Don’t Forget Small Business in Tax Reform

Small businesses should not be left out of corporate tax reform. Here's what can be done to help level the tax playing field between S Corps and C ...
Douglas S. StranskySeptember 25, 2013

Congress and President Obama are once again talking about corporate tax reform. And once again small businesses are saying: “Don’t forget about us.”

As part of his goal to get the U.S. economy moving, the president introduced a plan in July that included a proposal to lower the income tax rate on corporations from 35 percent to 28 percent (or to 25 percent for certain manufacturers). Such a reduction would make the corporate tax more competitive with other countries and has been a desire of many corporate executives for years.

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If you want to stimulate the economy through tax reform, however, you should also pay attention to the tax burden on the companies creating the most jobs. According to the U.S. Small Business Administration, firms with less than 500 employees accounted for 67 percent of the new jobs since the recession ended. Those are companies led by entrepreneurs, who are building businesses around new products or services and expanding their payrolls.

Yet the discussion about corporate tax reform has only focused on large, multinational corporations, and not small businesses. That’s because for tax purposes, major companies are structured as C Corporations, while small businesses are usually formed as S Corporations, partnerships and sole proprietorships.

But there’s a huge difference between major companies and small businesses— not only in size, but also in how their profits are taxed. C Corp income is first taxed at the corporate rate of 35 percent and then taxed again at the personal income tax rate when dividends are paid to shareholders. Owners of companies who operate their businesses as S Corps, partnership and sole proprietorships are not taxed at the corporate level but pay business taxes as part of their personal taxes at a rate of up to 39.6 percent.  In fact, with the imposition of the 3.8 percent investment surtax imposed by the 2010 healthcare legislation, the top rate could approach 45 percent for many small business owners.

The S Corp, partnership and sole proprietorship tax rate has not been the focus of corporate tax reform in Washington. But it should be. If the C Corp rate of 35 percent is reduced to 28 percent it will leave an inequity in the tax structure between large and small businesses. This is senseless, especially when it’s assumed that lower income tax rates would enable employers to have more money to reinvest in their companies and create more jobs.

The dilemma for President Obama and Congress is that to lower rates on small businesses means opening the door to a debate on personal income tax rates. Last year the president and Republicans reached a hard-fought agreement to raise the personal income tax, but only on unmarried individuals earning more than $400,000 per year and married individuals (filing jointly) earning more than $450,000 per year. Many small business owners likely have annual incomes above these thresholds. No doubt the president would prefer to avoid the personal income tax issue again, let alone lower the rates on a class of taxpayers he targeted only months ago.

Yet it’s possible to provide tax relief for small business owners without adjusting the rate. One way would be to provide those individuals who operate small businesses with a dollar-for-dollar credit against any tax due on their income from those businesses.  For example, if a small business passes through $1,000 of income to its owner/shareholder, the usual federal tax on that amount would be $396. If the tax law were changed to provide a credit of perhaps 20 percent of that amount, it would reduce the tax bill by $80 to $316. Thus, the 39.6 percent tax rate stays in effect, but the amount of tax that a small business owner would pay is reduced through a credit.

Changes might also be made to the current Domestic Production Activity Deduction, which is an income tax deduction to encourage domestic manufacturing production and related activities. The DPAD applies to S Corps as well as C Corps but provides little benefit to small businesses because of the way it is calculated. It too could be used to provide tax relief for small businesses and generate greater employment without changing the current S Corp rate.

Another possibility would be to create a different tax rate for shareholders of S Corps (or partners in partnerships or sole proprietorships) vs. someone earning their money from a salary. President Obama has proposed a 28 percent rate for corporations and a 25 percent income tax rate for manufacturers. Although these rates should be enacted immediately, could we not draw a tax distinction between someone earning $450,000 per year as a small business owner compared to someone making the same amount of money as a an employee?

The average American thinks corporate tax reform will apply to any U.S. business. But what is being discussed will apply only to a small percentage. Small businesses are the engine of our economy. If we reform taxes for S Corps as well as C Corps, that engine will run more efficiently.

Douglas S. Stransky is a U.S. international tax partner for the law firm of Sullivan & Worcester in the firm’s Boston office.