We don’t yet know for sure what will be included in the final legislation or when provisions of any new rules will go into effect. But we can take a look at the proposals, their potential impact on small business owners, and what small business owners think about what’s happening on Capitol Hill right now.
It’s pretty likely that the final tax reform bill will involve a change to the treatment of non-corporate businesses such as sole proprietorships, Subchapter S corporations, partnerships and LLCs. These small businesses make up 90 percent of all businesses and, unlike C corporations, these entities do not pay income taxes themselves.
Instead, income from the business “passes through” to the business owner or owners, who pay taxes on business profits at their marginal income tax rate (which can be as high as 39.6 percent) as well as self-employment tax or the net investment income tax of 3.8 percent.
Meanwhile, corporate tax rates range from 15 percent to 35 percent. Thus, many lawmakers have voiced their concern that under current law, corporations get a better deal than pass-through entities.
Recent tweaks to the Senate’s version of the bill mean that most pass-through businesses would not have to pay tax on 20 percent of their income. Remaining income after the 20 percent deduction would still be subject to the owner’s marginal tax rate. However, there are some limitations.
Service businesses (including law firms, accounting firms, engineers and doctors offices) would not be eligible for the deduction unless their income is below $150,000 for a married couple filing jointly or half that for an individual.
C Corporations make up only about 10 percent of all businesses, but lawmakers on both sides of the aisle agree that their 35 percent top tax rate is too high and not competitive with the rest of the world. The Senate bill will likely lower that rate to 20 percent, starting in 2019.
Businesses that have more expenses than income in any given year may have a Net Operating Loss (NOL). Under current law, businesses can carry those losses back two years (to recover past tax payments) or carry them forward for up to 20 years to offset taxable income in subsequent years.
Both the House and Senate versions of the tax reform bill eliminate the ability for businesses to carry losses back. Instead, NOLs will be carried forward indefinitely but limited to 90% if taxable income.
Normally, business assets with a useful life greater than one year must be capitalized and depreciated over a period of several years rather than expensing the cost of the asset in the year it’s purchased.
However, Section 179 of the Tax Code allows small businesses to take an immediate deduction for the full cost of tangible, depreciable personal property (i.e., not land or buildings) in the year they are purchased and placed in service.
The Protecting Americans from Tax Hikes (PATH) Act, increased the limit for Section 179 deductions to $500,000. Early versions of the Senate bill doubled that limit, allowing businesses to expense up to $1,000,000 in qualified property.
In addition, the Senate bill will likely give businesses an incentive to make larger investments by allowing them to expense the cost of real estate over a shorter time frame.
Currently, commercial real estate must be depreciated over 39 years. In other words, a business that purchases a building costing $1 million would receive an annual depreciation deduction of $25,641 ($1M / 39 = $25,641). Residential property (i.e., rental houses) are currently depreciated over 27.5 years.
The Senate bill would reduce the asset lives for both residential and commercial property to 25 years. For that same $1 million property, the annual depreciation deduction would be $40,000 ($1M / 25 = $40,000).
The Section 199 deduction (also known as the domestic production activities deduction) is a tax break for businesses that perform production and manufacturing activities within the U.S. While this incentive typically applies to business activities such as manufacturing, construction, agriculture and film production, some businesses have successfully expanded the definition.
In fact, in 2013, a gift basket company successfully argued that the assembly of candy, chocolates, cheese, wine and crackers into gift baskets qualified as manufacturing a product for the purposes of taking a Section 199 deduction.
Unfortunately for the gift basket maker and other businesses that have benefitted from the DPAD, tax reform will likely eliminate the Section 199 deduction.
While the majority of provisions in the tax reform bill seem aimed at helping small businesses pay less tax (and simplifying tax return preparation overall), the proposals are not receiving wide support from small business owners.
According to an opinion poll released Monday by Businesses for Responsible Tax Reform, 51 percent of small business owners oppose the tax plan being considered by Congress and only 34 percent support it. Fifty-two percent of the 795 small business owners polled believe the current proposals favor large corporations over small businesses.
That’s because, in order to pay for cuts to business tax rates and other changes to individual income tax rules, the bills will almost certainly eliminate many of the deductions that many small business owners take on their individual tax returns.
You see, when income from your business passes through to your individual income tax return, changes to income tax rules for businesses and individual taxes never happen in a vacuum.
According to the poll, some of the individual tax deductions that small business owners oppose are:
Only 38 percent of small businesses support eliminating these deductions in order to reduce their tax brackets. The tax reform proposals also make corporate tax cuts permanent, while tax cuts for pass-through entities are scheduled to sunset in 2026.
In conjunction with Businesses for Responsible Tax Reform, nearly 1,200 small business owners sent a letter to Congress voicing their opposition to the bill.
If the Senate passes its plan, Congress will still need to work out a deal in conference committee to reconcile the significant differences between the Senate and House versions of the bill and pass that final conferenced legislation.
The White House is putting pressure on Congress to push final legislation through by year end, but whether that happens remains to be seen.