Eager for a legislative victory, the Trump administration released its tax reform blueprint this week. While far from a final version, the framework significantly changes tax considerations for small businesses.
Owners and aspiring entrepreneurs should monitor the national debate closely.
Flat tax on LLC and S-corporations
Changes in tax rates for pass-through income has the greatest potential for impact. If your business is a Limited Liability Corporation or S-Corporation, the profits from your business are taxed based on your personal income rate ,which can range from 10 percent to 39 percent and reported on your personal income tax return. Under the president’s proposal, pass-through income would be taxed at a flat rate of 25 percent.
For businesses that have a healthy profit, this may generate a net tax savings for owners. However, for newer enterprises with lower net profits, tax liability may increase.
Currently about two-thirds of pass-through entities are taxed at a rate of 15 percent or less, so most small business owners are likely to see an increase in their tax rate.
The framework released is silent on how losses from pass-through entities would offset other income. Many new businesses operate at a loss the first year or two of operations and writing off these losses on personal income taxes can help entrepreneurs make ends meet as they grow their venture.
Lowering corporate tax rates
The proposed framework would drop the top corporate tax rate from 35 percent to 20 percent for C Corporations along with closing some existing tax loopholes and deductions. This creates a potential choice for businesses to change their corporate structures to take advantage of these new rates. Owners may choose to move from pass-through entities to a traditional corporate structure to take advantage of this lower tax rate. Again the framework does not specify any changes to how corporate losses would be treated.
Accelerated depreciation on capital investments
Businesses owners who invest in new equipment or other capital costs will be able to immediately write off the cost on their taxes rather than depreciating over time. The specifics on the types of investments this would include have not been specified or if there would be any caps. However, businesses financing capital purchases may face limits on the amount of interest they can deduct each year.
Elimination of the manufacturing deduction
In Snohomish County, we have many smaller manufacturers that likely benefit from the Domestic Manufacturing Deduction (commonly referred to as Section 199). However, since the proposed corporate tax rates would be substantially lower, this specific deduction would be eliminated. Manufacturers would be more likely to benefit from the accelerated depreciation provisions when they buy new machinery or invest in new or expanded production lines.
Potential service business exclusions
While not called out in the nine-page framework, U.S. Treasury Secretary Steve Mnuchin made statements recently that some service-sector businesses would not be eligible for the reduced pass-through tax rates. The secretary cited accounting firms as an example where it would be appropriate to tax profits as regular earned income rather than at the lower rate. Most new small businesses provide services of some type either to consumers or businesses, and the details on this differentiation may have a profound impact on tax liability.
The debate on tax reform is early, and what changes will finally make it into the tax code remain to be seen. However, savvy entrepreneurs will pay attention to the debate and engage with their elected officials to ensure the voices of small business owners are heard.
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