Joe Biden’s tax plan could take a bite out of some small businesses

Biden’s plan to reverse Trump-era tax cuts could take a heavy toll on "pass-through" entities.

If you’re a small-business owner, you’ll be thinking a lot harder about buying that new backhoe, opening a second catering kitchen, or hiring another landscaper if Joe Biden’s tax platform becomes law.

The former vice president and Democratic presidential nominee has been open on his plans to hike taxes on big business. But he has had little to say on what his policies would mean for America’s 30 million owners of restaurants, construction businesses, and the other proprietorships that have long generated most of America’s new jobs. He did briefly address the issue at the primary debate in Las Vegas on Feb. 20, when asked whether he’d champion higher rates that could kill jobs for Latinos and other minority workers. Biden reassured America’s hometown entrepreneurs, “No, taxes on small businesses will not go up.”

The centerpiece of the Biden tax platform, however, is a plan to substantially increase the share of income that the federal government collects from individuals and families earning over $400,000 a year, reversing tax cuts enacted under President Trump. Hence, Biden’s policies would mean a big tax hike for a wide swath of America’s small businesses. That’s because most of their owners aren’t corporations but what are called “pass-through” entities that file individual returns, and pay individual rates. Owners typically report their business income on the IRS Form 1040 that some 140 million American singles and couples use to file each year.

To be sure, folks making that kind of money could afford to pay more. But these are also America’s growers and risk-takers. A bigger slice for the Treasury leaves them less money for opening another hair salon or restaurant and undercuts their incentive to take chances, since once they reach a certain size, they’ll pocket a lot fewer cents in profit for every dollar they invest.

“Higher taxes will make owners agonize a lot more on whether to add a new product or service,” says Scott Swain, a CPA and partner at Cohen & Co., an accounting and consulting firm in Cleveland. “When you’re risking serious capital to expand your business, and you see that you’re keeping less of the extra income it would generate than before, you’ll invest less. A heavier burden on small businesses is big disincentive to taking risks.”

Adds Vernon Hill, chairman of Republic Bank, a Philadelphia lender that specializes in serving the region’s Main Street stalwarts, “The Biden proposed tax and regulatory plan would destroy the success of the Trump deregulation and lower tax plan that’s created a boom.”

Biden pledges to repeal Trump’s Tax Cut and Jobs Act, the most sweeping tax reform legislation for businesses in 30 years, and an especially huge boon to small business. The TCJA introduced four major provisions that lowered rates for sole proprietorships and partnerships to well below their levels in the Obama and previous administrations.

Sole proprietorships and partnerships determine business income by subtracting rent, salaries, and all other expenses from revenue. That number goes on their Form 1040. The TCJA’s first and biggest break is the new qualified business income (QBI) deduction that reduces the amount of business income that’s taxable by 20%. In other words, the QBI effectively exempts from federal taxes one-fifth of every dollar the company earned, whether profits are $100,000 or $20 million or more. Second, the TCJA lowered the top rate on personal income from 39.6% to 37%.

Third, it allowed businesses to write off 100% of their spending on plants, equipment, and other capital projects the year the money was spent, whereas the previous rules required spreading the deductions for that spending over several years. Fourth, the TCJA killed the “Pease” provision that phased out itemized deductions by 3% a year for every dollar earned over certain thresholds.

TCJA was a blueprint for encouraging entrepreneurs to expand and hire. It did this in two ways: first, by allowing them to keep a lot more of their current income; and second, ensuring that they’d pocket almost the same big proportion as their profits swelled. It’s not clear from the U.S. employment statistics that the TCJA boosted already-strong hiring by small companies. From March 2018 to June 2019, for example, 53% of the 2.145 million net new jobs were created by enterprises with between one and 250 workers. Small businesses generally swell their payrolls more than big companies in good times and shed more workers, more quickly, in recessions.

In these worst of times, those fragile enterprises are shrinking their workforces to survive. America needs a great reversal, a big push from small-business hiring to rebound from the COVID-19 crisis. The question now is whether big tax hikes promised by a new administration could throttle that engine.

The Biden proposal wouldn’t raise rates on pass-throughs with incomes of less than $400,000. But it has been branded by opponents as a growth and jobs killer because it imposes a much higher burden on anything over that amount than under the TCJA. So if the owner of a carpentry contractor or data processing outfit swell their income from $400,000 to $500,000 or $1 million, he or she would pay a much bigger share of the additional $100,000 or $600,000 to the Treasury than the TCJA exacts.

A three-pronged increase

Three major changes would lift the government’s levy. First, eliminating the QBI; second, raising the rate for the highest income bracket; and third, and least noticed, enormously increasing payroll taxes. To see how these shifts create the gap between what owners now pay on income over $400,000 and the hit under the Biden blueprint, let’s use a simple example.

Take a hypothetical owner whose enterprise will make exactly $400,000 in 2020. When that income is recorded on their tax return, they get the immediate QBI deduction of 20%, or $80,000. The owner gets another longstanding deduction for the payroll taxes they pay in their joint role as employer and employee—more on that shortly. In this case, that number is roughly $12,000 (around half of all payroll taxes). In addition, the filer has $50,000 in mortgage interest, charitable contributions, and other itemized deductions. So deductions total $142,000, leaving taxable income of $258,000. That pushes part of that income, for a single person, into the second-highest bracket of 35%. Total federal tax due is $65,000. Add $24,000 in payroll taxes, and the full tab comes to $89,000. That’s a rate of a little over 22% on income of $400,000.

Now let’s look at what happens if that owner grows mightily, pushing his business income up to $700,000. The difference between what he or she would pay on that extra $300,000 if Biden wins and gets his agenda enacted, versus the current Trump take, could hardly be starker.

Under today’s regime, the QBI would increase from $80,000 to $140,000. The deduction for payroll taxes would also rise a bit; Social Security and Medicare combined would wax from $24,000 to around $31,000; and itemized deductions would stay at $50,000. The owner would take a slight hit as part of their income advances into the top 37% tier. The total bill, income and payroll taxes combined, would rise from $89,000 to $175,000, lifting the average rate a bit from 22% to 25%. The biggest factor in keeping the levy relatively flat is the boost from the QBI.

What matters most is how much of the additional $300,000 the owner got to keep. According to those who see low taxes as a big motivator, what owners pocket “on the margin” is what stirs their animal spirits. The Biden platform would still provide the QBI deduction of 20% up to $400,000, then quickly phase out the $80,000 benefit as incomes rise above that threshold. It’s a good bet the QBI would go to zero on an income of $700,000. So the first big change is that the $140,000 break would vanish altogether. Biden would also restore the “Pease” phase-out for itemized deductions, shaving what our filer can subtract by half, from $50,000 to $24,000.

Here’s the haymaker. The owner also works for the company. So he or she has to cover their own Social Security and Medicare taxes. For the former, they’re obligated to pay both the employer and employee halves, totaling 12.4%, since they both own the company and work there. Today, the 2.9% Medicare levy applies to all income, but Social Security’s “owner” tax is imposed only on the first $137,700. Biden would leave that cap but impose the full 12.4% on all income over $400,000, leaving a “doughnut hole” in between.

That change would double total payroll taxes on $700,000 from Trump’s $31,000 to $63,000. The Biden plan would also push all of the additional $300,000 into the new 39.6% bracket that’s 2.6 points higher than today’s max, assuming the filer is a single person. (Under Trump, going from $400,000 to $700,000 merely pushed part of the owner’s income into the second-highest 35% tier.)

All told, the “Biden taxes” on $700,000 in pass-through income would total roughly $214,000, for an average rate of 31%, six points higher than under Trump’s TCJA. But the number to ponder is how much the owner gets to keep of the additional $300,000 that they invested their sweat and capital to reap. The Trump taxpayer paid a “marginal” rate of just 21% on that money, and kept $214,000 of the $300,000. The Biden filer would pay 41% on the increased income and would keep just $178,000, $36,000 less. (This calculus doesn’t include the impact of state tax laws: In New York and California, state taxes would raise the marginal rates by an additional 7% and 8% respectively.)

The Biden tax manifesto has garnered praise for targeting high earners who’ve gotten too sweet a deal under Trump. What’s lost is the small-business story—that’s where many of the jobs for carpenters and restaurant managers and nursing home workers come from. Hey, man, we’re talking the middle class here. It would be a mistake to take aim at the “rich,” and hit the working American instead.

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