While many small business clients would welcome the 25 percentmaximum tax rate for pass-through income proposed by the GOP taxreform framework, the proposed tax rate structure has the potential to hinderthese clients’ retirement planning options.

Although the issue itself could be resolved in the actuallegislation generated by the framework, there is a realisticpossibility that the proposal could very easily discourage smallbusiness owners from providing the currently available retirement savings options to theiremployees.

However, many have pointed to the significant non-tax reasonsthat can motivate small business owners to develop retirementplanning options for both themselves and employees.

We don't know yet which side Washington will find mostpersuasive.

Potential impact of the framework tax structure

Under the tax reform framework the GOP released,pass-through entities (which include sole proprietorships,partnerships and S corporations) would be subject to a maximum 25percent tax on pass-through income. This income is reportedon the individual business owners’ income tax returns, rather thanat the entity level.

Individual business owners, however, would see their personalincome taxed at a top marginal income tax rate of 35 percent(though the framework leaves open the possibility that an evenhigher tax rate would be established for the wealthiesttaxpayers).

Because income drawn from a traditional retirement account iscontributed on a pre-tax basis and is taxed at the account owner’sordinary income tax rate when it is withdrawn, that income couldpotentially be taxed at a rate that is 10 percent higher than therate that would apply if the income were taxed currently aspass-through income.

Further, capital gains tax rates are not included in theframework, so the maximum capital gains rate would presumablyremain at 20 percent—meaning that earnings on pass-through incomethat is invested in taxable investments would also be taxed at amuch lower rate.

For small business owners in the highest income tax bracket,this could create a powerful tax incentive to stop offeringretirement savings options (which can also subject these businessowners to fiduciary liability and administrative costs) and simplyplan for their own retirements by using taxable investments.

This tax dichotomy has the potential to create a wide-reachingdisincentive to retirement savings, especially because an estimated90 percent of businesses are organized using a pass-throughstructure.

Motivations to maintain retirement planning status quo

While the proposed changes in the tax rate structure couldpersuade some small business owners to cease offering traditionalretirement savings options to employees, many business owners maybe inclined to keep these options even if the framework tax ratestructure is adopted in its current form.

First, while many small business owners’ retirement plandistributions may be subject to the personal 35 percent income taxrate in the future, others may anticipate falling into a much lowerincome tax bracket during retirement (it is the tax rate thatapplies when the distributions are actually taken that isrelevant).

Secondly, many employees who contribute pre-tax dollars to theirown accounts may be in much lower income tax brackets, so that theretirement plan option can provide a powerful benefit forattracting and retaining employees.

Other small business owners might recognize that, for lowerincome employees, the employer-sponsored retirement savings optionmight be the only way that these employees are going to save forretirement.

Recognizing that providing employees with a retirement savingsoption can promote loyalty and reduce the costs associated withemployee turnover can give owners a financial incentive to maintainthese plans.

Expect negotiation

It is important to note that the framework proposal is justthat—a skeletal outline addressing the broad strokes of what taxreform could look like.

Advisors and clients should expect much negotiation before finallegislation emerges, meaning that it is entirely possible thatcomprehensive legislation will specifically address the retirementplanning issues caused by the framework.