The House Democrats released their tax proposal with big headlines about increasing taxes on the rich and big corporations. But if you have read my articles before, you know I care less about big corporations and more about small businesses. Where do they fit into the tax code changes? Is tax reform good or bad for them? Some small businesses will benefit from the proposed changes. Here's who wins and loses with this new tax proposal:
Corporations earning less than $5 million
Currently corporations are federally taxed at a flat rate of 21 percent of adjusted net income. The proposal in the house would create three new tax brackets for corporations:
- 18 percent tax for corporations earning $400,000 or less
- 21 percent tax for corporate income between $400,000 and $5 million
- 26.5 percent tax for corporate income between $5 million and $10 million
- 26.5 percent flat tax for corporations earning over $10 million
Small corporations earning less than $5 million per year in income will actually experience a tax decrease in this proposal, saving up to $12,000 in tax expense. Not huge, but not bad.
Small businesses competing against foreign companies
Substantial portions of the tax reform package seek to close loopholes or deductions taken by foreign entities or domestic entities paying foreign taxes. Small businesses that cannot afford the scale or reach of international operations will benefit from a leveling of the playing field as they compete with foreign entities facing larger tax burdens.
Anyone waiting for the IRS
The proposal includes $79 billion of additional IRS funding for enforcement of new provisions. That is more than a sixfold increase over the 2021 budget.
While entrepreneurs and libertarians generally cringe at the idea of more IRS bureaucrats issuing audits and investigating tax filings, there is a downside to our currently low IRS staffing: slow responses, terrible customer service, and delayed tax refunds.
Accounting departments nationwide have been struggling to file basic and time-sensitive forms like change in entity tax elections, often going 10-plus months without confirmation or response from the IRS. It is all but impossible to contact IRS customer service now, with their 800-number automatically hanging up on callers after three hours on hold. The worst part is most small businesses are still awaiting their 2020 income tax returns five months after filing.
The hope is extra IRS funding means more staff to process refunds, filings, and business negotiations faster.
In general, the more profit you earn the more you stand to lose from tax reform. Here's a list of the losers in the current tax proposal in the house:
Corporations earning more than $5 million per year
High-income corporations are facing a new income bracket of 26.5 percent. In fact, if you earn more than $10 million per year, you will have all your income taxed at 26.5 percent rather than just your incremental income.
Pass-through entities earning more than $400,000 per year
High-income S-corps, partnerships, and sole proprietors are facing three headwinds in the tax reforms. The top-tax bracket for personal income taxes (which affects pass-through entities like partnerships, S-corps, and sole proprietors) will be increased from 37 percent to 39.6 percent.
Second, the threshold for this tax bracket will be lowered, meaning a new set of earners will suddenly qualify for the top tax bracket. The new bracket limit for individuals will be $400,000 (down from $523,000) and $450,000 (down fro $628,000) for married filing jointly.
Lastly, high-income pass-through entities will be disqualified from the qualified business income deduction. The QBID (commonly known as the pass-through tax deduction) is a deduction worth up to 20 percent of your income. However, the rules for QBID are complex and include phase-outs for businesses with higher income, business activity, and even what year it is. It is difficult to know how much your business benefited from the QBID without reviewing your tax return.
The proposed tax reform eliminated the QBDI for anyone earning more than $500,000 per year jointly or $400,000 per year for a single individual. Consult with your fractional CFO or CPA to determine whether or not this would affect you.
Owners that sell businesses or business assets
The highest long-term capital gains tax rate (which applies to most businesses) would rise from 20 to 25 percent. This has a large impact on businesses that buy and sell appreciating assets like real estate, collectables, stocks, and even the business itself.
In fact, the most popular way to avoid paying capital gains taxes, known as section 1202, is also weakened in the proposed tax reforms. The gains exclusion would drop from 100 percent to 50 percent, creating up to $5 million per year in additional capital gains taxes per transaction.
Individuals with lots of money in retirement accounts
The new tax legislation seeks to limit the use of qualified retirement accounts, like IRAs and Roth IRAs, based on the total amount of money someone has in such accounts.
Overall Impact of Tax Changes on Small Businesses
The Biden administration and House Democrats have successfully targeted high-income corporations and business owners in these reforms. Although there are some benefits in the legislation, in aggregate, the House's proposed tax changes would be a burden on high-income small businesses.
These terms are being actively negotiated in Congress, so do not get too excited. There is still a chance that none of it will happen. Here's my recommendation to small-business owners facing the prospect of high tax liabilities:
- Wait until the legislation is signed into law,
- schedule a strategy meeting with your fractional CFO, CPA, or financial adviser, and
- collaborate with your team on your best tax strategy given the changes.
In reality, most small businesses will not change anything in light of the new tax structure. There are dozens of business elements more impactful on cash flow than your tax strategy -- for example, your sales and marketing strategy, operations strategy, pricing strategy, and exit strategy. As much as we wish we had a fleet of corporate accountants to find every tax loophole, that is not economically realistic for small businesses. Do your diligence, collaborate with your financial team, but always stay focused on fundamentals to ensure success.