If nothing else, the American Taxpayer Relief Act (ATRA), enacted on January 1 and designed to yank the nation back from the brink of the notorious fiscal cliff, has relieved small-business uncertainty about the price of government (the taxes businesses will be paying), if not the goods and services government will provide for that price (the consequences of the inevitable spending cuts Congress punted down the road).
On Tuesday the National Federation of Independent Business released its January “Small Business Optimism Index,” which, joked Kevan Chapman, the NFIB’s senior media manager, the small-business advocacy organization has taken to calling the “pessimism index” due to its reliably grim results. But the January survey was conducted in December, before the bipartisan fiscal-cliff compromise. Its findings of flat capital expenditures, a widespread reluctance to hire, and continuing anxiety about the overall business climate may be mitigated in part by the new act.
“It will be interesting to see how the deal will affect small-business optimism,” says NFIB tax counsel Chris Whitcomb.
Indeed, most of the pro-growth tax breaks and benefits that small businesses feared might disappear with the New Year were retained, and some made permanent. Here are CliffsNotes on some of the act’s provisions and how they affect small-to-midsize companies.
The individual income-tax rate was among the most hotly debated issues in last year’s Presidential campaign, and the angst it raised persisted right up to the end of 2012. The marginal tax rate directly affects most smaller businesses (whether S corporations or partnerships) because they tend to be organized as pass-through entities that pay the individual tax rate on business income.
ATRA preserves the Bush-era tax cuts and makes them permanent for all except those individuals earning more than $400,000 as single filers (or $450,000 for married couples filing jointly). The top rate for those high-income earners rose from 35% to 39.6%.
Whitcomb, while pointing out that his membership wasn’t exactly jumping for joy over the top-rate increase, allows that “permanency on the rates generally helps small business,” permitting it to plan with the greater confidence that comes from cost predictability. Chapman calls having permanency in the tax rates a “major cloud lifting on a lot of businesses. Uncertainty over what a business will be paying makes it difficult to decide whether to hire a new person or make a capital investment.”
Rhett Buttle, government affairs director of Small Business Majority, points out that another virtue of the ATRA deal for small businesses is that it keeps more money in the hands of middle-class consumers. “That’s important because that’s who’s shopping at small businesses,” he says. “The number-one thing we hear from small-business owners is that they want more customers coming through the door. Government can play a constructive role by cutting taxes.”
Estate and Gift Tax
The ATRA kept the estate and gift-tax exclusion at $5 million, indexed for inflation, increasing the top tax rate from 35% to 40%. The fear among family-owned businesses was that the exemption could fall back to its pre-2010 level of $3.5 million, or even further to the $1 million level of 2002 (with a top rate of 50%).
Urschel Laboratories CFO Dan Marchetti says the 100-year-old family-owned midsize company, which manufactures industrial cutting blades primarily for the food industry, was “cheered” by the continuance of the estate and gift-tax exemption. Before the fiscal-cliff deal, “some of the company’s significant shareholders took advantage of their one-time exemption and gifted shares to their children,” he notes.
Fearing the exclusion would be reduced, “we did additional tax planning, as we distributed a dividend prior to year-end. Historically, this dividend was paid on the first business day of the New Year,” Marchetti says.
Estate and gift tax is “a business-continuity issue,” says Whitcomb. If the exemption fell too low, he points out, asset-rich, cash-poor, ill-liquid businesses might have been forced to sell assets to pay off estate taxes, effectively destroying the business before it could be passed on to heirs. The effect could have been potentially widespread: according to the most recent PricewaterhouseCoopers Global Family Business Survey, 76% of U.S. family businesses plan to pass the business on to the next generation, an increase from the 55% that said so two years ago.
“The exclusion is more important than the [tax] rate,” says Jim Johnston, president of The Johnston Co., an advisory to CFOs, CEOs, owners, founders, and boards. If the exclusion had fallen to a million, he points out, that would subject most anyone “with a nice home and some savings” to the 40% estate tax. Now, he says, the estate tax feels “relatively painless.”
The estate-tax exclusion is “a win for small business,” PricewaterhouseCoopers tax partner Alfred Peguero says.
The good news for small businesses is that the ATRA hiked the immediate deduction businesses can take for capital purchases (new and used, financed or leased equipment, and off-the-shelf software) from 2012’s limit of $139,000 to $500,000 for 2013.
A child of the postmeltdown economic stimulus, Section 179 was designed to spur capital investment by allowing an extra write-off when an asset is purchased, according to Peguero. “If I buy a tractor for $50,000,” he explains, “I can expense 100% of that up to a certain dollar amount.” Since the maximum is only $500,000, Section 179 “is not for General Motors; it’s for smaller businesses.”
The bad news is that, unless extended, the limit on what a business can deduct will fall to $25,000 in 2014. “That means you can only plan for one year,” Whitcomb says. “It’s not a permanent fix. That doesn’t help with certainty.”
“Uncertainty,” says Peguero “causes people to hesitate and not act. With Section 179 settled for now, there’s a clear path. I know I can make this capital investment and here’s the tax benefit I can get.”
Section 179’s handmaiden, bonus depreciation, most often taken after the Section 179 deduction, allows companies to write off equipment over time. It can also be taken for used assets acquired before 2012. The bonus depreciation was due to expire before the fiscal-cliff deal was struck. Although the ATRA extended the bonus depreciation one year, it can now only be taken on new equipment, and not on software.
“The idea is to stimulate the economy; to get people to buy things,” says Peguero. “Hopefully, the economy turns around, and we can go back to generating revenue.”
The research and development (or experimentation) tax credit was extended through 2013. It allows businesses to deduct capital expenditures on R&D as business expenses, either taken in the year they are incurred or amortized for not less than 60 months. In 2005 the credit reduced “business’s costs of new qualified research by between 6.4% to 7.3%,” according to the Government Accountability Office. In 2009, that represented a $5.6 billion federal subsidy for R&D, the GAO wrote in a recent report.
Urschel Laboratories’s Marchetti says the extension of the R&D credit translates to about a 3% reduction in his company’s taxes. If the credit had not been extended, he says, “we would have continued to invest in R&D, but probably to a lesser extent.”
Capital Gains Tax
As hedge-fund managers and private-equity investors know only too well, capital gains and dividends will now be taxed at a 20% rate for individuals earning above the top income-tax bracket. Peguero points out that the 20% capital gains tax is really an effective rate of 23.8% when the cost of financing the Affordable Care Act is accounted for. The rate remains 15% for those making under $400,000.
Whitcomb acknowledges, however, that the capital gains tax increase doesn’t affect most smaller businesses. “Most of our members are pass-through organizations,” he says. “But they have sales of capital assets [and] dividends from investments that they use to reinvest in the business. It’s good to know what the rate will be, even though it rose a bit.”
Adds Chapman: “One thing we hear from our folks at higher income levels who are pass-through is that they’re frustrated by being mischaracterized as multimillionaires out buying boats. These people pay themselves a salary and reinvest in their businesses, and they sometimes feel they’re being unfairly punished.”
The ATRA did not extend the 4.2% Bush-era rate for employee Social Security tax, and it has gone back up to 6.2%. This will take money out of taxpayer pockets, something that concerns small-business owner Robert Skenderian of family-owned Skenderian Apothecary in Cambridge, Massachusetts. “I knew the payroll tax was going to go up. It was inevitable. The country has bills to pay. Am I happy about it? No,” he says.
“People have been buying less for the last four years, and they’ll continue doing that as they see their payroll shrinking. People aren’t spending as they normally do. They’ll buy the things they have to buy, like food, and put off optional purchases,” Skenderian adds.
The rise in the payroll tax is “taking money out of the hands of consumers,” says Small Business Majority’s Buttle. “We would have preferred extending it another year.”