Or will it, as well as other pass-through entities, become relics after enactment of a 28% corporate tax rate. That’s something that should be on the mind of most small business owners who operate their companies as sole proprietorships, partnerships, limited liability companies, or S corporations.
Proposed cut in the corporate tax rate
The President has proposed to cut the current 35% corporate tax rate down to 28%. This move is designed to make U.S. corporations more competitive worldwide and makes good sense from this perspective. Last October, Rep. Camp (R-MI), who is the chairman of the House Ways and Means Committee, proposed a 25% corporate rate. There is little argument from anyone of most any political persuasion to keep the current high rate in light of the U.S. having the second highest corporate tax rate (behind Japan).
When a change could be expected, and how the change would be paid for (e.g., from cutting corporate deductions as proposed by the President) remains to be seen. Many think that there won’t be any change before the presidential election in November.
Impact on small businesses
While it may be many months or more before there is any reduction in the corporate tax rate, it’s important for small businesses to assess what a change would mean to them. Most small business owners pay tax on their share of business profits on their personal returns, so their tax rates are personal, not corporate.
While the President has proposed a reduction in the corporate rate (the rate paid by C corporations), he has also suggested an increase in the top rate for “high income” taxpayers (those with income over $200,000 if single or $250,000 if married filing jointly). The top rate on these individuals could rise from the current 35% (the same top rate on corporations) to 39.6%. In addition, starting in 2013, high income taxpayers could pay an additional 3.8% Medicare tax on unearned income plus 0.9% on earned income. In effect, the tax rate on certain individuals could be more like 44% (depending on their overall level and type of income). This would be 16% higher than the highest rate on corporations after the rate cut.
How does this play out starting in 2013, assuming the corporate tax cut and personal tax hikes take effect? Let’s compare a one-owner C corporation with a one-owner LLC:
Say the corporation earns $2 million (after deductions other than the owner’s salary) and the owner takes a salary of $100,000. The corporation would pay tax on $1,900,000. Using the flat tax rate for purposes of this example (in reality the rates would be graduated), the corporation would owe $532,000 in federal income taxes; the owner would pay personal income tax (assume a 25% tax rate) of $25,000, for total taxes of $557,000.
Now assume that the LLC earns the same $2 million. There is no deduction for salary to the owner because he/she is not an employee (the owner merely takes a nondeductible draw). The $2 million passes through to the owner and is taxed at the owner’s rate. The owner would pay 39.6%, or $792,000, plus $0.9%, or $18,000 (this example again ignores the graduated rates and floor for the additional Medicare tax), for a total tax of $810,000. This is $253,000, or more than a quarter of million in extra taxes.
Again, the numbers aren’t exact; they are merely illustrative of the growing spread that will result between the tax on C corporations and the tax on owners of other types of entities.
Across-the-board tax cuts would be welcomed by business owners. However, cuts likely will be paired with reductions in various write-offs. There’s no free lunch, and business owners will continue to pay taxes on profits. Their tax bills could remain relatively constant after rate reductions if write-offs they’ve used in the past are eliminated. The November election will certainly have an impact on any tax changes to come.