Renewing a Small Business Tax Deduction Is Crucial for US Growth

Americans conduct business with flow-through entities more than 95% of the time—either as a partnership, an S corporation, or a sole proprietor. Small businesses overwhelmingly prefer the flow-through system, with over 80% of them selecting it.

These flow-through entities rely on tax code Section 199A to remain competitive. As part of the 2017 Tax Cuts and Jobs Act, Section 199A allows a deduction for non-corporate taxpayers equal to 20% qualified business income, subject to certain limitations and phase outs.

On July 1, the Senate narrowly renewed the TCJA, which preserved Section 199A but returned the deduction to 20%, rather than approve the House’s proposed 23% deduction. The House should insist on the rate of 23% to provide small business with the tools to combat inflation and weather the current economic instabilities.

Section 199A encourages economic growth and reinvestment, as well as domestic job creation, affecting American workers. Congress explicitly stated in 2017 that their intent was to prevent this harm while encouraging growth of small businesses in promulgating Section 199A as part of the TCJA.

Small businesses structured as flow-through entities allocate profits and losses to their owners, who are then taxed on their share of the business profits at the individual income tax rates. In contrast, corporate profits are subject to two layers of taxation. First, the net profits of the corporation are taxed at the corporate level. Second, the dividends paid by the corporation to the individual shareholder are taxed at the shareholder level.

The Tax Cuts and Jobs Act slashed the maximum tax rate at the corporate level from 35% to 21%. Applying the two layers of taxation, the maximum effective corporate tax rate fell from 48% to 37%.

Section 199A preserves the buffer that exists between the corporate and flow-through tax systems by providing a deduction that effectively reduces the flow-through entity owner tax rates from 37% to 30%. Prior to the TCJA, that maximum effective rate was 40%.

Without that buffer, it quickly becomes more tax advantageous to operate in corporate form. Shareholders would be subject to a maximum effective tax rate of 29% if the corporation distributes half of its profits. Contrast that with the highest effective rate for a flow-through entity without the 20% deduction of 37%.

For many small businesses, the additional legal and accounting costs required to form and sustain the operations of a corporation are an unviable option. Adding to that burden, corporations require regular meetings to maintain the legal entity.

Compounding further, tax compliance is more complicated and impractical for the owner to do it themselves. Forcing the corporate structure onto small businesses would make their daily operations more difficult.

A national small business organization reported that 87% of small businesses owners said tax cuts allow them to reinvest in, and grow, their businesses. In addition to the tax effects, sudden and radical changes to tax rules create uncertainty that could discourage economic activity as investors delay spending decisions, reduce their workforce, or invest in more stable markets.

At a time when uncertainty exists about small US businesses and their ability to compete and thrive in the global economy, Section 199A provides a steady and helping hand, particularly with an increased rate of 23%. US small businesses can use the tax savings from their Section 199A deductions to expand their workforce and invest in new technology to advance and facilitate their business operations.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law, Bloomberg Tax, and Bloomberg Government, or its owners.

Author Information

Brad Mowell is a manager with Baker Tilly’s Washington tax council practice.

Dinh Tran and Cameron Johnson are directors with Baker Tilly’s Washington tax council practice.

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