P.L. 115-97, the 2017 Tax Revision, and Small Business Taxation

P.L. 115-97, the 2017 Tax Revision, and Small Business Taxation

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Updated February 9, 2018
P.L. 115-97, the 2017 Tax Revision, and Small Business Taxation
Small business owners have long been an influential player
accounted for 68% of C corporation income tax returns,
in domestic debates over tax policy. This role stems in part
70% of S corporation returns, 89% of partnership returns,
from the widely held view that small firms make uniquely
and 98% of returns by sole proprietors. Still, large C and S
valuable and substantial contributions to the U.S. economy.
corporations and partnerships generate much of the
Current federal tax law contains a number of tax benefits
economic activity associated with these entities. In 2014,
(or preferences) that are only available to eligible small
firms with over $50 million in receipts accounted for 91%
firms (as defined in each of the provisions).
of total C corporation receipts, 40% of total S corporation
receipts, and 71% of partnership receipts; by contrast, large
One of the key policy issues in the recent congressional
sole proprietorships contributed little to total sole-
debate over tax reform concerned how to tax small business
proprietorship income.
income. The issue was particularly important for
congressional proponents of reforming the federal tax code
In general, the tax burden for a small business (or any
in order to simplify it, improve the code’s equity effects,
business for that matter) depends primarily on the statutory
and remove barriers to faster economic growth. These
rate at which its income is taxed, and on any tax preferences
objectives raised the question of whether small firms should
it is allowed to claim.
continue to receive special tax treatment.
Regarding statutory rates, the federal income tax has had a
Small business owners generally have agreed that their
graduated rate structure for corporate (through 2017) and
priorities for reforming the tax code are: (1) to lower the tax
non-corporate income. As a result, a firm’s marginal tax
burden on small business income and the cost of tax
rate depends on both its taxable income and whether it is
compliance for all small firms, and (2) to establish parity
organized as a C corporation or a passthrough entity.
between the tax rates for corporate and non-corporate net
business income.
Regarding tax preferences, the federal income tax contained
at least 13 tax benefits targeted at small firms before the
Impact of Previous Law
enactment of P.L. 115-97, according to CRS Report
To understand how federal tax law affects small business
RL32254. Table 1 shows the top five benefits, ranked by
income in general, it is useful to first consider how a small
their estimated revenue cost in FY2018, under previous tax
business is defined for tax purposes. The answer is that
law. Tax preferences shrink the tax burden of companies by
there is no uniform or standard definition. Rather, several
lowering their average effective tax rates. Many small firms
different criteria are used (including asset, receipt, and
also benefit from tax preferences that firms of all sizes may
employment size) in tax provisions targeted at small firms.
claim, such as the research tax credit; they are not included
in Table 1.
Business income is taxed according to how a business is
legally organized. Basically, a business has two choices: to
Table 1. Top Five Small Business Tax Preferences in
operate as a C corporation or a passthrough entity. The
FY2018, Ranked by Revenue Cost
latter can be a partnership (including a limited liability
company or LLC), S corporation, or sole proprietorship
Estimated
(largely a self-employed person). The profits of a C
FY2018
corporation are taxed at two levels. First they are taxed at
Federal Tax
Revenue
the corporate level; then they are taxed a second time at the
Small Business Tax
Code
Cost
individual level of the owners when the profits are
Preferences
Section
($ billions)
distributed to them as dividends or capital gains. By
Limited expensing allowance
179
$45.7
contrast, the profits of passthrough entities (whether
distributed or not) are taxed only once: at the individual
Graduated corporate income
11
3.1
level of the owners. Under the tax rules that apply to 2017
tax rates
income, the top corporate income tax rate was 35% and the
Non-farm cash basis
446
2.3
top individual income tax rate 39.6%. Capital gains and
accounting
dividends were taxed at a top rate of 23.8%. This rate
structure meant that passthrough net income was taxed
Full exclusion of capital gain
1202
1.3
more favorably than corporate net income.
on the sale of qualified small
business stock
Some mistakenly believe that small companies are
Nonrefundable credit for
45R
0.7
organized as passthrough entities and large firms as C
small employer cost of
corporations. The truth is that most businesses are small. In
employee health insurance
2014, for example, firms with $500,000 or less in receipts
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link to page 2 P.L. 115-97, the 2017 Tax Revision, and Small Business Taxation
Source: CRS and the Joint Committee on Taxation.
39.6% to 29.6% (37% x 0.8, reflecting a 20% deduction for
passthrough business income), within certain limits. The
The most costly small business tax benefit, by far, is the
new tax law also repeals the corporate alternative minimum
section 179 expensing allowance, which operates as a form
tax (AMT) but not the individual AMT.
of tax deferral. Its estimated FY2018 revenue cost exceeded
the combined revenue cost of the other small business tax
P.L. 115-97 also makes the following changes in the small
benefits for which a cost estimate was available by $54
business tax preferences available under previous law:
billion (a difference that is projected to decrease to $20.9
billion in FY2020, owing to the deferral effect of the
 Increases the expensing allowance under section 179
expensing allowance on tax liabilities).
from $510,000 in 2017 to $1 million in 2018 (and its
phaseout threshold from $2.0 million to $2.5 million)
Expensing allows a company to deduct the full cost of an
and indexes both amounts for inflation beginning in
asset in the year when it is placed in service. Such an
2019, among other things;
allowance lowers the cost of capital for the investment,
boosts the firm’s cash flow, and simplifies its tax
 Exempts firms with average annual gross receipts of $25
accounting for depreciation. As a result of the new tax law,
million or less in the three previous tax years from the
a company may expense up to $1 million of the total cost of
uniform capitalization rules (section 263A);
qualified assets it places in service during 2018; this
amount phases out when the total cost exceeds $2.5 million.
 Allows firms of the same receipt size to use the cash
method of accounting for tax purposes, even if they
P.L. 115-97 and Small Business Taxation
maintain inventories (section 448);
The impact of any tax reform proposal on the tax burden of
small firms is shaped by three elements: (1) the tax rates for
 Exempts firms with $25 million in average annual gross
individual and corporate net income, capital gains, and
receipts in the last three tax years from a new
dividends; (2) the difference (if any) between the income
requirement under section 163(j) that limits the amount
tax rates for C corporations and passthrough firms; and (3)
of business interest a firm can deduct in a tax year to
the availability and extent of small business tax preferences.
30% of its adjusted gross income; and
In December 2017, the House and Senate agreed on a bill
 Repeals the graduated rate structure for corporations
(H.R. 1) to reform key sections of the federal tax code.
under section 11, as well as the option to defer the
President Trump signed it into law (P.L. 115-97) on
recognition of capital gain on the sale of publicly traded
December 22. Key elements of the new tax law affecting
stocks under section 1044.
small business taxation are shown in Table 2.
The cut in the top income tax rates for business profits
Table 2. Key Elements in the Taxation of Small
under P.L. 115-97 is likely to reduce the federal income tax
Business Income Under Previous Tax Law and P.L.
burden, relative to previous law, for many passthrough
115-97
businesses. The net effect for any particular firm also
depends on any tax benefits it gains or loses as a result of
Key Elements
P.L. 115-97
Previous Law
the law. Greater uncertainty surrounds the impact of the
Top corporate tax
21%
35%
new tax law on the tax burden of small C corporations. This
rate
is because the new tax law sets a flat corporate tax rate
(21%) that is greater than the lowest corporate tax rate
Top individual/
37/29.6
39.6/39.6
under previous law (15%).
passthrough
income tax rates
P.L. 115-97 could also contribute to an increase in the
Top capital gains
21
23.8
number of sole proprietors in the short run. This is because
tax rate
of the new 20% deduction for non-corporate business
income under the newly created section 199A. While
Individual and
Individual: 26 or 28 Individual: 26 or 28
various limits and exclusions apply to the use of the
corporate
Corporate: 0
Corporate: 20
deduction, it does have the effect of taxing wage income at
alternative
a 20% higher rate than the same amount of passthrough
minimum tax
business income. For example, for taxpayers subject to the
(AMT) rates
top three individual income tax rates (33%, 35%, and 37%),
the deduction lowers the top rate for passthrough business
Small business tax
12
13
income to 29.6%. Some wage earners may respond by
preferences
converting their work status to an independent contractor to
Source: Compiled by CRS.
take advantage of the lower tax rate on passthrough
business income.
P.L. 115-97 lowers the top marginal tax rates on corporate
and non-corporate business net income. Specifically, it
Gary Guenther, Analyst in Public Finance
replaces the graduated corporate tax rate structure (with a
top rate of 35%) under previous law with a flat rate of 21%;
IF10723
the top rate for passthrough business net income falls from
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P.L. 115-97, the 2017 Tax Revision, and Small Business Taxation

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