Which one of these are small business—the local dry-cleaner that employs 5 people, Koch Industries which employs 70,000 people, or Price Waterhouse Coopers, an accounting firm with $26 billion in annual revenue? Most of you are probably guessing the dry cleaner, and that would be right. Well, partially at least. According to the IRS, all of these are small businesses.
When most of us think of a small business, we imagine, as Governor Romney remarked in the recent Presidential debate: " the guy who is […] in the electronics business in […] and has four employees." Both President Obama and Governor Romney agree that taxes on these firms should not be increased; in fact, both make strong cases that reductions in taxes for these small businesses can spur job creation.
The disagreement comes when we ask whether Price Waterhouse Coopers or Koch Industries are small business. While many of us would say these companies are certainly not small businesses, a provision in the tax code allows them to be considered small. Essentially, when a corporation registers with the IRS it can either be a "C corporation" or a "S corporation." C Corporations are the "Fortune 500 companies" with large revenues and more than 100 shareholders (think Wal-Mart, Microsoft, Exxon). S-corporations, on the other hand, tend to be the "small businesses" with less revenue and fewer than 100 shareholders (think local grocery store, 2-man DJ business, or the burger joint down the street). Companies like Koch industries and Price Waterhouse Coopers, which are not Fortune 500 nor are they the local small business, have a choice—should they register as a C-corporation or an S-corporation?
Well, their decision comes down to tax rules—essentially, the profits of S-corporations are "passed through" to the owners and taxed at the personal rate, whereas the profits of C-corporations are taxed at the corporate rate. Thus, if the personal rate is lower than corporate rate, these companies are incentivized to register as S-corporations even though they are not truly "small businesses." For example, if a company has profit of $100,000, and then if registered as an S-corporation, the owner faces a 25% top marginal rate, but as a C-corporation, the profit would be taxed at a 34% top marginal rate. Given this reality, companies like Koch Industries, and Price Waterhouse Coopers, among others, have decided to register as S corporations.
When President Obama says: "under my plan, 97 percent of small businesses would not see their income taxes go up," he refers to the 97% of S-corporations that are truly small businesses and have profits below $250,000." Alternatively, when Governor Romney replies that President Obama's plan raises taxes on small businesses, he is referring to the 3% of S-corporations that earn above $250,000 profit annually (i.e. companies like Koch Industries). These 3% of S-Corporations may not be so small, given that they employ 50% of all Americans employed in small businesses. In other words, if 100 Americans work in small businesses, 50 of them are employed by 3% of the companies. As such, referring to those 3% of S-corporations, which also includes the $54 billion investment firm KKR and Ferrellgas an energy company that had $2 billion in revenue last year, as "small business" seems a bit imprecise and unclear.
Thus, when politicians refer to small businesses, ask them—do you mean companies like Bechtel which employ 44,000 people or my local barber which employs 5 people.