A Question for DU Accountants re Sub S Corps & the Bush Tax Cuts

[MyUncle]

This is for the accounting professionals and the like. I confess I'm not even sure how to ask this question properly but here is my shot at it.

Are there many small Sub S corporation businesses that have employees that would have their rates go up if the Bush Tax Cuts expire?

If so, is there any legitimacy to the claim that the rise in rates that they pay will go up enough that they will have to choose to either lay people off or not hire people? Are there other forms (other than individual proprietor) of business that will see their rates go up similar to the above situations? If so, what kind and are there a lot of them.

I'm trying to figure out how many employees will be affected by their employers change in tax rates, if any.

Thanks accountants.

[Bonhomme Richard]

1. employees will be affected by their employers change in tax rates, if any. " Zero

I own an S Corp and all profit is considered taxable income. I can't imagine a business owners personal tax rate effecting how many employees he has. A company only hires the employees if the contribute to the bottom line and that is based on the needs of the company, not the personal tax rate of the owner. Actually, if anything, the owner is more likely to invest in the business if the tax deduction is eliminated because investing in the business and lowering it's profit is the only way he can lower his tax liability.

[MrModerate]

2. Not an accountant, but . . .

An employee of an S-Corp whose tax rate will go up if the above-250K cuts expire. In my case, the company is big (and why we qualify as a S-Corp is something of a mystery to me -- but like I said, I'm not an accountant).

But to the point: my tax rate going up will have zero impact on my company (except that it might be a bit cheaper for them to manage tax equalization for expatriate employees based in high-tax countries). In my case, the claim is totally bogus.

[MyUncle]

4. I'm not talking about your tax rate but the tax rate of your employer.

If their rate goes up, I have to imagine it is the same as any other expense. I could be wrong that is why I am asking, do the tax cuts affect income or net income? There is a big difference in how a business would react.

[The Velveteen Ocelot]

6. All profits made by an S corporation are taxed to the individual owners (shareholders).

There's no separate corporate tax. So the tax cuts would affect the rate at which the individual shareholders of the S corp. I can't imagine why a (slight) tax increase for the individual shareholder on the net profits of the corporation would have affect employee head-count decisions. A business will hire/keep the employees it needs, regardless of how much income tax the owners pay.

[The Velveteen Ocelot]

3. I'm not an accountant, and I don't even play one on TV, but

the notion that taxes significantly affect an employer's ability to hire (or avoid laying off) employees has never made any logical sense at all. A business hires as many employees as it needs to deliver its products or services -- no more and no less.

Suppose you own a business that manufactures doo-dads. You employ ten people to produce, ship and keep track of your doo-dad production. You don't need any more or less than ten people because that number is exactly what's needed to satisfy the demand for your doo-dads. So let's say the tax rate goes up. If it's an S corporation there's no corporate tax; the profits are taxed to you as an individual, so your individual taxes will be a little higher. When you do your taxes there are a whole lot of deductions that the business can take, including costs associated with wages. Also, the top marginal tax rate would increase by only 3%, so unless your net profit (on your 1040 form) is well in excess of $250,000 you aren't looking at a whole lot of money. But that's beside the point. If the demand for doo-dads remains steady, you will keep enough employees on your payroll to produce them -- regardless of an increase in your individual taxes -- or you will lose business; your customers will go elsewhere.

The opposite is also true. Suppose the government decides to reduce your taxes. Will you hire more employees now that your taxes are lower (this is the claim the Republicans make to justify tax reductions for businesses)? No, not unless the demand for doo-dads increases. If the demand for your product does not increase, you will not hire more employees to just sit around and do nothing, or make stuff nobody is buying. You will not buy new equipment to make stuff nobody is buying. No, you'll just pocket the extra money. Or else you'll use it to build a plant in China, lay off your American workers, and make even more money importing cheap Chinese doo-dads.

The basic point is that for a S corporation the tax paid by the individual owner is unlikely to have any effect on a decision to hire or lay off employees.

[MyUncle]

5. But price does affect demand.

If do dads cost more because expenses go up (taxes, wages, materials, whatever) than demand could go down. I am trying to find out how much the costs go up and to how many real businesses if these tax cuts expire.

Thank you for the analogy and explaination with the absense of price I concur with all you said.

I guess I am asking a very narrow question.

[The Velveteen Ocelot]

7. If tax rates go up for everybody, then theoretically

the business' competitors would also be inclined to raise prices. But an S corporation pays no taxes as a separate entity. Any profit is attributed to the individual shareholders, who pay the taxes at whatever rate applies to them.

So let's say the doo-dad business has four owners who own equal amounts of stock and it makes a net profit of $200,000. Each owner would have to pay taxes on their $50,000 share of that profit (even if they decide not to distribute the money but roll it back into the corporation -- it's recognized profit and therefore taxable). Maybe owner A has no other income, so he pays income tax on $50,000 (less whatever personal deductions he might have). If the Bush tax cuts expire for everybody he still won't have to pay very much at all. But maybe owner B has another job that pays $75,000, so the additional $50K will put him in a higher bracket and he'll pay more. Maybe owner C already makes $200K, and the $50K will put him in an even higher bracket. And maybe owner D is Bill Gates, who won't even notice the $50K.

All of these owners of the S corporation pay income tax at different rates because of their different circumstances. But presumably they all want the business to profit, even if their taxes are higher, so they won't lay off employees that are needed to produce the product. The only thing that really matters is demand. If there is demand for the product the business will employ enough people to satisfy it, regardless of how much tax the shareholders pay on the eventual profit.

[quaker bill]

8. The point is

if taxes go up, then they go up on level, so that all likely competitors pay roughly the same rate. It is a wash. If all the doo dads go up in price some fraction of 3 percent, then the competitive balance remains the same, the playing field is level. It is possible that the consumption of doo dads drops, particularly if doo dads are a discretionary item, however there is little evidence that such a modest change in price has a measurable impact on aggregate demand.

Tax rates, do not significantly impact employment at anything approaching current rates. It is possible at massively higher rates, some impact could be reliably measured. However, it is useful to recall that the boom of the 1950s occurred with marginal tax rates as high as 91 percent for upper income earners, so even at much higher rates the effect can be negligible.

[The Velveteen Ocelot]

9. Bingo.

In other words, the Republicans are full of crap. As usual.

[MyUncle]

11. Let's prove it with real numbers.

That is what I am working toward here.

[MyUncle]

10. But if a Sub S or individual is competing against regular corp

the corp rates are not going to go up. That means the sub S pays more under the current scenario.

Your example is helpful, but my main question is how many Sub S companies (or similar) are there that will or will not employ people because of this tax hike or not.

[The Velveteen Ocelot]

12. My supposition is that it will make no difference.

S corporations have other advantages. It's interesting that the size of the corporation does not determine whether it can be a C corp or an S corp. Many S corps are quite large (many employees, not so many owners). Sometimes there is an advantage to passing profits through to the shareholders, sometimes not.

[quaker bill]

16. I used to run a sub S corp

Taxes had no relevance to hiring decisions, signed contracts for deliverable goods was the only relevant consideration. Taxes only apply to profits, profits came from sales of delivered goods and services. The better I did with quality control, prompt delivery, and marketing, the more sales I made. When contracts in hand exceeded our capacity to deliver over the next quarter I hired people. Profits were the funds left over when their salaries, expenses, and consumables were paid out. Since I only hired people when I had contracts for their work, more people I hired, the bigger the profits. If profits went up, then so did taxes. More money is still and always more money. Taxes never make more money into less profits. When we went from a quarter million in profits to a half million in profits, we did owe more taxes, but I would take 61 percent of a half million ($305,000) over 65 percent of a quarter million ($162,500) every day.

No one turns down a lottery jackpot because of all the taxes they will owe on it.

[nessa]

13. I suspect many S-corps are service businesses..

not so much manufacturers. If you're a consultant, you could hire someone to help or you could do the work yourself. If you are near the threshold of the next highest tax bracket you may decide to chill, and not take on the extra work for the extra revenue that is just going to be taken away in taxes. If making more is not going to throw you into higher taxes you may decide it's worth it to grow the business and perhaps hire help so you don't have to work so hard personally.

I'm not an accountant either.

[The Velveteen Ocelot]

14. Actually, there are a lot of manufacturers and construction companies

incorporated as S corps. And many of these companies are quite large. An S corp can have no more than 75 shareholders but otherwise they can be as big as the owners want them to be.

http://www.irs.gov/pub/irs-soi/02scorp.pdf

[jberryhill]

15. I run a business that makes over 250k

Whether I hire anyone is going to be determined by how much work there is. Period.

Raising taxes doesn't make me any less likely to hire anyone, since their wages are an expense in the first place.

It doesn't affect what I pay current employees either for the same reason

It's not like I would wake up one morning and say, "Gee, I'm making a lot of money, I guess I'll hire somebody." To do what? Sit around and get paid, just because I was in a good mood?

[Bonhomme Richard]

17. I own an S Corp and I manufacture. You have to remember that

Companies file as S Corps for the tax advantage over being a C Corp. basically so that their income is not taxed twice.
Now for reality. People just do not understand how businesses work. A well run business only invest in what it believes will increase the bottom line whether that's new machines or new employees. I could never understand the bullshit that companies need tax breaks to succeed. The big thing for years has been tax relief to increase R&D. Total crap. Are they telling me that a company will not spend on R&D if they don't get a tax break? That's ridiculous. The profits of that company are based on market share and continuing to come up with new products. I don't care if it is a pharmaceutical company or a car manufacturer. R&D is what you did to come up with your first product and you will continue working on R&D to come up with new products or your company will fade. Period. If a company is not moving forward it is dying. Therefore companies will spend on R&D for their own survival whether they get a tax break or not. Sure, they will take the money, who wouldn't, but do they need it? Not if they are managed properly and if they aren't managed properly they are going to go out of business anyway.
There is another reality. Most business owners are not like wall street financiers. Most owners of successful companies pay themselves what the business can comfortably pay. Typically the guy that starts a business know his product and is most interested in building the business willing to defer big payouts to himself if he believes that the money available is better spent on the company. I know of companies with sales in the millions whose CEO gets paid about 80K/year while some of the people they hire are paid substantially more. They do that so the business grows. There is a completely different mind set when compared to financiers that buy companies. They are only looking for a payout as soon as possible. They are not interested in growth per say. Only the growth of their investment. Sure, they will push for tax cuts because that gives them a faster return on investment by cutting expenses.
I could go on but I think you get my point.

[Sgent]

18. I am an accountant

and the issue is that Sub S manufacturing and retail corps have to pay taxes on phantom profits. This really isn't a problem in service industries, but is a huge issue in businesses with large profits or capital needs.

For instance, assume following scenario:

+Sales: 5,000,000
-expenses -4,000,000
=Profit 1,000,000
Taxes approx 1,000,000 * .35 = 350,000
Net cash flow: 650,000

Now, say I want to buy a new machine, or I get more orders and want to ramp up inventory, I DO NOT get a tax deduction for doing that, and it IS NOT an expense. In the case of inventory, I can only expense it when it is sold (not purchased), and in the case of machinery, I have to depreciate it usually over 8-10 years, with only 1/2 year depreciation in the first year.

So... If I increase my inventory by 200,000 widgets, and buy a 400,000 machine, my net cash flow is 50,000, even though I show a profit of 1,000,000.

This is is not specific to S Corps (LLC's or sole prop. / partnerships have the same issues), but is a real issue in setting tax rates.

In theory, I will make up that money in future years, but I'm paying taxes on it this year.

[MyUncle]

19. Sgent, I hope you check back, follow up question.

I am really trying to zero in on the net effect of the tax cut for the wealthy scenario. In the case of what you outline above, what is the net effect to the business if the tax cuts expire on the "wealthy". How much more will they pay in the $5 mil $1mil profit example.

Thank you so much, this I believe is what I was looking for.

[Sgent]

20. In the above example

under current rules, a S corp will pay approximately 1mil * .35ish + 1 mil * .029 + 109,000 * .145 = 394,800, with the old tax rates, it would be 1mil * .39ish = 434,000.

So if I want to take home 100,000 in cash, I could invest in equipment / increase inventory by 502,000 currently, but only 466,000 in the old system.

Now, it should be noted that there are a few tax incentives that reduce current taxes for investing in some personal property (usually equipment excluding passenger autos, lease buildouts, etc.) which reduce taxes in the current year but increase it in future years. These advantages don't apply to inventory (for ex. a manufacturer who wants to build more widgets for sale).

Service businesses (think lawyers, doctors, etc.) are not really effected by this, since they generally don't use accrual accounting, don't have much (usually) in equipment, and generally generate cash fairly quickly. A manufacturer however may not see cash for 6mos-years after building inventory (including work in progress).