Congress is continually giving lip service to its desire to help small businesses, but rarely does something important taxwise in this regard. Much assistance goes to “large” small businesses (remember the SBA definition of a small business in most instances is up to 500 employees). With Congress currently in the midst of talks about tax legislation, I wanted to focus on some ideas that could really benefit “small” small businesses.
Standardize the definition of small business
There are more than 3 dozen tax rules exclusively for “small business,” but the definition varies considerably from rule to rule. Sometimes, the definition is based on the number of employees (e.g., 50 or more to be subject to the employer mandate under the Affordable Care Act, but up to 100 for the pension startup credit) or the number of shareholders (e.g., to be an S corporation), sometimes it depends on revenue (e.g., a gross receipts test for the exception to using the accrual method of accounting), and other times the definition turns on assets or capital (e.g., ordinary loss treatment for small business stock requires the corporation to have capital of $1 million or less).
My proposal:
Create a single definition for the tax rules designed exclusively for small businesses. It can be a multiprong definition, such as one based on employees or gross receipts, and meeting one or the other is sufficient.
Make above-the-line business deductions as offsets to business income
Currently, self-employed individuals can deduct certain business-related expenses only as personal deductions. These are:
- One-half of self-employment tax
- Health insurance premiums for themselves, spouse, and dependents
- Retirement plan contributions for themselves
My proposal:
Treat these 3 deductions as an offset to business income, which would reduce net earnings from self-employment. In round numbers, using this tax treatment for these deductions would save self-employed individuals about 15% of these total amounts; the savings results from lower self-employment tax.
For example, say health insurance premiums for a self-employed individual are $8,000 for the year. From an income tax perspective, it doesn’t matter whether this deduction reduces business income or personal income; the income tax outcome is the same. But using the deduction against business income means that $8,000 is not subject to self-employment tax ($1,224). Yes, one half is deductible, but it still costs the self-employed person over $600 more in tax for the year.
It’s interesting (and not fair) that these 3 above-the-line personal deductions are used to reduce net earnings for purposes of the qualified business income (QBI) deduction.
Simplify the QBI deduction and make it permanent
The qualified business income (QBI) deduction was created to give some—but not full—parity to owners of pass-through entities with the 21% flat tax rate on C corporations. In general terms (because there are so many wrinkles), the QBI deduction is 20% of net business income. It’s a personal deduction based on business income used by owners of pass-through entities to lower the effective tax rate on business profits. For owners in the top tax bracket of 37%, it means that their business earnings are taxed at 29.6%.
The QBI deduction is set to expire at the end of 2025, and proposals now being considered would let it expire, extend it, make it permanent, or extend it or make it permanent but with modifications.
My proposal:
Create a 21% flat tax on the business income of owners of pass-through entities. The idea of segregating types of income and taxing them differently is nothing new:
- Capital gains and qualified dividends are subject to special tax rates.
- In the past, a special tax rate was applied to earned income. When the top tax rate on individuals was 70%, there was a 50% “max tax” on earned income. The maximum tax on earned income disappeared when the top tax rate dropped to 50%.
Increase the upfront deduction for startup costs
It costs money to start a business. These are investigatory costs (e.g., searching for an analyzing a prospective activity) and ordinary and necessary business expenses before the business commences in order to create a business (e.g., advertising; training employees). You can elect to deduct up to $5,000 of business start-up costs and up to $5,000 of organizational costs. The $5,000 deduction for start-up costs and the $5,000 deduction for organizational costs is reduced by the amount that start-up or organizational costs exceed $50,000. Any remaining costs must be amortized over a period of 15 years.
My proposal:
Greatly increase the dollar limits. These dollar limits have been in effect for more than 40 years and are not adjusted for inflation. They are unrealistic given today’s costs. There are bills under consideration to increase the limits. For example, the American Innovation Act (H.R. 1778) would raise the deduction limit to $20,000. It would also raise the reduction threshold to $120,000. I think upping the limits to $50,000, and $150,000, respectively, would not be out of line.
Allow expensing for all acquisitions
Currently, the cost of buying tangible property can be written off various ways:
- Regular depreciation, which is an annual deduction for part of the cost, the percentage of which depends on the type of property.
- First-year expensing, up to a set dollar limit that can be adjusted annually for inflation but only benefits profitable businesses.
- Bonus depreciation, which is an upfront deduction of a percentage of the cost (it had been a 100% deduction in 2022, but is being phased out).
- De minimis rule allowing purchases to be treated as materials and supplies (not added to the balance sheet) up to an IRS-set limit ($2,500 per item or invoice for businesses without an applicable financial statement).
The cost of acquiring intangible property, such as patents, trademarks, and copyrights, have complicated rules on how to deduct costs. The cost of acquired intangibles (e.g., getting a trademark when you buy a business) must be amortized (deducted ratably) over 15 years. The tax treatment for the cost of creating intangibles is more complicated. For example, with patents, there’s a choice of deducting cost (patent application and legal fees) up front or amortizing them over the life of the patents.
My proposal:
Allow full deductibility as costs are paid or incurred, and that this rule be made permanent. Simplicity and certainty are 2 key desirables for small businesses when it comes to taxes.
Make first-time abatement penalty relief automatic
Penalties and interest for these failures can be significant, and in some cases, be the undoing of a business. It’s so easy to make mistakes…miss deadlines, forget to file certain forms, make errors that results in underpayments of tax. That’s because most small businesses don’t have in-house accountants or even outside CPAs on retainer to inform them of their obligations and remind them of deadlines. Small businesses and their owners may use tax professionals for return preparation, but can’t afford continual communications. Currently, taxpayers can request that penalties be abated for reasonable cause or first time abate (an IRS administrative action if certain conditions are met).
My proposal:
Allow first time abate to apply automatically to failure-to-file, failure-to-pay, or failure-to-deposit penalties. No request would be necessary; the IRS would not have to manually review the request to abate because computers could spot the need and determine eligibility. This isn’t my idea; the National Taxpayer Advocate suggested it.
Final thought
I’ve been writing about taxes for nearly 50 years and have seen so many changes in the rules for small businesses—good and bad. My proposals here are not a complete list, but you’ve read enough. Congress has a great opportunity to create helpful tax rules for small businesses.
When my daughter was a toddler, she heard me say something and she repeated it as “hope brings a turtle.” What she heard me say was hope springs eternal…for Congress to do the right thing.
