Let's face it. American's aren't very fond of taxes. The current tax code has been called unfair, overly complex and burdensome. Most taxpayers find the thought of doing their tax return on a postcard very appealing.
Tax reform has not been finalized, but it certainly looks like it is getting close. We have a House bill and a Senate bill. Assuming the House and Senate can resolve their differences, President Trump has vowed to sign tax reform into law before year-end.
But what do they mean for business owners? Are there tax strategies that can benefit entrepreneurs? If you take a closer look, three areas could be game-changers.
1. Pass-Through Entities
Pass-through entities are not a new concept. Many business owners utilize these structures regularly in their business dealings. Such entities include partnerships, limited liability companies (LLCs) and S-corporations.
It is important to note that these entities generally do not pay any tax. The net income or loss flows through to the owners and is taxed at their individual rate. In both the House and Senate plans, taxes are lowered on pass-through income. They just do it in different ways.
Under the House plan, owners that conduct business in a pass-through would be subject to a rate of 25 percent, rather than the top rate of 39.6 percent. The bill also establishes a nine percent rate for the first $75,000 for some smaller entities.
The Senate bill allows business owners to deduct 23 percent of their income with the remaining income taxed at ordinary rates. However, both plans carry limitations and safeguards that try to prevent taxpayers from manipulating the system by foregoing wages (taxed at ordinary rates) in exchange for the beneficial treatment of pass-through income.
One significant difference is how certain service businesses are taxed. This includes, but is not limited to, physicians, attorneys, and CPAs (too bad for me). The House bill prohibits these businesses from taking advantage of the reduced rate. The Senate plan prohibits them from the 23 percent deduction, except for ones with taxable incomes below $250,000 ($500,000 if married).
The United States currently has one of the higher top corporate tax rates in the industrialized world. The top rate is 35 percent and any dividends distributed to shareholders are taxed again at the qualified dividend rate.
The House and Senate bills call for personal tax rates of 39.6 percent and 38.5 percent, respectively. Combine this with state incomes taxes, employment taxes and any surcharges and many taxpayers might be paying more than 50 percent at the highest tax bracket.
But the good news is that both bills lower the corporate tax rate to 20 percent. This significantly widens the gap between corporate rates and individual rates. One difference, however, is that the Senate is calling for a one-year delay in the rate reduction.
C corporations have always been great for fringe benefits (medical reimbursement plans, education assistance, etc.). But because of double taxation, it usually is not the best entity for small business owners. With this rate reduction, we should see an increased shift to C corporations.
3. Capital Investments
When a company acquires certain fixed assets (equipment, computers, etc.), it is required to write-off (or depreciate) these assets over their useful life. This treatment is applied even if the company pays the entire cost of the asset in year one.
The Senate plan wants to make it possible for business owners to immediately expense (deduct) new equipment for five years. The provision is then phased out by 20 percent per year thereafter. The House plan limits the deduction to five years.
The tax code currently allows for a full deduction of many assets under code section 179. However, there are specific exclusions and limitations. Both plans offer added flexibility and enable companies to invest sizable amounts into capital projects.
This might be an excellent opportunity for someone considering business expansion. If you are contemplating acquiring new locations or investing in infrastructure, you might now have a little more investment incentive.
So which tax plan is best for your business? It really depends on your income level and the nature of what you do. Certain service businesses might not fare as well. But many businesses looking for lower tax rates, more fringe benefits and seeking expansion should come out ahead.
Unfortunately, if you are looking to do your tax return on a postcard, you are probably out of luck. But as business owners we will take any help we can get. Assuming tax reform is signed into law, you should be able to find a few opportunities that can work for you. Stay tuned.