Information about tax changes the Biden administration is considering recently leaked, creating some big headlines in media. “First major tax hike since 1993” according to Bloomberg. As a fractional CFO, my first reaction to any tax reform is: what does this mean for small business? Although we do not have an official White House plan yet, I have reviewed Biden’s campaign promises against the leaked info and have some strategic tips to offer small businesses.
How does tax reform affect small business?
There are two proposed changes that will affect small business income taxes. Which change you care about depends on your entity structure (sole proprietor, partnership, S-corp, or C-corp).
Increase in corporate income taxes
The latest information suggests a corporate income tax increase from 21% to 28%. While this is a massive increase, 28% is still less than the pre-Trump tax rate of 35% and almost half the peak corporate tax rate of 52% during the 1950’s. Nonetheless the rate adjustment could significantly reduce C-corp cash flows.
Many small business owners are obsessed with pass-through structure to avoid double taxation. The Trump-era tax reforms intentionally lowered corporate tax rates to a level where double taxation was a negligible concern. As a result, we saw (and advised) many clients to change to C-corp structures over the past 4 years.
Will companies change back to S-corp and pass-through structures with an increase in corporate taxes? Maybe, but choosing your entity structure based solely on income tax rates is myopic. C-corp structures come with many long-term benefits, such as qualifying for section 1202 or rolling net operating losses indefinately. Moreover, S-corps and pass-through companies are facing tax increases too…
Elimination of pass-through tax deductions
If you are an S-corp, partnership, or sole proprietor, the proposed tax plan will eliminate your Qualified Business Income Deduction, commonly referred to as the pass-through deduction. This deduction was worth up to 20% of your business income – but, in fact, is so complex and restricted that most business owners do not even know whether they have been benefiting from it. The value of this deduction will depend on your personal income, your business activity, and even what year it is! Moreover, since pass-through income tax rates are based on personal income tax brackets, it is impossible to precisely quantify the value of this deduction in any general terms.
What might you be losing when this deduction goes away? You need to ask your CPA that question. In general, I have found that business owners benefit less from this deduction than they believe they should. Nonetheless, with the right combination of income, business activity, and other factors, losing this credit can create a massive increase in taxes due.
Changes to capital gains taxes
Although there are no specifics yet, rumors say that capital gains tax rates may be increasing for anyone earning more than $1 million annually. Capital gains taxes are the quintessential “good problem to have” taxes – if you are earning more than $1 million in capital gains, you are being taxed on your success. While this is a major tax for business owners hoping to sell their company and earn millions, it is not as directly impactful to a businesses’ cash flows or an owner’s livelihood as income tax rates.
There are still many great ways to sell your business and defer or avoid capital gains taxes entirely. These include:
- Selling to an ESOP
- Selling to a cooperative
- Harvest capital losses to offset the gains
- Donate your equity
- Qualify for section 1202
- Roll gains into Qualified Opportunity Zones
- Bequeath your stock after death
All the other tax changes
Do not forget there are plenty of other tax changes in 2021. Check out our article on deferred social security taxes, sales taxes, and more.
Small business income tax strategy
As with most tax problems, the more profit you are generating the more these changes may affect you. If you are a startup business that is losing money every year, there is no need to also lose sleep over current Washington politics. On the other hand, if you are a lifestyle business that is generating ample owners’ income, you should take these changes seriously.
Here’s my recommendation to small business owners facing high tax liabilities:
- Wait until the legislation is drafted and/or signed into law.
- Schedule a strategy meeting with your fractional CFO, CPA, or financial advisor.
- Collaborate with your team on your best tax strategy given the changes.
Spoiler alert: most small businesses will not change anything in light of the new tax structure. There are dozens of business elements more impactful on cash flow than your tax strategy – sales and marketing strategy, operations strategy, pricing strategy, exit strategy… As much as we wish we had a fleet of accountants to find every tax loophole like Amazon, that is not economically realistic for small businesses. Do your diligence, collaborate with your financial team, but always stay focused on fundamentals to ensure success.
LJ Suzuki is a Fractional CFO and Founder of CFOshare, where he helps small businesses grow with professional financial strategy. His expertise includes M&A, capital planning, turnaround work, pricing strategy, cost of growth analysis, forecasting, budgeting, and incentive plan work.