LLC Tax Update

David Health, of the Nashua Chamber of Commerce which has been pushing back hard against the new LLC tax, has an informative write up detailing the tax's impact on small business in today's Union Leader:

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 percent 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 percent 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 percent business profits tax (BPT). When DRA audits convert "compensation" into "profit," the small business owner's aggregate tax burden dramatically increases from the .75 percent BET rate to the 8.5 percent BPT rate.

Add the 2009 tax law and small businesses 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 percent to 8.5 percent. But now, the amount recharacterized as "profit" will also be treated as a "dividend" subject to the 5 percent income and dividends tax. Taxing the audited "profit" at the 8.5 percent BPT rate and again as a "dividend" at the 5 percent income and dividends tax rate means a combined tax rate of 13.5 percent.

So, after the 2009 tax law, tax advisers 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." Moreover, 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 percent (the BET rate) and 13.5 percent (the combined tax on compensation converted to "profit"). Rightfully, entrepreneurs must reject such uncertainty.

Thankfully, it is starting to appear as though elected officials in Concord are picking up on the outrage:

In passing a law expanding the state's interest and dividends tax to all partnerships and limited liability companies, mistakes were made, Senate Majority Leader Maggie Hassan, D-Exeter, told the Exeter Rotary Club on Monday. Because mistakes were made, changes might be necessary, she hinted.

"Our biggest mistake is not communicating what we did. We had a July 1 deadline, we had $11 million bearing down on us," Seacoastonline.com reported her saying. "If we need to change it, we can."

That is the first hint we have seen from Democratic leadership in Concord that this burdensome tax could be revisited. That's a good sign.