Jan 5, 2023 — Accounting — Eric Giguere
The House Democrats released their tax proposal with big headlines about increasing taxes on the rich and big corporations. If you've read my articles, you know that I care more about small businesses than big corporations. They are where they should be in relation to the changes to the tax code. What is the impact of tax reform on them? Some small businesses will benefit from the proposed changes. These are the winners and losers of this tax proposal.
Companies earning less than $5 Million
Currently corporations are federally taxed at a flat rate of 21 percent of adjusted net income. The House would create three new tax brackets in order to tax corporations.
This proposal will allow small corporations to receive a tax decrease, which could result in up to $12,000 savings in tax expenses. Although not very significant, it is still quite acceptable.
Small businesses compete against foreign companies
A substantial portion of the tax package is designed to close loopholes that allow foreign entities to deduct taxes from domestic entities. A level playing field will be beneficial for small businesses who cannot afford international operations. They can compete with larger foreign tax burdens.
Anyone waiting for the IRS
The proposal contains $79 billion more IRS funding to enforce new provisions. This is more than sixfold the 2021 budget.
Entrepreneurs and libertarians cringe at having more IRS bureaucrats issue audits and investigate tax filings. But there's a downside to the current low IRS staffing. It can lead to slow responses, bad customer service, delayed refunds, and poor customer service.
There have been many instances where accounting departments have not been able to file time-sensitive and basic forms, such as changes in entity tax elections. It has taken them up to 10 months to receive a response from IRS. It is difficult to contact IRS customer care right now. After three hours on hold, their 800 number automatically hangs up. The worst thing is that most small businesses still wait for their 2020 income taxes returns five months after filing.
It is hoped that more IRS funding will result in more IRS staff processing refunds, filings, or business negotiations quicker.
In general, the more profit you earn the more you stand to lose from tax reform. Here's a list naming the losers of the House's current tax proposal.
Corporations that earn more than $5,000,000 per year
High-income businesses are now facing a 26.5 percent increase in their income. In fact, if you earn more than $10 million per year, you will have all your income taxed at 26.5 percent rather than just your incremental income.
Pass Through entities earning more $400,000 or more per year
The tax reforms have three major headwinds for S-corps, partnerships, as well as sole proprietors who earn high incomes. The highest tax bracket for personal income taxes will be raised from 37 to 39.6 percent. This affects pass through entities like partnerships, sole proprietors, and Scorps.
The second is that the threshold for this bracket will be lower, which will mean that new earners will suddenly be eligible to the top tax bracket. Individual bracket limits will fall to $400,000, from $523,000, and marriage filing jointly will fall to $450,000, from $628,000.
High-income pass-through businesses will be excluded from the qualified income deduction. QBID, also known as the pass through tax deduction, is a deduction that can be applied up to 20% of your income. QBID rules are complicated. They include phase-outs that apply to businesses with higher incomes, greater business activity, and what year. It is hard to assess your tax return and determine how much your QBID has helped your business.
Proposed tax reform eliminates the QBDI for those earning more $500,000 per year together or $400,000 for a single individual. Talk to your CFO fractional or CPA about how this could affect you.
Business owners who sell assets or businesses
The long-term capital gains tax rate, which applies to most businesses, would increase from 20 to 25%. This has a large impact on businesses that buy and sell appreciating assets like real estate, collectables, stocks, and even the business itself.
In actuality, section 1202, which is the most popular means to avoid capital gains tax, has been weakened by the tax reforms. The gains exclusion would be reduced from 100 percent to 50%, and additional capital gains taxes per transaction could reach $5 million annually.
Persons with a lot of money in retirement accounts
The new tax legislation seeks to limit the use of qualified retirement accounts, like IRAs and Roth IRAs, based on the total amount of money someone has in such accounts.
House Democrats and the Biden Administration have targeted high-income businesses and business owners with these reforms. Although there are some benefits in the legislation, in aggregate, the House's proposed tax changes would be a burden on high-income small businesses.
These terms are currently being actively negotiated by Congress. Don't get too excited. It is possible that none of this will occur. Here's my recommendation to small-business owners facing the prospect of high tax liabilities:
The reality is that most small businesses will not make any changes in light of the new tax structure. There are many business elements that have more impact on cashflow than your tax strategy. These include your sales and marketing strategies, pricing strategies, exit strategies, and operations strategy. Even though we wish we could hire a whole team of corporate accountants to help find every tax loophole we can, that's not realistic for small businesses. You can do your homework, work together with your finance team, but you must remain focused on the essentials in order to succeed.