May 27, 2024

Lana Pol, owner of four small businesses including trucking and warehousing services, credits the new tax law with helping her reduce her taxes this year.

Much has been made about cutting corporate tax rates. But what about those affecting millions of pass-through businesses, like S corporations, partnerships, and sole proprietorships? Hari Sreenivasan reports.

1. New Deductions for Pass-Through Entities

Pass-through entities, like partnerships, S corporations and sole proprietorships must report business income on individual tax returns instead of filing as C corporations do. With the passage of Tax Reform Law 2017’s deduction for qualified business income lowering the top individual tax rate from 37 percent down to 29.6 percent.

This deduction, however, is only available if your business fulfills certain requirements and excludes personal services firms like law, accounting and health care practices; income derived from licensing an owner’s likeness or reputation; rental income and the costs of certain depreciable properties.

Lana Pol, owner of two Iowa small businesses, says she’s already reaping savings from the newly expanded tax deduction. Additionally, she’s using Section 179 expensing to write off six semitrailers purchased for trucking and warehousing businesses; federal law has reduced limits on interest deductions related to business expenses.

2. Limits on Interest Deductions

Tax status of a company can have profound implications for its owners. For instance, an S corporation structure subjected its net income to the highest individual tax bracket of 37%. Switching tax structures could result in substantial tax savings; but first consult with an accountant to run an in-depth cost-benefit analysis before making your decision.

Countries typically restrict interest deductions in order to prevent base erosion and equalize the treatment of debt-financed investment against equity-financed investment. Unfortunately, TCJA changed this definition and limited deductions to 30 percent of earnings before interest, taxes, depreciation and amortization (EBITDA), effectively tightening it just when interest rates are increasing and could cause firms to reduce investment and slow economic growth.

Reducing itemized deductions to 4 percent of AGI also eliminates any incentive for individuals to overspend on items eligible for deduction, since most taxpayers claim only standard deduction. It will also decrease revenue by $4.0 trillion over 10 years – although partially offset by eliminating both Net Investment Tax and AMT.

3. Increased Deductions for Business Expenses

Tax deductions available to small business owners can vary widely. According to the Internal Revenue Service (IRS), a tax deduction is defined as any cost subtracted from your taxable income in order to reduce tax liability, such as marketing costs or professional fees paid out during opening of new locations. Most expenses fall into particular reporting categories; if in doubt about eligibility speak with a SCORE mentor for assistance.

According to NBER research, reduced personal income taxes have an enormous effect on a firm’s growth rate, and may have even more of an effect on smaller firms due to their smaller fixed costs. Reduced rates enable entrepreneurs to invest more into their businesses and hire additional employees – thus stimulating economic growth and job creation.

4. Increased Tax Rates for Corporate Income

Business owners are currently assessing how new tax reforms will have an effect on their bottom lines, including how deductions for entertainment expenses like office holiday parties may increase their taxes. Although some changes could prove beneficial, others could lead to greater expenses; such as eliminating deductions.

Along with the lower corporate income tax rate, the new law also eliminates domestic production activities deduction and modifies smaller credits such as orphan drug credit and life insurance reserves computation to generate greater revenue for government. All these changes require them to bring in additional revenues.

However, this higher rate will not impact businesses filing as pass-through entities such as sole proprietorships, partnerships and S corporations. This protects 97 percent of small business owners across America from tax increases; tax rates for these entities depend on federal concepts while state/local rules may differ accordingly.

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