Although the new tax law makes a number of changes that affect businesses organized as pass-through entities, the typical small business should not expect to see significant new tax savings. The law’s small business provisions are structured in a complicated way, so business owners should be prepared to incur significant expenses to navigate the law’s numerous changes. Additionally, small businesses may see heightened competition from larger competitors who are better able to adjust their business to the new changes.
In our tax system, many businesses are not taxed at the business level, the way that corporations are. Some owners of businesses are instead assessed taxes on their profits when they pay individual income taxes; “pass-through” income refers to this sort of business income, which is returned to owners of businesses and then filed on an individual tax return. Businesses you think of as small businesses – like a local dry cleaner or family-owned catering company – are usually organized as pass-through businesses, but this tax category also includes businesses not typically thought of as small businesses, including large financial institutions (like hedge funds and private equity firms), real estate developers, and large law firms. In fact, most pass-through business income does not go to small businesses at all – 81 percent of all business profits went to the largest 1 percent of businesses (those with over $10 million in receipts).Most pass-through income flows to the very highest-income people, and from very large businesses. In fact, over half of all pass-through income is claimed by the top 1 percent of tax filers. And although only a tiny fraction (0.4 percent) of pass-through entities (also known as S-corporations) had receipts over $50 million in 2012, those businesses earned 40 percent of all S-corporation income. Higher-income people get a larger share of their total income from pass-through businesses: The top 1 percent of households get nearly a quarter of their income from pass-through businesses, compared to 5 percent for middle class families.
So, despite the fact that the law includes a new and complicated 20 percent deduction for certain types of pass-through income, that deduction is not directed at traditional small businesses. Its structure ensures that its primary benefits actually accrue to large companies and wealthy households – particularly those who are positioned to hire the best accountants and tax-planning lawyers.
How does the 20 percent deduction for pass-through income work?
The tax law includes a provision that will allow eligible owners of S-corporations to take a 20 percent deduction on their income. In other words, if you are eligible, you can reduce your taxable business income by 20 percent. However, there are complicated eligibility requirements for individuals to use that deduction – the biggest is that their income must generally fall into a “qualified” category. This category, in turn, is defined as any income that is not 1) wage income, or 2) profits from any business listed in the law as a “specified service trade or business.” The list of service trade or businesses – whose profits are not eligible for this deduction – includes the fields of health, law, and athletics. Eligibility also depends on the taxpayer’s taxable income: If a taxpayer’s taxable income is below a certain threshold, then they may still be able to claim the deduction even if they are in one of the industries excluded from the benefit, depending on what types of other income they receive. Given the complicated restrictions for eligibility for this deduction, many small business owners will have to invest a considerable amount of time and money into figuring out whether or not they are eligible for the deduction.
The rules are complex, and it is hard to find any underlying logic in them. For example, independent contractors and partners benefit, but not employees; the owner of hospital real estate can claim the deduction, but not the doctor working in the building. Because of the structure of the deduction, the windfall is automatically available to owners of certain types of firms that employ no workers and pay no wages but rather simply own certain types of favored property. Tax planners can receive significant tax benefits by re-characterizing wage and salary income as pass-through income.Even the law’s so-called “guardrails” against abuse are complicated: Taxpayers are asked a series of questions, each of which can disqualify them from eligibility for the deduction. So, taxpayers will face a strong incentive to answer these questions strategically, to fit as much of their income into the favored category.
The structure of the deduction is likely to entice many unscrupulous taxpayers – aided by well-compensated lawyers and professional accountants – to work to place themselves on the tax-saving side of each line. And, high-income individuals will be able to use this deduction to reduce their top tax rate – provided that they are able to shoehorn their income into a “qualified” category. Since each dollar of pass-through income that’s deducted is worth more for high-income people (a deduction reduces taxable income and because high-income people face higher marginal tax rates, the same dollar deduction results in greater tax savings for them than for someone in a lower tax bracket, with a lower marginal rate), they are more incentivized to do just that.
All of this will invite plenty of avoidance opportunities for individuals with good accountants and is further likely to result in a massive restructuring of employment and service arrangements. Meanwhile, the United States Treasury and IRS – understaffed and overworked, trying to implement this new law in a matter of weeks – are unlikely to be able to ensure meaningful protection against even egregious abuse. For this reason, one prominent group of tax law professors recently wrote that they “expect 2018 to be something of a ‘wild west’ for well-advised taxpayers and their advisors.”
Other parts of the tax law could inhibit small businesses’ competitiveness
The law includes the enactment of a “territorial” corporate tax system, which gives foreign corporate earnings preferential treatment over domestic corporate earnings and creates incentives to off-shore business operations and income. This provision will allow large, multinational corporations to funnel their profits to tax shelters and other low-tax foreign jurisdictions – something that most small businesses are unable to do. As a result, taxpayers with international operations will have access to new loopholes, providing them with a significant tax advantage over domestic corporations and small businesses – and creating an even more unequal playing field for true small businesses.
The tax law also creates uncertainty for small businesses looking ahead. Although the tax law makes its deep corporate rate cuts permanent, almost all of the changes to the individual code, including those affecting pass-through entities and small businesses, expire after 2025. The law is also poised to add at least $1.5 trillion to budget deficits, which could increase the risks that policymakers will cut investments in areas important to small businesses, like infrastructure and education, to make up the difference.