By David Heath
The Legislature’s recent expansion of the interest and dividends tax to payments by partnerships and LLCs to their owners is a new tax on small business owners that will undermine New Hampshire’s ability to attract small business owners and the jobs they create. This 2009 tax law, known as the “LLC Tax,” is bad tax policy and must be fixed in 2010 to preserve New Hampshire’s competitiveness.
As an accountant in Nashua for over 25 years, I have advised hundreds of entrepreneurs on how and where to establish and grow their small businesses. According to the U.S. Small Business Administration, small businesses and the jobs they create are a major force in our economy, with over 32,000 small businesses accounting for 96.6% of the state’s employers and 54.9% of private sector employment
I believe that the 2009 tax law, which for the first time applies the 5% interest and dividends tax to certain payments received by small business owners from partnerships and limited liability companies, will severely compromise New Hampshire’s tax competitiveness unless the Legislature quickly remedies its flaws.
The new tax law is flawed tax policy for three reasons.
Burdensome Record-Keeping. First, the new tax law requires owners of partnerships and LLCs to keep very burdensome records. DRA rules require the business to account for their “accumulated profits,” and if the records are unsatisfactory, all payments will be taxed as “dividends.” No other state requires partnerships and LLCs to keep such records. Accordingly, this brand new record-keeping burden on small businesses places New Hampshire at a marked disadvantage to other states.
Unprecedented “Debt Tax“. Second, the new tax law imposes an unprecedented “debt tax.” Often, small business owners will borrow money against successful businesses and then invest the borrowed dollars in a new business that will create new jobs. Under the new tax law, distributions that are related to business borrowings will be taxable as “dividends,” even though the owner has no income because he still owes the lender. No other state, nor the federal government, imposes such a “debt tax.” This new “debt tax” is reason enough to advise a client to steer clear of New Hampshire.
A 13.5% Tax on Small Business Income. Third, the new tax law highlights the negative impacts of DRA audits challenging deductions of “reasonable compensation” with the result that small business owners in New Hampshire could be subject to a 13.5% total tax on their aggregate income. This is a complicated point, but it is critical to understanding why the new “LLC Tax” critically undermines New Hampshire’s competitiveness.
Until recently, I have been confident in recommending New Hampshire as the lowest tax state for small businesses because these businesses pay only the business enterprise tax (BET) at 0.75% on compensation paid to owners and employees, and the owners pay no personal income tax. Compare this result to Massachusetts, where the unincorporated business pays no business tax, but the owner pays 5.3% personal income tax on his compensation income. New Hampshire wins!
In recent years, however, this winning status has been eroded by increasingly frequent DRA audits challenging deductions of “reasonable compensation.” In these audits, DRA asserts that small business owner compensation is actually “profit” subject to the 8.5% business profits tax (BPT). When DRA audits convert “compensation” into “profit,” the small business owner’s aggregate tax burden dramatically increases from the .75% BET rate to the 8.5% BPT rate.
Add in the new 2009 tax law and small businesses now face a “tax double whammy” that will kill small business growth. Prior to the 2009 tax law, when DRA audits of partnerships and LLCs converted deductible “compensation” into taxable “profit”, the tax rate increased from .75% to 8.5%. But now under the new law, the amount recharacterized as “profit” will also be treated as a “dividend” subject to the 5% I&D tax. Taxing the audited “profit” at the 8.5% BPT rate and again as a “dividend” at the 5% I&D tax rate means a combined “double whammy” tax rate of 13.5%.
So, after the 2009 tax law, tax advisors can no longer recommend New Hampshire as a good tax home for small business because the new law imposes burdensome record-keeping and an unprecedented “debt tax.” Morevoer, due to vague standards and increasingly frequent DRA audits of “reasonable compensation,” no one can provide precise guidance on the combined New Hampshire tax rate on small business income. One can only say that the combined rate would be somewhere between .75% (the BET rate) and 13.5% (the combined tax on compensation converted to “profit”). Rightfully, entrepreneurs must reject such vague uncertainty.
Given these significant negative effects, one has to wonder how some can try to defend the “LLC tax” as “just closing a loophole,” or as “not a new tax,” or that “it only affects a few taxpayers.” These defenses are particularly questionable when the DRA projects that the new law will raise $15 million in new tax dollars each year. This substantial tax increase seems far more than a technical “loophole” fix, and the recent public outcry is evidence that it indeed more deeply threatens the small business community.
The 2009 tax law is bad tax policy that was adopted without public hearing or review. The Legislature must take steps now to enact clear, bright-line standards to end the “Monday-morning-quarterbacking” of “reasonable compensation” audits, and it must reform the interest and dividends tax to remove the negative effects of the 2009 tax law. By taking prompt and responsible action now, we can correct the new tax law so that New Hampshire is restored to its winning status as the best state for small businesses and the jobs they create.
David is a CPA and Director of Tax at Melanson Heath & Company, PC and the Chairman of the Nashua Chamber of Commerce Government Advocacy Committee