February 2003

Demonstrating Leadership in the Public Interest

By Richard L. Hecht, CPA, New York, N.Y.

When the Bush administration announced that one of its major legislative goals is to change the tax laws to encourage economic growth, news stories indicated that the emphasis will be to make permanent the elimination of the estate tax, reduce taxes on dividends, and continue to reduce individual tax rates.

If our profession analyzed these proposals, I believe we would conclude that the proposed tax law changes would not do much to stimulate our economy. Other than the reduction in individual tax rates, it is difficult to see how any of the proposed tax changes will improve economic growth.

CPAs know that small and medium-sized businesses are the strongest growth engines in our economy but are limited by the current tax structure. Where has our profession been in representing our core constituency of small and medium-sized closely held businesses? While the AICPA and the Big Four clearly represent their clients, major publicly held corporations, who is representing the clients of the rest of the public accounting profession? The effort required is more than the NYSSCPA can do on its own. A unified effort by the major state societies in Washington is needed. This effort is needed not only to represent our clients. It is needed to represent the American people, something our profession appears not to have been doing lately.

One simple change could have far-reaching effects on economic growth that no one—the Bush administration, Congress, the press, or our profession—is discussing: Reduce income taxes on small and medium-sized closely held businesses. Despite having been the primary economic engine driver in our economy for many years, smaller business have not seen their income tax rates reduced in 15 years. The current small corporation tax structure discourages small and mid-sized corporations from building capital that could be used to fund and stimulate economic and job growth.

The IRC provides only limited tax benefit to small corporations that pay income taxes (C corporations). The first $50,000 of income is taxed at a 15% rate and income between $50,000 and $75,000 is taxed at a 25% rate, compared to the general corporate rate of 34%. This limited benefit is handed back to the IRS if the C corporation has taxable income over $100,000, through a 5% surcharge applied to taxable income between $100,000 and $335,000.

This recapture of the income tax benefit on the first $75,000 of taxable income has two major consequences. First, most small corporations elect to be taxed as S corporations, which pass the taxable corporate income to the shareholders. With an effective corporate tax rate of 34% (39% on corporate income between $100,000 and $335,000) and a maximum personal tax rate of 38.6% for 2002, the tax rate differential is not significant enough for the shareholders to elect to use the C corporation structure. A practical consequence of the S corporation structure is that the shareholders typically want all the income taxed to them to be paid out to them, thus reducing the capital available to the corporation to reinvest in the business.

Second, those corporations that elect to be taxed as C corporations plan to limit their taxable income to remain under the $100,000 level, so they avoid the 39% tax rate on the excess. Once taxable income exceeds $100,000, the shareholders, who are often also employees, elect to take the excess taxable income out of the company as compensation because their individual maximum tax rate is less than the 39% corporate rate on this income. The end result discourages the creation of capital, the basic foundation for a strong, growing business.

Another anomaly that hurts small corporations is that the tax brackets for the lower tax rates have not been indexed for inflation like the individual tax brackets. The consumer price index is now 160% higher than 1986, the last time the current structure was changed. On an inflation-adjusted basis, a C corporation in 2002 pays 28.5% more in income taxes on the equivalent of $100,000 of taxable income reported in 1986.

Our profession, as advisors and counselors to these businesses, should lead the discussion on this taxation issue. We, better than any group, know the economic and job growth that could be generated if significant tax incentives existed to encourage businesses to retain more capital. It’s time we spoke up as a profession serving the public’s interest.

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