News & Analysis

News & Analysis

McConnell Takes Broad View of 'Small Business' to Fight Tax

The Senate Republican includes movie stars and investors in his definition to claim half of small-business income would be hit with a tax increase 

By Ryan J. Donmoyer

(Bloomberg) — Senate Republican leader Mitch McConnell says President Barack Obama wants to subject half of all small-business income to a tax increase, a move that he says would strike a blow at the U.S. job-creation engine. McConnell's numbers only add up if you consider people like billionaire investor George Soros, most movie stars and Obama himself small-business owners, tax experts say.
That's because the lawmaker is basing his figure on a broad definition of the term that experts say includes authors, actors and athletes who employ few if any workers. It also encompasses businesses that many people wouldn't consider small, such as Soros's hedge-fund firm and major law partnerships.
"Every student who is a part-time Web designer, partner in a law firm with a billion dollars of revenue and investor in a hedge fund gets lumped together in the data, along with real small businesses," said Ed Kleinbard, a former staff director of the congressional Joint Committee on Taxation and now a law professor at the University of Southern California. "We are being over-inclusive in our use of small-business income."
McConnell and other Republicans have thrust small business to the center of the fight over whether to extend Bush-era tax cuts or limit the break to couples earning less than $250,000 as Obama wants. The tax cuts for all income levels will expire Dec. 31 unless Congress acts.

'Most Productive' Firms

Obama and congressional Democrats contend that 97 percent of small businesses will be unaffected by increasing the top two marginal rates, which would go to 39.6 percent from 35 percent, and to 36 percent from 33 percent. The 97 percent figure itself is too broad, since it includes unprofitable firms, consulting income and investment conduits, says Roberton Williams, a senior fellow at the Tax Policy Center in Washington.
McConnell, House Minority Leader John Boehner and other Republicans say even if only 3 percent of small businesses will be hit with the tax increase, they are the "most successful" and generate most of the real business activity. "The last thing you would want to do is raise taxes in the middle of a recession on our most productive small businesses," McConnell, of Kentucky, said in a Sept. 15 Fox News interview.

No Employees?

While tax experts such as Kleinbard, Williams and the Obama administration itself say McConnell's 50 percent figure exaggerates the share of income earned by traditional small businesses, they say they're unable to rebut the percentage with an accurate one of their own.
The reason is the debate revolves around three types of businesses: partnerships, sole proprietorships and so-called S corporations, which often have one or two shareholders. These structures are popular because they allow profits and losses to be reported on business owners' personal tax returns without first going through a layer of corporate tax. Yet the Internal Revenue Service can't tell if the income comes from a small or large business or whether the entity had any employees at all. Obama, who last year earned more than 10 times as much from his work as an author as he did from his $400,000 presidential salary, reports that business income on his personal tax return the same way as does a shareholder in a machine shop with 50 employees.

Freezing the Rates

McConnell introduced legislation on Sept. 13 that would freeze the current tax rates across-the-board for the next year. He bases his argument on a July 12 finding by the joint tax committee that 50 percent of about $1 trillion of "business income" in 2011 will be reported on about 750,000 tax returns that pay the top marginal rates. He says those are small businesses.
"We believe the nonpartisan joint tax committee is the final authority on the matter," said McConnell's spokesman, Don Stewart. Yet the committee staff report said the data "do not imply that all of the income is from entities that might be considered 'small.'" Almost 20,000 of those businesses had receipts of more than $50 million, it said.
A Sept. 3 report by the Congressional Research Service, a nonpartisan agency that analyzes issues for lawmakers, said the tax committee also counted many businesses that have no employees other than the owner. More than 21 million of the country's 27 million businesses have no workers, according to the U.S. Census Bureau; 1.9 million pay taxes as corporations and wouldn't be affected by increases in individual tax rates.

Poor Targeting

Jane Gravelle, who wrote the research service report, says small businesses with employees will pay 12 percent of the taxes generated by increasing the top marginal rates. "Across-the-board tax cuts for high-income individuals are not efficiently targeted to small businesses," Gravelle wrote.
The Tax Foundation, a Washington research group that favors lower taxes, calculated differently, on an assumption that income is always taxed at the owners' top rate, and concluded the small businesses will pay 39 percent of the share. &quote;Small business is whatever you want it to be," said Mitchell Kopelman, chairman of the tax group at Habif, Arogeti & Wynne LLP, an Atlanta-based accounting firm. His firm, which he called "middle-market," would be counted under McConnell's definition, he said.
Kopelman said his firm represents many bona fide small businesses whose owners earn enough to face higher taxes under Obama's proposals. "They're concerned," he said. "Some are going to spend less, they're going to save less, they're going to invest less."

Donmoyer is a reporter for Bloomberg News.