Could Small Plan Formation Be a First Casualty of Tax Reform?

If the tax reform proposal drafts put forward by President Trump – and previously in the House Blueprint – come to pass, establishing and saving in a retirement plan could have a big negative financial impact for small business owners – perhaps as much as 20%!

Stated simply, under President Trump’s draft proposal, these small business owners – partnerships, S Corporations, REITs, RICs and small business limited liability corporations – would only be subject to a 15% maximum tax on pass-through income. On the other hand, if they invest that money in a retirement plan, when withdrawn it would be taxed at the maximum ordinary income rate, which could be in the neighborhood of 35%.

The Blueprint published by the House of Representatives incorporates the same problematic structure, albeit with different rates; it calls for capping the tax rate on these pass-through entities at 25% (in addition to providing the 50% exclusion to the reinvestment of that income), and applies the ordinary income tax rate on retirement plan distributions – which for many successful small business owners under the Blueprint is 33%. Thus, and as has been previously noted, the owners of these pass-through entities – remember that we’re talking about 90% of American businesses – would have no incentive to defer their current income in the form of retirement plan contributions. In fact, if either of these approaches are implemented in their current form, these owners will be financially worse off – and preliminary calculations indicate it could be by as much as 20%!

The buzz around Capitol Hill is that the House is leaning toward an approach outlined in the reform proposal put forth in 2014 by then-Chairman of the House Ways & Means Committee Dave Camp (R-MI). That would presume that a certain percentage (say, 70%) of the pass-through income is deemed to be ordinary income, with the rest being “profit” taxed at the lower pass-through rate. Under the Trump rate proposal (a top rate of 35% and a 15% pass through rate), those small business owners would be looking at a blended marginal rate of, say, 29%. If their current income is taxed at 29% but income deferred in retirement savings is taxed at 35%, there is no monetary advantage for the business owner to defer income or invest in the plan – indeed, there would seem to be a real financial disadvantage.

The key to encouraging small business owners to sponsor and administer retirement plans is maintaining a tax structure that doesn’t penalize them for doing so. Under the approaches currently being considered, the first casualty of tax reform could well be small business retirement plan formation – and the coverage and savings opportunity those plans provide.

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