Keep The Small Business Tax Deduction

Editorial

With the Republicans winning the presidency, control of the Senate and probably the House, the country will have unified government for the first time since 2017. One issue demanding prompt attention after the new Congress is sworn in is to address the expiring tax provisions of the tax act of 2017, which changed personal and business tax rates and provisions, like the standard deduction for personal income taxes.

One provision that will sunset after 2025, unless renewed, affects thousands of small businesses across America that operate as sole proprietorships, partnerships and S-corporations. The Tax Cut and Jobs Act, as the 2017 legislation is officially known as, changed the rules on so-called “pass through” income that is earned by the business, but has to be declared by the business owners on their personal income tax return. Effective for tax year 2018, small business owners were able to deduct 20% of their businesses’ qualified business income, which is added to their personal income to make up their federal taxable income.

Keep in mind that just because this business income appears on the owner’s tax return does not necessarily mean that the owner is pocketing the money. He or she may be taking a salary, and possibly a dividend or profit share personally, but there may still be profits retained in the business. It’s just that all income for the owner and the business are getting reported on one tax return, at personal income tax rates.

Proponents of extending the deduction say that it helps small businesses thrive and grow. With all the headwinds that small businesses deal with, a bit of a tax break could make a real difference in the ability of the business to amass capital, or even remain in business. Lexington small business owner Tina Miller, who owns Walkabout Outfitters with her husband Kirk, wrote an opinion piece for the Richmond Times-Dispatch last week asking both the Democrats and Republicans to extend the deduction. She wrote that the deduction, “… has enabled my small business to grow, thrive and survive the ravages of the pandemic and the past few years.”

Miller says that the deduction helps their small business compete with larger corporations by, in effect, leveling the field in terms of taxation. Under the 2017 tax law, C-corporations are taxed at a flat rate of 21 percent. Personal income tax rates are graduated from 10 percent to a top rate of 35 percent. If a business owner’s federal tax income from their personal salary compensation is added to the business’s income, you can see how this pushes the total federal taxable income into higher tax brackets. If the same business was organized as a C-corporation, the owner would pay federal tax on their salary income only, and the business would pay federal tax at the 21 percent rate on the business income. That seems fairer to the small business.

Just to note, the 2017 law made the 21 percent corporate tax permanent. The small business tax deduction, and a lot of other tax provisions, expire next year.

Critics of extending the deduction point to the cost to the federal government in lost revenue. While true, simple fairness would dictate that small businesses and large corporations should receive similar tax treatment in terms of rates. If the concern is revenue, then Congress needs to look at the corporate tax rate at the same time.

Critics also point to studies that don’t show evidence of its effectiveness. The only study we found, though, was done in 2022 looking at tax year 2018, the first year the deduction was available. A lot could have changed in the five years since.

Small businesses are critical to the health of our economy. As long ago as 1819, John Marshall wrote in McCulloch v. Maryland that, “the power to tax is the power to destroy.” We’re certainly not arguing that taxation is necessarily destroying small business, but it’s certainly a factor in a business’s ability to survive and grow. And arguably, tax structures should be as fair as possible between small entities and large.

When Congress returns in January, we urge both parties to support extension of the small business tax deduction.