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Tax Reform Proposal Could Undermine Incentives for Small Business Plans

By Craig Hoffman • September 27, 2017 • 0 Comments
An outline of the Republican tax reform plan was released today — a plan that includes a proposal to cap the tax rate on small business “pass-through” income at 25%.

More than 90% of businesses are organized as “pass-through” entities (i.e., partnerships, S corps, and small business limited liability corporations). More than 320,000 of these entities sponsor a retirement plan (with the average size being 75 employees). Unfortunately, many of these businesses may reconsider adopting or maintaining a qualified retirement plan because of significant financial disincentives woven into the fabric of the tax reform proposal. These disincentives arise because of the difference between the 25% maximum “pass-through” rate and the 35% top rate on “ordinary income” (as well as the favorable tax rate on capital gains income at 20%).

Financial modeling shows that the owner of a “pass-through” business is likely to pay far less in taxes if amounts are “passed-through” and taxed at the 25% rate rather than contributed to a qualified plan. (In addition, any earnings generated by reinvesting those “pass-through” amounts would be eligible for the very favorable 20% capital gains tax rate.) In contrast, amounts contributed to a qualified retirement plan (and the earnings generated from reinvesting those amounts while they are held by the plan) would be subjected to ordinary income tax rates as high as 35% when ultimately distributed from the plan. In other words, the small business owner’s plan contributions and accumulated earnings will be taxed at 35% instead of the 25% “pass- through” rate and the 20% capital gains rate on accumulated earnings.

Unless this mismatch of tax rates on current “pass-through” income and deferred retirement savings is addressed in tax reform, the owners of “pass-through” entities will be financially penalized for saving in a retirement plan — and that doesn’t consider the additional administrative costs and ERISA liability risks that business owners assume in sponsoring a workplace retirement plan. Based on a preliminary analysis, over a 16-year period, a $50,000 contribution made on behalf of the the owner of a “pass-through” entity would accumulate approximately $40,000 less than if the same amount had been “passed-through” and reinvested at capital gains tax rates. And that is $40,000 less for only a single year’s contribution. Over a working career, the difference could easily be excess of $1 million. The ultimate result is the likely abandonment of many small business retirement plans since they no longer make economic sense particularly given the fiduciary risks and the costs of administration.

The ASPPA/ARA Government Affairs team is working hard to fix this unintended consequence of tax reform. We believe this technical glitch can easily be fixed by including within tax reform a provision that would apply ordinary income tax treatment not only to plan distributions but also at the time amounts are contributed and deducted. Under tax reform, only the business income portion of a “pass-through” entity’s total income will qualify for the lower “pass-through” rates. The remainder will be classified as compensation income that is subject to the business owner’s normal ordinary income tax rates. The simple technical correction is to provide that the business owner’s contribution amount (which includes the owner’s deferrals, matches, and profit-sharing plan contributions or defined benefit accruals) will flow through and be taken as a deduction against the wage or personal services income that would otherwise be taxed at ordinary individual income tax rates. In this way, the tax treatment would be consistent when contributed and deducted.

Encouraging workplace retirement plan sponsorship is critical to the millions of non-owner employees who participate in these plans. Data shows that individuals who make between $30,000-$50,000 a year are 15 times more likely to save for their retirement if a workplace retirement program is offered rather than having to do it on their own. Tax policy should not discourage the sponsorship of qualified retirement plans by “pass-through” businesses. This technical glitch must be corrected to avoid potentially disastrous unintended consequences. We will keep you up to date with our efforts and ways that you can help us in this cause.

Craig Hoffman is General Counsel for the American Retirement Association.

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