The Psychology Of Taxes
an accountant, I have a unique vantage point to observe how
entrepreneurs change their decisions based on tax policy. My focus
as a business advisor is making businesses more profitable first,
then dealing with the tax implications of profit.
much as I would like to focus on profit, I regularly have to
�reprogram� the entrepreneur�s thinking on taxes. With new clients,
I often have to overcome the advice given by their former CPA, who
would inevitably advise them to buy more equipment at the end of
each year to avoid paying taxes. Folks, this is just plain dumb
unless your goal is to never build wealth from your business.
would classify entrepreneurs into three groups when it comes to
No Taxes, No Way Nate
� This guy will do anything possible, including cheating, to pay no
taxes. From our experience with clients we turn down or terminate,
this problem is likely bigger than even the IRS estimates.
Accidentally Profitable Alex
� This fellow is so focused and passionate about his business, that
he forgets to plan for success, and the resulting taxes often come
as a surprise. Many times this is from a cash-out event rather than
Eddie the Enduring Entrepreneur
� This is my favorite type of entrepreneur to work with, because he
is building a lasting business that will be a tremendous
wealth-generating engine for himself and his family. This
entrepreneur is often held back by bad advisors who encourage him to
waste wealth to avoid taxes, but his instinct and common sense
frequently help him overcome the faulty counsel.
only type of tax that you can make No Taxes Nate pay, would be a
sales tax or VAT (value added tax). But given Nate�s predisposition
to not pay any taxes, he will find a way to skim or avoid the tax
all together. Unfortunately for us honest entrepreneurs, we will
endure audits because of Nate, since that is the only way the tax
collector can find him.
Accidentally Profitable Alex does not make decisions based on taxes
until his first major tax event occurs. Once that event happens, he
may change his name to Nate if he perceives the tax impact is too
great. Alex is likely to be a one-timer, which is the term used for
someone who can be profitable once, but cannot repeat the success.
Eddie is the guy we should focus tax policy around because he is the
guy that employs the bulk of the workers in the U.S. economy.
Employment studies have shown that 70% of all employees are employed
by privately held businesses, and 100% of all new job growth comes
from private business.
Publicly held businesses kill as many jobs as they create and that
is just the nature of the beast. Every time a publicly held business
has purchased one of my clients, the public business has decreased
employment of the company purchased, not increased. They are
inherently geared toward buying the business that�s done by the
private company, bolting it on to their infrastructure, and
off-loading the private company�s management.
Since I started in public accounting in 1978, I have seen multiple
tax ideas played out, and the varying business decisions resulting
from each policy. I can honestly say that no policy proposed has
ever caused the result the policy maker wanted, with the possible
exception of the 1986 Tax Reform Act.
This is the tax act that eliminated tax shelters and lowered tax
rates to 2 simple brackets, 15% and 28%. This was the first time I
saw my clients get focused on making profits and just pay the taxes.
Unfortunately, the 2 brackets eventually turned back into 6 brackets
that topped out at 39.6%. In addition to federal taxes, states have
continued to raise rates as well, and the average income tax rate
runs around 6%.
What is the optimum rate? I can honestly tell you that it is
somewhere between 25% and 30% (federal and state tax combined). That
is the point where entrepreneurs will push forward to make more
money rather than just put it on pause and take care of their own.
It also helps to have fewer brackets and get to the top bracket
relatively quickly. Simplicity has a tremendous power to move people
to action and release them from the paralysis that lack of
Policy makers need to understand that entrepreneurs can always trim
growth and just take care of themselves and their core employees
when uncertainty abounds. When they are presented with a flat
economy like the one we face now, they need long-term certainty to
encourage them to take some risks. When they think their hard work
will be eaten up in taxes, it takes all the incentive away.
my interaction with entrepreneurs from around the world, through the
Entrepreneurs� Organization, it struck me that U.S. entrepreneurs
are significantly under-capitalized compared to their counterparts
in Europe and Asia. Easy credit played a big part in this, but tax
policy also plays a huge role. The typical U.S. entrepreneur rubs
two dollar-bills together and tries to make a profit. They start
without capital, with just and idea and a dream, and find a way to
make it work.
disconnect between cashflow and taxes that policy makers do not
understand is that during the capital building phase of the business
(typically the first 5 years in business) all of the after-tax
profits are plowed back into the business. Politicians make comments
about taxing the rich people, but the ones I deal with that have a
business that shows $300,000 in profit are having to pay an average
of $120,000 in taxes (40% federal and state) which only leaves
$180,000 to put back into the business to repay debt (remember, you
encouraged them to start a business and borrow to start it).
Until you have sat in the conference room going over the final year
end numbers with a business owner, you have no concept of the
disappointment they feel to learn that what appeared to be a success
of $300,000 in profit is really only $180,000 (which they used to
repay debt so their cash balance did not change). And if they are
diligent and have no bumps in the market, they will be out of debt
in 5 years.
Those are big �ifs.� We found that we have to monitor this quarterly
with clients because they spend their profits and leave no cash for
taxes. When they have no cash for taxes, this starts the death
spiral of their business, because the IRS is now a creditor of last
Taxes may never be simple, but folks, we can do better than this.
Also, I would be a happy practitioner if I never had to help someone
file another tax return. We do not need tax preparation to be a jobs
program, all of those folks can easily be used to do other useful
and more productive things.
Here are my ideas from the real world:
Go back to
2 simple brackets, 15% and 25% . You need to keep the top bracket at
25% since we need room for inevitable increases in Social Security
and Medicare tax rates or limits. All income would be treated the
same (i.e. no capital gains).
taxation of C-corporations by allowing a tax deduction for dividends
paid. This will encourage public companies to pay out excess capital
back into the marketplace, plus you can withhold taxes on the
payment and increase tax cash flows to the Treasury. This would also
help small privately held C-corporations eliminate double taxation
and put them on a level playing field with the S-corporations and
taxes on flow of funds. Since the tax brackets are lower, it is more
reasonable to withhold taxes on payments made to owners. Any money
taken out by an owner of an S-corporation, C-corporation or LLC,
would have taxes withheld on the payment (no shareholder loans!)This
would encourage owners to not fall into bad habits of taking money
out of the business without considering tax implications until it is
itemized deductions. It is time for us to realize we only pollute
the thinking of the taxpayer when we make something deductible. You
can adjust personal exemptions and a standard deduction to some
reasonable level to protect the lower income levels, but after that
make it simple and non-tax motivated.
(Greg Crabtree has
worked in the financial industry for more than thirty years and
founded Crabtree, Rowe & Berger, a CPA firm dedicated to helping
entrepreneurs build the economic engine of their business. In
addition to serving as the firm�s CEO, he is the author of
Straight Talk, Big Profits!)