A post-reform tax review - small business and new tax laws

Nation's Business, Jan, 1988 by Thomas P. Brock

A Post-Reform Tax Review

Many--perhaps most--small businesses are in for a surprise when they prepare their 1987 returns now that changes under the 1986 tax-reform act have gone into effect.

This is particularly true if the owners and managers of those businesses have not looked beyond the highly touted statements that the law substantially reduces tax rates on individual and corporate income.

The tax-reform law does that. But Congress' top priority in writing the tax law was revenue neutrality--total tax collections could not be increased or decreased. Reductions in one area were offset by increases in others.

Individual tax rates have been reduced significantly. Some of this reduction is offset by eliminating previously allowed deductions. Another part is offset by a number of revenue-enhancing provisions that mostly apply to businesses. The remainder of the individual tax-rate reductions is offset by $120 billion in higher corporate taxes over five years.

Thus, the typical individual is better off under the new tax law, and the typical corporation is worse off. But small-business owners--whether their businesses are incorporated or not--will be trapped by the revenue enhancers.

This is the big surprise in the new law. It will result in small-business owners being the only broad group of individuals who will pay significantly higher taxes under the reform act.

Here's how it happens:

Corporate Tax Rates

The typical effect of tax reform on small businesses operating as regular corporations is to provide a small reduction in tax rates, which is more than offset by the loss of the investment tax credit.

The Tax Reform Act was billed as a law that would lower corporate tax rates by 26 percent--from a top rate of 46 percent to 34 percent. But only corporations with taxable incomes of more than $1,405,000 will enjoy the benefit of the full 26 percent reduction, and the savings for other small businesses will be considerably smaller (see chart).

A firm with $25,000 in taxable income gets no relief through the cut in corporate rates, and one with $50,000 in income gets a 9 percent reduction. At $200,000, the decrease is 15 percent.

Even that relief can be offset by the repeal of the investment tax credit, which is retroactive to Jan. 1, 1986. And many small businesses will not fare well in that exchange because they will receive smaller tax reductions to make up for the loss of the investment credit.

Before it was repealed, the investment credit allowed a direct reduction in taxes owed of up to 10 percent of the cost of all types of machinery, equipment and vehicles.

While the investment-credit loss may affect service firms less than those in manufacturing, service companies will feel the impact when they cannot claim credits for purchases of equipment such as computers, office furniture and delivery trucks.

An incorporated enterprise with less than $25,000 taxable income faces an immediate tax increase through any loss of the investment tax credit.

The effect is almost as bad for small firms with larger incomes. A corporation earning $50,000 a year has to lose the investment credit on only $7,500 of equipment purchases to offset the full effect of the tax-rate reduction. A corporation earning $300,000 of pre-tax income is worse off under the new law if it typically acquires more than $175,000 of new equipment each year--a relatively modest amount.

Thus, the loss of the investment credit will probably outweigh the small savings from lower tax rates for most small corporations.

Individual Tax Rates

To reduce rates while not reducing tax collections, Congress increased the income on which the lower rates would apply. The new law will have only two regular tax brackets in 1988--compared with up to 15 previously--with rates of 15 and 28 percent. But the law also establishes a third and higher bracket of 33 percent for unmarried taxpayers earning between $43,150 and $89,560, and for married couples reporting joint incomes between $71,900 and $149,250. In addition, the upper limit of these brackets is expanded by about $11,000 for each exemption claimed.

The amount of money subject to the lower rates was increased through steps such as eliminating deductions for sales taxes and for most nonbusiness interest, as well as curtailing deductions for medical expenses, investment expenses and the fees paid for preparation of tax returns.

These reduced deductions were partly offset by an increase in the personal exemption for those not in the higher tax brackets, but for most small-business owners there will be a significant net loss of deductions.

That loss will combine with the elimination of favorable treatment on long-term capital gains to push up many tax bills in spite of rate reductions. The maximum tax rate on long-term capital gains is going from 20 percent to as much as 33 percent in 1988 (or even 49 1/2 percent in some cases; details below) as a result of the decision to treat such gains as ordinary income.

The 49.5 Percent Tax Rate