Flat tax would have uneven effect on businesses

Staying Ahead

January 29, 1996|By Jane Bryant Quinn

NEW YORK -- AH, THE flat tax. The idea is seductive: a tax system so easy that you can file your return on a postcard.

By now, you've doubtlessly read and heard that the flat tax, as currently proposed, rains more riches on the rich, socks the working poor and shows mixed results for the middle class. At the rates currently proposed (16 percent to 19 percent), the federal budget deficit goes up. As for the promise that the tax cut will grow us out of the deficit -- well, we've heard that before.

Actually, many businesses would pay much higher taxes, while others would escape tax free. "The loopholes in all the proposals are large enough to drive a truck through," says tax practitioner Vern Hoven of Missoula, Mont.

For example, consider this proposed change in law: When a business makes a capital expenditure (on land, buildings or equipment), all of the cost can be deducted right away. You'd no longer write it off slowly over several years.

Under that rule, you might buy a $1 million farm that nets $100,000 a year on grain. That $1 million cost -- taken up front -- will shelter your income for the next 10 years. And what would you do in the 11th year? "Buy another farm," Hoven says, to continue your tax-free life.

Now take an accountant netting $100,000. Once he's bought a computer, he has no noticeable capital expenditures. So he can't offset his income the way the farm owner can.

Result: capital-intensive businesses would probably pay little or no tax. Service businesses, by contrast, would have to pay their tax in full.

That is, unless the service business had plenty of ready cash. For example, take a rich accountant who's due $400,000 from his partnership. He could buy a $400,000 rental condominium in Vail, Colo., and immediately deduct the full cost from his business income. He'd wind up with a capital asset and avoid the income tax. If he buys the condo with a mortgage, he'll have plenty of cash left over to pay his bills.

Employees couldn't play games like this. But independent contractors could. Where possible, workers would restructure their jobs to become independent contractors.

Businesses would restructure to reduce their tax, perhaps changing the way that workers are paid. Under the flat-tax proposals, only wages are deductible, not money spent on fringe benefits. "Employer-paid health insurance would end," Hoven predicts. "Employees would be given a raise and told to buy it themselves." Some employees wouldn't or couldn't -- thus increasing the number of uninsured. Employer-backed retirement plans also would go into decline.

Businesses would also restructure their cash flow, to maximize deductible expenses (purchases, wages) and minimize nondeductible ones (interest payments). "This could potentially erode a good portion of the tax base," says William Gale, senior fellow of the Brookings Institution in Washington.

IRS auditors would be hard-pressed to catch cheaters because they'd be getting so much less information on income tax returns, Hoven says.

Certain businesses would pay an even higher tax than they do now. Take a company that netted $100,000 after deductible expenses and, additionally, paid out $80,000 in interest and employee benefits. The cost of benefits and interest wouldn't be deductible anymore. This company would be taxed on $100,000, even though it netted only $20,000 after paying valid costs.

In trying to judge how much they'd pay under a flat tax, many business owners are looking at their taxable incomes, and applying a new, low rate. But that doesn't give you the right answer, because many of your current deductions will be wiped out.

For a better guide to what the flat tax would cost (or save) a business owner, write for the Flat Tax Worksheet, free with a stamped self-addressed envelope from the California Society of Enrolled Agents, 3200 Ramos Circle, Sacramento, Calif. 95827.

You can write to Jane Bryant Quinn at: Newsweek, 444 Madison Ave., 18th floor, New York, N.Y. 10022.

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