Funding for these growth essentials comes from three capital sources: 1) direct equity investment; 2) bank debt; 3) retained earnings, the net profits left in the business.

That third source, retained earnings, is an important one for small businesses. But by IRS definition, before business profits can be retained, they’re diluted by income taxes—the first and greatest impediment to capitalizing the growth of a profitable small business. That’s why the new tax law President Bush signed last May was good news for small business capitalization.

The Job and Growth Tax Relief Act quadrupled the direct expensing of capital purchases allowed from $25,000 to $100,000 for the 2003 tax year. For tax year 2004, that top number increases to $102,000. And for technology buyers, the new law extends the expensing provision to include off-the-shelf software, which previously had to be amortized over the life of the product.

There is also good news in the new tax bill when direct expensing is not chosen. According to Barbara Weltman, perennial author of J.K. Lasser’s Small Business Taxes, if expensing is not elected, or if capital asset purchases for the year exceed the allowable expensed amount, a first-year bonus depreciation of 50% now applies, which is up from 30% prior to May 6, 2003. This bonus deduction is in addition to the regular depreciation allowance.

The net benefit for profitable small businesses is that more earnings can be retained in the business as working capital to fund growth. Of course, be sure to consult with your tax professional about the options that are best for your tax situation.

Besides the direct impact of the new tax law provisions, here are two indirect, but still very important additional benefits:

1. Direct expensing is available even if the capital item purchased is financed over multiple years. For some small businesses, this scenario could actually result in positive cash flow to further fund growth.
2. Much of capital purchases involve technology. Since the old depreciation tables just weren’t compatible with the pace of new innovations, direct-expense increases help small businesses replace out-dated equipment sooner, which enhances their ability to gain and maintain a competitive advantage.

When President Bush signed the Job and Growth Tax Relief Act last year, many of us predicted it would provide much-needed stimulus to the economy. For example:

• Chad Moutray, Ph.D., Chief Economist for the SBA’s Office of Advocacy, pointed out that since small businesses create over half of the U.S. $10 TRILLION annual GDP, and employs more than half of the private workforce, the tax cuts would provide new fuel and lubrication to the real economic engine of the U.S. economy.

   

• Small Business Survival Committee’s chief economist, Ray Keating, offered the calculation that if the 20 million U.S. small businesses increased their capital spending by an average of only $3,000 each, that would result in more than $60 BILLION in annual economic growth.

So, after almost a year of road-testing the benefits of the Job and Growth Tax Relief Act, what do we know?

Well, we know that businesses took advantage of the array of new tax reduction elements, especially the direct expensing provision. The result was a huge business transfusion to the market sector that has been anemic since the fourth quarter of 2000 — capital goods. Indeed, purchases of capital goods helped propel the 2003 Q3 growth numbers to a breathtaking 8.2%, which was followed by a more down-to-earth — but still pretty handy — 4% growth in Q4 2003.

Have small businesses been important to this economic growth? David Malpass, chief global economist at Bear, Sterns, thinks so. Malpass has written recently that our current expansion is a durable one to a large degree due to the efforts and investment of America’s small businesses. Indeed, if there ever was a marketplace petri dish where you can watch what businesses do — especially small businesses — when they get to keep their precious working capital, this is it.

Clearly, the multiple benefits of increased direct expensing of capital items is significant for individual small businesses. But when the direct economic impact—like the Keating example—is aggregated with the increased efficiencies and productivity this half of the marketplace can create with new equipment and capital, the compound benefit of this tax policy to the national economy is — and will continue to be — enormous.

Write this on a rock — Make sure your small business is maximizing its competitive position by taking advantage of the tax benefits found in the Job and Growth Tax Relief Act.