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It has been called the largest overhaul to the US taxation system since its inception, however, whereas the clearly named Tax Cuts and Jobs Act has made far-reaching changes to the way tax will be administered, will it lead to financial losses or gains for small businesses?
There have been many nervous entrepreneurs awaiting the final decisions on what the act would contain, now it has been passed what does the act mean for business owners across the USA?
It has been promised to be an act which would support business. As Donald Trump stated, "my administration will work tirelessly to make good on our promise to the working people who built our nation and deliver historic tax cuts and reforms — the rocket fuel our economy needs to soar higher than ever before." It now seems President Trump has kept his promise but at a price, House Ways and Means Committee Chair Kevin Brady, the author of the tax bill, said it would add $1.51 trillion to the federal deficit over the next 10 years. The expectation is this would be outweighed by increased profits from corporations and an overall increase in the US economy.
Who actually drives the American economy?
It would be simple to think the lion's share of the US economy was driven by large corporate entities and massive multinationals and therefore tax advantages would be made solely in their favor, however, this is not the case. Small businesses make up 99.9 percent of our country’s enterprises and employ almost 58 million people – almost half of all workers nationwide. With this in mind it is clear small businesses are a vital part of the economy.
One of the most important aspects of the new tax reforms directly affects these small businesses in terms of changes to taxation for pass-through businesses.
What is a pass-through entity?
Pass through businesses make up the vast majority of all businesses in the US. In 2014, out of the 30.8 million private businesses in the United States, 28.3 million were pass-through businesses. The pie chart below, produced by the Tax Foundation, shows that the proposed tax rate changes will, therefore, benefit the majority of US businesses.
Pass-through businesses are sole proprietor companies (an unincorporated business owned by a single individual), unincorporated partnerships, limited liability companies and ‘S’ corporations (domestic corporations which can be owned only by U.S. citizens and can only have up to 100 shareholders).
Traditional ‘C’ corporations pay their tax through corporate income tax and the owners and shareholders are then taxed again on the income when they receive dividends or sell their stock. Pass-through organizations are required to pay their full tax on any business income in the year the business earns it as opposed to being able to spread the tax burdens as C corporations may. However, they avoid the double taxation firstly on the corporation and then on their earned income, the business income passes directly to the owner. The crucial tax point related to pass-through businesses is their business income is taxed solely on the business owners tax returns as opposed to being charged additionally as corporation tax.
One of the main drivers for tax reform has been to allow the US to remain competitive and to grow the economy. In the past, tax reforms have concentrated on improving the corporate tax rate, and again in the latest act, the rate has been cut from 35% to just 20%. As useful as this was for larger organizations it did not support smaller businesses, this is why the pass-through rate changes are so vital.
The Joint Committee on Taxation of the U.S. Congress analysis shows the expected effect of the new taxation scheme will be an annual average increase of gross domestic product of 0.8% during the 2018-2027 period relative to the CBO baseline forecast, due to an increase in labor supply and business investment.
The latest tax reform has introduced a single 25% tax rate for pass-through business profits regardless of the income level as opposed to individual tax rates. This is a benefit for all but the smallest organizations who would have been paying up to almost forty percent (39.6%) with the previous highest pass-through tax rate. It adds up to a welcome $1.1 trillion in net tax benefits for small businesses and entrepreneurs.
It is expected the changes in taxation will clearly boost confidence within the business community. A CNBC/SurveyMonkey Small Business Survey undertaken earlier in the year showed a quarter of small-business owners felt that taxes were the most critical issue facing their business. 42% believed that changes to the tax policy will have a positive effect on their business.
Changes to tax brackets
President Trump also called for a simplification of the tax code system, reducing the brackets from seven to four as well as reducing the tax rates. The downside is there are fewer deductions allowable under the new tax scheme.
In real terms it means that in 2019, 9% of taxpayers will end up paying more than under current tax scheme, increasing to 12% in 2025, and 50% in 2027. This is mostly driven by reduced benefits, including lower health care subsidies, the new tax law means up to 13 million fewer people will be covered with public health insurance and Medicare cuts of up to $25 billion annually.
Updated Tax Brackets
12% $0 - $89,999
25% $90,000 - $259,999
35% $260,000 - $1 Million
39.6% > $1 Million
The 28% and 33% tax brackets have been eliminated in the new tax system, additionally the highest rate now is only applied for incomes greater than $1 million as opposed to $480,050 as in the previous system.
In order to avoid raising taxes for those individuals currently in the 10% tax bracket, the standard deduction for all taxes would increase to $12,000 for individuals (up from $6,350) and $24,000 for married couples (up from $12,700). This may look attractive, however many of the personal deductions have been removed. Therefore, the student-loan-interest deduction, medical-expense deduction, moving deduction and alimony-payment deductions have all been eliminated. Depending on personal circumstances individuals may have a lower tax bracket but still end up out of pocket.
The Committee for a Responsible Federal Budget (CRFB) stated whereas individual tax changes (increases and decreases) nearly offset with tax cuts of $3.3 trillion being almost matched by separate tax increases of $3.1 trillion, leading to a $200 billion, real term tax cut. However, business taxes will be significantly reduced over the coming ten years under the new tax law. There are planned business tax cuts of $2.4 trillion (with the reduction of corporate and pass-through tax rates). This will be partially offset by business tax increases of $1.3 trillion, a net $1.1 trillion tax cut. Business owners receive five times the total tax cuts as opposed to employed individuals.
It is yet to be seen if the new tax law does give business and the economy the boost it requires.
Of course each business is different, the full act runs to hundreds of pages and includes many different aspects. If you need more than a simple overview you should speak with a qualified tax advisor who can guide you through the maze of taxation and ease the stress of your financial process!