about it …

Don’t we want small business owners to reinvest their earnings?

Isn’t that what starts the engine for job growth?

Isn’t that what leads to BIGG success for our whole economy?

What do you think about the small business tax penalty?

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(Image in today's post by GMDee)