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What the Senate Tax Plan Means for Small Business

Dan Caplinger, The Motley Fool

The Senate passed its version of the tax reform bill on Friday by a 51-49 vote, with a flurry of last-minute amendments to the original Senate proposal in order to keep Republican holdouts from voting against the measure. With the vote, lawmakers from the Senate and the House will now confer to try to iron out differences between the two versions of tax reform and seek a compromise that both chambers can pass.

One important aspect of the tax reform measures that many people have focused on is their impact on small businesses. Although the provision that reduces maximum corporate tax rates from 35% to 20% has gotten the most attention from investors, many lawmakers have worried that those moves would have minimal effect on smaller companies that they see as the hope for spurring economic growth in the years to come. The Senate bill differs from the House's proposal in the way that it treats small businesses, and there will be some work to do before the two chambers can come to agreement on what small businesses will end up getting in the final version.

U.S. Capitol offset outside view of dome and main building from ground level.

U.S. Capitol. Image source: Getty Images.

How the Senate bill treats small business

The biggest issue facing small businesses involves the fact that most of them get taxed differently from big corporations. The vast majority of small businesses are set up as what are known as pass-through entities, such as partnerships, limited liability companies, or sole proprietorships. For most of those entities, corporate tax rates don't apply, and so the proposed reduction in the corporate tax rate won't give them any relief. In fact, many small businesses complained that the way the reform package was initially drafted, they would suffer a competitive disadvantage to bigger businesses because of the huge cut in the maximum corporate tax rate.

The Senate decided to give small businesses a tax break by offering their owners a deduction on a portion of the income that passes through to their individual tax returns. Under the final proposal, qualifying business owners will be able to deduct 23% of their pass-through income on their tax returns, subject to a limit of 50% of wage income in order to prevent potential abuse. Many service providers are ineligible for the deduction, with the intent being to favor more typical small businesses compared to the professional business entities that many sole proprietors and single-member LLCs use. This provision will be in place until the end of 2025, after which it would potentially disappear under the sunset provisions of the bill.

The approach that the Senate took differs fundamentally from how the House approached the issue. Rather than offering a deduction, the House suggested changing the tax rate that applied to the business income that pass-through businesses generated. A maximum tax rate of 25% would have applied to pass-through income, but limitations would have treated 70% of income as wages at the full ordinary tax rate unless a business could prove that a different percentage was appropriate. An even lower rate of 9% would apply to businesses earnings less than $75,000. Professional services companies, such as those operated by lawyers and accountants, would have been excluded from the preferential rate entirely.

Should small business owners be happy?

Reaction to the bill among small business advocates was mixed. Some groups praised the measure, arguing that it's the first meaningful tax reform in more than 30 years. Others argued that the bill doesn't go far enough to help small businesses, with the more meaningful reform efforts focused on large corporations that threaten to leave their smaller counterparts behind.

Yet beyond the pass-through deduction, there are some other provisions that could help small businesses. For instance, the Senate version would make current expensing rules more generous, allowing more businesses to write off the new equipment they purchase immediately over the next five years and then retaining a portion of that write-off over the following several years.

Small businesses will get some favorable impact from the Senate tax plan if it becomes law. However, the much more visible tax breaks will go to larger corporations, many of which those small businesses see as rivals. Business owners, investors, and average Americans will have to see how that dynamic plays out in the weeks ahead as lawmakers seek to find consensus on tax reform.

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