Pass-Through Tax Cut May Impact Small Business Owner Retirement Savings Strategies
May 17th, 2017
This article, written by our own Adam Bergman, originally appeared on Forbes.com –
President Donald Trump’s plan to cut the tax rate to 15 percent for so called pass-through businesses, such as partnerships, LLCs and S Corporations, will help many small business owners reinvest in their business by saving on taxes. President Trump also plans to cut the corporate tax rate to 15 percent. While many applaud the President’s plan to cut taxes on businesses, which they believe will help stimulate the U.S economy as well as make American businesses more competitive globally, the discrepancy in tax rates between businesses and individuals could prove problematic, especially for retirement savings.
President Trump has announced that he plans to cut personal income tax rates by reducing the number of individual income tax brackets from seven to three — 10, 25 and 35 percent. Individual tax rates currently have a ceiling of 39.6 percent and a floor of 10 percent. Most Americans pay taxes somewhere between the two. With corporate and business pass through tax rates at 15 percent compared with generally higher individual income tax rates for most Americans, various tax planning opportunities will present themselves, including the ability to structure business payments at a 15 percent tax rate versus taking compensation at a generally higher income tax rate. For example, under the Trump tax plan, if an LLC owner has $100,000 of net income currently taxed at 35 percent, the allocated portion that is compensation would be taxed at 35 percent while the portion that is allocated as business income would be taxed at a 15 percent tax rate. Thus, taking compensation of $20,000 versus $60,000 could save a significant amount of taxes. Furthermore, since retirement savings is based on the amount of compensation one receives and not on the amount of profits the business generates, the less compensation one receives will directly impact the amount of retirement savings that may be available. For example, a husband and wife business partnership would be incentivized to take less compensation and allocate more of the available income to business income in order to reduce their tax liability. If the partnership has established a 401(k) plan or SEP IRA, the maximum amount they would be able to contribute would likely be reduced since their maximum plan contribution amount is directly based on the amount of compensation they earned from the business in a year.
In general, many economists believe that cutting taxes for small businesses is a positive plan by the president. However, sizable tax rate discrepancies between different forms and categories of income could create decisions that are more tax than business based and run counter to the principles of tax neutrality. In addition, such circumstances will likely invite abusive tax schemes, as well as some unanticipated results, such as a potential cut in retirement savings for small business owners.