Feeling Confused by the New Tax Law's Small Business Provision? You're Not Alone.
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I’ve been a small business accountant for 30 years, long enough to see just about all there is to see when it comes to the U.S. tax system. But, never in my three decades have I seen the level of confusion and disarray caused by the small business deduction enacted by the GOP's Tax Cuts and Jobs Act passed by Congress last year.
The new law provided for a 20 percent deduction for qualified business income from so-called "pass-through" entities, including corporations and limited liability companies.
This became an issue on June 15, the latest deadline for small business owners to file their quarterly taxes. The problem was -- and is, for future payments -- that the IRS still hasn’t issued guidance on how the “pass-through deduction” actually works. This is a huge problem because most small business owners pass their business income through to their personal tax returns.
But the new provision that's meant to benefit these same businesses includes a number of indeterminate rules about what income is and isn't eligible for the deduction.
The law was so hastily written, with so little time for thorough scrutiny or feedback, that many provisions are vague and unclear. The IRS has said clarification for the pass-through deduction is on its priority list, but six months into 2018 nothing has been done.
Business owners estimate and pay their taxes quarterly, and clarity in those calculations is crucial because both overpaying and underpaying can have consequences for small businesses, where cash flow is king. Given that the IRS charges 5 percent interest on underpayments, miscalculating an estimate could have serious ramifications for an owner.
And there is simply no way of knowing right now whether the IRS will accept owners' not having guidance from the agency as reasonable cause to avoid 2018 underpayment penalties. Also, given that the IRS charges interest on underpayments by the day, if you're an owner who couldn't make the full payment you wanted to make by June 15, it's still better to make it late than to not make it at all. And, if you’re risk-averse, you should overpay just to be safe.
So, what does a small business owner do?
The question, then, is how do you determine what you might owe if the rules used to calculate those estimates are fuzzy and open to interpretation? I’ll tell you how -- you hire an accountant. You pay a professional to try to figure it out and hope that that professional has a better understanding of a provision that most accounting professionals think is, well, clear as mud.
Under my rate structure -- which is typical of the industry — small business owners can easily spend up to $2,000 to figure out the deduction. The average small business owner earns $50,000 a year, according to the Small Business Administration. By my calculations, the new 20 percent deduction could save that person $1,500 --- easily wiped out by the fees charged by tax professionals with the expertise to navigate the new tax code.
On the other hand, large corporations and wealthy businesses are reaping enormous benefits.
Also out the window is the idea that the deduction, much lauded by lawmakers eager to score political points with small business owners, could generate enough money for a business to hire additional full-time employees or offer current employees raises. While C-corporations received a flat 40 percent rate cut -- from 35 percent to 21 percent -- small business owners, the majority of whom are structured as something other than a C-corp, got a convoluted deduction that will do little to help them grow their businesses.
In fact, the Joint Committee on Taxation recently found that 44 percent of the tax benefits for small businesses will go to just 200,000 business owners making $1 million or more. By 2024, millionaires will be receiving over half of that tax relief. This means that less than 1 percent of small business owners are receiving the lion’s share of the benefit.
What’s more, because the deduction is so vague, it encourages businesses to turn to attorneys and pricey tax specialists to search out every loophole and tax advantage.
The lack of guidance and its consequences
In fact, lawmakers, tax experts and others have voiced concerns that a lack of guidance around the provision will allow people to game the system. In a letter sent to the Treasury Department and the IRS earlier this year, U.S. Rep. Richard Neal (D-Mass.) urged the agencies to issue guidance immediately, because, “Taxpayers are left struggling to understand its implications, and opportunities to exploit its ambiguities abound."
Main Street small businesses often can’t afford to pay tax professionals to exploit the law and, as a result, they will be at a competitive disadvantage to those large businesses that can search out the best tax rates and structure their businesses to take advantage of them.
So, what should you do?
If you're a small business owner just trying to do the right thing, the best course of action now -- for your next estimated payment, due in September -- is to make your payments on 100 percent of your 2017 tax liability (110 percent, if your adjusted gross income was over $150,000, or $75,000 if you’re married and filing separately). That way, you will fall under the IRS' safe-harbor rules and not be penalized, no matter how much you owe in 2018. For the June 15 deadline, you needed to pay only five-twelfths of your annual tax, rather than half the year’s taxes.
With that said, there’s no reason small businesses should have to struggle so much to pay their taxes. The pass-through deduction is, simply, a dud for the majority of small businesses. The IRS shouldn’t add insult to injury and complicate the matter even more by failing to clear up the provision’s ambiguities.