House Discusses How to Tax Small Businesses

A proposal presently being discussed before the House Ways and Means Committee (where tax laws begin) addresses how small business income will be taxed.  President Trump and the Republican-controlled Congress both desire major tax reform, and soon.    While much of the tax reform proposals have focused on reduction of the federal tax rates, taxing imports and not exports, and ending the federal inheritance or “death” tax, House tax writers are also grappling with how these new tax laws should affect small businesses.

Most small businesses that operate as legal entities apart from their owners are “limited liability companies” (LLCs) or corporations formed under Subchapter S of the Internal Revenue Code (S corporations).  Both of these legal entities generally do not pay income taxes, but instead file a return reporting income or loss, and then any net income or loss is reported to the owners of the business entity (through a “Form K-1”).  The owners then report their share of income or loss from the LLC or S corporation on their individual tax return (Form 1040).  In this manner, most LLCs and S corporations are referred to as “pass-thru” entities because they do not pay tax, and instead “pass-thru” their income/loss to their owners.

Where an owner of a small business, operated as an S corporation, is also an employee, the owner may be paid wages generally (W-2 income) in addition or as an alternative to receiving profit at the end of the year from the successful operation of the small business (K-1 income).  The distinction in this type of income is that wages and salary are generally subject to federal (and state) employment taxes (FICA, FUTA and wage withholdings), while profit distributions from a small business are generally not.

For years, small business owners operating S corporations have had difficulty with payments from their business, with some owner/employees receiving all salary/wages, others taking out their money all as profit, or a combination of both.  For owner/employees that take out all their money as profits, the IRS generally disfavors this approach, as profit payments are not subject to employment taxes.  Even having a small salary paid, and then taking the balance out as profits, does not make the IRS happy, unless the salary is “reasonable” for the services rendered by the owner/employee to the business.

The House now is trying to address these small business tax issues under the new tax legislation.  A proposal being discussed would make a standard allocation, such as 70% of the income of a business to profit and 30% to wages/salary for the owner/employer.  Another approach would have not strict allocation but the definition of a “reasonable wage or salary” would be better defined.  House writers are discussing how to tax LLCs and S corporations the same for this type of income.

Small business owners need to keep their eyes on these House hearings, as the new tax legislation will not simply affect “Big Business”.

About the Author

Erik P. Doerring
Erik leads the firm's economic development and tax practices. He is a business lawyer, with the skills of a tax litigator. Prior to joining McNair, Erik was an attorney with the IRS Office of Chief Counsel and the U.S. Department of Justice, Tax Division.