The law gives many sole proprietors, partnerships and S corporations a tax cut by taxing some of their business income at a lower rate.
Furthermore, even as you read this, Senate Republicans work on a similar tax reform package.
If you run a small business, therefore, you want to understand the new tax cut’s math and rules.
Reviewing the Tax Cut Math
The pass-through entity tax cut works like this: Some business income that would otherwise be taxed under the new law at a marginal rate of 35% or 39.6% gets taxed at only 25%.
If your small business makes, say, $1,000,000, you might pay a top tax rate equal to 39.6%.
Under the new law, however, if your business looks a certain way, you get to take 30% of that $1,000,000 (or $300,000) and pay a 25% tax rate rather than that 39.6% tax rate.
The savings in this example run about $43,800.
The 30% Default Applies Only to Some Businesses
The lower 25% tax rate only applies to some businesses, unfortunately.
Most professional service businesses, for example, can’t use the lower 25% tax rate.
Probably, and here things get a little murky, small service businesses also can’t use the lower 25% tax rate.
The proposed law uses another older chunk of tax law, Internal Revenue Code section 1202, to identify which sorts of businesses cannot use the new 25% tax rate. Here’s the relevant language:
(3) Qualified trade or business For purposes of this subsection, the term “qualified trade or business” means any trade or business other than—
(A) any trade or business involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of 1 or more of its employees
The first part of this chunk of tax law pretty explicitly prohibits traditional white-collar professional service firms, performing artists like musicians and actors, and then also athletes from using the 25% tax rate.
But then where the prohibition gets murky is with the last part of the definition that references trades or businesses where the principal asset is the reputation or skill of one or more of the firm’s employees.
Small businesses will need to wait and see what the “reputation or skill of one or more employees“ means in practice. For now, however, I think you assume small service businesses won’t be able to use the 25% tax rate.
My thinking here? How can a small business with a handful of employees and an active owner or two not reflect a situation where the principal asset is the reputation or skill of the owner or owners?
But All Passive Investors Get to Use the 25%
A quick point: You do get to use the 25% tax rate for income (all the income) from a passive investment in a business operated as a partnership or S corporation, as well as a passive investment in real estate.
In other words, if you own an interest in an active trade or business and you don’t actively participate (and so count as a passive investor), you shouldn’t have to pay more than the 25% tax rate on any profits you earn from the business.
Similarly, if you own passive real estate investments, you shouldn’t have to pay more than the 25% tax rate on any profits you earn from the real estate.
Note: The well-known and long-established material participation rules of Sec. 469 determine whether you’re passive or not when it comes to an investment in a business. And usually real estate investment counts as a passive activity.
Alternative Percentage Rule Available
That 30% figure I’ve tossed around a few times? The Tax Cuts and Jobs Act calls that the “capital percentage.”
This capital percentage identifies the percentage of the income that the law assumes stems from the capital invested in the business or investment rather than the labor contributed by the owners.
Business owners have the option, however, of calculating their own capital percentage in some cases based on the actual capital invested in the business.
To calculate an alternative capital percentage of the income, you first need to calculate something the law calls a deemed rate of return, which equals the federal short-term interest rate plus 7 percentage points.
As of November 2017, for example, the Federal short-term interest rate equals 1.38%, so the deemed rate of return equals 8.38%. (1.38% plus 7% equals 8.38%.)
You also need to total up the depreciable property used in the business as of the end of the tax year.
Then you multiply the total depreciable property by the deemed rate of return.
Here’s an example of how this works. Say your business holds $100,000 of depreciable property at the end of the year and the deemed rate of return equals 8.38%.
In this case, the alternative capital percentage of the income equals $8,380. And that’s the amount the business owner doesn’t need to pay more than a 25% tax on.
Two other wrinkles to mention here: First, if a pass-through business decides to use the alternative capital percentage approach, the election is a five year decision.
Second, a service business otherwise prohibited from using the 25% tax rate may be able to use the alternative capital percentage approach. But there’s a catch. The service business which can’t use the 30% default capital percentage can use the alternative percentage only if at least 10% of the business’s income counts as the capital percentage.
If $8,380 represents the alternative capital percentage for your own service business, for example, you use the 25% tax rate for that $8,380 chunk of income if the total business income equals no more than $83,800.
A general comment: In my back-of-the-envelope calculations, I don’t think many service businesses will get the alternative capital percentage math to work. Sorry.
A “Smaller” Small Business Version of the Tax Cut
The proposed new law provides five tax rates: 0%, 12%, 25%, 35% and 39.6%.
You need basically a six figure income in order to pay a tax rate higher than 25% on your business income. Under the new law, therefore, most individuals pay a top income tax rate of either 12% or 25%.
This means paying a 25% tax rate on, say, 30% of your business income usually will not produce any tax cut for a small business owner.
To deal with this reality, the proposed law creates a set of complicated, phased-in-over-time formulas that let small business owners pay slightly lower tax rates on income that would otherwise be taxed at the standard new 12% or 25% tax rate.
I really don’t want to get into the details, but I fear I must, so here goes…
If you’re married, under the new law the first $75,000 of business income you earn gets taxed at 9% rather than the “usual” 12%. (For unmarried business owners, only the first $37,500 gets taxed at that lower rate.)
But then, as your income rises up past the 25% tax rate bracket into the 35% bracket, you lose that low 9% rate.
For example, for a married person, as the family’s taxable income rises from $150,000 to $225,000, the 9% tax rate gets phased out.
Further complicating all this, you don’t actually get the low 9% rate immediately. Rather, the law phases in the rate over the next few years: 11% in 2018 and 2019, 10% in 2020 and 2021 and then (finally) the 9% in 2022.
If all this seems like a messy afterthought, know that it was. (This part of the law didn’t get jammed into the statute until the second public draft.)
But you can take a big picture approach here… just know that though the 25% tax rate probably won’t apply to your small business, you probably will still get a slightly lower rate on some of your business income. Eventually…
S Corporation Tax Gambit Still Works
One final thing to talk about with regard to the proposed pass-through entity tax cut rules.
Many tax accountants, me included, read the first draft of the proposed law and assumed that the non-capital percentage amount— typically that 70% of the business income except for when it’s 100%—would be subject to payroll taxes: Social Security taxes, Medicare taxes, self-employment taxes and the Obamacare surtax.
That tax treatment would have, essentially, killed off the S corporation option for small businesses.
With the second draft of the proposed law, I now think the S corporation tax planning gambit still works and that House Republicans don’t intend this tax law change to scramble the way that payroll taxes work for Subchapter S corporations, a conclusion based on both the language of the second draft and this statement from the Ways and Means Committee’s summary of their law:
The provision does not change the current-law payroll tax treatment of amounts earned through pass-through entities.
However, you do want to confer with your tax adviser… and gosh stay alert to any changes.
You really want to handle the shareholder salary thing in a thoughtful manner.
Set the shareholder-employee salaries smartly, for example, and you should be able to save thousands per year per shareholder.
Set the wrong salary and you either miss savings or bear extra audit risk.
Enough said, but if you’re interested? Take a look at our downloadable ebook, “Setting Low Salaries for S Corporations“. And now let’s finish up our discussion about the “Tax Cuts and Jobs Act” law…
What Do You Do With This Information?
Probably nothing at this point and for a couple reasons…
First, guessing whether or not the legislation becomes law? Gosh, who knows… (I predict the law won’t pass. And even if it does, the House version changes the law for 2018 and not for 2017.)
Second, we really need the details concretely fleshed out in order to plan for the new law or to prepare tax returns.
Third, finally, you want to know that the Senate is taking a different (and probably better?) approach to providing a tax cut to small business owners. (The Senate version of the pass-through entity tax cut provides eligible pass-through businesses with a simple deduction equal to 17.4% of their business income.)
P.S. This week is Thanksgiving of course! So let me wish you, your family and your friends a Happy Thanksgiving!
Other Resources You May Want:
The actual current Tax Cuts and Jobs Act law (as of the time I’m posting this)
How much tax can an S corporation save its owners (a primer at our S Corporations Explained website)