We repeatedly hear that the President has cut small business taxes 18 times.
That is both misleading and incorrect.
But there have been 18 changes in the tax codes that affect small businesses under certain circumstances. In 18 Tax Cuts for Small Business—Blockbuster Expensing we explain the $500,000 expensing allowance of Tax Cut # 10, as listed in http://www.lessgovsd.com/?p=4435). Here we will explain the pitfall that prevents many small businesses from using this potential tax break.
Assume that you have a small business and wish to take advantage of just $100,000 of this much larger tax credit. Assume also that the small business is in the
35% tax bracket, although the numbers can be readily changed to allow for different tax brackets.
Business 1: This business does not have loans subject to renewal or has exceedingly good cash flow. It is unusual. Most “mom and pop” businesses and most small businesses are not in this category. If this business has $100,000 or more in profit, it can buy $100,000 in capital equipment and save $35,000 in taxes. That is a strong incentive to make any needed purchase that qualifies. If it has $500,000 or more in profit, it could spend that money and save even more. No bank regulators are looking over its shoulder, it does not need access to additional capital, and it can simply make good business decisions.
Business 2: This business has some cash flow and does not have renewable loans. Spending $100,000 for capital equipment would be a stretch if they used cash. But they can finance the equipment, take the entire write-off in the year purchased to save on taxes, and still have monthly or yearly payments that they can handle. When good financing is available, this approach would be the approach used by most qualifying small businesses even if they had the necessary cash on hand. These loans are not subject to renewal so can’t be called by the bank as long as they are repaid on time.
All Business 1 and Business 2 have to worry about is paying their bills. As long as they do that, nothing bad can happen. But the rules are different for Business 3. Even if Business 3 makes all payments on time, it can be forced to sell or even forced to fail by virtue of new banking regulations imposed by the Dodd-Frank Wall Street Reform and Consumer Protection Act.
Business 3: This business it the most common by far. It has loans that are subject to renewal. The banks that make these loans are subjected to a phalanx of unsympathetic regulators whose job is to look for problems and to enforce the new regulations imposed by the Dodd-Frank Act. Virtually all business loans, including lines of credit, involve regulator scrutiny for renewal. What the regulators want to see, in addition to a strong equity position, is excellent cash flow. Multiply all business expenses by 1.25 to get the income that is necessary for loan renewal. By itself, that is a quite high hurdle. If this business wants to buy $100,000 worth of capital equipment, it needs to have offsetting income to avoid loan renewal problems. If we assume that Business 3 also saves $35,000 in taxes by virtue of the capital purchase, the net equipment cost would be $65,000 after the reduction in taxes is subtracted. The required offsetting additional income would be $81,250 ($65,000 x 1.25) in order to maintain the 1.25 ratio of income-to-expense. Voila! Most small businesses don’t have this offsetting additional income and are thereby completely excluded by virtue of regulations imposed courtesy of the Dodd-Frank Act.
If Business 3 does not maintain the proper income-to-expense ratio, the bank does not renew the loan and the business has to repay the entire loan immediately. This can force sale or failure of the business, even if all of the bills have been paid on time. In this manner, the Dodd-Frank Act has put a massive throttle on most potential benefits that could come from changes in the tax codes that require spending or involve access to capital. This Act insures that most small businesses must focus their concentration on their income-to-expense ratios rather than on making intelligent business decisions. Increasing business income is frequently not possible, so expenses must be vigorously controlled because failure to constrain expenses can be terminal to the business. That explains why my businesses as well as thousands of others are setting on the sidelines rather than hiring more employees or participating in any way in an economic recovery.
My businesses have many thousands of dollars worth of truly “shovel ready” projects that would contribute to the economy and cost the government absolutley nothing but which I can’t risk doing because of the Dodd-Frank Act.
***Gary A. Howie MSc, PhD*** is a business owner/rancher
