Senate tax reform plan — would it help or hurt small businesses?

MICHAEL REYNOLDS/EPA - Here’s a smalll-business breakdown of the latest tax reform plan from Senate Finance Committee Chairman Max Baucus (D-Mont.)

The Senate’s top tax writer has set out to overhaul the nation’s tax system, and while his plan would have the most direct consequences on large, multinational corporations, it would change the rules for many small businesses, too.

Senate Finance Committee Chairman Max Baucus (D-Mont.) recently started rolling out the specifics of his proposal, which is meant to stabilize and simplify the tax code and lower the base rate for corporations. Meanwhile, the proposed changes would impose taxes on earnings parked overseas and curb certain tax deductions, generating about $200 billion in added revenue for the cash-strained federal government.

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Baucus had been working with his counterpart in the House, Rep. Dave Camp (R-Mich.), to craft a bipartisan proposal, but with Republicans shifting attention to more timely matters, like the health care law and the looming budget batter, Baucus has elected to forge ahead solo on tax reform.

“America today is using a bloated tax code that was built for businesses close to 30 years ago,” Baucus said while releasing his plan, adding that “more must be done to simplify tax rules, lessen the burden on small businesses and jumpstart job growth.”

We dove into the proposal and found five ways the changes would affect firms on Main Street.

Section 179 expensing upped to $1 million

Section 179 refers to a federal rule allowing small companies to immediately expense their investments in certain fixed assets, like large equipment and property. This year, employers could deduct up to $500,000 from their tax bill by way of the provision, which is meant to encourage business investments.

Next year, the cap is scheduled to drop to $25,000, much to the chagrin of small business community. Instead of lowering it, though, Baucus wants to permanently double the deduction limit to $1 million.

His proposal would also greatly expand the number of assets eligible for Section 179 expensing — a potentially big win for firms hoping to expand or upgrade equipment in the coming years.

A lower corporate tax rate

While the majority of the country’s small businesses are organized as pass-through firms, meaning their owners include business proceeds as part of individual income when they pay taxes, many are structured as C corporations — as a result, they pay taxes at the corporate rate. At 35 percent, that corporate rate is currently the highest in the developed world.

Baucus would use some of the revenue generated by his plan to lower the rate, and while he has not specified an exact target, he says he would like to bring the rate below 30 percent. By comparison, President Obama has pushed for a corporate rate of 28 percent, while Camp has said it should be no more than 25 percent.

The latest available data from the Small Business Administration shows that the country had more than 1.3 million C corporations with fewer than 500 employees in 2007, many of which would likely benefit from a lower corporate rate. Meanwhile, a recent study by the National Federation of Independent Business, showed that 96 percent of all corporations have less than $25 million in assets.

Moreover, among corporations, it is those smaller firms (often without the resources to take advantage of available loopholes) that generally pay the highest rates. The NFIB study showed that C corporations with between $5 million and $25 million in assets pay an effective rate of around 33 percent, more than double the 15.5 percent actually paid by C corporations with more than $2.5 billion in assets.

Accounting rules reshuffled

Some business owners have an option of two common accounting methods, commonly known as cash accounting and accrual accounting. However, many are legally required (based on any number of factors, including the company’s structure or sector) to use the accrual method, which, for example, takes sales into account when a contract is signed, rather than when the payment is received (cash accounting).

The accrual method is generally considered a more complex system to manage, particularly for small firms. Currently, C corporations with more than $5 million must use that method, while most “pass-throughs” can use the simpler cash accounting system.

“Our current tax accounting rules are thus highly complex and force taxpayers, and especially small businesses, to spending precious capital on outside advisors to help with their tax compliance challenges,” Baucus wrote in a summary of his discussion draft.

Baucus’s plan would allow all every company with less than $10 million in annual sales to use the cash accounting method, regardless of the firm’s sector and structure — good news for small C corporations. On the other hand, S corporations, partnerships and other pass-through businesses with more than $10 million in sales would now be required to switch over to the more wonky accrual method.

New barriers to entry for start-ups

One of the ways Baucus would offset lowering the corporate rate is by slowing the rate at which firms can write off the cost of certain investments and expenses going forward. Currently, the rules often allow firms to write off the cost of equipment faster than it actually depreciates, a system intended to encourage more investments.

Under the new rules, tax collection would more closely match the depreciation window to the equipment’s actual rate of depreciation.

In a recent column, Ramesh Ponnuru, senior editor at the National Review, outlined one the potential pitfalls of that particular change:

Consider a company that is still seeing payoffs from an investment it made and wrote off years ago. It enjoyed a relatively speedy depreciation schedule and will now face lower taxes on its returns. . . A company that makes investments under the new rules, on the other hand, will have a lower rate on its future profits but will also get slower write-offs on its investments.

The reform will favor older and established companies over startups. So the startups will have a higher total tax burden than they would have had without the reform.

Not much help for S corporations and partnerships

We already mentioned that larger pass-through firms could lose out in the restructured rules for cash and accrual accounting — but there are other potentially detrimental changes on the horizon.

Baucus’s proposal would also take an axe to longstanding tax deductions for advertising investments, allowing firms to deduct only half of advertising expenses the year they are incurred (rather than the full amount right now). The Association of National Advertisers immediately slammed the proposal, arguing that it would “cause a substantial disincentive for companies to spend additional advertising dollars.”

His proposal would also eliminate some immediate tax deductions for research and development investments. Of course, those are tradeoffs for lowering the corporate tax rate — but again, that’s not the rate handed over by most small business owners.

Under the Baucus plan, pass-through firms would take a hit on various lost deductions but without the upside of a lower overall tax rate. In fact, with the highest individual rate already up around 40 percent, lowering the corporate rate below the current 35 percent could place S corporation and partnership owners at an even further disadvantage to their C-corp counterparts.

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