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Big Misconceptions about Small Businesses and Taxes

UPDATED
February 2, 2009

Supporters of various tax benefits for high-income households often claim that failure to maintain them would have an undue effect on many small businesses. But even assuming a broad definition of "small business," such claims are often exaggerated or false. This paper examines three such claims.

First, critics charge that allowing the 2001 tax cut's reduction in the top two marginal income tax rates for individual taxpayers to expire as scheduled would affect a large proportion of small-business owners. In fact, only 1.9 percent of filers with any small-business income are projected to face either of the top two income tax rates in 2009.[1] By contrast, more than 14 percent of filers with small-business income claim the Earned Income Tax Credit (EITC) for low-income workers. Thus, strengthening the EITC could help more than seven times as many small businesses as reducing the top income tax rates.

Second, critics often greatly exaggerate the burden of the estate tax on small businesses. Only a tiny proportion of the few estates that owe any estate tax have significant small business or farm assets. Furthermore, the small businesses and farm estates that do owe estate tax benefit from special provisions designed to help them reduce their estate tax liability.[2]

Third, critics often falsely claim that proposals to eliminate tax breaks for hedge fund managers would harm "mom and pop" businesses. Even the most expansive definition of a small-business owner does not fit the typical hedge fund executive.

This paper analyzes these claims. It likely overestimates the number of small businesses adversely affected by changes to the top two marginal tax rates, the estate tax, and loopholes available to hedge-fund managers because it: (1) adopts an extremely generous definition of "small business" (see Appendix 1) and (2) does not consider many valuable tax breaks that small businesses and small-business owners enjoy (see Appendix 2). Yet it still finds that the claims typically made about small businesses and taxes are highly exaggerated, misleading, or false.

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End Notes:

[1] Urban Institute and Brookings Institution Tax Policy Center estimates, with a small business defined as any tax unit that receives any income (or loss) from a sole proprietorship, farm proprietorship, partnership, S corporation, or rental income.

[2] Urban Institute and Brookings Institution Tax Policy Center estimates, with a small-business estate defined as one with more than half its value in a farm or business and with the farm or business assets valued at less than $5 million.