People have been talking about it for years, but it always seemed an impossible dream – just out of reach. Now it looks that it may actually happen. No, we're not talking about the new Star Trek television series. We're talking about tax reform. Here's how small business owners can prepare for tax reform.
The forces in Washington, D.C. are aligned to enact fundamental changes to the United States tax code. Because Republicans are in the majority, the tax "reform" will likely be favorable to business. Right now, that could include businesses of all sizes. The Trump Administration released a brief outline of what it wants tax reform to contain. To put it mildly, it gives businesses a "yuge" break. Here's what President Trump has proposed for business tax reform:
Regular C corporations are separate taxpaying entities that file their own taxes and have their own tax rates. For many years, the top corporate tax rate has been 35 percent. This is higher than in most countries, yet, few corporations pay this much because they take advantage of many corporate tax breaks.
Most smaller businesses are not organized as C corporations. Instead, they are pass-through entities. This includes sole proprietorships, limited liability companies, partnerships or S corporations. Profits earned (or losses incurred) by these entities are passed-through the business to the owner's individual tax returns, and they pay income tax on the profits at their individual rates. Profits earned or losses incurred by these entities are passed-through the business to the owner's individual tax returns. They pay income tax on the profits at their individual rates. Trump wants to allow owners of these entities to have their pass-through income taxed at a single 15 percent rate. This is a substantial reduction from what most pay now. Trump proposes a top 35 percent income tax rate for individual taxpayers, including employees. An employee who earns a high amount would pay a 35 percent income tax rate. If that employee was the owner of a pass-through entity, they would pay only 15 percent for the same amount. This could lead many employees to seek to form a pass-through entity to provide their services to their employer. The Trump plan does not explain how this problem would be dealt with. Presumably, there would have to be some enforcement mechanism to prevent employees from gaming the rules.
Large U.S. businesses hold nearly $2.5 trillion in foreign profits in their foreign subsidiaries. They have kept this money abroad to avoid having to pay U.S. income tax on it. Trump's plan would encourage these businesses to bring this money back to the United States. This would include a one-time tax at a special rate (one that's not yet defined).
Currently, the U.S. is almost unique in that it taxes its citizens on all the income they earn anywhere in the world. Trump wants to switch to a territorial tax system. This would tax businesses in the United States only on the income they earned in the United States. Income earned abroad would only be taxed abroad. Trump also proposes major changes for individual taxpayers, including:
It's unclear what, if any, business tax deductions would be eliminated.
It's important to remember that these are only broad-brush proposals. It's unlikely they will be fully adopted by Congress. Many tax experts think the 15 percent corporate rate is unrealistic. The 15 percent rate for pass-through entities may be unworkable, too. Still, it's too early to tell. The tax reform process is just starting. It's not likely we'll see any action on a final bill until the end of 2017 at the earliest. So, what should a business owner do right now?
Until we know more details about what final tax reform will look like, the best advice is to do nothing drastic. If the United States enacts Trump's plan, it may be a good strategy to form a C corporation to take advantage of the lower corporate rate. But don't take this expensive step until we see what the corporate tax rate will be. In the meantime, keep this in mind during 2017: There's a good possibility that taxes will be lower in 2018 and later than they are this year for most businesses. This means you'll likely save taxes by deferring as much business income as possible to 2018 and later. It's much easier to defer business income toward the end of the year. Don't forget: don't defer income from customers who you believe may have trouble paying later. Deferring taxes to future years is usually a good strategy anyway, but it looks particularly good for small business owners right now.