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It’s as if Amy Koch is refusing to understand taxes

by Eric Ferguson on May 17, 2011 · 25 comments

It seems by the time you’re a majority leader, you’d understand how this works. I hate to call anyone a liar, and I even hesitate to call someone willfully ignorant, so I’ll settle for being mystified that the majority leader of the State Senate doesn’t get how an upper income tax increase affects a small business owner who takes profit as personal income, and thereby pays income taxes on profits through the personal income tax.

It’s really not that complicated. If you take the profit as income, meaning you stuck the profit into your pocket and took it home, you pay income tax on it. If you put the profit back into the business, it isn’t personal income, and you don’t pay tax on it. So if the profit is $100,000, and you buy a $40,000 machine and take the remaining $60,000 for yourself, you pay income tax on $60,000, not $100,000.

Yet Sen. Koch seems not to get that the money put back into the business isn’t taxed, judging from what she said on Midday yesterday. Talking about her sister, who owns a business and takes profits as personal income, she said sometimes her sister took no pay (by the way Senator, that means she wasn’t subject to the income tax) and,

She will be impacted by this. It will affect her bottom line, and instead of having her expand, create new business and hire new people, the tax increases will be harmful for that.

[this is about 42 minutes in]

No, the tax increase won’t be harmful for that. If her sister expands the business, she reduces her taxable income. There’s actually an incentive increase investment: put the money back in the business, and it doesn’t get taxed.

I don’t blame most of the public for not getting this when political leaders keep handing out misinformation. It seems intuitive that if business owners pay more taxes, they’ll hire fewer people, so Republicans play on that, and don’t tell people that businesses actually avoid taxes if they invest. Legislators, however, are supposed to understand this stuff, and even if they don’t to begin with, it has been explained over and over again to them during the debate.

Alec May 18, 2011 at 1:13 am

It’s kind of like the catch-22 in reverse. Businesses want lower taxes so they can hire more people, but if they would just hire more people their taxes would be lower.

AO May 18, 2011 at 1:39 am

I thought you were close to understanding when you started to give the example with numbers, but you failed to finish the thought.  If the 60,000 in income is taxed at a higher rate, she will have less money and would therefore want or need to take a higher salary to compensate for the higher tax rate and thus have less to spend on the new machine.  

ericf May 18, 2011 at 2:56 am

Just as expressed, it’s not making sense. Do you understand that if she invests in the business, the invested money isn’t counted as take home pay and doesn’t get taxed? If she takes home more, she has more personal income and pays more tax. I’m unclear on what’s not clear.

AO May 18, 2011 at 7:24 pm

a person doesn’t always have the luxury of reinvesting more money into their business.  The 60,000 that she would have taken in previous years may not pay all of her personal bills after it is taxed more highly.   She would therefore have to take a higher salary, say 65,000 and be left with only 35,000 to pay for the new machine.  

The point is that higher tax rates are designed to take in more revenue on the whole.  This means less money being invested by those small businesses who have a profit motive, and more money spent by government who spends it on things they make think is morally right, but will not help grow the economy.

Alec May 18, 2011 at 8:32 pm

Someone in the 60k tax range will see an increase of less than a tenth of a percent in taxes. .o6% to be exact. 60,000*.0006=$36.

Under Dayton’s plan, she’d have to make up $36 dollars. To make up for that, she’d have to increase her salary from

60,000 to 60,036.02

So yes, under Dayton’s oppressive plan she will have one family dinner at Apple Bee’s less to spend on equipment.

ericf May 18, 2011 at 8:41 pm

You’re trying to make it much more complicated than it is. The small business owner who takes the profit as personal income can reinvest the money and not be taxed on it. Take it home, get taxed. That’s an incentive to invest. That helps explain why lower taxes don’t result in more investment. We might assume lower taxes mean more investment, but that isn’t what we’ve seen. Choose to take less than $150,000 for a single filer/$250,000 filing jointly as personal income, and that person won’t be subject to the proposed tax increase at all. That’s an incentive for reinvestment.

AO May 19, 2011 at 12:51 am

to Alec’s point first, the 60000 was just the number given, but it just represents hypothetical profits.  Obviously we’re talking about the profits that would be taxed at the proposed higher rates.

The small business owner will certainly try to shield profits from being taxed, but it’s not as if the owner’s other personal expenses suddenly become smaller or that the owner or other investors are content to keep reinvesting their profits until the government lowers taxes and they can actually pocket the money.  

While it is true that higher tax rates do push some people away from profiting as the reward is less, the government would still see increased revenue from some tax hikes in the short term.  Therefore, that additional revenue that the government receives is the same money that individuals would spend of their own free will and seek to profit from.  The government lacking that profit motive will instead seek to provide healthcare to the poor and build trains–things which will not grow the economy but some think is the morally correct thing to do.

Mauser May 18, 2011 at 6:58 pm

It’s not the 60K in income at the end that’s taxed at the higher rate, it would have been the other 40K.

bizthought May 18, 2011 at 4:35 am

What your analysis misses is that many MN small businesses are seasonal in nature.  This means they make money in the late spring, summer and fall.  Their invoices dry up in December and they’re forced to coast into April on whatever cash they have on hand.

This cash on hand, which is actually seed money for the following year and critical to helping those businesses pay expenses which exceed income in the first four months of the year looks like profit/income to the tax man who doesn’t run on a seasonal calendar.  

Taxing this unspent cash as though it were simply profit/income does indeed impact a business owner’s ability to invest in equipment or otherwise build their business.  

To invest this money in a way that avoids seeing it taxed as profit/income, the business owner would have to blow a lot of money at the end of the year (when they finally have it in hand) and/or to rely on borrowing to get them through the slow winter months.  

dan.burns May 18, 2011 at 5:06 am

in Minnesota, did just fine prior to the Ventura/Pawlenty move to a welfare-for-the-wealthy tax system.  And Minnesota was a better place to live, and do business, then.


ericf May 18, 2011 at 8:09 am

If the money goes into the business, the profit is reduced and the next income is still lower. The important thing though is don’t get lost digging into the weeds of details. The important point is Koch, and to be fair I’ve heard this from other Republicans, can’t tell the difference between revenue and profit, or at least they pretend they can’t when they mislead the public on tax policy.

username May 18, 2011 at 8:30 am

The bigger picture is that recovery must be demand driven.  Our economy suffers from broad based excess capacity, as is typical of recessionary and post-recessionary times. Business owners have no sound reason to invest further in their businesses without increased demand, or the anticipation of increased demand, for their goods and services.  

Government needs to drive demand by spending, and by getting money into the hands of those most likely to spend it.  This means providing tax and other incentives to the lower economic classes, not the upper crust, as the lower groups spend the largest fraction of their income.

Tax incentives for business expansion in such times encourage investment activity that’s not economically well advised.  Taxing the rich, on the other hand, is an effective way to keep more money in the hands of the middle class and the poor, who are more likely to spend it effectively.  Incentivizing demand, not supply, is the key to recovery.

markmwhite May 18, 2011 at 9:08 pm

…who think repubs are not intellectually curious.  small businesses formed as S-Corps get taxed either way.  either the owner takes wages, or they get Schedule E income.  same either way, though slighty different tax effect.  if they invest the money back in their business (ex. buy equipment, etc.) the expense does not offset income in the same year.  so you may want to get curiouser before you comment (yes, intentional ironic diction).

as to stimulating demand through confiscatory taxation and increased government spending/redistribution, why don’t you address the moral justification for taking from those who earn and giving to those who take.  then contrast that with the concepts of liberty and personal responsibility.  then expand the comparison to the US Constitution and the Communist Manifesto.  please report back.

dan.burns May 18, 2011 at 10:11 pm

someone who honestly believes that the rich man in this country started with nothing, and got to where he is through working harder and smarter than everyone else.  ”…taking from those who earn and giving to those who take…” is exactly what’s been happening – taking from the poor and middle class and handing it to the super-rich.

Fortunately, your delusional ranks are dwindling.  I suggest taking your failed, farcical Hayek/Friedman drivel (yeah, I’ve read it) elsewhere.  ”True North,” maybe.

ericf May 19, 2011 at 12:15 am

Not a successful try, but a nice try. At least you help prove my point that conservatives don’t want to understand the difference between revenue and profit.

AO May 19, 2011 at 12:54 am

Profit is good!  We invest in order to profit.  Growing revenue is only good as long as the profits will be seen in the end.  

Alec May 19, 2011 at 1:04 am

At the same time that Republicans trumpet the profit motive, they claim businesses will just hire if they have more cash reserves. They will hire if there is profit in it. there is only profit in it if there is increased demand. A supply side theory is irreconcilable with the profit motive.

seano May 19, 2011 at 1:26 am

Some economic problems are supply-side problems, some aren’t.  The problem Republicans have is that they see EVERY problem as a supply-side problem.

As you correctly note, we currently have a demand problem.  Lack of free cash isn’t the problem for the business community today, not by any stretch of the imagination.

Alec May 19, 2011 at 5:47 am

You honestly believe, Mark, that if an S-corp takes in 200k in revenue, but has 250k in salary and benefit expenses that they will pay taxes on all 200k?

An S corporation, for United States federal income tax  purposes, is a corporation that makes a valid election to be taxed under Subchapter S of Chapter 1 of the Internal Revenue Code.

In general, S corporations do not pay any federal income taxes. Instead, the corporation’s income or losses are divided among and passed through to its shareholders. The shareholders must then report the income or loss on their own individual income tax returns. This concept is called single taxation; if the corporation is taxed as a C corporation, it will face double taxation, meaning both the corporation’s profits, and the shareholders’ dividends, will be taxed.

Alec May 19, 2011 at 5:51 am

While an S corporation is not taxed on its profits, the owners of an S corporation are taxed on their proportional shares of the S corporation’s profits.

Key word Mark, taxed on profits!

Example: Widgets Inc, an S-Corp, makes $10,000,000 in net income (before payroll) in 2006 and is owned 51% by Bob and 49% by John. Keeping it simple, Bob and John both draw salaries of $94,200 (which is the Social Security Wage Base for 2006, after which no further Social Security tax is owed).

Employee salaries are subject to FICA tax (Social Security & Medicare tax) –currently 13.3 percent–(4.2% Social Security paid by the employee; 6.2% Social Security paid by the employer; 1.45% employee medicare and 1.45% employer medicare). The distribution of the additional profits from the S corporation will be done without any further FICA tax liability.

If for some reason, Bob (as the majority owner) were to decide not to distribute the money, both Bob and John would still owe taxes on their pro-rata allocation of business income, even though neither received any cash distribution. To avoid this “phantom income” scenario, S corporations commonly use shareholder agreements that stipulate at least enough distribution must be made for shareholders to pay the taxes on their distributive shares.

Quarterly estimated taxes must be paid by the individual to avoid tax penalties, even if this income is “phantom income”

Alec May 19, 2011 at 6:15 am

Here it is straight from a CPA. I understand my limitations, so I usually ask experts.

Notice that a loss is written OFF your personal income.

The General Rule on S Corporation Taxation

The general rule for S corporation taxation works like this. An S corporation calculates its income just like a regular corporation. However, rather than taxing the corporation the corporation on those profits, the corporation’s owners get taxed on their shares of the corporation’s profit

Suppose, for example, that an S corporation is equally owned by Tom, Dick and Harry. Each shareholder owns one-third of the corporation’s stock. In this case, if the corporation makes $300,000 in profit, the corporation doesn’t pay the income tax on this profit. Instead, each shareholder includes his share of the corporation profit–$100,000 per man-in his taxable income. The shareholders pay the taxes owed on the $100,000 of corporate profit on their individual income tax returns.

Just to flesh out this example a bit more, suppose that a corporation loses $30,000. In this case, each of the owners includes a $10,000 loss in his taxable income.

markmwhite May 20, 2011 at 2:07 am

yeah, real hard to understand the difference between revenue and profit.  oh yeah, i’m a CPA too – so not impressed by your experts.

if you understand S-Corps, you know that the owner can take a salary and get taxed as W-2 income or not take a salary and instead take taxable distributions of profit.  The salary is a reduction of the S-Corp’s taxable income.  The S-Corp’s income flows to the owner(s) and is taxed as Sched E income of the owner(s).  Either way the owner gets taxed on it, either as salary or Sched E.  My point was that the owner get’s taxed on profit irrespective of whether they re-invest the profits by purchasing non-expensible assets.  This was a refutation of the point that the owner always has incentive to re-invest in the company and is merely being greedy if they don’t.  

but how about my more important point about the moral justification of stealing from the productive?  All I’ve seen is some lame unsupported assertions that are either of the flavor: 1) the productive loot the middle class and poor, or 2) the productive are endowed with certain unfair advantages and can’t achive only on their hard work and good judgment.  The answer to both is BS, show me you failers.

You ninnies would rather use the force of government to redistribute wealth as you see fit, in your superior wisdom.  I prefer to have the market place redistribute wealth.  you know why?  because the market redistributes wealth based upon merit and is accomplished through voluntary exchange.  that is right voluntary exchange, as opposed to government sanctioned coercion.  so if you aren’t made better off from a certain exchange or transaction, you are not obligated to participate.

it isn’t that hard to comprehend, once you extricate your head from the proverbial sand of the progressive education you were brain-washed with/by.  yep, ended with a preposition.

ericf May 21, 2011 at 12:29 am

You must win a lot of arguments with the other five year olds.

seano May 19, 2011 at 12:59 am

If the owner can’t afford their personal expenses, they should cut back, like non-business owners do.  

The notion that providing health care or transit doesn’t grow the economy seems rather mind-numbing.  Having lots of unhealthy people around isn’t good for the economy.  It’s certainly not good for small business owners, who are less able to afford illness among their workers.  Having less mobility — of products and services — isn’t good for the economy, either.

AO May 19, 2011 at 5:53 am

They’d cut back because of being taxed higher.  What’s easier to cut, your house payment, or the new machine for the business?

Higher taxes results in less money for the business owner and more money for the government.  This isn’t that hard.  Of course higher taxes leads to less investment because there is less money at the business owners disposal and less incentive to invest because the return is less.

Providing health care for the poor and building trains is done with other people’s money.  That money will always get more economic return in the for-profit world.  If companies would profit more by building trains and giving healthcare to the poor, they would.  There certainly are legitimate functions of government necessary to keep the free market free, but there are many social programs which are not necessary and do drag the economy.

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