Tax Fairness and the Small Business Owner

This article was written with Steve Cordasco, of Cordasco financial network. It's part of a series of articles developed under an agreement with to work with a variety of contributors and assist them in delivering actionable investment ideas each week.

David Evanson and Steve Cordasco, Fall, 2012

NEW YORK (TheStreet) — While the middle class has been getting “crushed” over the past four years, therezzs another class that has been in the crucible, too: The high-income small business owner.

The chart below, which is a simplified, but accurate picture of members from each group, tells the story pretty well in my view. In addition, the chart also offers some surprising insights on how you should be investing depending on which group you reside in.

On the left side of the chart is a local small business owner. On the right hand is a hard-working city employee.

From a tax standpoint, I feel the above two scenarios close the book on so-called tax fairness. Specifically, the small business owner makes nearly eight and a half times what the city worker makes. However, note the small business owner pays 60 times — thatzzs 60 — what the city worker pays in tax.

But it doesnzzt end there.

The city worker, because of his lower wage rate, gains greater access to financial aid for his childrenzzs college education. The entrepreneur, on the other hand, might be able to access subsidized loans.

The city worker gets health insurance coverage for his family, and in some cases 100% of his premium paid. The entrepreneur foots 100% of the bill for his own insurance, and some of the bill for his workers. The premium payments he makes represent foregone income for the entrepreneur.

The city worker gets paid time off, sick days and in several situations, a protected leave of absence. Theoretically, the entrepreneur gets none of these benefits and actually pays for otherszz vacations and sick days, resulting in foregone income.

The city pays a share of the workerzzs contribution to Social Security and Medicare, approximately 7.6%. The entrepreneur pays 13.3% for Social Security and Medicare on the first $110,100 of his income. He also makes matches his workers contribution to Social Security, reducing his profits.

Finally, the city worker receives a pension of $49,000 annually, starting at age 59, guaranteed by the taxpayer. The present value of the pension is approximately $1.6 million — using a discount rate based on 30-year Treasury Bond. The business owner gets nothing. He can sell his business, if itzzs salable, and perhaps earn a windfall. But unlike the city worker, there are no guarantees. If he did sell the business he would have to fetch $1.6 million after taxes and paying off all debts to come out ahead of the city worker.

I think discussions about tax fairness are fine. As practical, we should share the burdens equally for living in this great country. But in terms of whether wealthier Americans are paying their fair share, to me, therezzs simply no argument to be had.

Whatzzs also interesting about the two scenarios above is what they suggest about the appropriate risk profile for each family. Specifically, the guaranteed pension payments of the city worker, and their attendant value of $1.6 million actually puts their “savings” well ahead of the business ownerzzs savings.

When investing each should take a different path toward a secure retirement. Accordingly, itzzs the city worker who should be the more aggressive, risk-taking investor. The risk of the city worker is a pension that will not keep up with the cost of living, and inflation will chisel away his purchasing power over time.

The city workerzzs cash flow is fixed and therefore should be matched with an equity portfolio that can grow over time and keep up with inflation. (See my article on the neo-classical retirement portfolio.)

The business owner, though less risk-averse by nature, should be more conservative in how he and his spouse invest their savings. Why? The absence of guarantees in their retirement income, and at age 50, a very short timeframe to make up any losses in their portfolio.

Also, if the business should fail, the business owner does not qualify for unemployment. Therefore the business owner should be more concentrated in fixed and guaranteed return investments with a smaller allocation to equities and risk assets

As a result, if you are a hard-charging entrepreneur, check your natural instincts and create an oasis of calm and balance in your retirement investments. One the other hand, if you are mild-mannered worker by day with a guaranteed pension, you might want to channel your Gordon Gekko at night.

So, where do you stand on retirement and taxes? Who has your vote, the left or the right?

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