Ending Tyranny

– By: Larry Walker, Jr. –

In Part I, we focused on unfair tax policies surrounding S-Corporations and Partnerships. The prospect of increasing tax rates on business owners is a far cry from what most of us would consider meaningful fiscal reform. Part II examines how government, both federal and state, milks corporations, and specifically small Personal Service Corporations (PCs) out of billions of dollars every year. In terms of combined taxes, if we add together federal and state corporate taxes, payroll taxes, and taxes levied on the wages and dividends of its owners; when the smoke clears, government walks away with approximately 76.6% of a PC’s pre-tax profits, and 45.4% of its gross income.

And just what is the end result of all the government’s efforts to hoard and redistribute our wealth? Well, as far as the federal government is concerned, with revenues of $2.2 trillion in fiscal year 2010, and a national debt of $13.6 trillion, it appears that Congress has already spent all of next year’s revenue times six. So when is enough, enough? Meaningful fiscal reform necessarily involves massive spending cuts, and major tax cuts. Our problem is government spending. Tax cuts have the effect of broadening the tax base, and are the only way to effectively increase government revenues.

“An unlimited power to tax involves, necessarily, a power to destroy; because there is a limit beyond which no institution and no property can bear taxation.” ~ John Marshall, McCullough v. Maryland, 1819

What is a Personal Service Corporation?

A personal service corporation (PC) is a corporation composed of employee-owners who perform substantially all of its services. Personal services include any activity performed in the fields of accounting, actuarial science, architecture, consulting, engineering, health (including veterinary services), law, and the performing arts. Like other C-corporations, PCs are subject to income taxes; but unlike regular C-Corps, PCs are taxed at a flat rate of 35% of taxable income.

Corporate Income Tax Rates

The following table shows the 2010 federal income tax rates assessed on corporations. [In the examples which follow, the company is based in the state of Georgia and is subject to its corporate tax rate of 6% of taxable income.]

Sample Personal Service Corporation

In the following example, Taxed Enough Already, PC (TEA-PC) is a small personal service corporation with ten employees, and annual revenues of $800,000. In tax year 2010, TEA-PC paid salaries and wages of $300,000, payroll taxes of $25,805, and had pre-tax profits of $474,195. The total amount of corporate income tax paid was $194,420, after-tax profits were $279,775, and employee-owners were paid dividends of $150,000. TEA-PC’s sample income statement follows:

The Issue: Combined Taxes

Examining its total contribution to federal and state taxes, we find that TEA-PC paid $220,225 in combined payroll taxes, and corporate income taxes. We also discover that its employee-owners paid an additional $112,950 in social security, Medicare, and federal and state income taxes. Finally we see that TEA-PC’s employee-owners got soaked for another $30,000 in taxes on dividends received out of the company’s after-tax profits. Overall, TEA-PC has been milked out of $363,175 in combined taxes. In other words, TEA-PC’s employee-owners have been assessed total taxes amounting to 76.6% of their pre-tax profits. That’s pathetic. How can American businesses grow, when they are being milked out of 76.6% of pre-tax profits every year?

Proving that TEA-PC was responsible for all of these taxes is easy. We know that the company directly pays payroll taxes on its employee’s pay, and corporate income taxes. What many non-business types don’t understand is that a corporation is also responsible for withholding and paying its employee’s share of taxes. Also, since in this case, the employees are owners, their after-tax dividend receipts are subject to double taxation. Dividends are first levied a 35% tax at the corporate level (plus 6% in state taxes), and then subject to another 15% on the owner’s personal income tax returns (plus 5% in state taxes).

Tax Ratios

An examination of TEA-PC’s tax ratios reveals the following:

1. Corporate payroll and income taxes paid were 27.5% of gross income.

2. Corporate payroll and income taxes paid were 46.4% of pre-tax profit.

3. The company was directly and indirectly responsible for paying combined taxes of 45.4% of gross income.

4. The company was directly and indirectly responsible for paying combined taxes of 76.6% of pre-tax profit.

5. The total taxes paid on dividends, which are taxed both at the corporate and individual level, amounted to 61% ((35% + 6%) + (15% +5%)).

The Proposal

In order to make the tax code more equitable, Personal Service Corporations, as well as regular C-Corporations, should be allowed to take a deduction for annual dividend distributions. This will lower corporate taxable income and the amount of corporate income taxes paid, put an end to double taxation; and enable more income to be distributed as dividends, and/or reinvested towards future growth. This is accomplished by adding a line to page one of Form 1120 for the dividend deduction.

In addition, the tax rate on PC’s should be cut dramatically. According to the tax rate schedule above, PC’s are taxed at the same rate as corporations with taxable income greater than $18,333,333. Why are PC’s with taxable income of $50,000, $100,000, or $400,000 taxed at the same rate as corporations making over $18,333,333? Does this sound like a pro-growth strategy? The government’s present fiscal commission is recommending cutting corporate rates to 26%, while others want them to be repealed entirely. Under the Revenue Act of 1926, the tax on corporations was 13.5% of net income (individual tax rates ranged from 1.4% to 25%). Today, we have a complex set of codes, rules, and regulations, which basically amount to nothing more than government lordship. It’s time to level the playing field so that no corporation has an unfair advantage over another, and so that government may no longer oppressively impose itself over private enterprises. I therefore propose a maximum corporate tax rate of 13.5% of net income.

The Effect

My proposal will effectively lower the amount of taxes paid by corporations, and personal service corporations by ending the double taxation of dividends. By allowing corporations a deduction for the amount of dividends paid, more income is distributed to the personal level for efficient consumption. Also lowering corporate tax rates to the level imposed during the Roaring 20’s will allow our economy to return to a policy of robust growth. Once enacted, my proposal will result in economic growth on steroids, massive jobs growth, skyrocketing levels of entrepreneurship, greater freedom, and less dependence on the federal government.

Stop Swindling Paper Profits

– By: Larry Walker, Jr. –

Much of the debate against raising tax rates on the upper bracket centers around how income taxes are computed on small business owners. The debate focuses on the way that pass-through income, which is earned by the shareholders of S-Corporations and Partnerships, gets taxed. What we need is a fundamental transformation in the way that businesses are taxed. A business should be treated as an investment, not a person. Once we have correctly defined the nature of a business, and how businesses ought to be taxed the rest of tax reform is easy.

“An unlimited power to tax involves, necessarily, a power to destroy; because there is a limit beyond which no institution and no property can bear taxation.” ~ John Marshall, McCullough v. Maryland, 1819

Defining Pass-Through Income

S-Corporations and Partnerships do not pay income taxes. Instead, income is passed through to its owners and taxed on their individual income tax returns. Owners of pass-through entities receive income from their businesses in primarily two ways. The first way is through salaries and wages, and the second is through K-1 distributions. Salaries and wages are reported on W-2 Forms and are subject to withholding, social security, Medicare, and federal and state unemployment taxes. K-1 distributions are reported to the shareholder on Schedule K-1, and are not taxable, nor subject to withholding or payroll taxes.

What are K-1 Distributions?

K-1 distributions represent distributions of profit paid to the owners of S-Corporations and Partnerships. K-1 distributions get their name from the tax schedule on which they are reported, Schedule K-1. In addition to reporting the amount of K-1 distributions, Schedule K-1 also reports the shareholders share (as a percentage of ownership) of net business income, non-deductible expenses, capital gains income, and any pass-through deductions and credits (i.e. accelerated depreciation).

K-1 distributions are similar to the dividends paid by C-Corporations, with one key exception. Taxable dividends are reported on Form 1099-Div, and taxed to the recipient as current year income. K-1 distributions are reported to the recipient on Schedule K-1, but are not taxed to the recipient as current year income. The recipient of Schedule K-1 is instead taxed on the entire net income of the business, which is usually far greater than the amount physically received as a distribution.

The Issue

The discrepancy lies in that S-Corporation and Partnership shareholders are taxed on their share (as a percentage of ownership interest) of the net income of the business, not on the amount of distributions they physically receive.

Example – A small business has net income of $400,000, only one shareholder, and paid the owner a salary of $100,000 plus a distribution of $50,000.

Under current tax law this shareholder has taxable income of $500,000, the entire net income from the business of $400,000, plus a salary of $100,000. But in reality, the owner has only physically received $150,000, a salary of $100,000, and a distribution of $50,000. The remainder of $350,000 was earned by the company, but has yet to be spent or distributed. Is it fair to tax the small business owner on $500,000 of income when she has only physically taken custody of $150,000? Foul! Anyone who thinks this is fair should make a voluntary tax-deductible charitable contribution to the federal government, and earmark it towards the national debt, which by the way is allowed under the tax code.

This is the issue at hand. On one side, you have those who want to treat the lowly small business owner as a millionaire, and to tax her on income she has yet to receive; and on the other side, you have those who think it hurts the economy to tax unrealized small business profits, which businesses need to retain for future expansion.

The Proposal

In order to make the tax code more equitable, shareholders of S-Corporations and Partnerships should only be taxed on the amount of income actually received. The amount of income received is comprised of salaries, wages, and K-1 distributions. Small business net profits should not be taxed until they have been physically paid out to shareholders. What is required is a simple change to Schedule K-1, instructing the shareholder to report the amount of distributions as taxable income, instead of the amount of net profit.

Other pass-through income, losses and deductions will be capitalized at the corporate or partnership level and kept up with on a cumulative basis. When the business is sold, or otherwise disposed of, the original investment, plus any capitalized earnings, losses and deductions will be taken into account in determining whether the sale or disposition is a long-term capital gain, or loss.

The Effect

What my proposal will do is simply return businesses to their original purpose. A business is an investment, not a cash cow for the government. Think about it. If you invest in $100 worth of corporation stock, and the value goes up to $10,000, you are not taxed on the unrealized gain each year, but rather on the realized gain which occurs when the stock is sold. Businesses are investments and should be allowed to grow as investments, and the only way this is going to happen is for the government to stop taxing unrealized business appreciation.

My proposal will effectively lower taxes on small businesses which are operating as S-Corporations and Partnerships. Once enacted, it will result in economic growth on steroids, massive jobs growth, skyrocketing levels of entrepreneurship, greater freedom, and less dependence on the federal government.

Q&A

[Q] What if the S-Corp never distributes all of its income?

[A] The income will eventually be distributed either in the form of K-1 distributions, salaries and wages to the owner, salaries to new employees; or it will be used to re-invest in new plant and equipment, or to make acquisitions. Any remaining accumulated profits will eventually be taxed upon the sale or disposition of the business. Among the reasons a business retains its income in the first place are to invest in the future, to repay debt, and to guard against future downturns.

[Q] What about the tax on distributions in excess of a shareholders basis?

[A] This problem is simplified by taxing pass-through shareholders on all distributions. There will therefore no longer be a need for tracking the shareholders basis for the purpose of taxing excess distributions. The shareholders basis will instead be tracked for the purpose of determining gain or loss upon the eventual sale, or other disposition of the business.

[Q] Is a business an investment or a person?

[A] Check the corporate resolutions. A business is an investment, which is owned by investors (i.e. shareholders).

[Q] What about the issue of double-taxation on C-Corporations?

[A] I believe it’s wrong to subject a C-Corporation to income tax, and then to turn around and tax a recipient of dividends on the same income. This is double taxation. A simple solution is to give C-Corporations a deduction for the amount of dividends paid. It’s just that simple.