Back at the beginning of November – as you’ll doubtless already know – the bill language was unveiled for the much discussed and long awaited, federal tax reform. One important provision highlighted in the bill, would lower the pass-through rate for business income to 25%, leaving the top individual tax rate at 39.6%,
What is ‘pass-through’ business income?
Pass-through business income is basically any income coming from a business, that gets ‘passed through’ to business owners and is taxed at their individual rates. A significant amount of business owners’ incomes, are then taxed at a lower rate than what would be the standard maximum individual tax rate.
The growth of pass-through businesses has gradually begun to erode corporate and payroll revenues.
S corporations and payroll:
For tax purposes within the U.S. an S corporation is a closely held one that makes a valid election to be taxed under subchapter S of chapter 1 of the Internal Revenue Code. They do not generally pay income taxes, rather the corporations income or its losses, are split and divided among its’ shareholders. The shareholders must then go on to report the income or the loss, on their own personal income tax returns.
The way the law stands currently, shareholders of an S corporation are permitted to receive both regular wages, and a share of the company’s profits. The relevant payroll taxes are then subtracted from their wages, just as they would be for any regular employee. Their profit sharing goes on to be taxed as income, and at a different rate.
How tax reform might encourage underreporting of wages:
Reform, as it currently stands, may provide shareholders of S corporations with an incentive to inaccurately report their wages and go on to claim more as pass-through business income. In doing so, they would not be legally required to pay Medicare payroll taxes.
As a form of payroll tax avoidance, this occurs frequently, but it may occur even more often if a larger differential is put into place as part of the tax reform, between payroll and pass-through tax rates.
Other effects of tax reform which may have an impact upon payroll:
Some examples of other aspects of the new tax bill that may go on to affect U.S. business owners are listed below:
- WOTC or ‘work opportunity tax credit’, which allows some employers to request a tax deduction for qualified military veterans working for them, would begin to be phased out
- Adoption assistance, education assistance, work related entertainment or employer provided childcare, to name but a few tax-free benefits offered to many employees by their employers, would either be eliminated completely or significantly reduced.
- Estate tax would be eliminated, possibly affecting a great number of smaller businesses. This tax applies to estates that are worth at least $5.6 million in assets, and the threshold would begin by increasing to $10 million, and go on to be phased out entirely after a period of six years.
As the tax reform bill is in its early stages, it’s vital that if you’re a business owner, you try to keep as up to date as you can on all issues surrounding tax reform and payroll, and to ensure that you have the correct information at any given time, you can always seek professional help in the form of a company offering a range of payroll services, of which there are many reputable ones throughout the country.
The tax reform package still must be approved in committee, and then it will need to pass both the House and Senate. In other words, there’s a long way to go before anything like what’s being proposed might be put into place. It’s important for business owners to stay up to date on all that’s happening at the federal level, including how it could affect their payroll taxes and other obligations.