The Taxes of Being an Entrepreneur

January 30, 2007

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For businesses, taxes affect location decisions, job creation and retention, competitiveness, and the long-term health of the state and nation's economy. While entrepreneurs and small businesses constitute a larger portion of today's workforce, they also contribute a larger share of tax revenue. Here are some facts and developments every entrepreneur should know.

A record number of Americans started companies last year. Small businesses have long been referred to as the engine of the national economy. Today they're also providing the fuel. While entrepreneurs constitute a larger portion of our workforce, they also contribute a larger share of tax revenue.

Engaging in entrepreneurship and starting a small business can be made more or less difficult by the structure of income taxes. Although federal income taxes are the single largest tax on small business, state and local taxes can also affect small firms.

According to nonprofit research institute the Tax Foundation, the owners and partners of privately held companies pay more than 54 percent of all individual income taxes. Further, the majority of business tax returns are now filed by small businesses; the Tax Foundation estimates that 60 percent of all corporate tax returns are now from S-corporations. In fact, between 1980 and 2005, the number of S-corporations, farms, sole proprietorships, and partnerships filing business returns grew by 572 percent, to 3.7 million.

Earlier this month, the Senate Finance Committee held a hearing on whether tax credits should be used to "offset the harm done to some businesses as a result of the minimum wage increase." The tax breaks aimed at easing the burden on small businesses of increasing the minimum wage sailed through the Senate's tax writing committee.

All told, the Senate measure would provide about $8 billion in tax incentives for small biz. The legislation includes the following components:

• Work Opportunity Tax Credit. A five-year extension of the tax credit provided to employers who hire workers who have experienced barriers to entering the workforce. Also, a modification to the work opportunity tax credit to include a tax credit for employing veterans disabled after the September 11, 2001, terrorist attacks. • Expensing. A one-year extension of a provision allowing small businesses to combine as much as $112,000 in expenses into one annual tax deduction. • Leasehold Improvements. An extension through March 31, 2008, of a provision that allows business owners to more quickly deduct the cost of making improvements to a leased property. Also, modifications to the provision that provide retailers who make improvements to property they own and people who build new restaurant properties the same treatment renters receive under this provision. • Cash Method of Accounting. A permanent change to the tax code that will allow more businesses to simplify their bookkeeping by allowing them to use the cash method of accounting for tax purposes. • S Corp Reforms. A modification to the standards that allow small businesses to qualify for or stay within the S Corp tax rules. • Certified Professional Employer Organizations. Establishes a certificate program for companies that provide and oversee employees for other corporations. The certification would require these companies to meet certain standards set by the Internal Revenue Service (IRS). Businesses that contract with certified professional employer organizations would be assured they would not be liable for those taxes already paid to the certified professional employer organization.

Although most recent research has focused on federal taxes, state tax policies should not be left unexplored.

The Small Business Administration's "State Tax Policy and Entrepreneurial Activity" report, released in November, noted:

As states continue to grapple with difficult issues in business taxation and development incentives, a thorough consideration of the effects of state tax policies on entrepreneurial activity becomes even more important, especially when considering the possible benefits that could follow new entrepreneurial ventures through economic growth, innovation and the like.

Forrester Research found that, in 2006, U.S. small businesses spent about $138 billion on technology products and services, accounting for 19 percent of all IT spending. And according to a 2005 study by fellow research firm Gartner, companies that employed 20 to 99 expected to increase their IT budgets by 7 percent in 2006 — a figure that fell to 2 percent among companies that employed 500 to 999.

Taken from another perspective, the SBA projects that 544,800 small businesses closed in 2005, a slight increase from the 540,658 that closed in 2003. An additional 39,201 probably filed for bankruptcy, up from 35,037 in 2003, according to SBA estimates.

In its November report, the SBA explored the extent to which state tax policies actually influence entrepreneurial activity. It provided the following findings:

• Higher top tax rates on individual income, higher sales tax rates, and the existence of state-level inheritance or gift taxes all tend to slightly reduce a state's share of the national entrepreneurial stock; • Top marginal tax rates on individual and corporate income do not have statistically significant effects on state entrepreneurship rates, but states with higher sales tax rates tend to have higher entrepreneurship rates; • States with combined reporting and throwback rules for corporate income taxes tend to have higher entrepreneurship rates; and • The composition of state tax portfolios (i.e., which taxes are imposed and what share of total taxes each imposes) is not a significant determinant of state entrepreneurship rates.

An IRS ruling from May could provide some tax relief, saving both small businesses and individuals money on their 2006 tax bills. The IRS said in May that taxpayers can get a refund for a portion of the long-distance telephone excise taxes paid during the 41-month period between March 2001 and August 2006. Individuals must request their refund on their 2006 tax return: for businesses and tax-exempt organizations with 250 or fewer employees, the maximum refund is 2 percent of the total telephone expenses incurred during the period; for those with more than 250 employees, the maximum refund is 1 percent of the telephone expenses during the same period.

Additional:

10 best states for taxes

IRS Tax Information for Businesses

Entrepreneur Tax Center

Resources

Everyone wants to start a business by Phaedra Hise Fortune, Jan. 23, 2007

Senators Unveil Small Business Tax Cut Package by Mike Godfrey Tax-News.com, Jan. 16, 2007

State Tax Policy and Entrepreneurial Activity by Donald Bruce and John Deskins Small Business Administration, November 2006

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