Tax Law Benefits Small Businesses and the Wealthy

Small businesses came out ahead in the new tax law. (Dreamtime)

The tax and spending legislation passed by Congress and signed by President Donald Trump earlier this month included several business- friendly provisions that are wins for wealthy individuals, too.

Chief among them was Congress’s acquiescence to a workaround that allows flow-through entities—businesses structured as partnerships or S corporations that pass cash flow and losses through to their owners—to deduct state and local taxes at the business level. That allows business owners to skirt the state and local tax (SALT) deduction cap.

The bill also includes a continuation of the 20% qualified business income deduction for pass-through businesses and expansion of qualified small business stock rules that gives a boost to investors in start-ups.

The workaround for SALT taxes affecting pass-through businesses offers significant benefits to the wealthy.

“Flow-through entities are by far the predominant business structure utilized by high-net worth individuals,” says Mark Sommer, group head of the tax, benefits and estates practice at Frost Brown Todd, a national law firm.

The new tax and spending law raises the SALT cap deduction for individuals from $10,000 (where it was capped in the Tax Cuts and Job Act of 2017) to $40,000—although just through 2029. The cap reverts back to $10,000 in the 2030 tax year. For high earners, the larger SALT cap deduction is scaled back immediately, however. For those who have a modified adjusted gross income of $500,000, the SALT cap is reduced in increments to a minimum cap of $10,000.

When the SALT cap was cut to $10,000 in the 2017 legislation, several states —about 36 in all—agreed to allow pass-through entities to pay the tax instead of flowing it through to the owner. The Internal Revenue Service sanctioned this maneuver in a 2020 notice.

House Republicans aimed to get rid of the tactic altogether, but then agreed in their version of the tax and spending bill to allow it for all but certain kinds of service businesses, including law firms, investment advisors, and medical practices. The Senate, however, swept that caveat away, allowing the workaround to remain in place.

To Sommer, that’s significant. “For the first time, Congress has their fingerprints on the whole structure,” he says. Although the IRS had approved the workarounds approved in 36 states (out of 45 that have state and local income tax), an IRS notice could be “subject to literally deletion off the internet,” Sommer says. “There’s not a formal rule-making process. It could be rejected. It could be withdrawn. It could be usurped.”

The new tax law also retains a 20% tax deduction on qualified business expenses for certain pass-through entities originally passed in the 2017 tax law. Affected businesses include family offices as well as bricks-and-mortar shops set up by families—any enterprise with paid staff and tangible, depreciable property, according to William Kambas, a partner in the U.S. Private Client and Tax team at Withers.

Business owners and families were concerned the deduction could be scrapped in new tax legislation this year. One reason is the cost: an estimated $737 billion through 2034, according to the nonpartisan Joint Committee on Taxation. The House version of the bill actually proposed boosting it to 23%, however, although the final legislation retained the existing 20% deduction.

The beneficiaries are “Main Street as much as anything,” Kambas says.

Another provision in the legislation expands a longtime benefit to start-up investors—albeit at a cost of $17.2 billion through 2034, according to the Joint Committee on Taxation.

Among several changes, investors who buy so-called qualified small business stock before July 5 can now realize tax benefits sooner. Instead of waiting five years to be exempt from capital-gains taxes through a sale, investors can now exclude 50% of the gain when the stock is held for more than three years, and 75% if it is held more than four.

“Sometimes a strategic buyer comes in” before five years, says Steve Baxley, head of tax and financial planning at Bessemer Trust. Investors now “will at least get some tax benefits if they didn’t meet the [previous] five-year holding period.”

The new legislation also now applies to small businesses with assets up to $75 million at the time the stock is purchased, up from $50 million. That makes it easier for an investor to qualify for benefits if they put money into a company as it grows, Baxley says. “It’s a nice change.”

The new changes also raise the dollar amount of gain an investor can reap to the greater of $15 million or 10 times the basis of the stock being sold, according to a summary by RSM, a tax and consulting firm that serves middle-market companies. Previously, the gain was capped at $10 million or 10 times basis.

The revision may greatly benefit families by allowing business founders to gift shares of stock to family members ahead of a sale into separate irrevocable trusts through a process called stacking, says Jillyn Hess-Verdon, who leads Frost Brown Todd’s family office practice. Now those shares can be worth as much as $15 million each.

“The owner can’t get that money back—it’s there for the kids,” Hess-Verdon says. At the time of a sale, “instead of paying all the taxes, taking the net and trying to gift with [the realized] money it was much better to gift stock and stack the trust that way.”

The Tax Law Center at New York University Law has recommended repealing or amending the qualified small business stock provisions of the tax code—known as section 1202—to prohibit this gifting of unappreciated stock, which, the center argues, allows wealthy individuals to take advantage of the gain exclusion.

The center also argued in a 2023 analysis that qualified small business stock provision hasn’t increased the flow of long-term equity capital to small firms as originally intended. “Instead, section 1202 has served as a windfall to investors in corporations that already have a very large market value and easy access to equity capital, primarily in the technology sector,” the center wrote.

Write to Abby Schultz at abby.schultz@barrons.com