Proposed Tax Overhaul and Small Businesses

As Congress debates overhauling the Internal Revenue Code, a push-pull has emerged between small and large businesses. Large businesses argue that the corporate tax rate must be lowered in order for them to compete internationally, despite several large businesses paying no or very low taxes. In the tax overhaul in the 1980s, regulations were put forth to allow businesses to operate as pass-thru entities- eliminating the double taxation of a c-corporation in favor of taxation at the shareholder/owner level of LLCs and s-corporations. Many small businesses are formed as LLCs due to this single taxation element, as well as the relatively low cost of starting and maintaining an LLC.

Most businesses now operate as pass-thru entities. Of the 34 million business tax returns filed in 2009, the most recent data available, 32 million were pass-throughs, representing about 70 percent of net business income, compared with about one-quarter in 1980. The original pass-thru tax was meant to help small businesses, but is increasingly used by large businesses, thus draining the Treasure of tax revenue. The IRS notes that many large businesses are using pass-thru status to avoid paying taxes: “Large companies are increasingly avoiding tax by organizing themselves as pass-through businesses” an administration issue paper noted, putting traditional corporations at a disadvantage.

Small businesses are concerned that any changes to the tax code will disadvantage small businesses and benefit large businesses. Proposals have been floating to limit or eliminate deductions (for both businesses and individuals) such as the mortgage interested deduction, which makes passing a tax overhaul difficult. Further creating difficulty is the division between small and large businesses. A 300-employee business in Ohio wants different tax provisions and changes than a 300,000 multinational U.S. based business.

The current House bill wants to change the pass-thru taxation. Under current law, small businesses organized as sole proprietorships, partnerships, limited liability companies, and S-corporations, known as pass-through entities, are taxed at the individual owner or shareholder level.

That means these owners are paying taxes on their business income at tax rates, which top out at 39.6 percent.

The GOP bill would create a 25 percent small-business tax rate that would apply to all passive investment income, such as interest, and to a portion of active income, including profits and salaries. The active income portion comes with limitations that tax writers have described as “guardrails” to prevent abuse of the reduced rate.

The proposed bill allows for two methods to calculate pass-thru taxes. One is to have 30 percent of such income taxed at the reduced rate while the remaining 70 percent would be subject to individual income tax rates.

The alternative is to apply a formula based on their level of capital investments that could result in a higher percentage of income being taxed at the 25 percent rate. The catch for those choosing the formula method is that they are bound to it for five years

Obviously, some businesses would benefit from these changes, while others would pay higher taxes. One concern is that this proposal would lower taxes for manufacturing firms, but raise taxes on service firms, such as doctors and lawyers since these businesses do not qualify for the 30/70 option. Another concern is that the proposal would not benefit most small businesses since they don’t make enough profit to qualify for the 25% tax rate.

Only time will tell what the changes to the corporate tax rules will be. Tax overhaul is always complicated- that’s one reason the last major change was in the 1980s. Schmidt and Long will keep you posted.

To discuss your business needs, please contact Benjamin Long of Schmidt and Long.