If you run a small business (or even a large closely-held business) taxed as an S corporation or partnership, don’t get too excited about the tax rate reduction headlines in Congress’ latest tax reform proposals.
The House bill touts a 25% tax rate for business income from these entities. Passive investors would enjoy the 25% rate on all business income, which may encourage more investment and lower equity financing costs. But for an entrepreneur actively involved in the business, the lower rate only applies to 30% of annual income from the business, or to annual business income up to approximately eight percent of adjusted tax basis (roughly, the un-deducted investment amount) in the business assets. So the House bill is friendly to passive investors, and offers only limited benefits to traditional entrepreneurial small business operators.
The Senate proposal touts a 17.4% deduction against S corporation and partnership business income, but limits that deduction to 50% of the amount the individual taxpayer business owner receives in wages. In other words, you have to pick up a dollar of income tax at the full individual tax rate and pay employment taxes on that amount, to enjoy the reduced tax rate on fifty cents of non-wage income. This mix is not much different than the House’s 70% wage income-to-reduced-tax-rate business income ratio.
Like the House plan, the Senate small business tax rate proposal limits benefits to entrepreneurs. Unlike the House bill, the Senate does little for passive investors, who may have a hard time justifying high wages to bolster their deduction.
The proposed 20% tax rate for traditional C corporation income is more straightforward than the S corporation and partnership tax rate proposals. This may cause some small businesses to consider converting to C corporation status (the tax status of many larger companies and the vast majority of publicly-traded companies). But in so doing the businesses (including, especially, Florida businesses) may become subject to state income taxes they otherwise avoid. Further, any cash removed from the business will either be subject to the full individual tax rates or to a 23.4% dividend tax. Finally, when the business is sold, the seller may receive a lower price (because the buyer can’t depreciate the purchased assets) or pay tax at an effective tax rate significantly higher than received or paid by the seller of a business structured as a S corporation or partnership. So while taking advantage of the 20% C corporation tax rate may seem desirable to a growing business that reinvests its profits, the business owner may suffer a significant detriment upon a business sale and pay a higher tax rate on cash removed from the business in the meantime.
Conceivably, if you operate a small business, some flavor of the House and Senate proposals could reduce your tax liability. There are some clean wins. For example, both bills would allow many small businesses to immediately deduct much larger volumes of annual asset purchases, rather than take depreciation deductions over time. But if enacted, the tax rate proposals will not make life more simple or reduce difficult choices.
Changes to business tax rates are just the tip of the tax reform iceberg. The bills would make significant changes to many other areas of the tax law. More to come…
Here is a link to a summary of the House bill: https://waysandmeansforms.house.gov/uploadedfiles/tax_cuts_and_jobs_act_section_by_section_hr1.pdf
Here is link to a summary of the Senate bill: https://www.finance.senate.gov/imo/media/doc/11.9.17%20Chairman’s%20Mark.pdf
E. John Wagner, II