Here's why small businesses will love Trump's tax plan
President Trump is ready to take on tax reform, and his plan is sure to win over the hearts and minds of small business owners.
Small business owners have been clamoring for similar tax treatment to corporations for decades, to no avail. But under the tax overhaul proposed by President Donald Trump on Wednesday, it seems that may be about to change.
The vast majority of American business entities are small businesses. How vast? According to 2012 U.S. Census Bureau data, businesses with fewer than 20 workers made up 89.6 percent of American businesses, and firms with fewer than 500 workers described 99.7 percent of businesses. Accordingly, most American businesses aren't that concerned with the corporate tax rate of 36 percent and the lip service paid by politicians to reduce it.
Instead, most American firms are structured as pass-through entities, such as S-corporations, partnerships and limited liability corporations (LLCs). These types of companies do not pay federal taxes at the corporate tax rate, but rather pass along profits and losses to their shareholders -- in many cases, the business owners themselves -- who are then taxed at the individual rate.
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So for millions of American business owners, dropping the corporate tax rate -- something both President Trump and Treasury Secretary Steve Mnuchin have long championed -- is much ado about nothing, leaving most small business owners feeling lukewarm about the President's promises to alter the tax code.
Until Wednesday, that is.
The current top personal tax rate, which is how these entities are taxed, is 39.6 percent. The President has proposed cutting the rate for pass-throughs to 15 percent, which would be a massive windfall for small business owners. Just how substantial? According to the Wall Street Journal, the upside is great, particularly if pass-throughs utilize some creative accounting tactics.
"Say a business owner has net income of $1 million a year from a partnership, plus substantial other income. Currently the top tax rate on the $1 million is 39.6 percent, or $396,000, whether the income is wages paid by the partnership or business income," writes Laura Saunders. "But if the rate on pass-through business income is cut to 15 percent, and the top rate on the owner's compensation is 37 percent, some owners could try to lower their reported wages to bring their income-tax rate down. The owner with $1 million could split that net income into a $50,000 salary and $950,000 in business income. The income tax bill would then drop by more than 59 percent to $161,000."
It's not hard to imagine that plan becoming very popular with small business owners. Congress, however, could be a different story.
The Journal also says that cutting the pass-through rate to 15 percent would add more than $1 trillion to the 10-year cost of any tax plan. And the challenges created by policing individuals from converting higher-taxed wages into lower-taxed business profits, both from a legislative language perspective and an enforcement perspective with the limited resources of the IRS, would be near impossible. That means more debt on the ledger, which isn't likely to make the House any friends come mid-term election time.
The Trump Administration counters that critique by saying that these cuts will be deficit neutral, with individuals enjoying economic growth stemming from these cuts and reinvesting that windfall into the economy, an argument that Mnuchin delivered at a Wednesday press briefing announcing the plan.
"We believe we can get back to 3 percent or higher GDP that is sustainable in this country," Secretary Mnuchin told the White House press corps. "The overall economic plan consists of massive tax cuts and tax reform, regulatory relief, and renegotiating trade deals, and with that, we will unlock the economic growth that has been held back for too long in this country."
So whether it's possible for this plan to become law, and whether it's necessarily the right plan for the country's current landscape, remains to be seen. It's worth noting that not all pass-through entities are small businesses. Many hedge funds and large owner-run organizations are taxed as pass-throughs. So this is bound to be a hot-button issue. But for the meantime, small business owners have something to rally behind on the President's tax agenda, and that's something that they've been waiting for from a politician for a long, long time.