The House Republican plan to cut taxes for small businesses has a big problem: Most apparently won't benefit from it.
The typical small business, whether it's a sole proprietorship, partnership or limited liability company, doesn't pay taxes itself, but its owners do as individuals.
And already about 86% of these so-called pass-through businesses pay no more than 25% under the individual code, the new top rate proposed for small-business income in the tax bill unveiled this week. So they won't get the legislation's much-hyped small-business tax cut.
On top of that, the bill makes it very difficult for lawyers, engineers, doctors, consultants and other personal services providers, who make up a good share of small businesses, to qualify for the 25% rate.
"The whole thing doesn't work for most small businesses," said Jack Mozloom, spokesman for the National Federation of Independent Business, which has declared it does not support the bill at this point.
"We think there ought to be a substantial benefit for everybody," he said.
Rep. Brad Sherman (D-Porter Ranch), an accountant and attorney who practiced tax law before being elected, said the pass-through tax changes were of no benefit to the vast majority of small businesses.
"It's the worst idea I've seen in a long time," he said. "It's able to combine incredible unfairness with a level of complexity beyond any provision of the tax code dealing with domestic income."
The centerpiece of the Republican bill are business tax cuts to spur economic growth and job creation.
The tax rate for corporations will be slashed to 20% from 35% and they no longer would face U.S. taxes on most foreign earnings.
But specifically cutting taxes for pass-through businesses, which also include S corporations — a structure often used by mid-sized businesses that might sell shares of stock — is more difficult. Their net income is subject to the individual tax code, which has a top rate of 39.6%.
So House Republicans proposed a new way to encourage investment by small businesses through a formula that seeks to tax revenue applied to capital expenditures at 25%. However, ordinary wage income paid by small businesses would not get the preferential rate and would continue to be subject to the individual tax code.
"We drive almost half a trillion dollars of tax relief for our Main Street job creators," said Rep. Kevin Brady (R-Texas), chairman of the tax-writing House Ways and Means Committee.
But most of the benefit from that new 25% rate — which the congressional Joint Committee on Taxation estimated would reduce taxes collected from small businesses by $448 billion over the next decade — would flow to a small percentage of business owners.
Only about 13% of businesses paid more than the 25% tax rate this year but they accounted for 77% of all pass-through income, according to the nonpartisan Tax Policy Center. Depending on their income, they now pay top marginal rates ranging from 26% to 39.6%
"It's only people above the 25% bracket who can even possibly benefit from the preferential rate," said Joseph Rosenberg, a senior research associate at the center.
The current 25% rate kicks in for income above $91,900 for individuals and $153,100 for couples. The House Republican tax bill would raise those thresholds to $200,000 for individuals and $260,000 for couples.
But the typical NFIB member wouldn't benefit from such changes, Mosloom said, since the average small business has five employees and $75,000 in taxable income.
"If the point of tax reform, as the drafters claim, is to lift the U.S. economy and boost Main Street America, it ought to boost Main Street America," he said. "The way they've structured it now, it's not truly a business pass-through rate."
Pass-through businesses with net income above the 25% tax bracket level would have two options for claiming the preferential rate under the bill.
The simple method would automatically allocate 30% of net income as business income subject to the new rate. The rest would be classified as wage income and subject to the individual tax rates.
"I anticipate a lot of small businesses do not want to hassle with the other options. They'll just take that one," Brady said.
Pass-through business owners also could choose to calculate their own percentage based on the amount of capital investment that they have made.
"If you are a business owner … you own your building, you're buying that equipment, you're putting capital at risk, [then] you're operating not as a wage earner," Brady said. "You can have a higher percentage of your income classified as business income."
Further complicating the matter, a person who is a "passive" owner and does not "actively" run the business would be able to use the 25% top rate on all business income that currently would be taxed at a higher rate, according to the legislation.
"An investor who's just making an investment in the business and isn't active in decision-making or the conduct of the business would typically be a passive investor," said Jeff Erickson, a principal in the national tax practice at Ernst & Young.
Existing Internal Revenue Service rules determine active and passive business owners. But the rules were put in place to prevent people from falsely claiming to be active in order to claim tax losses.
Under the new tax bill, the incentives would flip so that people would want to be passive business participants, so those rules might need to be changed, Erickson said.
Another potential area for abuse would be lawyers, hedge fund managers and other personal service providers classifying their wages as business income to use the 25% rate. The tax bill does not allow those businesses to use the simple 70/30 formula in order to prevent such abuses.
Those businesses could use the second option for calculating their capital investments to try to claim the 25% top rate. But they would have to prove they have made such investments.
"The idea is you have a lawyer or accountant just providing their labor you don't want to give a break for that," Rosenberg said.
Preventing personal services businesses from getting a tax break is unfair, said Keith Hall, president of the National Assn. for the Self-Employed.
"Many of our members probably wouldn't have a tax break because of that," Hall said of the group's 150,000 members.
House Republicans should change the bill so that new hires, such as a doctor hiring a nurse or an accountant hiring an assistant, are considered business investments subject to the 25% top rate, he said.