FICA Tax Holiday Will Allow More Businesses To Succeed

Note: This is the second in a series of posts about policy changes that make starting a business easier.  The first post on heath care is here.

According to the US Department of Labor, there are a little over 1 million new businesses created in the US each year.   The popular misconception is that 90% fail within five years.  Although real data only show that at least 25% fail within the first year and at least 44% fail within the first three, that percentage is still very high.  Looking at real numbers, over 250,000 firms go out of business within one year.

Businesses fail for many reasons.  The market may change or a competitor could enter the market.  It could be a bad business idea.  The founder might decide to do something else or not have the time or make the necessary committment.  The business may have poor access to credit or funding.  Margins could be too small or the owner cannot make enough to live comfortably. 

Most startups are taxed by FICA (Social Security and Medicade) at a 15% rate on any net profit they earn.  FICA taxes cost small businesses and startups over 15% of net profits, as business owners have to pay both the employer and employee sides of the contribution.  Unlike the progressive income tax, FICA taxes start at $400 of income and end at a little over $100,000, making FICA a very regressive tax.

The 15% FICA contribution is a huge obstacle for new businesses.  For example, take a person who starts a dry cleaning business that makes $30,000 in net profits in year 1.  The founder has to make enough money to reinvest in the business and pay themselves a salary in order for them to stay in business.   The founder owes around $4,500 in FICA taxes.  Instead of taking home $30,000, less income taxes, the owner takes home $25,500.  For many people, $4,500 can be the difference between keeping the business open for year 2 or closing the business.  The same thing can happen to tech startups, too.  Many small businesses and startups need that little extra push to get them over the hump in the first three years.

I propose a FICA tax holiday for new businesses.  Here’s how it would work:

For the first two years, new businesses do not have to pay FICA taxes.  Instead, their FICA tax liability is “banked” and becomes due in year three, assuming the business is still around.  If the business fails, the founder would not have to pay FICA, but if the business succeeded, the founder would have to pay the FICA taxes from years 1 and 2.  Going forward, the business would pay their taxes normally.  

This plan is very similar to what many professionals like lawyers, accountants and others do with startups that they work with.  For example, its common (at least in Madison) for lawyers to agree to withhold bills for a year or two, or until the company is profitable or raises money.  It allows the startup to worry about business operations and not drown under expenses during the startup period.  If the business becomes profitable, the lawyers get their fees in full, plus more fees in the future.  

FICA taxes would work the same way.  Imagine if instead of 25% of businesses failing in year 1, only 24% failed.  Considering Americans start over 1 million new businesses per year, a 1% drop in the failure rate would lead to 10,000 new businesses making it into year 2.  These businesses would continue to generate profits and create jobs, thereby strengthening the economy.  If more business succeed, the FICA taxes that the government could collect in year three would be greater than the current solution.

I think a plan like this is politically feasible, as it helps both tech startups and small businesses alike, especially with the need to for stimulus during the current recession.  I think it could have broad support from both sides of the aisle nationally, but it may be too big for Congress to act nationally.  It would be interesting if a state would offer a plan like this that offered rebates on FICA taxes for businesses located in the state.  It would be another incentive to get business to stay or move to the state that would not cost much.  I am hopeful that government will think about incentives like this plan to help entrepreneurs of all types succeed.