Tax Hikes for Small Businesses

During COVID-19, many small businesses had the opportunity of tax benefits being available to help them during the pandemic. However, now that they (hopefully) see the end in sight, they are being faced with the obstacle of tax hikes.

Small businesses are greatly impacted by individual as well as business tax rates being raised. While President Biden has proposed many increases, advisors are trying to get ahead of it by using various strategies to plan against their impact.

Biden has big things on the horizon planned, such as a new infrastructure bill and programs to fight climate change as well as inequality. These plans are contingent upon raising tax rates for not only businesses but also the wealthy. Currently the rate for corporations is 21% and the proposed increase would bring it to 28%. A 20% tax benefit for businesses such as sole proprietorships, S corporations, partnerships and LLC’s, would be scaled back. In addition, the top individual rate would return from its current 37% to 39.6%, however this would only affect those who make a minimum of $400,000 or more a year.

In this process, President Biden has considered raising the top capital gains rate to the same as the top individual rate for those making a minimum of $1 million a year, 23.8% to 39.6%. In addition, some Democrats in the Senate are proposing a tax of unrealized capital gains at the time of death that are $1 million or more.

However, despite these big plans, it’s very unlikely that they would be approved by Republicans which by and large are responsible for the tax cuts we saw in 2017. Janet Yellen, Treasury Secretary, said that tax hikes would not immediately take effect. However, even with that assurance, many financial planners are advising their clients to consider them now in the case they do pass.

One strategy that advisors have given is the possibility of accelerating income. By this they mean to say that if you were to invoice customers in 2021, assuming that these effects wouldn’t take place until 2022, it would lock that taxable income into this year. This is the opposite of what most small businesses owners would typically do; you usually see them trying to defer income in order to defer their tax bill. However, we advise that if you have income that you could take next year, that you should try and take it this year instead.

Another strategy advisors are suggesting is to cash in profits. That’s to say that if you are anticipating a large capital gain, that you should try to take it this year if possible. Since there is the possibility of the rate on capital gains increasing, it is best to try to cash in on those in this fiscal year.

Another strategy is to postpone deductions for business expenses until next year. This is because if tax rates are rising, then it would make deductions more important for next year. Perry Green, CPA/PFS, CFP and CFA and chief financial officer at Waddell & Associates, a RIA in Memphis, Tennessee, is also advising his clients that are close to retirement that they should consider selling their commercial real estate and companies this year, because of the possible rate change on capital gain profits over $1 million.

Pass-throughs are typically small businesses that pass their income straight to their owner’s individual return. In 2017 there was a corporate rate cut that led to some small businesses moving over to C Corporations. However some advisors are saying that even if the corporate rate rises, perhaps they should stay that way due to a special tax break which encourages start-ups. It allows people that have owned C corporation stock for at least five years to avoid a large capital gains tax bill once they decide to sell their company. This allows owners to avoid capital gains tax up to $10 million or 10 times what their original investment was, whichever is greater. While their profits are technically capital gains, Biden has not yet made any proposals to dispose of that benefit.

LJ Suzuki, the founder of financial and accounting company, CFOShare, mentions a client who owns a software company with losses. He says that C corporations without profits won’t owe income taxes for their business so hiking up the rate won’t matter. However, if the company was to make $1 million in profits under Biden’s new proposal, they would owe $280,000 in taxes.

However, if in five years the company owners decided to sell for $50 million, they would end up owing $10 million in capital gains taxes under the benefit that Biden hasn’t opposed. If they didn’t sell, they would owe that $280,000 a year for as long as the new rate is in place which could quickly outweigh an immediate tax bill. Suzuki also says that the capital gains event is so substantially important that Biden raising the corporate rate doesn’t matter.

I encourage you to speak with your tax preparer very soon to discuss your situation and plan for this year’s potential tax bill as we as what you may experience in years to come.