May 25, 2018
The House Ways and Means Tax Policy Subcommittee held a hearing Wednesday optimistically called “Tax Reform and Small Businesses: Growing Our Economy and Creating Jobs.” I say optimistic because the evidence is stacking up that this tax law does little to help our Main Street small businesses — and despite assurances from proponents that the new tax law would simplify tax code, many small-business owners are struggling to understand what exactly The Tax Cuts and Jobs Act means to them.
This is something I, as a CPA specializing in small business, see firsthand every day. There has been a spike in concerned and confused clients coming through my doors in the last couple of weeks — an unusual sight right after Tax Day, when the last thing most people want to do is talk more about their taxes.
But they are right to ask questions and get prepared because the new law is complicated, confusing and likely to be costly for small business owners.
Under the new tax law, small businesses face increased complexity, steep competition from large companies with the means to take advantage of low tax rates created by the territorial tax system, and a 20 percent deduction on pass-through business income that does not apply equally to all, according to a study I co-authored for Business for Responsible Tax Reform, a group that I co-chair.
Here are the realities illuminated by our report that entrepreneurs need to know:
- The 20 percent deduction on qualified business incomefor pass-through entities applies differently to different types of small businesses. Small businesses that are primarily providers of a “specialized service” are subject to greater limitations on the deduction. The formula for figuring out how it impacts an individual’s business is complex and the results are likely unique to each individual’s situation.
- The new territorial system of taxation adds complexityfor small businesses operating internationally. On average, the international taxation of business income gives corporations a larger tax break and, as a result, puts small pass-through businesses at a competitive disadvantage.
- The new tax law may not translate into significant savings for small businesses, many of which will require the outside expertiseand incur the additional cost of accountants and tax lawyers in order to navigate and satisfy their tax obligations.Top of Form
What these changes mean, of course, is that small businesses will likely require the services of costly tax experts to handle the complexity. Under my rate structure — which is typical of the industry — they could easily spend up to $2,000 on an accountant to figure out the new pass-through deduction and file their taxes.
The average small-business owner earns $50,000 a year, according to the Small Business Administration. By my calculations the new 20 percent deduction could save that person $1,500 — easily wiped out by the fees charged by tax professionals with the expertise to navigate the new tax code. Also out the window is the idea that the deduction could generate enough money for a business to hire additional full-time employees or offer current employees raises. But small-business owners were skeptical that the tax law would allow them to make meaningful investments in their companies even before talking to their accountants.
On the other hand, large corporations and wealthy businesses will be able to turn to attorneys and pricey tax specialists to search out every loophole and tax advantage. And they will find them.
Some experts expect the 20 percent deduction will be an important factor in how businesses organize themselves to take advantage of the tax code. They expect an increase in businesses creating an LLC branch in order to maximize their eligibility for business deductions. Because LLCs are eligible for the deduction, businesses that do not qualify will find the LLC structure extremely attractive.
Economists also predict many businesses will use other strategies, such as “cracking” and “packing” to split and restructure their businesses in order to qualify and maximize their deduction eligibility. “Cracking” a business entails breaking apart revenue from a service partnership in order to reclassify it into a category that qualifies for the deduction. The second strategy is to “pack” businesses that qualify for the deduction into a service partnership in order to transform the business into an entity that is not considered a specialized service trade or business.
Douglas Holtz-Eakin, an economist who heads the American Action Forum, recently told the Senate Finance Committee that the pass-through provision drew “haphazard lines in the sand” that “are the exact kind of lines that tax lawyers and experts will attempt to try to game.”
Pursing these types of strategies is usually done with the help of a tax professional — at a cost, of course. Main Street small businesses often can’t afford such luxuries and, as a result, they will be a competitive disadvantage to those large businesses that can search out the best tax rates and structure their businesses to take advantage of them.
When it comes to the new tax code, the bottom line for small-business owners is to get ready now. And be prepared to pay for it.
Anne Zimmerman is the co-chair of Businesses for Responsible Tax Reform, a coalition of small-business owners and organizations, and the founder and owner of Zimmerman & Co. CPAs, a public accounting firm with offices in Cincinnati and Cleveland, Ohio.