In a prior post, we discussed how President Biden’s tax proposals under the American Jobs Plan could increase the taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. burden on small businesses in the corporate sector. This post will examine how the tax proposals under the American Families Plan could affect businesses in the non-corporate sector. While these proposals primarily target taxpayers earning more than $400,000, and most businesses earn less than that in net income, the changes to capital gains taxA capital gains tax is levied on the profit made from selling an asset and is often in addition to corporate income taxes, frequently resulting in double taxation. Capital gains taxes create a bias against saving, leading to a lower level of national income by encouraging present consumption over investment. ation at death in particular could impose large costs on small businesses.
President Biden’s tax proposals targeting high-income taxpayers include:
- Raising the top marginal tax rateThe marginal tax rate is the amount of additional tax paid for every additional dollar earned as income. The average tax rate is the total tax paid divided by total income earned. A 10 percent marginal tax rate means that 10 cents of every next dollar earned would be taken as tax. to 39.6 percent;
- Applying the net investment income tax to active pass-through income for those earning more than $400,000;
- Making 2017 tax reform’s limitations on “excess losses” permanent; and
- Taxing unrealized capital gains at death for gains above $1 million.
Given that 99.7 percent of all businesses in America are considered small according to the U.S. Census Bureau, two-thirds of which structured as pass-through entities, it is worth exploring how the above proposals could impact small businesses.
While IRS tax data does not allow us to identify small businesses specifically, we can use this data to identify taxpayers with pass-through net income to approximate how many businesses could be affected by these tax changes. Their 2011 public use data shows that only 6 percent of filers with pass-through net income had adjusted gross income greater than $400,000 (adjusted for inflationInflation is when the general price of goods and services increases across the economy, reducing the purchasing power of a currency and the value of certain assets. The same paycheck covers less goods, services, and bills. It is sometimes referred to as a “hidden tax,” as it leaves taxpayers less well-off due to higher costs and “bracket creep,” while increasing the government’s spending power. ). However, this small group of filers alone was responsible for slightly more than half (52 percent) of all pass-through income reported to the IRS.
The data indicates that in any given year most taxpayers with pass-through income will not be directly impacted by the increase in the top marginal tax rate or the change to the net investment income tax, but they may be indirectly impacted for two reasons:
- Business income is volatile such that many businesses, even small businesses, can expect to earn over $400,000 in a future year even if they earn below that level currently; and
- Tax increases on such a large share of pass-through businessA pass-through business is a sole proprietorship, partnership, or S corporation that is not subject to the corporate income tax; instead, this business reports its income on the individual income tax returns of the owners and is taxed at individual income tax rates. income can depress economic activity generally, which ultimately reduces demand for business of all sizes.
Regarding the loss limitations, which apply to losses in excess of $250,000 ($500,000 for joint filers), the data indicates that less than 1 percent of all tax filers with pass-through income report such losses in a given year. However, again because profits are volatile, a much larger percentage of businesses can expect to one day be exposed to these loss limitations, and that includes businesses earning less than $400,000.
Taxing capital gains at death for those with unrealized capital gains above $1 million could potentially hit many small, family-owned businesses. Under current law, when a business owner dies and transfers the business to an heir, the heir does not incur any additional capital gains tax liability (but does potentially incur estate taxAn estate tax is imposed on the net value of an individual’s taxable estate, after any exclusions or credits, at the time of death. The tax is paid by the estate itself before assets are distributed to heirs. liability). Furthermore, the heir may “step up” the basis of the asset to the current fair market value, so that if the heir sells the business, capital gains tax is due only on the gain occurring during the heir’s ownership.
An analysis from the Agricultural and Food Policy Center of a similar proposal to repeal step-up in basisThe step-up in basis provision adjusts the value, or “cost basis,” of an inherited asset (stocks, bonds, real estate, etc.) when it is passed on, after death. This often reduces the capital gains tax owed by the recipient. The cost basis receives a “step-up” to its fair market value, or the price at which the good would be sold or purchased in a fair market. This eliminates the capital gain that occurred between the original purchase of the asset and the heir’s acquisition, reducing the heir’s tax liability. and tax capital gains at death found that as many as 98 percent of family-owned farms could be impacted, resulting in an increase in tax liability of more than $700,000 on average. Another analysis looking at several stylized examples of family businesses, by Ernst & Young, found that the increased tax liability could potentially exceed the yearly income generated by these businesses and force some owners to liquidate.
The Biden administration has primarily focused on increasing taxes on top earners to generate revenue to fund its spending priorities. However, these proposals would hit many pass-through businesses and much of pass-through business income, including small businesses, family-owned businesses, and farms.
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