Yes, You Can Be a Billionaire and a Small Business—at the Same Time!

Of all the political topics drowning in spin and obfuscation, nothing can beat the combination of tax policy and small business. Republican or Democrat, legislator or executive, any American politician who has an opportunity to pander to small business will grab it, eagerly tossing facts aside as necessary.

The American imagination fetishizes small business, as part of the mythology of individual enterprise; we revere the mom-and-pop grocery store and the plucky Internet startup. Mythology has its uses, but let’s also try some truth: Most entities in this country that are categorized as small businesses don’t look anything like the icons. A large portion are simply freelancers; when real companies lay people off, many workers become “small businesses.” Another chunk are companies that exist only on paper as a way to pass income from one entity to another. Even the Small Business Administration, which exists in part to advocate on behalf of “small businesses,” acknowledges that about 80 percent of so-called small businesses in America have zero employees .

And thus emerges the peculiar fact that many of the very, very wealthiest Americans report a sizable portion of their income in the same category as small businesses. In 2007, according to Internal Revenue Service data (see Table 1, Page 4), of the 400 tax returns showing the largest adjusted gross income, a little more than half reported making money through S corporations and partnerships, the category that also includes many small businesses. On average, these high-fliers reported earning more than $83 million in this type of income—which, of course, makes them much, much larger than what most people think of when they think of a “small business.” Such a distortion—overall, this is $16.8 billion in income from only 202 taxpayers—is at the heart of much of our shouting about taxing small businesses.

Now, I’m not suggesting that these ultra-wealthy folks are doing anything wrong; they’re presumably taking advantage of whatever tax rules they can. After all, partnerships and S corporations are very commonly used by people who make scads of money—as a way, for example, that Wall Street executives invest large bonuses, or that people buy real estate as a group. (Indeed, almost as many of the top 400 tax returns showed losses through these types of entities, though the losses were on average much smaller.)

No, the problem here is with a tax code that views as equivalent a struggling 100-employee business and a zero-employee “business” that only further boosts a billionaire’s wealth. This is why the debate over whether the top rate of taxing this kind of income should be 35 percent or 39.6 percent or something else is rancorous but practically meaningless. If we’re ever going to have an honest and effective debate about the right level at which true small businesses should be taxed, we need to have a better way of separating out the vast differences between the entities that get treated as small businesses.