Election Tax Preview: Small Biz’s Fiscal Cliff

With Bush-era tax cuts expiring and election uncertainty in full throttle, small manufacturers are facing the possible loss of bonus depreciation a...
Kathy HoffelderOctober 2, 2012

When Michael Retzer, controller of Strohwig Industries, a Richfield, Wisconsin-based tooling and machining manufacturer mostly serving the auto industry, thinks about the upcoming election, he immediately goes on the defensive. “For us, our planning is to play it close to the vest instead of going out willy-nilly build-it-and-they-will-come. We can’t take that tack anymore,” he says.

That caution doesn’t apply to soliciting new business. Instead, the company’s just won’t be as proactive if there is indeed another term for President Obama, who plans to raise taxes on individuals earning more than $250,000 annually.

That would hit firms like Strohwig right in the pocket, Retzer says. The company falls under the classification of an S corporation, one in which the company’s earnings are taxed at the individual-shareholder level rather than at the corporate one. In a way similar to a partnership, such organizations pass earnings on to shareholders.

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Robert Spielman, tax and business-services partner at Marcum, an accounting advisory firm, explains it is almost certain that taxes will go up for small and middle-market S corporations. The highest individual tax rates are expected to jump, particularly with the tax cuts enacted under former President George W. Bush expiring. “If tax rates go up, then their income tax will go up,” he says. About 85% of manufacturers today are S corporations.

Double Whammy
Already hurting, small companies are likely to be hurt much more if taxes rise, managements contend. Retzer says S corporation manufacturers like Strohwig typically funnel the money that would be taxed back into the operations of a company. With less money to go around, the company will lose wiggle room to keep many of its workers on its payroll if demand for his precision tools drops.

Similarly, William Smith, chief executive officer of Termax and a former president and CFO of the Lake Zurich, Illinois-based plastics and metals-fastener company, asserts that S corporation manufacturers need special consideration. “Because we are putting all of our money back into the company, it’s not like we get to keep anything,” says Smith, who hopes Congress will provide “a deduction based on earnings that stayed within the company itself.”

The increase in tax rates for S corporations will “stifle business growth,” argues Retzer, “whether it’s investing in capital equipment, investing in hiring employees to go out and sell more, or investing in wages for the employees.”

Since S corporation status can help certain organizations avoid being taxed twice, switching to another status is an unattractive option for companies like Strohwig. Further Internal Revenue Service penalties for making such a switch can be quite extensive.

Expiration Dates
Aside from higher taxes for S corporation shareholders, smaller manufacturers have their own “fiscal cliff” to deal with. Just as the nation as a whole faces automatic expense cuts and tax hikes across the board if Congress can’t agree on a solution to the nation’s debt woes, small businesses face a number of specific expiring tax incentives and credits that they have grown accustomed to using. Many are slated to expire at the end of the year, while others already expired at the end of 2011.

The Research & Development tax credit, for one, which offered a 20% credit for certain projects through 2011, had grown to be a tool that manufacturers of many sizes relied on to compete internationally. “We’re bidding against Canada, Germany, Italy, Japan, China, of course, which have all kinds of subsidies and value-added taxes. If we don’t get those orders, jobs will be lost,” explains Retzer. Although it is considered to have bipartisan support and could eventually be among the first to be extended, the R&D credit remains expired for now.

Extending the credit, though, could very well depend more on changing the perception of R&D’s usefulness in the United States, which still lags behind other countries when it comes to its tax-incentive generosity, many believe.

According to an Information Technology & Innovation Foundation study in July, the United States ranks 27th out of 42 countries reviewed in terms of the largesse of the incentive. The study found that expanding the R&D tax credit would not only increase innovation but also lower the effective corporate tax rate, which is already one of the highest in the world at 35%.

In other areas, too, the United States could do much more to help manufacturers, company executives say. Bonus depreciation, under which companies can write off an extra amount spent on equipment over time, remains a concern for manufacturers. Currently it can be claimed for assets used before 2012, but it is due to expire entirely in 2013. The maximum 2012 limit on equipment purchases is $560,000.

In his budget proposal, President Obama has called to extend the bonus depreciation 100% through 2012 if he is reelected. Mitt Romney, meanwhile, has not pinpointed an exact percentage of how much he might extend the depreciation.

Some help on extending bonus depreciation for manufacturers has also been under way from House members this year. In March Pat Tiberi (R-Ohio) penned H.R.4196, which called for 100% bonus depreciation through 2012. Tiberi had help from co-signers John Larson (D-Conn.), Erik Paulsen (R-Minn.), Richard Neal (D-Mass.), Kenny Marchant (R-Tex.), and Bill Pascrell Jr. (D-N.J.). A companion bill by Debbie Ann Stabenow (D-Mich.), S. 2240, was also submitted at that time.

The bonus depreciation especially helps manufacturers in times of uncertainty. “You get that depreciation over time,” says Retzer. “The bonus depreciation makes it easier for companies to make the decision to initiate expansion.” But an executive would need a “much clearer crystal ball” on the tax front to plunge into all-out expansion mode.

Termax’s Smith, while also worried about the potential loss of bonus depreciation, has already begun to pull back on capital expenditures. “We are not going to invest that much more into our businesses until after the election and after the fiscal cliff works its way out,” he says. “This year, even though we brought in more people, we have reduced our capex. We are planning only $1 million to be spent on this next year.” Termax normally spends $2 million annually on new equipment.

Rocking and Reeling
Other small manufacturers are also reeling from the reduction in what can be expensed under Section 179 of the IRS tax code for new and used equipment or software. For 2012 businesses can deduct $139,000, which is reduced to $25,000 for 2013.

For some firms, though, the uncertainty over another issue — the tax on capital gains — is causing so much grief for small manufacturers and other businesses that they are staying in business longer than they might otherwise want.

Jeff Porter, vice chair of the American Institute of Certified Public Accountants and co-founder of CPA firm Porter & Associates, says instead of selling their business, smaller companies are choosing to remain in business just due to tax reasons. “Many small businesses sell using installment plans, but people are reluctant to do that right now since the capital gains rates could be higher next year and in future years if they are going to get payments 5 or 10 years out,” he says.

Still, aside from the specific tax credits and incentives that are worrisome at election time, a larger issue for small manufacturers is at stake, according to Smith. Firms like his are still far less represented in Washington than their larger manufacturing brethren, which is hindering their voice on Capitol Hill. The largest manufacturer may not see the more pressing needs of smaller firms that must compete on a dollar-for-dollar basis with international firms, he notes.

More than any other firms, Smith maintains, small manufacturers need stability when it comes to tax issues, not to be changing based on the whims of politicians year after year. “American manufacturers can compete with anybody in the world as long as we are stable,” he says.