Small businesses are a driving economic force in the United States, with nearly 32 million firms (including sole proprietors) employing almost half of the nation’s private workforce (Small Business Administration).
While there has been considerable focus on increasing the corporate tax rate, most small businesses are structured as pass-through businesses and are not subject to the corporate rate. However, there are several ways that small businesses may be impacted by the recent House Ways and Means Committee tax proposals.
Small-business impact
Source: Small Business Administration, 2020. Small businesses defined as having fewer than 500 employees.
Higher tax rates may impact certain pass-through businesses
Most small businesses are S corps, LLCs, partnerships, or sole proprietorships, and are structured as pass-through entities. Net income generated from these businesses flows-through to the owner’s individual tax return. Under the current House proposal, higher-income business owners would face a top marginal tax rate of 39.6% instead of the current 37% tax rate. Under the proposal, the top rate would apply to those with more than $400,000 in taxable income ($450,000 for married couples filing a joint return). The higher rate would apply to taxable years beginning after December 31, 2021.
The 3.8% surtax to include “active” business income
For nearly a decade, higher-income taxpayers have been subject to a 3.8% surtax on net investment income including, for example, interest from investments, capital gains, dividend income, rental income, royalties, and income from a business activity where the taxpayer is not considered an “active” participant. Under the current rules, income received by an individual who is actively participating in the business as defined by the tax code is not subject to the 3.8% surtax. The new proposal would modify this to impose the surtax on net investment income derived in the ordinary course of a trade or business.* This provision would apply to those with modified adjusted gross income exceeding $400,000 ($500,000 for couples) and is effective for taxable years beginning after December 31, 2021.
* The proposal would ensure that all pass-through business income of high-income taxpayers is subject to either the net investment income tax (NIIT) or self-employment tax.
Limits on the deduction for qualified business income (QBI)
The Tax Cuts and Jobs Act (TCJA) introduced a provision in the tax code which provides a 20% deduction for certain taxpayers receiving income from pass-through businesses depending on the nature of the business and their income. The current House proposal would set additional limits on claiming that deduction by limiting the amount of the total deduction to $400,000 for an individual tax return and $500,000 for a joint return. Note there are some other proposals being discussed in Congress, including the Small Business Tax Fairness Act, that would disallow the QBI deduction for taxpayers with income exceeding $400,000.
Restrictions on certain wealth transfer strategies
Since the House proposal calls for reducing the lifetime gift and estate tax exclusion from almost $12 million per person to roughly $6 million beginning in 2022, those holding a significant portion of their net worth in closely held business interests may need to review their current estate plans. There are a number of advanced strategies available to taxpayers to transfer closely held business interests tax-efficiently with respect to estate and gifts taxes, and potentially to income taxes. For instance, applying valuation discounts when transferring shares of a closely held business to the next generation. For example, the IRS allows a “lack of control” discount when minority interest shares of a business are transferred. The lower the business ownership shares are valued, the greater the number of shares can be transferred under the existing gift tax rules. Another strategy involves selling appreciated shares of a closely held business to an intentionally defective grantor trust in exchange for a long-term promissory note. There are generally no capital gains realized on the sale of the assets to the trust, and transfer of assets to the trust removes them from the grantor’s taxable estate.
The House proposal targets both of these strategies. First, valuation discounts would no longer apply to non-business assets, defined as passive assets that are held for the production of income and not used in the active conduct of a trade or business. Passive assets may include investment securities held by the business, for example. Valuation discounts would still be available for assets that are utilized during the normal course of operating the business. Lastly, the proposal would also, for example, consider the sale of assets to a grantor trust a taxable event if the grantor is deemed an owner of the assets. The effective date for both of these proposals is after the date of enactment, which means when the bill is signed into law.
House plans underscore the need for tax planning
The House proposals, and the larger debate to follow on budget reconciliation, could result in higher taxes for businesses. There are many ways that smaller businesses could face higher tax liabilities if these measures are approved. As with all policy developments, it’s important to monitor potential changes and discuss the impact on financial plans and tax-smart planning with a professional advisor or tax expert.
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