How Tax Reform Hurts Many Small Businesses

Friday, May 4, 2018

The Tax Cuts and Jobs Act gives big business an even bigger edge.

While the Republican-led tax reform bill contains some benefits for small businesses, it also hurts them -- at least indirectly. In some cases, provisions that ostensibly were put in the Tax Cuts and Jobs Act (TCJA) to help small business owners either don't actually help them or won't be taken advantage of by those they're supposed to aid.

In reality, the new tax laws were written with big businesses in mind. If you're not a large corporation or in the top 1% of earners, only about 17% of the benefits of the TCJA will impact you, according to Frank Knapp, writing for The Hill. Most benefits, he explained, will go to C corporations, and most small businesses aren't classified that way. According to Knapp:

Corporations had their tax rate slashed from 35% to 21% with no conditions. Easy. What did small businesses get? An even more complicated tax code that is tilted even further in favor of big businesses and that will do little to help them grow their businesses and the economy.

Why not become a C corp?

While there are lots of positives for larger companies to be organized as C corporations, it comes with a bit of a whammy for smaller businesses. Income from a C corp is taxed twice -- once at the corporate level (21%) and again when income is distributed to owners.

Sole proprietorships, partnerships, and S-corporations are what's called pass-through businesses. That means the owners of the business pay income taxes (once) on whatever income passes through their company. A cut to the corporate tax rate does nothing for small businesses, but it does put more cash in the hands of the big businesses they compete with.

It's Not that Simple

Congress didn't entirely ignore the needs of small businesses. The TCJA includes a provision that allows for a 20% off-the-top deduction of pass-through income. That sounds easy, but it's not that simple, according to Knapp.

The tax cut for small business pass-through income is a hard-to-understand, convoluted mess that CPAs will be trying to figure out for their clients for months, maybe even years, to come. Instead of a large, straight reduction of tax rates on income, the law offers a meager tax cut via a complex formula. Pass-through income will have 20% excluded from taxation but with stipulations for which small businesses qualify and for how much, depending on W2 wages paid.

Basically, the new rules certainly will be good for one type of small business -- accountants. The value to others -- specifically, actual small companies employing one or a handful of people -- is very much in doubt due to complicated formulas and exceptions. To make matters worse, the changes expire in 2025. That means that even if a small business benefits from the changes, those benefits will expire, while the tax change for C corporations is permanent.

It's About Competition

While you could argue that the tax code changes are either neutral or slightly beneficial for small business, in reality, many will be hurt by them -- at least indirectly. Larger corporations will have more cash on hand, and while much of that will go to owners through dividends or share-buyback programs, some of it will be invested.

Bigger companies with more money to spend is bad news for small businesses. They could be hurt as larger competitors invest in infrastructure, people, or less-direct ways, like putting a pool table in the break room or offering high-end free coffee.

The reason there hasn't been a major outcry over the new tax code by small businesses is because its negatives aren't that obvious. Basically, the TCJA makes the rich richer by lowering taxes on C corporations, and that's going to hurt a lot of small businesses, even if they don't realize what's happening.

From the Motley Fool