Two years ago in this space, April 30, 2017, I began warning about the impending tax law –nine months before it was passed – specifically how it might not be fair to small businesses. The Washington rhetoric pointed to one thing on their mind – significantly reducing the top tax rate for big business. So, when they revealed their number – 20% – I piped up that small business should get the same number.
It’s important to note here that there are essentially two kinds of business tax reporting: 1) C Corps, mostly all the large corporations, which file and pay taxes like an individual, but at their own rates; and 2) most small businesses are legally structured as S Corps and LLCs, which file a return, but – and this is important to remember – “pass through” any net profit as income on the shareholders’ personal returns. Most small businesses – millions – are “pass-throughs.”
Three months before the new law passed, in my October 1, 2017 article, my concerns proved justified as I revealed a single paragraph in the proposed law that began with the tax writers revealing that while they were holding on to the top C Corp rate of 20%, small businesses (pass-throughs) should expect the top tax rate to be no less than 25% – one-fourth higher than corporate America. And then, adding insult to injury, the second part of the paragraph revealed this smoking gun: “The committees will adopt measures to prevent the recharacterization of personal income into business income to prevent wealthy individuals from avoiding the top personal tax rate.”
As I pointed out then, anytime the government combines the terms small business and wealthy individuals in the same instructions, buckle up and pull the straps tight. It was becoming clear that not only was small business not going to get the same tax advantage as corporate America but by firing that shot across our bow, the tax-writing cohort admitted they had an attitude about how pass-throughs allocate taxable income. At the time, we didn’t know how that attitude would manifest, but it was strong enough that they were willing to reveal it in writing. By the way, there was no such restrictive rhetoric for corporate America.
Three months later, when The Tax Cuts and Jobs Act (TCJA) became law, as promised, it included certain instruction for those “wealthy” small business owners. Instead of having a significantly lowered top tax rate, like corporate America – 21% in the final bill – certain “qualified” pass-throughs would instead receive a 20% deduction applied to the income created by business activity. That’s right – “qualified” means does not apply to all small businesses. Apparently, some of us are children of a lesser god. Remember the attitude that gave rise to the smoking gun? Well, here is exactly how it manifested in the law identifying those certain small business owners who don’t “qualify” for the 20% deduction:
“… a trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services … or any trade or business where the principal asset is the reputation or skill of one or more of its employees or owners … the receipt of income from endorsing products or services, the use of an individual’s image, likeness, voice …”
Single business owners who fit any of these exceptions, and make over $315,000 in taxable income, do not qualify for any of the 20% deduction. For married filers, the number goes up to $415,000. So, thousands of small business owners who’ve worked their backside off for years to build successful “reputation” businesses – accounting or law firm, a personal brand as an entertainer, thought-leader, etc. – and finally are able to cash in some of that deferred gratification in the form of financial success, have now been targeted as “wealthy individuals.” And as promised, the new tax law has a separate, more expensive and discriminatory provision for this large group.
But it gets worse: Small business tax planning for 2018 was hampered because the law wasn’t fully promulgated until the end of the year. And even if you qualify for the deduction, and even if your effective rate went down compared to 2017, you still may have to amend your return as the new provisions continue to be interpreted by the IRS. In the meantime, you’ll pay a preparer more for the extra effort in research to interpret the unfinished law. My own very smart CPA had to work overtime and consult with other experts to complete our return. Other preparers I queried responded with the same experience of increased brain damage and expense. The minimum extra effort reported was 10% more than for 2017.
It must be said that the TCJA did cut taxes at least somewhat for the majority of small businesses. But the cut wasn’t as much as it should have been, and the compliance degree of difficulty it created – that big businesses don’t have – makes the new law a kind of Hobson’s Choice: “Take the cut we gave you and be grateful.”
Incredibly, there is one more shameless provision the new law handed America’s small businesses: Enjoy the cuts while you can because they go away in 2025 (no such sunset for Big Business). Even Hobson didn’t take away the horse he gave you.
Finally, the good news: The ugly stuff just revealed can be fixed. But only if enough small business righteous indignation is rained down of Congress. Get busy.
Write this on a rock … Small business owners are not children of a lesser god. We create half the economy and employ half of the workers. We deserve the same tax advantages as big business.