2017 Tax Bill: Small Business is Punished for Raising Wages

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Normally I don’t like to comment on a tax bill before it becomes law, hence the reason I’ve only commented once on the current bill as it wound its way through the halls and committees of Congress. Now that the bill is sitting on the President’s desk awaiting his signature I’m comfortable opening a dialog on some of the issues I see the regular press has missed.

Since the beginning I’ve called this a Swiss cheese tax bill because it has so many holes in it I can drive a truck through with my eyes closed without a worry I’ll hit a wall. I suspect many of these holes will be closed in time. Until then, fuel up the truck fellas. We’re going for a ride.

The Missing Link

Pass-through entities don’t pay taxes at the corporate rate, instead, passing certain items, including profits, to the owners to be reported on their personal tax return. Income is generally taxed at ordinary rates.

The current bill reduces the tax rate for regular corporations (C corps) to 21% while individual tax rates top out at 37% for individuals. To level the playing field between regular corporations and pass-through entities (S corps) the bill included a 20% deduction on pass-through business income.

The deduction is limited to $315,000 of eligible income for married couples and $157,500 for single filers. However, a last minute change greatly enhanced the advantage!

A formula was inserted which will allow the 20% deduction of income on amounts greater than the income limits. The formula for the deduction is the greater of: 1.) 50% of wages, or 2.) 25% of wages, plus 2.5% of the value of qualified property at purchase.

Real estate is the target of this formula. It will allow for massive deductions for certain real estate investors at rates tremendously higher than many other small business owners will get.

But that isn’t what I want to talk about today.




A Load of Swiss Cheese

Traditional news outlets will give you the basics of the tax bill. I’ll touch on the same issues in the near future. For now there is a pressing issue we need to discuss instead.

The above business deduction for pass-through entities makes current year (2017) business deductions more valuable than if taken next year if you are under the income limit! This includes real estate investors where the deduction can be much higher.

As I read the bill, my interpretation is the deduction extends to sole proprietors and small landlords. When the IRS provides regulations on how the new deduction is handled I may have to give updated advice later. It’s unclear if small landlords and sole proprietors get the deduction without creating a pass-through entity. As I read the bill it is allowed without the extra paperwork. But the IRS may disagree and it might be necessary to hold real estate in a partnership, or if there is only one owner, an S corp. (Gulp! Did I say that?) I’ll keep you up to date. As soon as I have more clarity I’ll pass it along. Either way, there should be a way for owners of income property and sole proprietors to take advantage of the new deduction.

There are two reasons for business owners/landlords to accelerate expenses before year-end: 1.) Tax rates are declining slightly for many individual taxpayers, and 2.) A deduction is worth less next year.

This might seem counter-intuitive, but Congress may have passed a tax bill that discourages pay increases and capital expenditures by small businesses and investors of investment property.

Deducting as much as possible this year makes sense with rates going down in 2018. Buying an asset and expensing it, if possible, is worth more now than it will be in a  week and a half after publication of this post due to the lower rates AND the business income deduction!

An example illustrates the disincentive to invest in more capital expenditures and payroll next year. Suppose we have a small business with $200,000 of profits. If the business is planning an investment in a new piece of equipment costing $50,000, the owner’s tax benefit is reduced by 20% in 2018 and after! It looks like this under the new tax bill:

Without equipment purchase:

Income: $200,000

20% business deduction: $40,000

Income reported on personal tax return by owner: $160,000

With equipment purchase:

Income: $200,000

Deduction for expensed equipment purchase: $50,000

Income after equipment deduction: $150,000

20% business deduction: $30,000

Income reported on personal return by owner: $120,000

The equipment cost $50,000, but the reduction in income is only $40,000! The business owner saw a reduction in tax benefits from the increased expense by 20%.

We can debate the method used to deduct the property (expense versus depreciate), but the premise is the same: every business expense is worth 20% less starting January 1, 2018!

Look at it this way. If a small business owner increases wages, as Congress says they are incentivized to do, they will suffer the cost of the higher wages AND a reduction in the new business credit! The business owner will cough up the added payroll expense, plus payroll taxes, and face a decline in the business credit.

If the small business owner REDUCES wages, they are rewarded under the new tax bill! If a business owner cuts payroll by $100,000, she will save payroll taxes AND have a higher income of which 20% is deducted. The $100,000 increase in business income will only have $80,000 subjected to tax.

One last example: Prior to January 1, 2018 it is illegal to deduct 20% of a business’s profits for fake business miles or other non-cash deduction. Starting January 1, 2018 you don’t have to cheat to get the benefit; it’s codified!




Final Thoughts

Congress has sold this massive tax bill as a job creator. Instead of taking time to get a solid piece of legislation written, they rushed it and it shows.

The incentive to small businesses is clear: CUT PAYROLL! This will have the opposite effect of what was intended.

Sure, businesses will need to spend on updating equipment eventually. But the longer they can hold off the better they will fare; they get a 20% deduction off the top before they spend a penny. A smart small business owner will have more incentive than ever to CUT wages and capital expenditures. And for the altruistic business owner, a tax penalty applies in the form of a reduction in the new business deduction if they do increase wages.

Real estate investors tend to hire fewer people so the effect is less. Even still, spending on improvements entail up to a 20% penalty for each outlay as the business deduction is reduced.

My favorite deductions have always been of the non-cash nature; I get a deduction and keep the money, too.

I hope y’all love Swiss cheese because there will be plenty to go around until they change the tax law.

 

Note: This is self-serving as all get-out, but this is one simple example of how this tax bill will harm the economy and the workforce, the backbone, of America. If you can see past my self-promotion, spread this post everywhere: social media, email and links. Don’t forget your elected officials in Washington. Don’t be afraid to expand on the consequences of this tax bill. There is plenty to spur the economy. But there is also plenty to slow the economy as well. With small business employing so many people in this country it is imperative to get the word out so the people who can facilitate appropriate change can take action with this new knowledge.



Personal Capital: You can't manage what you don't know.

Keith Taxguy

27 Comments

  1. Mike at Balanced Dividends on December 22, 2017 at 8:04 am

    Thanks for your overview, Keith.

    Likewise, I also waited a while for posting about the reform until it moved at least to the executive branch (although, I thought it would have been signed by now).

    Swiss cheese is my favorite (for taste as well as for having fewer calories than most other cheeses – and not because the holes), but I can see your points about the excess in this bill.

    • Keith Schroeder on December 22, 2017 at 8:09 am

      There is plenty more to write about on the tax bill, Mike. I’ll have a few wide reaching posts with a large number of posts focusing on a narrow topic. To achieve the greatest benefit people will need to think this thing through. And that’s why I’m here. To periodically zap folks with a cattle prod so they take the appropriate financial steps.

  2. Jeff on December 22, 2017 at 8:59 am

    I appreciate all of these tax posts (REALLY appreciate). I’m going to selfishly ask for more explanation on the 20% pass through deduction. Would you mind giving one or two quick, fuzzy math, examples of owner income at $250K and $500K?

    Are you saying a business owner that this year would pay escalating taxes on 500K of income… next year would only pay escalating taxes on 400K (20% deducted). And that 20% deducted (100K to the owner) has NO tax on it?

    • Keith Schroeder on December 22, 2017 at 11:19 am

      There are too many variables to cover all the possibilities in a short answer. I will share a few additional points now that I have coffee in me this morning.

      If you are under income limits (really small businesses) then you get a 20% deduction of income from a pass-through entity. Higher income doesn’t have the same affect. What I am explaining in this post involves smaller employers under the income limit.

      Your escalating income question is only slightly right. If under the income limit you get a 20% reduction in reportable income from the pass-through. If over the income limit the formula applies and the deduction can be above the income limit, but the business deduction is still only UP TO the 20% of income. So yes, $500k of income this year is worth less after-tax than $500k of business income in 2018.

  3. 2017 Tax Bill: Small Business is Punished for Raising Wages – Talking FI on December 22, 2017 at 9:54 am

    […] current bill as it wound its way through the halls and committees of Congress. Now that the… 2017 Tax Bill: Small Business is Punished for Raising Wages Source: Wealthy […]

  4. TaxBeginner on December 22, 2017 at 11:12 am

    But if the formula is limited in respect to the wages paid, doesn’t wages have a positive and negative effect? If you lower wages by $100,000 you are also reducing the deduction allowed by $50,000 or $25,000 depending on the formula you use.

    • Keith Schroeder on December 22, 2017 at 11:25 am

      Taxes have no effect under the income limit. Over the limit the formula causes a pivot. More wages might help, BUT you forget who the formula is for, real estate investors. That is how they got Republican Senators to switch their vote; buy paying them off in the form of a massive tax break. Senator Corker railed against deficits. They didn’t fix that problem, but added the formula so Mr. Corker will enjoy nearly $2 million in tax savings a year. I gues there is a price when it come to serving yourself, ah, I mean your country.

      Real estate investors have few employees, hence the 2.5% of real estate at purchase price allowed. You don’t need employees and in fact want to pay them as little as possible. I guess you could tweak the formula to show instances where more payroll would benefit the business owners, yet in real life situations most real estate investors and small business owners will want to reduce payroll (and other expenses, including capital expenditures and upgrades) as much as possible. If they don’t they will lose the 20% non-cash deduction on those expenses and payroll.

  5. JOHN MARINO on December 22, 2017 at 4:42 pm

    Keith, you’re not thinking clearly on this one. Sorry, but your logic makes no sense.

  6. Mick on December 22, 2017 at 6:33 pm

    So it incentivizes small business to reduce payroll, but incentivizes large corporations (AT&T, Comcast, Boeing, etc.) to increase compensation and invest in workforce?

    From a personal perspective, I ran a quick comparison based on my 2017 income and deductions taxed under current law vs. the new and I see a reduction of between 1 and 3% of my AGI. I am pretty happy with that, but I still can’t fit it on a postcard.
    I ran a few different levels of charitable giving . Currently my SALT deduction is a few hundred more than the standard deduction, so any charitable giving gets fully itemized under current law. Under the new law (with $10K SALT limit and $24K standard deduction) I would have to give a lot more or aggregate every other year to pierce the standard deduction. But I am paying less tax anyway, and now I don’t have to worry about keeping every record, or if a charitable recipient is not qualified.

    I will definitely accelerate my 2018 property tax and giving into 2017 though.

    I do not see this as a great bill, but it seems like a move in the right direction. I mean, lowering individual rates, moving people away from schedule A, and reducing corporate tax rates sounds good. Maybe it is the “most significant tax reform … since 1986” but, to quote George Will, that is “like bragging about the tallest building in Boise.” OTOH, I don’t think I can agree with Nancy Pelosi calling it “the worst bill in the history of the United States Congress.”

    I see the projected $1.5 Trillion “cost” bandied about, but that is over ten years and amounts to about 1% of GDP over that period. I will wait and see how it plays out in promised economic growth.

    • Keith Schroeder on December 22, 2017 at 9:13 pm

      Mick, this isn’t a political diatribe. I don’t care about Pelosi or other politicians’ opinions. The tax law has a few large corporation giving out a one-time $1,000 bonus. Big deal. Since they’re getting a 40% reduction in their tax bill you’d think they’d at least make it permanent. The reason it isn’t permanent is because the corporations know if they spend it all on additional payroll their earnings will not climb and shareholders will see the stock market decline once they realize the tax bill didn’t do them a lick of good.

      And the rules for the big corps is different from small businesses. Big corps get a permanent tax reduction from 35% to 21%. Small business gets a business income deduction thanks to Senator Johnson from Wisconsin, my home state. Johnson is a businessman and refused to sign on to the bill until small business got something out of the bill. I like that part.

      So run the numbers for a mom and pop business and see if I’m wrong. Millions of small businesses have less than $300,000 of profit annually. If they increase spending, including payroll, they are not rewarded by the tax bill. Small business experiences their greatest benefit by reducing costs. Run a side-by-side; I dare you.

      I spend one or two days a week doing nothing but consulting in my office. Most of these people own a business. We’ve run the numbers and we’ve come to the same conclusion every time. Every business owner has said the same thing, “So I get a 20% deduction without spending a dime more, but lose the 20% deduction on any increased spending?” I have to answer “Yes” each time. After several reviews with the same outcome it was time to write a post on it.

      There is a possible out, however. If pass-through businesses convert to a regular corp (C corp) they might still benefit more from the lower corporate tax rate even after the double taxation of C corp dividends.

      Regardless, there is another wrench in the tax machinery. Reducing taxes is fine, but that is where we should have stopped. Individual rates should have been lowered MORE instead! It would have had more value. We lowered taxes for business owners as long as they don’t call me at year-end and ask how much they should buy in capital assets to reduce their tax bill. The new answer is, You get 20% off the top anyway without spending a dime. Most small businesses aren’t looking to spend 20% or more of their income to get a tax reduction. And now they don’t have to, they get the reduction without the spending; something I like. But it will not help jobs or the economy except for major corporation.

      Taxes for individuals should have been lowered more so the tax gimmick for small businesses wouldn’t have been necessary. Senator Johnson balked because big business saw a 40% decline in their top tax rate while pass-through businesses saw their top bracket drop from 39.5% to 37%. The 20% business income deduction was the fix settled on. I can’t imagine it lasting more than a few years as the consequences percolate through the economy.

      Then again, I could be wrong. But if you disagree, show me the numbers and prove me wrong.

      • Mick on December 23, 2017 at 11:10 am

        Keith,

        Thank you for “schooling” me with that detailed response. I was making a static comparison, which looked good for small business. I see the disincentive to investing in the business (be it through improvements, employee compensation, or whatever)., and yeah, that is a huge flaw.
        Could a small business owner “game” this by reducing employee compensation, pass that money to personal income, then gift it back to the employee (up to $30K per year for a couple tax free)?

        Sorry for the political comments, but my point was that comments on both sides are so grossly exaggerated. But I guess that is just politics, and the truth is somewhere in the middle.

        • Keith Schroeder on December 23, 2017 at 11:25 am

          I wasn’t trying to school you, Mick. Rather than respond to several comments separately I tried to encompass my thought process. My “political” comment response was less about you, Mick, and more about heading off more comments based solely on political ideology. Sorry about sending a warning shot a quarter inch past your left ear. On a brighter note, How’re your shorts?

          I like your thought on gaming the system. It would be a big no-no however. Recharacterizing wages as gifts would end badly. That said, if I could do it I would and the new tax bill wouldn’t be the cause; it’s the payroll taxes I’d avoid.

          There is a real interplay for business owners here. A simple deduction is no longer so simple. Business expenses, looked at another way, are business expenses plus 20% of profits, adjusted for the reduced profits whenever an expense occurs. I might revisit this topic again when I have more time. (I do take time for family over the Christmas holiday so this post was shorter when it really needed more fleshing out.)

          Sorry again, Mick, for the “schooling”. I knew it was coming out a bit harsh as I wrote, but hoped you’d understand. It was my fault. This whole concept needs more work to present to readers so they get the full flavor of the interplay involving pass-through entities.

          • Mick on December 23, 2017 at 1:13 pm

            Keith,
            I meant the comment only in a good way. I appreciate a different point of view or interpretation–I always assume I might be missing something and could possibly be wrong.
            I did not think it was harsh at all. After all, schooling–education–should be a good thing.
            Problem is that in a text-only exchange you miss a lot of nuance of F2F. For this reason, I always try to imagine and apply the most benign, positive interpretation of texts and emails.



  7. Fred on December 22, 2017 at 10:06 pm

    Did the plan to allow you to withdraw 25% from a qualified retirement account to pay down or pay off a mortgage and only be taxed at a 10% rate make it into the final tax bill

  8. Matt Leonard on December 23, 2017 at 12:22 pm

    Hey Keith, absolutely love your content and can’t wait for further breakdown of the new bill and how we can maximize tax efficiency through it. Your blog is one of my few Must Reads on the Internet, keep up the good work.
    I think I have found a flaw in your example… while moving any expenses you can to 2017 is a no brainer, I think you are missing a key factor with the “all business expenses are worth 20% less in 2018”. That factor is that a business owner would be an idiot to make a 50k investment with no expected increase in profits, either by reducing operating costs or expected increase in revenue. Your 200k income comparison does not include the expected additional income generated by that 50k investment, which would be worth 20% MORE in 2018 than in 2017 due to the 20% deduction. Am I missing something?

    • Keith Schroeder on December 23, 2017 at 2:28 pm

      I didn’t miss it, Matt. A business owner will still find reasons to increase wages or invest in new equipment. The tax bill shifts he decision somewhat since the business gets a 20% regardless (usually) if they spend the money. The choice now is: receive a 20% or 100% deduction. The 20% deduction doesn’t require any cash outlay.

      If the investment outperforms the free ride then I expect a business owner will open her wallet. But there is a free ride factor now to consider. The incentive is to spend less in some (not all) instances due to the new 20% deduction.

      If even a small amount of improvements are delayed for tax considerations or mis-estimating the value of the tax deduction, we could see a slight slowdown in economic performance. Worst of all, it could cause a drag on productivity which is where real wage increases come from.

      • FullTimeFinance on December 24, 2017 at 1:30 pm

        I guess I can’t really agree with the logic Keith. Business investments should almost never be based on taxes imho. Taxes are part of what defines the amount available to invest which the deduction increases regardless, but business outcomes should drive expenditure. Ie if I have a company making 500k and I invest 50k it better now return more then 500k or I wouldn’t do it. At least in the near term I believe it’s a forgone conclusion this bill will increase business investment either directly to the business or via bank loans on savings to other businesses. I think the bigger issue is the mid term. Ie will the glut of funds lead to a poor choice in investments and ultimately just inflation.

        • FullTimeFinance on December 24, 2017 at 1:53 pm

          One caveat after rereading my comment. The deduction in taxes obviously can change investment roi at the margins for an individual company. But it’s one of many factors and in the overall economy there’s always someone willing to lend the money if the government increases supply and sentiment is ok. They just may use it somewhere stupid like bitcoin on margin…

        • Keith Schroeder on December 24, 2017 at 7:00 pm

          Then cutting taxes never helps the economy since the business owner will not consider taxes, FTF. So why ever adjust the tax mix except to fund government expenditures?

          Let’s use your $50k investment. In the past in would probably make sense to expense (Section 179) the whole cost if allowed. But deducting the full $50k means your business deduction is reduced by $10k! Your decision tree has a few more branches and the obvious choice in the past may not be the obvious choice now.

          I agree that business owners should make decisions based on if the investment provides an adequate return. I wish it were true, but just like stock investors don’t always make good decisions, basing their actions instead on fear and greed, business owners will talk with their accountant and learn they get a $10k deduction which they’ll lose if they have a $50 deduction*. It will play a role in the decision making process. How could it not?

          * $50k deduction reduces profits which means the business income deduction of 20% is based on a lower number.

          • FullTimeFinance on December 24, 2017 at 8:44 pm

            Technically the real boost from a tax increase is an increase in the money supply… lending, investment, etc when money is tight. At full employment I don’t believe there is a middle to long term benefit.



  9. shawn devooght on December 24, 2017 at 12:42 pm

    very interesting sh&^%%$$%t kieth, i want to hear more about the real estate specifics for pass through entities. for obvious reasons.

    u referenced “50% of wages”, is that to be interpreted as any money taken? like is a draw treated the same? and when u reference 2.5% of property im assuming were talking about buying a piece of real estate? so if you pass through 100,000 in profits and buy a 100,000 property you would add 25,000+2,500 or 50,000 and get 20% or 10,000 added deduction over the limit of 137,500 amount? not sure if im asking the question right but all the same i think i understand what ur saying.

    • Keith Schroeder on December 24, 2017 at 6:50 pm

      Shawn, it was your consult that led to this post. For RE it’s 50% of wages OR 25% of wages AND 2.5% of tangible assets at the purchase price. Even with no employees there are advantages.

  10. shawn devooght on December 24, 2017 at 12:54 pm

    ok after further research i see that the wages ur talking about are not the buis owners wages necessarily but the total wages that a co pays. that makes more sense , pls disregard that part of my question/comment .

  11. Jim Howard, EA on December 24, 2017 at 3:59 pm

    If a small business could cut payroll by 20% would not they have already done that? And isn’t kind of risky to assume that if I cut my payroll by 20% my income would remain the same?

    You’ve got some good points here, but that example is a little far fetched.

    • Keith Schroeder on December 24, 2017 at 7:13 pm

      I agree with you, Jim. Employers will probably not increase wages as much if they can help it. Another point to consider: A one-time improvement that replaces an employee is worth more now since 20% of future earning will be excluded regardless if funds are spent unless the tax law is changed.

      I used a far-fetched example so it’s easier to see. If I would have said employers might shave a bit off the top of wage increases it would have made a muddy example more difficult to understand. It will be easier to see in an equipment purchase and expensing choices. There will also be added incentives for cost-cutting. That isn’t always a bad thing.

      The interplay on this will be interesting. I predict we will hear more about this as more people realize the cause and effect of the new tax deduction. There are plenty of additional moving part. The ACA also caused businesses to change their behavior. I do NOT predict a large level of layoffs from the tax bill. But with any whiff of a slowing economy employers might be faster to cut employees loose and slower to hire back. And, as I said, technology might be a better choice than flesh and blood as the machine is a one-time cost while an employee is a long-term expense. The employers still gets a 20% deduction once the initial machine cost is absorbed.

      For the record, the tax bill already caused my firm to stop new hiring. (We will hire three fewer new staff for the new year and employ technology instead due to the higher after-tax ROI.) New technology was cheaper to employ the last days of 2017 and only 80% of the excess profits are taxed. All I have to watch is the 50% of wages part. But as a tax pro, you know most businesses have payroll high enough to cover the max business income deduction.

  12. […] will cover a wide variety of tax issues that are changing. It will repeat a few facts published here and here […]

  13. […] the tax code now punishes added payroll expenses significantly since if you didn’t spend on payroll the extra profits are barely taxed (big […]

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