By now, you have probably read the partisan arguments as to whether the GOP Unified Tax Framework is a good idea or not, but do you know what it actually means for small business owners?
You are not alone. Uncertainty exists because there aren't many details, but let's break down what we do know.
What does the GOP Unified Tax Framework Actually Say For Small Business?
The Tax Framework is just that -- a framework. Regarding small business, on page 7 out of a total of 9 pages, it says:
How Are Small Businesses Taxed Now?
To understand the impact of this plan, we first have to look at how small business is taxed now. Most small businesses such as sole proprietorships, LPs and LLCs make an S Corp election so that the profits of the small business are only taxed once. Without the S Corp election, C Corps incur what is often called "double taxation" because the profits are taxed at the corporate level and then when the profits are distributed to the owners, they are taxed again at the individual level. In contrast, there are no taxes on the profits of an S Corp at the corporate level. When those profits are passed through to the owners, they are only taxed once -- at the individual level.
By way of example, without an S Corp election, if a company has two owners and has a profit of $1,000,000, then the corporation pays taxes on the $1,000,000. For this example, let’s use the current estimated corporate tax rate of 35% or $350,000 in taxes paid by the company on the profits. Then, the remaining $650,000 is distributed to the two owners. The two owners would then pay tax on their share of the $325,000 at their taxable rate. The current estimated tax bracket for a single person who earns $325,000 is 33%. So, the owners, under this scenario, would each pay roughly another $100,000 in taxes at the individual level and net $225,000.*
If there was an S Corp election, there is no tax at the corporate level on the $1,000,000. As a result, $500,000 is distributed to each owner. The owner is then taxed at the individual level for their $500,000. The current tax rate for single individuals earning $500,000 is roughly 39%, so each owner pays about $175,000 in taxes netting $325,000.* Both owners saved more than $100,000 by making their S Corp election.
Swyft Filings can help you with your S Corp election which you can do regardless of what happens with the proposed tax changes.
How Does the Trump Tax Plan Affect Small Business Taxes?
The key part of the Republican Tax Framework for small business would tax pass-through income at 25% rather than whatever tax rate may apply to the individual business owner. Let's see how that impacts our hypothetical profitable small business. Just like before, there is no tax at the corporate level, so both owners receive a distribution of profit of $500,000. Rather than taxing the owner at his individual tax rate of 39% (the framework proposes to lower the highest individual tax rate to 35%), the owners would be taxed at 25% for their pass-through income. That means each owner pays $125,000 in taxes and nets $375,000.* The savings to each owner is $50,000 totaling $100,000 for the company.
The policy for this framework is to encourage small business ownership. Advocates argue small business owners are the ones creating jobs and growing the economy. Therefore, the small business owner is treated more favorably than the salaried individual who may make $500,000 in W-2 salary income. For example, the minimum salary for a rookie in the NBA is reportedly $543,000, but let's lower it to $500,000 for our example. Even under the Trump tax plan, the NBA rookie would pay 35% (as opposed to the current 39%) on that salary meaning he pays $175,000 -- $50,000 more than the small business owner. The supporters of the tax plan argue that our two small business owners would take their additional $100,000 in savings to hire more employees or expand their business thereby growing the economy.
While the Republican tax proposal certainly benefits the profitable small business, when the small business profits are more modest, the benefits are much less clear. For example, let's look at what happens if a business owner who made an S Corp election has profits of $75,000. Under the framework, this small business owner would also pay 25% on this pass-through income or $18,750 in taxes. Meanwhile, under existing tax laws, an individual who earns $75,000 is already in the 25% tax bracket so there would be no savings for this small business owner.
* The tax estimates are rough estimates because it is much more complex than simply applying a percentage to a total amount because it excludes any deductions and the tax brackets are staggered.