Increasing tax brackets may not result in increased taxes

Small businesses and tax increases

The President’s tax proposal to increase tax rates for families earning over $250,000 would seem to impact small business owners. Many of these businesses are formed as sole proprietorships and flow-through entities. The taxable income of these businesses flows through to the owners and is taxed on their personal returns. However, in most cases, the income actually remains in the business to finance growth.

Paying higher taxes will reduce the amount of profits business owners would otherwise re-invest in their companies, making them less likely to expand and hire more workers. Many economists agree that tax increases in general limit economic growth.

The President’s tax proposal would affect different types of small business owners differently. Many more small business owners who run partnerships and Sub Chapter S corporations will face higher taxes than small business owners who run sole proprietorships. That’s because S-Corps and partnerships tend to generate more income.  Of the 30.2 million pass through businesses that the Internal Revenue Service estimates are in operation in the United States, 77 percent are sole proprietorships. The effects on income are even more extreme because the income of S Corps and partnerships is more skewed than the income of sole proprietorships. An analysis by Ernst and Young shows that the tax increases will hit only 24 percent of sole proprietorship income, but 73 percent of S Corp income and 70 percent of partnership income.

How the AMT mitigates tax rate increases

However, a closer look at the president’s plan shows that a large majority of families making up to $300,000 — as well as hundreds of thousands of families with even larger incomes — would not pay taxes at a higher marginal rate. This is because the complexity of the tax code, such as the Alternative Minimum Tax (AMT), makes it difficult to draw clean lines.

After preparing several tax projections for clients assuming that their 2013 income will be the same as 2012, I am finding that many are in the 28% tax bracket for both years due to AMT. In other words, increasing taxpayers’ marginal rates will not result in a tax increase to the extent they are still in the AMT after calculating their regular tax using the increased rates. They are still in the 28% marginal tax bracket.

Note that yesterday the White House revised its plan to permanently extend Bush-era tax cuts on household incomes below $400,000, meaning that only the top tax bracket, 35 percent, would increase to 39.6 percent. The current cutoff between the top rate and the next highest rate, 33 percent, is $388,350. Still, most taxpayers with incomes over $400,000 are impacted by the AMT and may find that their tax increase is not as significant as they may have originally thought.

By Don James CPA/PFS, CFP


About Don James, CPA/PFS, CFP
Don is the Tax & Financial Planning partner with Kiplinger & Co., CPAs headquartered in sunny Cleveland, Ohio since 1982. He partners with business owners and families and specializes in goal achievement solutions, tax minimization strategies and serves in the role of gatekeeper of sound financial advice.

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