Paco6945's  Instablog

Defer income taxes on small business revenue to the extent cumulative working capital is less than twice annual payroll cost, exclusive of owners’ payroll and distributions.

Small business owners would then be taxed on their actual income rather than on the net income of their businesses. Small business owners would be treated the same way as corporate executives, wall street brokers, celebrities, and professional athletes – taxed on what they actually receive in salary and bonuses rather than being taxed on net working capital.

Consider this example:ABC Services, LLC, is a successful small business owned equally by Ralph and Denise. They have 30 employees, including themselves. Total employee payroll costs in 2011, including payroll taxes, was $1.6 million. In addition, Ralph and Denise pay themselves a salary of $100,000 each.

ABC Services net income for 2011 was $800,000. Under current tax law, the total income subject to tax for each of the owners would be $500,000 ($100,000 salary plus half of the business net income) even though they actually only received $100,000. Based on tax liability averages for individuals, Denise and Ralph would each owe $108,525 – more than their annual salary. Assuming the $800,000 net profit represents ABC Services’ entire working capital for 2012, income taxes would reduce their working capital by more than 27%. This 27% comes directly from the top line of working capital – the very dollars that small businesses depend on to invest in new employees and capital equipment.

How would deferring income taxes on some multiple of payroll costs create more jobs?

In the example above, ABC Services working capital is reduced from $800K to $582K. In the case of ABC Services, that represents about three months gross revenues – the absolute minimum a small business needs to prudently manage cash flow. With the proposed change, the full amount of working capital is preserved and that would free up working capital to hire more employees. In addition, because the amount of working capital allowed to be deferred from net income for tax purposes is tied to total payroll, there is a strong incentive for ABC Services to hire additional employees during 2012 so that additional working capital can be preserved. Adding these jobs will more than offset the temporary deferment of income taxes that would be paid under the current tax laws.

But even if the additional taxes paid by new employees is discounted, over the long term the amount of taxes paid by Ralph and Denise would be more under the proposed change than they would be under the current rules.

Let’s assume that ABC Services continues to be successful and over the next five years builds up working capital to $3.2 million (i.e., twice the annual payroll costs stated above). In 2017, if Denise and Ralph sell ABC Services, at the time of sale they would draw out the entire $3.2 million in working capital and taxes would be due at that time. Most of the distribution would be taxed at the highest marginal rate. This would generate significantly more tax revenues than would have been generated under current rules during the five previous years.

I call this proposal the "Small Business Working Capital Preservation Act of 2012."

While small businesses such as law, medical, and investment partnerships would be able to take advantage of the change, due to the way the amount of the deferment is calculated based on gross payroll costs excluding owners’ payroll, they would only be able to defer taxes on an amount based on staff payroll. This will act to mitigate any criticism that this is a "give-away" to the rich.

The politicians or political party responsible for enacting a change such as this will lock in small business votes and contributions for many years.