The economic engine of the United States was built by the efforts of small businesses, not large ones. This is validated even today, for example, by the fact that more than 60 percent of new jobs are created by companies with fewer than 500 employees.
I'm also probably biased to say it, but the vast majority of innovation (which can't be objectively measured) continues to be provided by smaller entrepreneurial companies. This is why it alarms me that, despite the growth in the cultural popularity of entrepreneurship, the rate of new business formation is in a long-term decline. And what's worse, the young are a smaller share of entrepreneurs than they were 25 years ago. In 1992, 44 percent of business owners were under age 45; now only 22 percent are. That is a very disturbing trend that we need to reverse.
This is why I believe it's so important that the Republican tax plans passed by the House and Senate are positive for smaller entrepreneurial companies.
Today, if you're running a small business that is an S corporation (which includes many LLCs) or an LLP, the profit you earn from the business is considered personal income to you and you are taxed at your individual income tax rate. So, let's say your S corporation earns $100 of profit in a year. The $100 (assuming you owned 100 percent of the entity) would be taxed at your individual tax rate — a rate that could be as high currently as 39.6 percent.
To give this some context, there are approximately 3.4 million small companies that are classified as S corporations, LLCs or LLPs, and these firms employ more than 32 million people. That doesn’t even include sole proprietorships, which comprise 21.9 million of the 29.6 million businesses in the U.S. (Compare that with large firms that are S corporations, LLCs, or LLPs; they number fewer than 10,000 and employ 10.7 million.)
Under both the House and Senate tax plans, the tax rate of the owners of these small companies will go down from the rate under the scenario described above. Specifically:
Under the Senate bill, the maximum individual tax rate for these "pass-through" firms would be 38.5 percent, but many firms would be able to deduct a significant share of their income, creating a lower marginal rate.
Under the House bill, the lowest rate for the smallest S corps and LLPs would go to 9 percent and would increase from there as the income level of the business increased.
Therefore, with no exceptions outside of certain limits due to each individual’s tax situation, this plan is a boon for small corporations and partnerships run by individuals. This aspect of both the House and Senate tax plans is clearly entrepreneur-friendly.
On a specific point of implementation, it is also important to note that the new lower tax rates or deductions for small companies go away for companies making the most profit. So these business tax breaks are not for multinational corporations - they are for small, closely held companies whose owners are often struggling to make payroll. Keep in mind that the average net profit margin of the vast majority of private companies is significantly under 10 percent. To put that in perspective, if a business' sales are under $500,000 a year, its owners are often lucky to make $50,000 a year in profit for themselves under often fairly risky conditions. In other words, the tax breaks under the House plan especially are targeted toward small firms, which is a good thing.
The tax plan’s skeptics will point out that the proposed tax breaks would also benefit those business owners who are not in financial need and who don’t struggle as much as the owners of low-income small businesses. It may not be perfect, but for those who are willing to do the almost impossible -- which is to look beyond the antics of the current administration -- the tax plans as they relate to small businesses are targeted and reasonable to help those providing the most innovation and jobs.
Brian Hamilton is founder and chairman of Sageworks. Mary Ellen Biery, research specialist at Sageworks, also contributed to this oped.
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