The $250,000 Small Business Tax Question

New data released by the bipartisan Tax Policy Center show that most small business owners won't be taxed at higher rates under Obama's proposed budget

By Karen E. Klein

In the weeks since President Obama proposed rolling back federal income tax rates on the nation's top two marginal tax rates as part of his federal budget, the term "small business owner" has turned into a political football.

Proponents of the budget proposal claim that less than 3% of small business owners have net household income above $250,000, the threshold over which tax rates go up under Obama's plan. Budget opponents, on the other hand, claim that 15% or more of small business owners will be negatively affected, and at a time when many small companies are struggling.

What's the reality, and why is it so tough to parse? Confusion reigns for a number of reasons, among them the definition of "small business owner" and various methods for calculating taxable income. Wrap all that up with the charged language of politics and it's not surprising that conflicting claims are put forward, experts say.

Mom-and-Pop Misperception?

But tax analyses show that the percentage is likely to be on the lower side, and those taxed at higher rates—if the budget is approved as presented—are unlikely to be those most people think of when they hear "small business owner."

"Most small business owners aren't in the top two marginal tax rates. In my opinion, there's some misunderstanding in these political debates that the people who'll be affected are middle-income Americans who run mom-and-pop stores," says Benjamin Harris, senior research associate at the Tax Policy Center, a bipartisan venture of the Urban Institute and the Brookings Institution that aims to provide independent analyses of current and longer-term tax issues.

Mike Schenk, senior economist for the Credit Union National Assn., predicts that the tax increases will have a large negative impact, but only on a small number of small business owners. "I would ultimately conclude, as an economist, that on balance there are some real positives to come out of [the proposed budget]. The negatives will be apparent to a small sliver of the universe," he says.

Why only a small sliver? Because individuals who file IRS Schedules C, E, and F (which is how tax calculations are made about "small businesses") and are taxed at the two highest rates are likely to be investors and wealthy wage-earners, some of whom have income from small businesses, rental properties, or royalties, Harris says.

Projecting the Impact in 2012

So why invoke the "small business owner" in the debate? "It's easier to say these people who are getting hit by the proposed tax policy are small business owners," Harris says, than to fully describe the range of people in the category.

An analysis done by the Tax Policy Center shows that 8.9% of individuals who report small business income or loss (including self-employment income; income from S-corps, partnerships, and limited liability companies; farm income; and income from rental property and royalties), have household income greater than $250,000. But fewer than 2% of those filers fall into the top two tax brackets, according to the center's analysis.

New data the center released this week goes a step further, to show the projected impact in 2012 on individuals who report small business income and whose rates would be raised if Obama's budget is enacted as proposed. President George W. Bush reduced the top two tax rates, along with two lower rates, in 2001 and 2003. The rate reduction is scheduled to expire, and rates revert back to the higher figures of the 1990s, at the end of 2010. Obama’s budget proposes allowing the tax cuts to expire as scheduled, but only for families earning more than $250,000 per year or single filers earning more than $200,000 per year.

Under the Obama proposal, those currently taxed at 33% would be taxed at 36% and those taxed now at 35% would be taxed at 39.6%.