Small businesses and taxes: Not what you think

The reality of small businesses is vastly different from the image presented by many politicians—and casts the debate over how these firms are taxed in a very different light.

In the politics of taxation, nothing may be more controversial than the hot-button issue of small business. But important new research by career staffers at the Treasury Department concludes that there are lots fewer of these firms than manythink, they account for only about 17 percent of total business income, and hire many fewer workers than the political
rhetoric would have you to believe.

Using newly available tax data, the Treasury staff has refined its definition of small business and found there are no more than about 20 million owners of these firms in the U.S.– far fewer than the 35 million they previously figured. And only about five million have any employees.

Small businesses take on an outsized importance in the tax policy debate for two reasons: These firms play into the great American entrepreneurial narrative and, in the current political debate, they are the “job creators.” Raise their taxes, goes the argument, and you further wreck an already-weak economy by discouraging these firms from hiring and investing.

Well, it turns out most of the firms those pols define as small businesses don’t hire or invest very much at all. There is no question that other companies whose income is reported on individual tax returns do hire and invest (quite a lot in some cases), but they are not small businesses, at least not according to this new definition.

So what is a small business? The Treasury team, led by Mark Knittel at the Office of Tax Analysis, defined one as a firm that has combined income or deductions of at least $10,000 but no more than $10 million and one that operates in a businesslike manner. In other words, it has expenses such as wages, office supplies, rent, and the like.

This is very different than the Small Business Administration, which uses multiple definitions but can include firms with sales of as much as $35.5 million with as many as 1,500 employees. It also is an effort to distinguish between those who report business income on their individual returns and actual small businesses. Treasury finds that many partnerships, S corporations, and others who file on an individual return don’t meet the small business test—either because they make too much money to be “small” or too little to be a real business.

Those distinctions are extremely important since many politicians love nothing more than to happily label all firms whose owners report income on their individual returns as iconic small businesses. If nothing else, the Treasury staff analysis shows how bogus that exercise is.

For example, using tax year 2007 data, Treasury found that of the 23.2 million people who reported income on Schedule C, fewer than half met its small business test—nearly all because they were too small. On average, the excluded firms reported just $7,000 of total income and $4,600 of net income.

About small business as job creators: Treasury found that only about 5.4 million small businesses paid any wages at all. Of the more than 10 million with income of less than $100,000, only about 10 percent paid any wages, and about half that compensation went to owners and other officers.

This picture of small businesses is vastly different from the image presented by many politicians—and casts the debate over how these firms are taxed in a very different light. Knittel and his colleagues acknowledge there are other ways to measure these businesses, but conclude that most competing definitions tell roughly the same story they do.

Congress would do well to get its facts right. But unfortunately, when it comes to rhetoric about small business, lawmakers seem to prefer their own version of don’t-ask-don’t-tell.