Reprinted from Chris Mittelstaedt’s column Eureka on Inc.com
The capital gains tax has been touted as the brass ring for business owners. But if you self-fund your growth, it's anything but.
For too long self-funded business owners have been led to believe that they are part of the group that could benefit from capital gains tax rates, notably when they sell their business (and this is true!). The problem is, the capital gains tax puts these same entrepreneurs at a big competitive disadvantage as they try to grow their businesses.
Our tax code has created a situation in which owner-operators are generally taxed at an earned income tax rate; meanwhile, people who fund businesses with money earned through investments pay a lower capital gains tax rate. It’s time to touch the third rail of business politics and speak out about why capital gains tax policy hurts entrepreneurs.
Capital gains offer an unfair competitive advantage
Take my business, The FruitGuys: We are an LLC. As an LLC our income flows through at a personal income tax rate (S-corps, which many small business people also use, have the same flow-through personal tax rate designation). For ease of calculation let’s say we earn $1 million a year. On the federal side, we would be taxed at our average earned income tax rate somewhere around 31%. That would leave me with $690,000.
Now consider an investor whose income is derived through investments that qualify for capital gains. This person makes the same $1 million in a year but these profits are taxed at the capital gains tax rate of only 15%. Thus the investor is left with $850,000.
Let’s say that I want to take all of my remaining $690,000 and put it back into my business. Meanwhile, my investor friend invests in my No. 1 competitor with all of his $850,000—that's a difference of $160,000 in capital that the investor has over me just because of the way that income was earned.
Your business is an investment that deserves a fair shot.
Why, from a tax standpoint, should a self-funded business owner's income be treated differently than the income of investors? Often for entrepreneurs, their largest investment is their own business and they serve as the primary investors. Why should they be penalized for reinvesting their own profits back into the business? Where is the call for a fair capital playing field?
We're incentivizing a "cash out" economy.
From a tax policy perspective, selling your business and putting that money into investments that benefit from capital gains status is a better financial bet than running and growing a business. So what kind of economy are we developing when we incent people to buy and sell business assets for transaction value rather than supporting the reinvestment of self-made profits into growth? I think there is great value for our society in trying to develop ways to motivate active business owners to stay in the game and grow their self-funded businesses and create jobs.
What the critics will say
This is a very complicated topic and there are many who say that trying to compare profit earned in an operating business versus capital earned through investments that qualify for capital gains is like comparing apples to oranges. In my business I compare apples to oranges all day and both are fruit. To me capital is capital when it comes to growth and if one form gets preferential tax treatment and creates a competitive advantage, then it should be on the table for discussion.
American innovation is well served by a boot-strapped, independent, do-it-yourself ethic. A growth-focused economy needs transparency and, at its core, the knowledge that no matter who you are, you can expect the same fair treatment everyone else has. While it seems that those who classify themselves as "job creators," place capital gains somewhere between a right and self-evident truth, there are everyday business owners and working folks hoping to start businesses that don't benefit from the investment advantage given to others.
Whether you agree with lower or higher taxes, a flat tax or a progressive system, VAT tax or something different all together, the fact that those who strive to grow our economy from the ground up are given higher hurdles than those who generally have greater access to capital to begin with is a policy that chokes the formative roots of American Capitalism. I'd like to see taxes become at least a neutral factor in competition so that entrepreneurs are not at a disadvantage when they self-fund the growth of their businesses.