Fact check: Plumber Joe's taxes

McCain has entrepreneurs spooked about tax hikes, but fewer than 2% of small business owners would pay more under Obama's plan.

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(CNNMoney.com) -- In speech after speech, presidential candidate John McCain hammers on the claim that his rival Barack Obama will raise taxes on many small businesses.

At the debate on Wednesday night, McCain said, "The small businesses that we're talking about would receive an increase in their taxes right now."

More typically he has said: "What [Obama] hasn't told you is that he would tax half of the income of small businesses in America," a line used in La Crosse, Wisc., last week.

Should small business owners fear for their wallets if Obama is elected? Not the vast majority, business and tax experts say.

To make its claim, according to a McCain spokesman, the campaign counts as a small-business owner any taxpayer who files a Schedule C, E or F - the forms used to report gains and losses from business ventures and farms.

Using that definition and citing IRS data, the campaign notes that "56.8% of total small business income is earned by businesses in the top two rates, which Barack Obama has pledged to raise."

It's true that Obama has proposed raising taxes on the top two income rates.

But there are three main problems with McCain's charge.

What is a small business?

First, it relies on a broad definition of what counts as a small business, including everyone who files a Schedule C, E and F.

But most people who file those forms don't run a business for a living: Those forms are also used to report income from freelance and consulting work, real-estate rentals, and most other non-salary sources.

For example, McCain and Obama both file Schedule C returns, thanks to their book royalties - but they hardly should be considered small business owners.

In 2005, there were 21.5 million Schedule C returns filed, according to the IRS.

A more realistic definition of small businesses turns up far fewer firms. The Small Business Administration estimates that there were 6 million small businesses in 2005, as measured by those with fewer than 500 employees and with staff on the payroll other than the owner.

Who pays?

Second, even using the broad definition of small business that McCain likes, very few owners would see their own taxes rise.

That's because the lion's share of taxable income comes from a small number of wealthy businesses. Out of 34.7 million filers with business income on Schedules C, E or F, 479,000 filers fall into the top two brackets, according to an analysis of projected 2009 filings by the nonpartisan Tax Policy Center.

The other 34.3 million - or 98.6% - would be unaffected by Obama's proposed rate hike.

That includes Joe "The Plumber" Wurzelbacher, whom McCain invoked nearly two dozen times at the debate Wednesday night to illustrate the plight of the average worker and small business owner.

"Joe wants to buy the business that he has been in for all of these years ... he wanted to buy the business but he looked at your tax plan and he saw that he was going to pay much higher taxes," McCain said.

In an interview afterward with WTOL, Wurzelbacher acknowledged that he'd still like to eventually buy the plumbing company he works for but that he wouldn't yet be hit by higher taxes.

"I want to set the record straight: Currently I would not fall into Barack Obama's $250,000-plus," he said. "But if I'm lucky in business and taxes don't go up then maybe I can grow the business and be in that tax bracket - well, let me rephrase it. Hopefully, that tax won't be there."

Few owners are that lucky in business. In a member survey conducted late last year, the National Federation of Independent Business (NFIB) found that only 14% of respondents said they had $200,000 or more in annual income.

As Tax Policy Center fellow Len Berman recently told Fortune Small Business: "Most owners of small businesses have small incomes."

What gets taxed?

Third, even if you're one of the rare business owners making enough money to be affected by Obama's proposed tax increases, you still won't see a big hike in your tax bill.

McCain's claim that Obama "will increase taxes on 50% of small business revenue" - the line he used in the second presidential debate - is incorrect because of how income is taxed.

If a business owner falls into the top bracket, that doesn't mean that all of his or her income is taxed at the highest level.

For example: If a small-business owner makes $210,000 in taxable income, he edges into the 33% bracket, one of the two top tax rates that Obama would like to raise.

But he would pay the higher tax only on the amount that exceeds the cutoff - in 2007, the two top tax rates applied to single filers with income of $160,850 or more and joint filers with income of at least $195,850. As a single filer, this business owner would see his federal taxes increase $1,475 under Obama's plan, which calls for raising the 33% tax rate to 36%.

"While Obama does favor raising the top two rates, the quote is not true because not all the small business income of those in the top two rates is taxed at the 33% and 35% rates," said Gerald Prante, a senior economist at the nonpartisan Tax Foundation.

The bottom line: McCain's claim only works by using an overly broad definition of what counts as a "small business" - and even with that definition, fewer than 2% of business owners would be hit by Obama's proposed rate increase. For those who are affected, the increase would be levied only on a part of their earnings, not all of them.

CNNMoney.com writer Emily Maltby contributed to this report. To top of page

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- Spate, Orange, Calif.

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