It’s commonly understood that the better you do in business, the more taxes you’ll pay. As Scottish whiskey distiller, Thomas Robert Dewar, said:
“Nothing hurts more than having to pay an income tax, unless it is not having to pay an income tax.”
But in view of new tax rules and other factors, there may be diminishing returns for success – and a price to pay.
Trending to Higher Taxes
There are a number of new tax rules and limitations that combine to substantially increase the taxes that successful business owners pay, starting with 2013 returns.
There’s a new tax rate of 39.6% that applies for individuals with taxable income over threshold amounts that depend on filing status. And yes, those subject to this new tax rate pay 20% (rather than 0% or 15%) on their capital gains and qualified dividends. In the words of infomercials – but wait, there’s more.
You also lose out on some of your itemized deductions and some or all of your personal exemptions. Once your adjusted gross income exceeds a threshold amount based on your filing status ($250,000 for singles; $275,000 for heads of households; $300,000 for joint filers), the limitations on itemized deductions and personal exemptions kick in. Because business income is taken into account in figuring adjusted gross income, a good year may mean new tax limitations for you.
And you may owe additional Medicare taxes:
- 0.9% tax on wages and net earnings from self-employment over a threshold amount ($200,000 for singles; $250,000 for joint filers). This is in addition to the Medicare tax you pay under FICA on wages and self-employment tax on income from an unincorporated business. The additional Medicare tax is not deductible.
- 3.8% on the lesser of net investment income (investment income minus investment expenses) or modified adjusted gross income over the same threshold amount that applies for the 0.9% tax. While income from a business in which you materially participate (and are just a passive investor in the business) isn’t treated as investment income, it still increases your MAGI, which can trigger that tax with respect to bank interest, capital gains, payments from a commercial annuity and other investment income.
The thresholds for additional Medicare taxes aren’t adjusted annually for inflation, as is the case for other tax thresholds. This means that going forward, as business income keeps pace with inflation or grows at an even greater rate, more and more small business owners may become subject to these additional taxes.
Increased Audit Risk
To add to the burden of paying higher taxes, you also face a greater possibility that the IRS will audit your return. For example, according the IRS Data Book for FY 2012  (PDF), the one for FY 2013 should be available soon, while the audit rate was 1% for individuals as a whole, it was 2.4% for individuals with business returns (Schedules C, E, or F) showing gross receipts of $25,000 to under $100,000; 3.6% for gross receipts of $100,000 to under $200,000; and 3.4% for gross receipts of $200,000 or more.
In other words, successful small business owners are nearly four times as likely to be audited then the population as a whole.
In view of the tax burdens on success, it’s enough to make you question whether it pays to be so profitable. But only for a moment. Most small business owners aren’t deterred by taxes. They have a desire to succeed, no matter what the tax cost!
Price  Photo via Shutterstock