Local business success story Bartell Drugs is emerging as Exhibit A in an argument against Initiative 1098, the high-earners income tax: The tax proposal—despite the fact that it reduces business and occupation taxes for small businesses (increasing the B&O tax deduction from $420 to $4800)—could include a tax increase on small(ish) businesses like Bartell.

George Bartell, the CEO of the Seattle-based family-owned business, made that argument in an editorial against I-1098 late last week.

I-1098 would impose a five percent income tax on individual income above $200,000 a year and on couples' income above $400,000 a year. (A secondary nine-percent bracket would apply to individual income over $500,000 a year and couples' income above $1 million a year).

The initiative, which is popular with progressives, would bring in about $2 billion a year to pay for health and education. And the B&O break would exempt 81 percent of small businesses from B&O taxes.

However, according to the fine print of the measure, it could amount to a double hit on some small business owners.

The text of I-1098 states:

"'S corporation income' includes both distributed and undistributed federal taxable income of the S corporation."

Here's what that CPA jargon boils down to: Profits of "S Corporations"—an IRS category for businesses with fewer than 100 shareholders (as opposed to C Corporations like Microsoft, which are much larger)—get taxed by the federal government as personal income. That's true even if the owners don't put the money into their personal savings accounts, but instead earmark it for reinvestment: A lease on a new location; a new fleet of delivery trucks; a hiring expansion.

Because I-1098 uses the federal guidelines, it also considers S Corp profits to be taxable income. Ding. S Corp owners get hit twice: Once by the feds and once by the state. (Worth noting, however, is the fact that business owners choose S Corp status because they only get taxed on corporate profits, while C Corp owners pay taxes on corporate profits and on dividends.)

S Corp owners complain that I-1098's corporate-profit-as personal-income model is a disincentive to running a responsible business—i.e., having a positive cash flow. For example, if an S Corp owner makes $200,000 a year and leaves another $200,000 in his business at the end of 2010 for reinvestment in 2011, he has to pay $10,000 in 1098 taxes.  That business owner can never get that money back, critics say, and can only spend $190,000 to grow next year.

Additionally, similar to the initial problem (now fixed) that the initiative ran into with gay rights groups for incorrectly pushing gay couples into 1098 tax bracket even if their joint income didn't justify it, if a business owner decides to take home a salary of $50,000 and leave $300,000 in the bank for reinvestment, he would get hit with the high-earners income tax.

Of course, it's unclear how much of a problem that would be for people like George Bartell. The personal income of Bartell's owners is not public, but we're guessing it's more tha $200,000 or $400,000 a year.

Bartell Drugs runs nearly 60 stores in the Puget Sound region.

So, I-1098 takes the money before the owner gets a chance to reinvest. Might as well hold on to your profits instead of earmarking them for expansion if you're going to owe money to the state regardless, right?

Well. No, say lefty 1098 advocates, including the folks at the Economic Opportunity Institute. EOI Policy Director Marilyn Watkins points out that S Corp.owners can simply deduct the investment from their income for tax purposes in the following tax year and get reimbursed.

Taking a hit up front may very well be worth it down the line. (The point of reinvesting the money is to create bigger profits in the first place.) In fact, I-1098 could be viewed as an incentive to invest instead of increasing your salary and taking that trip to Hawaii.
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