Pity the tax accountant. Year end is always a hectic time for them, but this year it has risen to a whole new level. The major tax reform bill that was signed in December 2017 by President Trump has caused a frenzy for those who tax plan. While many individuals pre-paid their real estate taxes, charitable contributions, and other state taxes to gain a tax advantage, many small business owners wondered what might be in store for them.
The big news was the announcement that corporate taxes would be reduced from 35% to 21%. But as most small business owners know, this did not apply to them—since about 94% of all businesses in the United States are “pass-through” businesses and, as such, ineligible for what amounts to be a 40% tax cut for large corporations. While the typical small business will not enjoy a huge tax cut, most will see a modest deduction in their 2018 tax liability.
Pass-through businesses—most often “S” Corporations—pay taxes on their net profits at the rate of the individual shareholders. Tax reform allows these businesses to deduct as much as 20% from their net profits for tax purposes. The deduction is limited to a figure equal to 50% of payroll.
Let’s consider the financial metrics of a theoretical small business owner:
- $3,000,000 in sales
- $300,000 in net profit
- $150,000 in payroll
Before tax reform, the business owner would pay individual income taxes on the $300,000 their company earned. Under the new law, up to 50% of payroll ($75,000) could be deducted from the $300,000 of net profit, as long as it does not exceed 20% of net profits. In our example, this would be $60,000. The reportable income in this case would be $240,000 as opposed to $300,000 prior to tax reform.
Clearly, most small businesses will see a tax advantage. While many will see a 20% deduction in net income from business operations, all will see an additional decrease given that individual tax rates have also been reduced.
Will these tax cuts cause small businesses to give increases to their employees or add to staff? Or will this be the time to reduce debt or save for retirement? What does this mean for our ever-increasing national debt? These are political questions that will only be answered in time. As for the present, it is clear that tax obligations for the small business owner, while not comparable to large businesses, will see tax relief—for now.