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How Will Proposed Tax Reforms Affect Payroll Taxes?

In early November, the House Ways and Means Committee unveiled the bill language for the long-discussed federal tax reform. One of its most important elements is a provision that would lower the pass-through rate for business income to 25 percent, while the top individual tax rate would remain at 39.6 percent.

Pass-through business income is any income from a business that gets “passed through” to business owners and taxed at their individual rates. This means business owners would have a significant portion of their income taxed at a considerably lower rate than the standard maximum individual tax rate.

Under current law, the shareholders of an S corporation may receive both regular wages and share in the company’s profits. Payroll taxes are taken out of their wages, just like any other employee. Their profit sharing gets taxed as income and at a different rate.

According to the Center on Budget and Policy Priorities, reform proposals as they currently exist could incentivize S corp shareholders to underreport the amount they receive in wages and instead claim more as pass-through business income. Doing so would allow them to specifically avoid paying the Medicare payroll tax.

This form of payroll tax avoidance already happens regularly. But it’s likely that it would become even more prevalent if a larger differential between payroll and pass-through tax rates is implemented as part of current reform efforts.

Additional effects on employers

Beyond the effects of the pass-through rate deduction, there are other elements of the proposed tax reform bill that would have significant impacts on U.S. business owners. Some examples include the following:

  • The work opportunity tax credit (WOTC) would be phased out. This credit allows certain employers to seek a tax deduction for qualified military veterans who work for them.
  • The bill would eliminate or greatly reduce many tax-free benefits many businesses offer their employees. These include adoption assistance, education assistance, dependent care assistance, transportation fringe benefits, on-premises amenities, work-related entertainment or recreational expenses, employer-provided childcare, achievement awards and employer-provided housing and moving expenses.
  • The bill would eliminate the estate tax, which applies to estates worth at least $5.6 million in assets. The estate tax threshold would first increase to $10 million, and then be phased out completely after six years. This could affect a small number of business owners.

The tax reform package still must be approved in committee, and then it will need to pass both the House and Senate. In other words, there’s a long way to go before anything like what’s being proposed might be put into place. It’s important for business owners to stay up to date on all that’s happening at the federal level, including how it could affect their payroll taxes and other obligations.