How Can Tax Reform Level the Playing Field for Small Business?

How are small businesses taxed?

Small businesses are sometimes referred to as “pass-throughs” because their profits are “passed through” the business and claimed by the owners of the business on their personal tax returns. This is different than corporations, whose profits are subjected directly to the corporate tax rate.

How does the current tax code treat small business and corporations differently?

Corporations face two layers of taxation, first at the corporate level (with its current top rate of 35 percent) and then again at the individual level when a business pays out a dividend or a shareholder sees a return on their ownership. However, they are able to deduct wages paid to employees.

Pass-through businesses face a single layer of taxation under the individual income tax code, but do so at a higher current top rate of 39.6 percent and can face significant self-employment and state income taxes that push top marginal rates well over 50 percent. Pass-throughs also must generally pay tax on income in the year it is earned, whereas shareholders in corporations have some flexibility in when they realize gains and pay tax on them.

How does the tax reform plan propose to fix this?

The tax reform package proposes a top corporate rate of 20 percent and a new cap on top rate for pass-through income at 25 percent (which puts both types of businesses roughly on par when accounting for total tax burdens). Traditional corporations would benefit from a more competitive (and territorial) corporate tax rate, while pass-through businesses would benefit from a system that puts them roughly on par with that rate.

In order to prevent gaming where individuals pretend to be pass-through businesses in order to benefit from a 25 percent top rate, the plan allows pass-throughs to elect to use a so-called “70-30” rule, which establishes a bright-line standard that they count 70 percent of income as ordinary wage income (and thus subject to ordinary income tax rates) and 30 percent as business income (and thus subject to the lower pass-through rate). Some professional services, like law firms, would be required to treat 100 percent as wage income.

Alternately, for businesses that feel a 70-30 rule would unfairly characterize too much income as wage income not eligible for the 25 percent top rate, the bill provides for a “facts-and-circumstances” option which calculates taxability based on a formula relating to capital investments and rate of return. This theoretically allows a “safety valve” for businesses that don’t fit the traditional 70-30 model well.

Why a 70-30 rule?

This rule is derived from historical data which shows that roughly 70 percent of returns accrue to labor (i.e. workers earning income) while 30 percent of returns accrue to capital (i.e. ownership). Using that historical precedent to establish a bright-line standard will provide taxpayers clarity on attributing income for tax purposes. For those that argue that a 70-30 rule is based off a broad view of the economy and unfairly penalizes some business models, the facts-and-circumstances option allows for a more tailored approach.

What is “wage income"?

Wage income refers to the income that is paid to employees, and thus subject to ordinary income tax rates. Under the tax reform plan, that would mean a consolidated rate structure with a lowest marginal rate of 12 percent and highest of 39.6 percent.

What is “business income"?

Business income refers to a company’s profits (or losses). Small businesses bear the burden of figuring out what part of their business profits they want to pay to their owners and workers and what part should be invested back in the business.

How can changes in the tax code impact small businesses?

Because small business owners pay their taxes on their personal tax returns, consolidating and decreasing personal income tax rates will provide relief to many middle-income business owners. Clarification of what businesses can claim as business and wage income will allow small businesses to plan and invest in their businesses and their workers, while remaining competitive with corporations.