The Trump administration unveiled its highly anticipated tax reform framework on Sept. 27. While the nine-page document lacks the specific details as to how its proposed changes will be implemented, its presentation to the public was as an offering of tantalizing tax advantages to business owners and investors.
There has been a lot of fanfare surrounding the proposed reduction of the maximum tax rate for “small and family-owned businesses.” On first glance, the proposed tax rate reduction appears to offer uniform relief to all businesses, large and small. Under the proposal, small and family-owned businesses, operating as a pass-through for tax purposes (i.e., not a traditional C-corporation where double taxation applies), would be subject to a maximum tax rate of 25 percent.
Many tax professionals are now undertaking the daunting task of quantifying what this new maximum rate for “small and family-owned businesses” means to their clients.
Under the current tax regime, pass-through businesses do not pay tax at the entity level, but instead pass the obligation to pay tax to the individual owners, who then personally report the income at individual rates, which today range from 10 to 39 percent. Therefore, reason would seem to dictate that a reduction of the maximum rate of 39 to 25 percent would result in tax savings. The question that then has to be asked is, “is it really that simple?” and as with many things tax, the answer is no.
The published framework fails to define “small and family-owned businesses,” providing no guidance as to what type of business will constitute a “small and family-owned business.” While the proposal has been touted as beneficial to small businesses, the advertised savings may not significantly translate, as historically smaller businesses and start-up operations do not generate earnings large enough to fall within scope of the current 39 percent maximum rate. However, for larger businesses with hefty profits the reduction from 39 percent to 25 percent could equal meaningful savings.
Following the launch of the proposal, commentary from various White House officials and insiders suggested that service businesses would be excluded from the lowered tax rate. The exclusion of service businesses presumably means that the businesses that will be labeled “small and family owned” are not businesses such as law firms and accounting firms, but are those businesses involved in real estate, goods or product manufacturing.
In reality, while not being touted as the intended beneficiaries of the rate reduction, it is the businesses operating with larger profit margins that will be in the best position to capitalize on the tax rate reduction. It is these more profitable businesses, in financial position to retain the most sophisticated advisers, that may elect (or may already) utilize well-designed and complex multi-tiered pass-through structures that will provide them with the opportunity to benefit from the tax rate reduction. Startups and businesses the average person may consider “smaller” may find that the reduction in personal tax rates is where they will achieve a savings, but without more detail on such reductions and on the changes to available deductions it’s too early to predict.
Additionally, while current regulations require business owners to report reasonable compensation, it is not uncommon for high earning taxpayers to limit how much of their income is reported as compensation and taxed at higher rates. Savvy taxpayers may be further incentivized by the lowered tax rate to re-characterize even more personal income in order to take advantage of the 25 percent ceiling. Interestingly, this possibility seems to have been anticipated as the published proposal includes a caveat that expressly states that committees will adopt measures to prevent this very type of re-characterization. While aimed at discouraging such re-characterization, in reality, the IRS already struggles to enforce in this area, as determining what exactly is reasonable compensation in any given business is no simple task, leaving many to believe that the lowered rate will result in even further manipulations.
Without greater detail, it is very difficult to meaningfully gauge the impact of the reduction of the corporate tax rate to 20 percent and the increase in permitted corporate expenses. Some believe the lowered rate will spur corporations to expand and hire more employees and stimulate the economy. Others point to the overall loss of revenue and the increase in the already sizeable national deficit. If the lowered corporate tax and increase in available expenses, even when coupled with the dividend tax, result in an effective tax rate lower than the 25-percent rate proposed for pass-through entities, those business owners with hefty earnings may elect to restructure their holdings to include corporations.
With only this framework, it is impossible to predict with any certainty whether or not there will be significant tax benefits. This high-level proposal reflects only the first efforts of what will have to be a much larger undertaking if the objective is to overhaul the tax code.
Rebecca Abrams Sarelson is a partner in Saul Ewing Arnstein & Lehr’s Miami office. She focuses her practice on international and domestic corporate transactions, taxation, wealth preservation, estate planning, tax-exempt organizations, and real estate transactions.