The Tax Cuts and Jobs Act aims to spur economic growth across the United States by adjusting tax structures for small businesses and corporations. Though the bill is still being debated, amended and adjusted, if it passes, it may have serious implications for you and your business.
It can be tough to wade through heavily politicized coverage and understand exactly how your business will be affected by the proposed changes. The National Federation of Independent Businesses, an organization that represents roughly 300,000 small businesses, has already said it cannot support the bill in its current form. Small business advocates are also frustrated by a few of the bill’s provisions, such as the change in the pass-through business tax structure, an exclusion of service-based businesses from proposed tax breaks and heightened competition caused by a low corporate tax rate.
Despite all of this, here is the bottom line: If you are a business owner making less than $260,000 a year, you won’t get hammered with new taxes, but you won’t benefit from any new tax breaks either. Here are a few other takeaways:
- The pass-through rate is structured so that businesses that generate more than $200,000 or $260,000 in income per year will pay a 25 percent rate on 30 percent on their business, and a normal rate on the remaining 70 percent.
- Service-based businesses like law and accounting firms are not included in the tax break.
- The corporate tax rate will drop from 35 to 20 percent.
- The 9 percent manufacturing bonus deduction is going away.
- The complexity of the bill is hoping to close loopholes.
- It is not a final bill, nor has it passed yet.
The problem with the new pass-through structure
The main component of the new bill deals with a change to the tax structure for what are known as pass-through businesses. Pass-through companies account for about 95 percent of U.S businesses – sole proprietorships, partnerships and S corporations are all examples of pass-through businesses. The change involves a lowered rate for only 30 percent of a business’s taxable income.
Essentially, business owners would pay a 25 percent tax rate on only 30 percent of their income, while the remaining income would be taxed under a standard tax bracket. For example, a business owner earning $2 million per year would pay a tax rate of 25 percent on 30 percent of the income, or $600,000. The remaining 70 percent, or $1.4 million, would be taxed according to the respective tax bracket at 39.6 percent. Under these conditions, this business owner would be paying roughly 11 percent less in taxes per year, which is substantial. This is often referred to as the 70-30 rule.
The catch is that, to qualify for this reduced rate, business owners need to reach certain benchmarks. Individual business owners need to have a business income of at least $200,000 per year, and married business owners need to have a business income of $260,000 per year. The average member of the NFIB earns around $75,000 per year and employs only five people. The NFIB says that this means a significant number of small businesses across America are left out of the tax break altogether.
“The first concern is the new pass-through rate is too high to benefit 85 percent of small business owners,” said Jack Mozloom, national media and communications director for the NFIB. “Most small businesses don’t generate $260,000 in income and above, which would qualify them for the new lower 25 percent pass-through rate. It’s not a true small business tax break.”
The bill’s biggest draw: Slashing the corporate tax rate
These ideas follow suit with the bill’s main event: cutting the corporate tax rate. By lowering the corporate tax rate from 35 to 20 percent, lawmakers are aiming for the United States to be a place for larger corporations to set up shop and create economic growth.
“What you’re going to have in the U.S. is effectively, at 20 percent, a tax haven country,” said Tom Wheelwright, author of “Tax-Free Wealth” and CEO of ProVision, a CPA firm specializing in entrepreneurial taxes. “You’re going to have companies that move their headquarters to the U.S. to avoid taxes in their countries … I think that’s going to be the biggest consequence of this legislation.”
If the corporate tax rate is the biggest component of this legislation, how will small businesses fare if they don’t receive similar tax breaks? Mozloom said that, while slashing rates for large corporations is beneficial for the economy, extending the same kind of cuts to small businesses would help even the playing field and promote business on all levels.
“If you’re going to create a competitive disadvantage for small businesses by reducing, substantially, the tax rate for other firms against who they have to compete, that’s a problem,” he said. “If a big corporation goes from 35 percent to 20 percent, but your little firm who competes against that corporation is paying the same rate it was, well, then you’re at a disadvantage. And small businesses are already oftentimes at a disadvantage.”
Despite having to deal with an uneven playing field, small businesses are by no means paying more taxes than they were before under the new pass-through structure. Instead, they’re not receiving the same kind of benefits as other areas of the economy.
Certain industries left out
The new pass-through structure may overlook businesses below certain thresholds, but it also completely bypasses certain service-based professions such as law, accounting and architecture firms. These businesses are ineligible for the 25 percent rate on 30 percent of their income, regardless of how much money they make per year.
“One of the real challenges here is for the businesses that are excluded from the 25 percent rate,” Wheelwright said. “If you’re a small business owner – let’s say you’re a lawyer – and you open shop and you have one employee, it makes sense that you would not get that 25 percent flow-through rate. But what if you’re Ernst & Young? And you have 20,000 employees … how do those businesses contribute less to the economy than a manufacturing business?”
The logic behind this bill
Leaving some businesses out of the tax break deals more with stopping current legal chicanery than with deliberately favoring other types of business in the United States. Wayne Winegarden, senior fellow in business and economics at the Pacific Research Institute and managing editor of EconoSTATS, said that the complexity of this bill is the result of lawmakers’ efforts to stop companies from skirting any laws.
“All of the complications that they’re adding [are] to make sure they’re not creating a giant loophole,” Winegarden said. “Because now that you have a small business rate that’s significantly lower than your marginal income tax rate on the personal side, all sorts of professionals would want to try and take advantage of that.”
In other words, lawmakers want to prevent a one-man shop from benefiting from a tax break that isn’t meant for that type of business in the first place. This is also where the 70-30 rule stems from. According to Winegarden, lawmakers are assuming that 30 percent of a business’s income is from capital income while the remaining 70 percent is from labor income. Capital income stems from assets that accrue value over time and should receive a tax break, according to lawmakers, while labor income is income generated from workers and should be left out.
The 70-30 rule is a guard against individuals who own generally service-based businesses, like lawyers or accountants, and want to take advantage of a low tax rate when the tax break is meant for businesses with capital income.
It’s important to remember that a lot of these concepts are still being debated by legislators and subject to change in short order. The bill may not pass at all. President Donald Trump has said that he wants a tax reform plan on his desk – meaning passed by both the Senate and House of Representatives – by Thanksgiving. If that did happen, most of the provisions would kick off on Jan. 1, 2018, so they wouldn’t affect any 2017 tax filings. This bill is big and complicated, and will have a lasting effect not only on businesses in America, but also on the way individuals pay taxes. Overall, it may be a few months before this bill passes, and it will likely change significantly before (if ever) it becomes law. We will keep you updated as the bill progresses.