The tax reform laws passed at the end of 2017 made massive changes to the way the U.S. government collects taxes. One of the biggest elements of tax reform affected the way that corporations get taxed, with massive tax decreases for companies of nearly all sizes.
Most of the attention that corporate tax reform has gotten has gone to the largest corporations and the billions in savings they might reap. Yet when you look at the actual tax rates, the biggest tax rate decline goes to more modestly sized small business with relatively small profits.
Why mid-sized businesses got the biggest corporate tax rate drop
The headline numbers on corporate tax reform emphasized the decline from 35% to 21% in the top corporate tax rate. The way that most reports explained the reduction made it seem as though corporations never paid more than 35% of their marginal income in taxes.
Yet when you look at the corporate tax brackets, you'll notice a strange phenomenon. The highest tax rate actually applies to corporations with incomes between $100,000 and $335,000, which are in a special 39% tax bracket.
The reason the two bolded brackets are there has to do with the intent of lawmakers. In general, the legislation setting previous corporate tax rates intended to have two general rates: 34% and 35%. For extremely small businesses, though, lawmakers wanted lower rates to apply in order to encourage start-ups. Still, once those small businesses grew to a large enough level, the brackets were set up to take away the benefit of those lower rates.
Here's how it works. For the first $50,000 in income, corporations pay 15% in tax, a 19-percentage-point savings compared to the higher 34% rate that works out to $9,500. On income between $50,000 and $75,000, the 9-percentage-point difference works out to $2,250, for a total of $11,750.
In order to claw back that $11,750 for larger small business corporations, lawmakers established a 5-percentage-point hike in the tax rate from 34% to 39%. Corporations therefore pay an extra 5% on the $235,000 in income between $100,000 and $335,000. Five percent of $235,000 is $11,750, so once you get to $335,000, you're paying an effective rate of 34%.
A similar effect occurs for larger businesses. After paying 34% on the first $10 million, lawmakers sought to claw back the $100,000 in savings from the 1-percentage-point difference between 34% and 35%. They did so by boosting the tax rate by 3 percentage points to 38% on $3,333,333 worth of income, as 3% of $3,333,333 is $100,000.
The real impact of the new corporate tax rates
The changes to corporate tax rates makes brackets a lot simpler: there's only one, 21%, which applies to all taxable corporate income.
Notice that that rate is actually a tax increase for those at the bottom of the income spectrum. Corporations with $50,000 in income will pay $3,000 more in taxes. Those with $75,000 in income get back some of those losses but still pay a total of $2,000 more. Yet once you get to $100,000, you'll pay just $1,250 less in taxes than you otherwise would have.
For those at the top of the 39% bracket, though, income of $335,000 produces tax savings of $43,550. Put another way, the tax savings on the extra $235,000 of income between $100,000 and $335,000 results in additional savings of $42,300 -- or fully 18% of that additional income.
How small corporations could potentially get even bigger savings
Given the new flat 21% corporate tax rate, the big question facing many small corporations is actually whether it makes sense to use a corporation at all as your business entity. With substantial tax benefits available to small businesses that are set up as pass-through entities like limited liability companies, it's questionable whether many new businesses will ever choose corporate status.
Nevertheless, the fact that the tiniest corporations will pay more in tax -- and mid-sized small corporations will see the biggest marginal tax savings from corporate tax reform -- is interesting in that it went largely unnoticed in debate among lawmakers. The new rules certainly give start-ups a big incentive to grow as quickly as possible.
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