I am a business owner.  I can tell you with 100% certainty that if the government cuts my taxes I’m going to invest more in my business.  That means hiring more people.  Creating jobs and providing more income to the middle class are the main reasons why Congress is considering updating the tax code.

There’s just one problem: I’m not convinced this plan is going to cut taxes for small business owners.

The proposed 25% tax rate excludes at least 20 million small businesses

The bill is considering a 25% corporate tax rate that also applies to pass-through business owners.  That means instead of paying taxes on my corporate profits as personal income, I’m paying the same rate as businesses.  The current business rate is 35%, so I get a 10% tax reduction, correct?  Nope.  I’m not a C-Corp – typically larger firms that pay corporate taxes and are subject to double-taxation.  I’m an LLC.  While I avoid the double taxation, I am required to pay personal rates as high at 39.6% on my corporate profits as well as both the employee and employer portion of payroll taxes on any salary I pay myself.

We have to compare the 25% tax rate to the real rate pass-through business owners are paying.  According to the Small Business Association, there are approximately 28 million small businesses.  73% of them – about 20 million – are sole proprietors.  Those sole proprietors pay an effective tax rate of only 13.3%  Why?  They don’t make a lot of money.  According to 2016 tax tables, a business would need to generate at least $91,151 of profit to get the benefit of a 25% tax rate.  At least 20 million sole proprietors, and probably a couple million other small businesses, will get no benefit from this new rate.

There’s a formula that could raise taxes on business owners with profits greater than $91,000 per year

There’s a provision that could raise taxes for those firms that are making over $91,000 per year.  The new plan is said to contain a formula that ensures business owners will pay a higher individual tax rate on income they receive as wages.  This is to prevent people from incorporating just to avoid taxes.  Right now, there is no guidance on how much income a business owner takes out as W-2 wages vs. profits.  We know we have to pay ourselves something or we run into problems with the government.  The problem is that our wages (what we report on a W2 statement) are subject to the full 15.3% payroll tax – the employee and employer portion of our pay.  We minimize our wages to avoid this tax.  If the bill changes to where a formula mandates a certain percentage of profits be paid as wages, then the payroll taxes will go up, potentially negating the benefit of the tax on pass-through income.

 This bill could actually curtail small business job growth

The real problem here is that this bill could curtail small business job growth.  According to the US Small Business Administration, small businesses account for 64% of all new private sector jobs.  When I examine provisions such as the loss of mortgage interest and state and local tax deductions I can see business owners being further squeezed by the loss of personal deductions.  This impact is felt most in high-cost, high-tax states like New York, New Jersey and California.  These states contribute much to the economy – and the US Treasury.  If job growth slows in those states tax receipts will be down.  These states are also the largest net exporters of federal tax dollars – they send in more than they receive back.

 Capitalism needs the middle class to spend more

I am a capitalist.  Capitalism doesn’t care about income redistribution or fairness.  It cares about demand and growth.  The central theme of this new tax plan is middle-class tax relief.  At least 20 million business owners are in this class.  Know why we need a vibrant middle class?  To spend money to keep the economy going.  Personal consumption accounts for about 70% of US Gross Domestic Product – about $12.8 trillion in 2016.  There are 126 million households in the US. Each household must spend at least $101,587 just to maintain zero growth (which nobody wants).  Household income in 2016 was a record $59,039.  See the problem?  Each household needs to spend $40,000 more per year than it earns.

I’m all for lower taxes.  In its current form, I don’t see this plan lowering my taxes.  In fact, I possibly see them going up.

Keep an eye on this one.

By Rob Ripp, Founder and President of Fintelligent. Fintelligent provides virtual CFO, Controller and Bookkeeping services to fast growing companies in New Jersey, New York and Philadelphia.

Sources:
1. New tax bill proposed by House of Representatives
2. US Small Business Administration Frequently Asked Questions
3. The New York Times, Republican Plan Delivers Permanent Corporate Tax Cut, Nov. 2, 2017
4. Here’s How Much Each State Contributes to US Economy
5. Components of GDP
6. US Number of Households
7. US Household Incomes