An American Primer on Taxes

I’d like to write a few (hundred) words about taxes today.  This isn’t going to be some political rant, just an explanation for those who don’t own US businesses as to the difficulties that we currently face in creating jobs and an explanation of the new-age myth that companies and the wealthy are somehow undertaxed.  It is important that people understand these issues as too many of those I run into are buying into the current raise the taxes on the rich dogma.  No I am not an expert in taxes, but I’m not an expert in climate either and we can intelligently discuss that here all year long.  I do seem to be quite good at paying taxes though and I am lucky to have partners who are far more versed on these matters who keep me straight.

First, there are 3 main types of corporations in the US, LLC, S and C types (there are sub-variants as well for lawyers and medical I believe but this is beyond my knowledge), there are also non-profits, sole proprietorships and other nuances but the three primary taxable entities we need to worry about are listed here.  Of the three LLC and S never, ever, ever pay any taxes.   Not one penny.  This is because they are pass-through entities and any income they make is placed directly on the personal income statements of the owners.  C corps pay taxes according to a schedule like this and people like Warren Buffet who own giant C corps don’t report their corporate income or taxation on a personal return – thus, much of their tax rate is hidden.  Typically, the largest companies are C corps.  Each corporation type has its own advantages, we have an LLC and an S corp.  The S corp is a manufacturing company the LLC holds technology and does other contractual work.  Again, there are legal reasons for doing this but both of our current corporations are pass-through types.

So the second disclaimer of this article is that it doesn’t cover the most massive corporations like GE or Siemens who operate internationally and take advantage of the accounting shelters, political contribution quid pro quo that the ultra-powerful can take advantage of.   International tax law IS a key factor in what the US must change to improve the economy but the biggest companies are also the biggest donors and receivers from politicians.   We must fix these laws to survive as a country, again though, another blog should cover that for you.

Lets talk about families earning more than 250,000 per year or individuals earning more than 200,000.

The rich! ………… allegedly

So I like to ask people, “Do you personally know anyone making that much?”  Very often, the answer is no but sometimes people say yes. I know of several.  Lawyers, doctors, business owners those sorts of people.  But really, even the best lawyers and doctors have a hard time crossing the more extreme half million per year mark yet there are still plenty of those.  Of the doctors and lawyers, their income is actual money taken home in their pockets, unless they too own the businesses.

If you own a business, the tax story changes compared to a lawyer or doctor, especially if you own a manufacturing company.   If you buy equipment, like an injection molder $100,000 or a vacuum coating machine 600,000, or a sonic welder 30,000, this is an immediate cash outlay but you can’t expense it immediately, meaning that even though you pay 100% out of your pocket, you can’t subtract it from the cash you made that year.  I’m not an expert on how fast different things are depreciated, but it is like 5, 7 or 10 years depending on the asset.  Of course we pay big money for the real experts.   In other words, you make some money and spend 300,000 on equipment and you pay tax on income of 270,000 on the first year and you write off 30,000 on the tax for that year.  You get the whole value written off over time at 30K/year, but the point is that the whole amount you were able to make and expend looks like income this first year.  Further, the point for an S corporation is that it looks like personal income to the business owner.  Yay, a family making more than 250,000.

It is true that you do own the machine, but it is also true that you no longer have that cash you earned as profit to buy the equipment, so the immediate machine cash impact is typically over fifty percent higher than the money you paid for it.  Forty percent to the feds, five to the state, plus sales tax plus any incidental taxes, Michigan even charges personal property ownership taxes on top of the rest.  Sure, each year after that you get to deduct a fraction until all the money is back in your pocket as an expense against income.  The feds simply hold the money while you use the equipment to generate income, which is taxed.   They pay no interest for holding your initial payment of course so you’ve lost in the end but the point is, it costs a lot of money in taxes to add equipment in the US.  I think of it as a business-repressing negative (less than zero) interest loan to the US government.

Obama put some kind of one year plan in place to allow business to write off 250,000 in equipment purchases this year.  They call it a ‘subsidy’, but from my view it should be standard for all purchases, however, in business 250,000 doesn’t get you far.  That IS life folks.

Let’s keep this simple though.

In manufacturing in an S corp, sole proprietorship or LLC which makes up most of the businesses in the US.

• the company pays no tax.  The company owners pay for the income of the company –  most people don’t know this.  Gas stations, stores, HVAC companies, machines shops, manufacturers often with hundreds of employes pay zero. Owners pay the tax on their personal returns.
• Inventory increases are dollars on the shelf which cannot be expensed.   Inventory increases are INCOME!
• Sizable equipment purchases can be expensed only over 7 plus years.   Actual cash outlay is not recognized by the government until years pass.
• US labor which creates increased inventory in a growing company at the end of the year cannot be expensed.  Months of US labor becomes INCOME rather than expense!
• Profits (corporate income) is passed through to the owners who pay at a very high rate.

So in our case, we are lucky to be a growing manufacturer well inside the top percentile of the US.   We get the advantage of paying enormous taxes on items sitting on our shelves waiting to sell.  We get the exposure of truly endless federal laws we must comply with.With all this anti-capitalist government financial pressure, the goal becomes minimizing inventory while delivering on time.   A difficult prospect for a company in a big market for a variety of reasons outside of the scope of this article.

Even if a small business owner paid themselves $1, there is a very good chance that they would be the family to fall inside the top tax brackets of the US.  If you own a business, that is your fate.  So despite my early promise not to turn this into a political rant, when Obama says: “Families earning over 250,000”,  yes he is targeting Wall Street families (easy targets), yes he hits some doctors and some lawyers, but MOSTLY, he is saying:  “Tax the business owners”.

He is saying, we need to raise taxes on the VAST majority of private “business” to pay for the federal overspending, in order to insure our future. — for extra credit, you work out whether taxation of private business to grow federal income makes sense long-term yourself.

Now personal top income taxes to the feds are at 40% while C corps ride at 35% plus extras.

So what does it mean when the media says things like the most wealthy don’t pay their fair share?   It takes a little more thinking but what the hell, conservative or liberal, god or gaia gave us a brain, so let’s not be wimps.

S corps, LLC’s and sole proprietorships pay zero tax directly but are taxed at the personal rates of the owners.   This means that they are not let off the hook on taxes in any way whatsoever any more than any individual.  They pay the company plus personal income tax as though they were individuals filing personal income tax forms.  In fact, they file many of the same forms.

C corps have advantages for tax level yet when profits are distributed, they are taxed at personal income levels.  Double tax –  no break there either.

What about capital gains tax?  An investor throws money at a company S, C or LLC with recognized potential is looking for a realized profit.  Say the investor takes a risk and throws in 500,000 and the company grows over two years such that the stock value doubles,  the investor sells the stock to a different investor for 1,000,000.  The tax paid is only 15% – capital gains tax – on the difference between the buy/sell — a measly 150,000.   The Warren Buffet special.   This is the rich dude, paid money to a non-bank viable company (or else they would have borrowed at 5%).  The value grew and the investor took a profit.  Banks don’t lend unless they already have assets to take  —- ever!  Today, in most cases, they won’t loan against business assets without additional personal assets on the line.

But wait!

If rich dude sells inside one year, he pays full income tax — 40 percent of the increased value — ouch!

If he sells after 1 year he pays only 15% of the increased value.

If it is an S corp, the income of the hugely profitable company in our example after one year, has ALSO been taxed at approximately 40% distributed to the wealthy shareholders.  The value of the company grows by the remainder.  One large tax has already been paid before the investor takes his profit and capital gains tax!  IOW, if it is a C, S or LLC corp, often the income of the hugely profitable company has already been taxed at approximately a 40% rate with the rest able to be distributed to the “wealthy” shareholders at rates determined by the type of corporation.

The 15%  is a second tax.

A double tax for the wealthy, not a single tax as some (too many recently) would opine.  The tax on investment that Obama recently wants to raise is the SECOND tax the corporation profit has experienced.  Everyone in the company has already paid full income (sized) tax on all the money earned.

So now, when you hear ‘tax the wealthy’, I hope you will consider how it sounds to my ears because I hear ——“Tax the Businesses”.   Does anyone in America really think that taxing business is the way out of the double dip recession?  Yes, the recession did happen again.  I warned of it two months ago because our industry sees it first.  I told you to expect bad news in the future.  The economy dropped twice and it is just a matter of time until people find out. Call me when you agree.  Better yet, save the phone tax and send an email.

As always in modern politics, tax the wealthy, has a true meaning entirely different from the stated message.

I am certain that many will have corrections/additions to the above, but please keep the GE and giant corporations out of the discussion.  I may even snip this time as this is an entirely different issue.

So as the seemingly benign discussion of increasing the progressive taxation of the wealthy continues on other threads here, does anyone really consider that expanding the ramp rate of payment vs income is good idea when income is company based?

This thread will be moderated for the MOOT giant corporation arguments.