[EDITOR'S NOTE: The House of Representatives passed its version of the bill on November 16. The Senate's bill is still being debated, adjusted and ammended.]
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, initially said that it could not support the bill the way it was written. After the Ways and Means Committee update issued on November 8, 2017, however, the organization backed the bill.
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, and it may even be in your best interest to switch to a C-corporation. Here are some other key points:
- 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.
- Business-owning individuals making less than $75,000 per year would be taxed at 9 percent for the first $37,500 of business income. If you're married, the dollar amounts double
- Service-based businesses like law and accounting firms are not included in the pass-through rate, but do qualify for the 9 percent rate.
- The corporate tax rate will drop from 35 to 20 percent.
- The complexity of the bill is hoping to close loopholes.
- It is not a final bill, nor has it passed yet. Both the House and the Senate have proposed bills they are debating and working on. When both houses agree on changes, President Trump must sign off on the bill for it to become law.
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 House Ways and Means Committee amended the bill to include a different break for businesses with income under $75,000. Instead of paying a 12 percent tax rate, the bill would cut the tax rate on the first $37,500 to only 9 percent, according to the New York Times. That's for individuals who own a business. The dollar amounts would double for married couples who own a business.
"The amendment would create substantial tax relief for millions of small business owners who were left out of the original bill," the NFIB said in a statement of support for the bill.
The bill's biggest draw: Slashing the corporate tax rate
The bill's main event is 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."
Wheelwright said that the amendment from the Ways and Means Committee helps put growing small businesses on par with corporations, from a tax standpoint.
"If you're talking about a small business growing, it's a huge benefit. If you're talking about a small business staying small, it’s some benefit, it's just not the big benefit," he said. "The big benefit are those that are going to be growing and expanding."
Certain industries left out
The new pass-through structure may overlook businesses below certain thresholds, but it also 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, if they make over $75,000 per year. Otherwise the reduced 9 percent rate will still apply.
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.
The Senate's bill
There are two tax bills currently circulating: One in the House and one in the Senate. The Senate bill, while changing a lot of the tax codes for individuals, would completely remove the pass-through benefit provided by the House. Instead, it would provide a 17.4 percent deduction for all pass-through companies. It would also delay the corporate tax cut until 2019.
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 these bills pass, and it will likely change significantly before (if ever) it becomes law. We will keep you updated as the bill progresses.