Tuesday, February 28, 2006

Question for Tax Accountants

One of the first lessons you’ll learn in any microeconomics class is the difference between accounting profit and economic profit. Loosely speaking, accounting profit considers only expenditures as costs, whereas economic profit counts both expenditures and forgone income as costs. The classic example is a sole proprietor who works 60 hours/week running his store. On paper, he might appear to be making a large (accounting) profit. But if you subtracted the income he could have received had he taken a job working the same number of hours for someone else, his (economic) profit would be smaller, maybe even negative.

What I’m wondering is how well tax law deals with this. Here’s a hypothetical: Suppose two men, Mark and Sirajul, are sole proprietors with identical (but independent) businesses. They are both making pre-tax accounting profits of $50,000/year, and also working 60 hours/week. Each man keeps his own accounting profits as his personal income. And then one day, Mark and Sirajul meet, and they come up with a plan. Each man will run the other man’s business, in return for an annual salary of $50,000. They will, in other words, becomes each other’s employees. Each man will receive just as much money as he did before, but now in the form of a paycheck instead of profits. Both businesses will now run an accounting profit of zero, despite being just as profitable as before from an economic perspective. Here’s my question: Will they pay more, less, or the same amount in taxes in comparison to what they paid before? Take into account taxes on both on personal income and business income; ignore complications like health insurance and other benefits. If the answer depends on the state of residence, then narrow the question to federal taxes only (or pick a state whose tax code you know).

Just to be clear, this is a genuine question. I really don’t know the answer.


Glen said...

Note that both businesspeople have to pay income tax and social security tax on that income if they take it as salary. A much better bet for tax purposes would be to delay paying yourself a salary for as long as possible and also delay letting the business make any profits. Instead, get really creative with "expenses". Instead of owning a car, have the business buy and insure a company car and loan you the use of it. Buy a family health care plan. Buy business clothes with a wardrobe allowance. And so on. Almost everything you would want to buy with a salary can be thought of as a necessary business expense, but paying it as an expense means you get to skip corporate AND personal taxes on the expenditure.

So find a way to pay yourself as close as possible to $50k in "expenses"; then the business has no income and therefore pays no tax.

But if you don't want to do that, wouldn't it be easier to pay yourself a salary than to switch jobs with somebody else?

R.J. Lehmann said...

To answer the question in the simplest terms (that is, ignoring all of the major deductions you can take on both the individual and business level), the federal corporate tax rate is 15% on the first $50,000 of taxable income ($7,500). If that same $50,000 is taken as income, the individual will have a personal exemption (I think that's $4,750 if it's a single with no dependents) then pay 10% on the next $7,150 of income ($715), 15% on the $21,900 above that ($3,285) and , finally, 25% on the remaining $16,200 ($4,050) to give you a grand total of ($8,050).

However, that's deceiving. After all, what are you going to do with the $50,000 in corporate profits? If you don't pay yourself a salary, you've got to do something with it. If you keep it in a personal holding company, it's subject to a 15% tax. If you kick it back to yourself as a dividend, it's likewise subject to a 15% tax. These taxes are in addition to the corporate tax.

So, clearly, you're better off doing as Glen suggests -- pay as many bills as you can get away with as business expenses to minimize your accounting profits, and whatever's left, that's your salary (which, of course, you should shield as many PERSONAL deductions as you can get away with.)