Last March, I published an article reviewing the small business impact of the then-leaked Biden Tax Reform proposal. This week House Democrats released their summary proposal to the public. With the new details available, let’s review the impact on small business financial planning.
How does tax reform affect small business?
There are three proposed changes that will affect small business income taxes. Which change you care about depends on your entity structure (sole proprietor, partnership, S-corp, or C-corp).
Change to corporate income taxes.
The proposal creates three tiers of corporate income taxes, which were previously a flat rate of 21%:
- 18% tax on income up to $400k
- 21% tax on income from $400k to $5 million
- 26.5% tax on income from $5 to $10 million
- 26.5% flat tax on corporations earning more than $10 million.
Very few small businesses earn more than $5 million in taxable income per year, so for many small corporations this will actually be an effective tax decrease.
Up until five years ago, small business owners were obsessed with pass-through structure to avoid double taxation. The Trump-era tax reforms intentionally lowered corporate tax rates to a level where double taxation was a negligible concern. As a result, we saw (and advised) many clients to change to C-corp structures over the past 4 years.
Will high-income corporations change back to S-corp and pass-through structures with an increase in corporate taxes? Maybe, but choosing your entity structure based solely on income tax rates is myopic. C-corp structures come with many long-term benefits, such as qualifying for section 1202 (see more on this below) or rolling net operating losses indefinately. Moreover, S-corps and pass-through companies are facing tax increases too…
Elimination of pass-through tax deductions.
If you are a high-income S-corp, partnership, or sole proprietor, the proposed tax plan will eliminate your Qualified Business Income Deduction, commonly referred to as the pass-through deduction. This deduction was worth up to 20% of your business income – but, in fact, is so complex and restricted that most business owners do not even know whether they have been benefiting from it. The value of this deduction will depend on your personal income, your business activity, and even what year it is! Moreover, since pass-through income tax rates are based on personal income tax brackets, it is impossible to precisely quantify the value of this deduction in any general terms.
While personal income levels already limited or reduced this deduction, the proposal will eliminate it entirely for joint tax filers with income over $500k, or single filers with income over $400k.
What might you be losing when this deduction goes away? You need to ask your CPA that question. In general, I have found that business owners benefit less from this deduction than they believe they should. Nonetheless, with the right combination of income, business activity, and other factors, losing this credit can create a massive increase in taxes due.
Increase of top-tax bracket rate
If you are a high-income S-corp or pass-through entity, your tax rate is increasing as well. For joint filers with income over $450k (down from $628k) or individuals with income over $400k (down from $523k) your federal top tax bracket will go up from 37% to 39.6% (do not forget to add your state taxes to that figure too.) The drop in bracket level, increase in rate, and elimination of the Qualified Business Income Deduction is a 1-2-3 punch that will impact any S-corp or pass-through business earning more than $400k/yr.
Changes to capital gains taxes.
The top capital gains tax rate will increase from 20% to 25%. Capital gains taxes are the quintessential “good problem to have” taxes – if you are hitting the top capital gains bracket by earning more than $1 million per year in income, you are being taxed on your success. While this is a major tax for business owners hoping to sell their company and earn millions, it is not as directly impactful to a businesses’ cash flows or an owner’s livelihood as income tax rates.
There are still many great ways to sell your business and defer or avoid capital gains taxes entirely. These include:
- Perform a 1031 exchange
- Selling to an ESOP
- Selling to a cooperative
- Harvest capital losses to offset the gains
- Donate your equity
- Qualify for section 1202 (see more below)
- Roll gains into Qualified Opportunity Zones
- Bequeath your stock after death
Changes to Section 1202
Section 1202 capital gains tax exclusion has been a favorite of venture capitalists and private equity funds for years. Under section 1202, the proper set of circumstances can lead to saving up to $10 million in capital gains taxes when selling qualified small business stock. The proposed tax reforms would cut this benefit in half for individuals with more than $400k/yr in income. That means when you sell your qualifying company you will still have to pay 50% of the capital gains tax (12.5% under the new proposal.)
All the other tax changes.
There is a significant number of tweaks and adjustments to taxation of foreign entities and entities with foreign operations. If your business has sizable foreign operations or benefits from writing off foreign taxes paid, your business may be impacted by one of these changes.
The proposal also limits the use of retirement vehicles like IRA’s and Roth IRA’s for high income individuals or individuals with high retirement balances.
Lastly, the proposal allocates $79 billion in increased IRS funding for enforcement. On the one-hand, this is much needed since the IRS is currently backlogged for months, creating great stress and disservice for small businesses waiting for tax refunds and dispute resolution. On the other hand, the extra funding will also be used for increased scrutiny including more audits. Check out our article about increased IRS enforcement to learn more.
Do not forget there are plenty of other tax changes in 2021. Check out our article on deferred social security taxes, sales taxes, and more.
Small business income tax strategy.
As with most tax problems, the more profit you are generating the more these changes may affect you. If you are a startup business that is losing money every year, there is no need to also lose sleep over current Washington politics. On the other hand, if you are a lifestyle business that is generating ample owners’ income, you should take these changes seriously.
Here’s my recommendation to small business owners facing high tax liabilities:
- Wait until the legislation is signed into law.
- Schedule a strategy meeting with your fractional CFO, CPA, or financial advisor.
- Collaborate with your team on your best tax strategy given the changes.
Spoiler alert: 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 – sales and marketing strategy, operations strategy, pricing strategy, exit strategy… As much as we wish we had a fleet of accountants to find every tax loophole like Amazon, 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.
If you do not have a CFO, you are missing the benefits of sound financial strategy. Schedule your free consultation with our team to discuss tax strategy or other challenges your business is facing.