If you’re a small business owner hoping to get a tax cut under proposed Republican tax reform, pay close attention. While there will be a few small business winners, most small business owners will see no benefit, and you might be one of the many small business losers.
While both the House and Senate bills are still subject to revision, both contain a provision directly aimed at small businesses. And it’s got a whopper of a bait-and-switch.
Whenever you hear them talking about lowering the rate on “pass-through” income—the kind almost all small business owners report—remember this: it won’t lower taxes on at least seventy percent of the money you make. It won’t help the overwhelming bulk of small businesses. It probably won’t help you.
How did we get here?
During the Presidential campaign, candidate Donald Trump promised to lower business taxes. But he meant “corporate” taxes—with a new lower rate applicable only to “C” corporations, generally the largest businesses in America.
Small businesses don’t operate that way. Virtually all pay tax on a “pass-through” basis, since they’re sole proprietorships, partnerships, LLCs, and “S” corporations, subject to the income tax rate of the individual owner or partner.
Oops. Candidate Trump realized he better include small businesses too. After all, there was an election to be won. So, he said small businesses would get a lower tax rate too.
Oops. Lowering taxes on “pass-through” entities would cost a huge amount of money in lost tax revenue, and the deficit would go through the roof.
So, politically, the Republicans were caught: they had to add some benefit for small businesses, but not enough to cost so much they couldn’t fund the tax break they wanted for big corporations.
Thus, a devilish detail: limit the lower pass-through tax rate to only a small amount of total small business earnings, a maximum of 30% of everything a small business owner makes. In other words, at least 70% of a business owner’s income would continue to be taxed up to the highest rate, 38.5% or 39.6%.
This provision is so unpalatable, wiping out benefits for over 90% of all small businesses, that even the reliably pro-Republican National Federation of Independent Businesses opposed it.
Oops. So, the House threw small businesses a bone, lowering the tax rate on the first $37,500 of pass-through income ($75,000 if married filing jointly) to 9% from the current 12%. The Senate bill would phase that lower rate in over three years.
The bottom line after all this manipulation? The effective new tax rate for pass-through income for most small businesses would be what they pay now or possibly, gulp, higher (it’s not clear whether 30% will have to be taxed at 25%). Some small business owners would actually see their effective rate reduced as the 30% of income added up: those small business owners making over $260,000 in take-home income. The rest of us, nope. Corporate tax rates—for “C” corporations—would only be 20%.
And here’s another whopper: If you receive pass-through income from businesses you do NOT work in, you enjoy the 25% maximum tax rate on 100% of such passive income, unlike the poor slob who actually does the work, who only gets it on 30%.
That may sound OK, right? Well, hold on. Because a whole lot of other provisions take away tax benefits many, if not most, small business owners currently receive.
Looking at the details, here are winners and losers, given current proposed tax bills:
- Professional service businesses and consultants, including health, law, architecture, accounting, financial services, engineering, and more. Explicitly denied lower pass-through rates.
- Owners and employees in startups and tech companies. The Senate bill potentially wipes out any benefit of stock options, which would be taxed when vested rather than sold. Individuals would have to pay real taxes on stock profits they haven’t received except on paper. It’s nonsensical.
- Businesses and residents that pay state or local income taxes. No longer deductible.
- Home owners, especially those in higher tax states such as California, New York, New Jersey. Property tax deductions eliminated or capped at $10,000. Tax exclusions on gains on the sale of homes are also more limited.
- Realtors and those in home-related businesses. Limited or no property tax deductions and less favorable treatment of home-sale gains may make home ownership less desirable.
- Non-profits. Higher standard deductions may mean fewer people donate to their churches or other non-profits.
- Sick people. Medical expenses no longer deductible.
- College educated. Interest on student loans no longer deductible under House plan.
- Individuals who do not itemize and currently take the standard deduction. The standard deduction will almost double, making filing easier and saving money for those with the lowest incomes.
- Small business owners who make over $260,000 a year. Maximum tax rate becomes effectively lower, since 30% of income may be taxed at 25%, lower than what you are currently paying.
- Small business owners who make under $37,500. House revised bill lowers taxes to 9% instead of 12% on the first $37,500 (single) or $75,000 (married filing jointly) of net business taxable income. Senate bill phases this in over three years.
- Passive, not active, investors in small businesses. Passive pass-through income gets lower 25% rate on 100% of income.
- Companies purchasing expensive equipment in the next five years. Both bills allow for 100% immediate write-offs (rather than depreciating over many years) of business equipment purchases.
Copyright, Rhonda Abrams, 2017
This article originally ran in USA Today on November 15, 2017