The Tax Cuts and Jobs Act aims to spur economic growth across the United States by adjusting tax structures for small businesses and corporations. The bill became law in December 2017. Businesses are already feeling its effects, and are predicted to face few things in 2018.
- There's a 20 percent deduction for all pass-through businesses.
- Married individuals who own service-based businesses like law and accounting firms can only receive the 20 percent deduction if they make under $315,000 per year ($157,500 if single).
- The corporate tax rate dropped from 35 to 21 percent.
- The alternative minimum corporate tax rate were eliminated.
The final bill was a slight departure from the complexities featured in the individual House and Senate bills – a special 70-30 pass through rate, restrictions on deductions and a different structure resulted in two complex bills. The final bill's overall benefits are a bit simpler and more direct for all American businesses. The main provisions that have made it through to the final bill are a reduced corporate tax rate and a significant deduction for all pass-through businesses.
The National Federation of Independent Businesses, an organization that represents roughly 300,000 small businesses, initially said that it could not support the bill, but has since said the bill will help the economy by providing significant tax relief to small businesses throughout the nation. But the National Association for the Self-Employed (NASE) said that 83 percent of small business owners don't fully understand the impact these changes will have on their business. And some 90 percent think the government didn't adequately prepare them for the system.
Here's the bottom line: Republicans are saying a slashed corporate tax rate could make the United States a tax haven country for corporations, and the 20 percent deduction for pass-through businesses may help economic growth throughout the nation.
Pass-through businesses get a deduction
The main component of the act 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 20 percent tax deduction for all pass-through businesses with one limitation: married individuals who own service-based businesses like law firms or doctor's offices can only claim the deduction if their annual income is below $315,000 ($157,500 if single).
This deduction is a broad and sweeping benefit to American small businesses. Tax deductions lower your business's taxable income. Under this act, a business's taxable income was reduced by 20 percent. So, if your annual business income is $100,000 per year, the IRS only taxes you on $80,000 of it. The hope is that this deduction provide small businesses with some financial breathing room – this allows business owners to reinvest that saved money back into their businesses by buying new equipment, hiring new workers or expanding operations.
Service-type businesses, like accounting and law firms, are left out of the deduction to close potential loopholes. Wayne Winegarden, senior fellow in business and economics at the Pacific Research Institute and managing editor of EconoSTATS, said that the exclusion of service-based businesses making more than $315,000 per year is the result of a lawmakers' efforts to provide a deduction on the right portion of a business owner's earnings.
"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 wanted to prevent a one-man law or accounting firms from benefiting from a tax break that isn't meant for their business. According to Winegarden, the tax deduction is meant to provide a break on a portion of a business's income that results from capital 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.
By capping service-based businesses at $315,000, lawmakers are trying to limit the possibility of certain business owners from benefitting from lower taxable income.
The bill's biggest draw: Slashing the corporate tax rate
The bill's main event was cutting the corporate tax rate. By lowering the corporate tax rate from 35 to 21 percent, lawmakers aimed 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 … 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."
Lower taxes are attractive for corporations because of profitability – corporations will move to whichever location provides the opportunity to make the most money. However, a lot of factors will have to be considered before a foreign corporation moves to the U.S. While it's not clear if new businesses will set up shop in America, Winegarden said that the new tax rate makes the United States more competitive in the global economy.
"There's a lot less drive for corporations to move overseas," he said, "and you have greater incentives to bring overseas money back home."
The changes started to take effect at the start of 2018. However, it will likely take a few months for businesses to see the effects of these changes. Corporations, for example, have already planned for 2018 – budgets are set, growth plans have been implemented and businesses are gearing up for the start of the new year. Under this new tax structure, businesses and corporations will have to adjust their plans and finances, causing a delay.
"Most corporations, they have already done, probably, the corporate planning for 2018," Winegarden said. "So, any changes in capital investments – it'll take some time because most large corporations are big bureaucracies and bureaucracies don't turn on a dime."
Broad policy impact
Another important thing to note is the impact these tax cuts have on economic policy across America. Since 2008, the Federal Reserve Bank has kept interest rates low to encourage businesses to borrow money and spur economic growth. Winegarden predicted that, with reduced taxes, we could see the Federal Reserve raise interest rates and try to offload some assets that it has accrued since the financial crisis.
"We have a lot of deregulation, which is going to be helpful for the economy," he said. "But we have the big overhang from the Federal Reserve, and how they start to unwind their balance sheets is going to have a very meaningful impact on overall corporate performance … The corporate tax reform is going to be positive, but the Fed can have an overwhelmingly negative role."
And, in fact, it happened. The Federal Reserve raised interest rates in March 2018 by a quarter of a percentage point and signaled that the central bank may raise rates twice more this year.
These tax cuts are a good thing for business, but it's important to keep in mind that these cuts will have a broad impact on the economy and future economic policy.
This was the first major tax overhaul in nearly 30 years. For businesses, these cuts are beneficial and Republicans hope that reduced taxes will help spur economic growth. This year it will become clearer whether corporations and small business owners plan on reinvesting this money back into their businesses, creating growth.