The devil is in the small business tax reform details

Jim Blasingame

While striving mightily to make a profit, the following facts cause small business owners to regularly ask the proverbial question: “What’s wrong with this picture?”

  • Profit is essentially what’s left after a business reconciles expenses against revenue.
  • The IRS renames profit income, taxes it, and then insists on being paid in cash.
  • But profit is not cash. Nor does it become cash when it’s renamed.
  • Much of a small business’s profit looks like inventory, receivables, and other illiquid assets.
  • So the thing that gives rise to a tax bill cannot be used to pay it, resulting in Phantom Income.
  • Phantom Income occurs when an event – like making a profit – produces a tax bill without producing the cash to pay it.

The foregoing dramatizes what’s at stake for small businesses as the government goes about “reforming” the income tax code. I started getting twitchy about the Republican plan several months ago (see my March 30 column) when they mentioned creating a new tax level for small businesses. Here’s why.

When structured as a legal entity, most small businesses are structured as a Sub S Corp or a Limited Liability Company (LLC). There are many distinctions between these and a C Corp, the apex legal business entity used mostly by big business, but the most important one is how the two are taxed. Unlike a C Corp, which actually pays taxes, an S Corp and LLC “pass through” profits as taxable income to the owners. When aggregated with the shareholder’s personal income – salary, rent, etc. – that total is taxed at the personal rate.

Not all of the details have been released on the new proposal. But it seems that Sub S Corps and LLCs will no longer be “pass-through entities,” since that separate tax level being considered will be calculated on their profits. Here’s half of the language on this part of the reform House Republicans released this week:

“The framework limits the maximum tax rate applied to the business income of small businesses … to 25%.” Apparently, there will be two lower levels.

Please note that the newly announced C Corp top number is 20%, one-fifth lower than the new small business rate. My unabashed, unapologetic, and unrepentant bias toward small business is well earned. But only in Bizarro World is it appropriate to establish the first small business tax rate higher than the new top rate of major corporations, regardless of the income number eventually applied to that percentage.

But there’s a second sentence in that release that could be even more perilous, if not more expensive: “The committees will adopt measures to prevent the recharacterization of personal income into business income to prevent wealthy individuals from avoiding the top personal tax rate.”

If that doesn’t make you twitch, consider this small business fact: A small business owner can allocate income within the business. For example, there’s leeway to adjust salary and distributions. They can also adjust the rent charged by the company to lease the property from the owner, within market comparables. So projecting the implications of this language out a couple of steps, I have to ask two questions:

  1. How does this not turn into the IRS having even greater license to scrutinize the decisions small business owners make?
  2. Who the hell-bent-for-reform gets to define a “wealthy individual?”

Small businesses create half of the U.S. economy, sign the front of half of the private sector paychecks, and are planted in the ground on Main Street. If the tax writers need to balance their cuts, by Godfrey don’t do it on the backs of the heroes of the American economy.  Cut that top rate to 20%.

Oh, and that “recharacterization” crack sounds like it came from Elizabeth Warren or Bernie Sanders.

Write this on a rock ... Making the new small business tax rate higher than the top big business rate is bad economics, bad policy, and bad politics.

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