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Potential Tax Reform & Its Impact on Small Business

The White House announced its tax reform plan on Wednesday, April 26, 2017, by releasing a breakdown of the key points of the plan in what is likely to be the opening bid of a long negotiation process.

Of particular note for our business clients is the aggressive cut in corporate tax rates to 15 percent from the current 35 percent. Since the last major tax reform in 1986, establishing businesses as “pass-throughs” (those formed as S-corporations, partnerships and limited liability companies) has become increasingly popular for entrepreneurs, since it typically gives them lower tax rates than paying the corporate rate. Under the current proposal, not only would the 15 percent rate apply to C-corporations but also to “pass-through” businesses. These businesses’ incomes are “passed through” to owners who pay taxes based on the individual income rates, currently ranging from 10 percent to 39.6 percent. The proposal reduces the seven individual tax brackets to three tax brackets of 10 percent, 25 percent and 35 percent.

As currently proposed, owners of “pass-through” entities would still accrue the income of their businesses. What’s new is business income will be taxed separately at the newly reduced, single rate paid on all business income, rather than at the personal rate of the owners.

By allowing small business owners of “pass-through” entities to pay a lower business tax rate (in a separate calculation from their personal income), they will have more working capital to invest in the business. However, with the single 15 percent rate, many business owners may want more of their income as business income taxed at the new low rate — rather than the higher individual rates — increasing potential for abuse. For example, employees may want to be released from employment contracts and be rehired for services through a “pass-through” business they create, since salaries are likely to be taxed higher than consulting revenue.

The White House has not disclosed how it plans to address potential abuse of this bifurcated structure, though it is likely the issue will receive significant attention in the legislative process and potentially lead to a new regulatory scheme that business owners will comply with when trying to take advantage of the new structure.

Throughout the month of May, the Trump administration will hold listening sessions with stakeholders to receive input. To see the 2017 Tax Reform for Economic Growth and American Jobs fact sheet, click here.

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