Right now, no one knows whether President Biden’s business tax proposals will become law. Which means planning for any changes is tricky.
Yet the proposed tax laws change vast parts of the Internal Revenue Code. Especially for entrepreneurs and active investors.
And then the real issue here: By the time we do know all the details? Your room to maneuver may be limited.
Given all this, entrepreneurs and investors want to understand now how Mr. Biden proposes changing the tax laws that apply to small businesses. And in this blog post, we focus on one part of the proposed change: how small business C corporation tax laws might change.
But let’s get into the details… and then let’s also talk briefly about what you might want to do soon to minimize the impact on your ventures.
Biden Tax Plan Hits Small C Corporations Two Ways
Two tax rate changes proposed by Mr. Biden hit a handful of small business corporations hard.
First, the corporate tax rate increases from 21 percent to 28 percent. But not all corporations pay federal income taxes. The Biden administration proposal discussed here affects those corporations, called C corporations, that do pay income taxes. So that’s the first change small business corporations face.
And a second tax rate increase also impacts some of the entrepreneurs who own and operate these small business corporations. If a small business owner has other income that equals or exceeds $1,000,000—say the entrepreneur and his or her spouse earn $1,000,000 in wages and other income—the tax rate on C corporation dividends goes from 20 percent to 39.6 percent.
In combination, these two tax rate changes bump the federal taxes some high-income small businesses pay by about 50 percent as shown in the table that follows:
|Current tax law for “C” corp||Proposed tax law for “C” corp|
|Corporate tax (either 21% or 28%)||$210,000||$280,000|
|After-tax income paid as dividends||$790,000||$720,000|
|Dividend tax (either 20% or 39.6%)||$158,000||$285,120|
|Net investment income tax||$30,020||$27,360|
|Actual after-tax income||$601,980||$407,520|
To summarize, federal taxes currently take roughly 40 percent of a really successful C corporation’s business income. And Mr. Biden proposes taking as much as 60 percent of these businesses’ profit when the owners earn a seven-figure income.
Avoiding the Biden Tax Increases: Option #1
Most small business corporations don’t operate as C corporations. And those that do, mostly don’t generate enough profit to pay all of the higher tax rates proposed. (Even the smallest profitable C corporation, however, will pay the new higher 28 percent corporate tax rate.)
However, if your small business corporation will get really hit? You probably want to talk with your accountant now about taking steps to reduce or even avoid some of the tax bump.
Two options seem worthy of consideration:
First, small business corporations with large retained earnings balances may want to pay large qualified dividends before 2021 ends.
Mr. Biden’s American Families Plan taxes qualified dividends earned by high income taxpayers at a lower rate in 2021 (20 percent or 37 percent) than in 2022 and later years (39.6 percent).
Note: Mr. Biden wants to step up the tax rate on qualified dividends twice for the highest tax bracket taxpayers. The first step from 20 percent to 37 percent occurs sometime during 2021—but no one is sure exactly when. A second step from 37 percent to 39.6 percent occurs on January 1, 2022.
Avoiding the Biden Tax Increases: Option #2
Some small business C corporations should consider another change: Electing Subchapter S status.
An S corporation typically pays no federal income taxes. Furthermore, the current tax proposals from Mr. Biden suggest that the Section 199A deduction still exists. This deduction means a business owner pays federal income taxes on only 80% of the business income.
The one new rub with the Subchapter S option? While in the past, active shareholder-employees avoided the 3.8 percent net investment income tax with an S corporation, Mr. Biden proposes eliminating that loophole if the shareholder earns a high income.
But even so, an S corporation saves significant amounts of tax for high-income small business owners, as shown in the table that follows:
|Proposed tax law for “C” corp||Proposed tax law for “S” corp|
|Corporate tax (either 28% or 0%)||$280,000||$0|
|After-tax income paid as dividends or distributions||$790,000||$1,000,000|
|Dividend tax (either 39.6% or 80% of 39.6%)||$285,120||$316,800|
|Net investment income tax||$30,020||$38,000|
|Actual after-tax income||$407,520||$645,200|
Roughly speaking, then, under the new proposal an S corporation might pay roughly a 35 percent tax rate. So actually less than it would have paid under current law as a C corporation.
A Technical Reminder for Tax Advisors
A quick sidebar to tax advisors and sophisticated entrepreneurs: A C corporation electing Subchapter S status may pay a built-in gain tax once it becomes an S corporation on unrealized profits from the years it operated as a C corporation.
The built-in gain tax rate equals the corporate tax rate. Because that tax changes from 21 percent to 28 percent under the Biden proposals, the timing of the S election matters here.
For example, tax advisors and their clients may want to consider whether a late S election can be made, thereby paying some or all of the built-in gains tax using the 21 percent tax rate applicable to 2021 rather than the 28 percent tax rate applicate to 2022 and later years.
A Final Caveat: Section 1202 Qualified Small Business Stock Loophole
One final quick comment: If a C corporation qualifies for Section 1202 tax treatment? Yeah, that probably trumps the idea of electing Subchapter S status. Or maybe one should say that option possibly trumps the Subchapter S status idea.
Here’s why: A small business entrepreneur pays a 0 percent capital gains tax rate on Section 1202 Qualified Small Business Stock gain.
Mr. Biden explicitly proposes leaving the Section 1202 loophole in place while bumping the top capital gains tax rate to 39.6 percent. If a business owner operates a firm that can qualify for Section 1202 tax treatment and she or he plans to exit soon, temporarily paying higher taxes for a few years but then selling out without paying any capital gains taxes might save the most tax.
Other Resource You Might Find Useful
We have a couple of Evergreen Small Business blog posts that discuss how Section 1202 works: Section 1202 Qualified Small Business Stock Exclusion and Section 1202 Qualified Small Business Stock Pitfalls.
The Department of Treasury’s General Explanations of the Administration’s Fiscal Year 2022 Revenue Proposals (also known as the Greenbook) appears here.