Taxing some of the rich can backfire

by Steve Hammes

We've heard much discussion lately about plans to pay for health care reform with higher income tax rates and surtaxes on people making more than certain levels of income, $500,000 to

$1 million.

In my experience as a CPA, individuals in these income ranges are usually in one of the following categories: very high specialty, highly productive professionals; top executives in large corporations; people who have accumulated or inherited large amounts of wealth with large investment income; or small/midsize business owners. It is my belief that the large majority of $1 million-plus annual income individuals in Iowa today are in the last category.

Most small and midsize businesses today are structured as pass-through corporations because the entity itself generally pays no income taxes. The business income is passed through to the owners in proportion to their ownership and they pay tax at individual tax rates.

Assessing higher taxes on business owners who report $1 million-plus annual income is vastly different than the first three categories where the income is usually in cash with no related reinvestment commitments and somewhat predictable.

Look at a one-owner business that reports $1 million of income. First, the income is seldom in cash. It is in the business entity and may not have even been collected from the customer at year's end. It is tied up in working capital that tends to grow as revenue grows.

Second, there usually are significant debt service and reinvestment obligations attached to this income. Purchases of business equipment, technology systems and real estate improvements have to be paid for from this income. Often it is a struggle for such a business to pay income taxes.

Assume the effective federal and state income tax rates are raised from 30 percent ($300,000) to 36 percent ($360,000) - another $60,000 in taxes. Where will the cash come from to pay it? Often this capital has been committed to debt repayment, hiring additional personnel, technology and equipment purchases, real estate improvements or additional working capital - all intended to help the business grow.

Debt-repayment obligations cannot be modified simply because of higher tax obligations. Usually, additional business investment and business growth will have to be compromised. When this happens in hundreds of businesses across the state, it's reflected in lower economic growth and higher unemployment.

The next time you hear about taxing the rich, don't just think of doctors and CEOs - think of the business you work for.

Steve Hammes of Cedar Rapids is Managing Director of Hammes Business Planning and a retired partner with McGladrey & Pullen.