Bracket creep is when bigger profits from your business move you into a higher tax bracket, causing you to pay a larger percentage and more total taxes. This happens because the IRS divides your income into segments and the tax rate increases for each segment as your small business profit grows.
C-corporations and LLC’s taxed as C-corps don’t need to worry about bracket creep because they have a flat tax rate, but it affects small business owners or partners in other structures since business income from sole proprietorships, partnerships, LLCs, and S-Corps pass through to the owner(s) and are taxed as personal income.
While it’s not always a bad thing, since moving to a higher tax bracket means more money and the IRS adjusts brackets and deductions for inflation each year, bracket creep can cause some headaches if you’re not expecting it. Here’s how to calculate it, why it happens, and how you can manage it for your business.
How bracket creep works
Bracket creep is sometimes unavoidable, and more take-home money isn’t a bad thing, but if you weren’t expecting it, you might have preferred reinvesting the money into your business before taxes rather than taking it home in after-tax profits.
The table below shows how bracket creep affects your take-home income when the tax percentage for your marginal tax rate (the rate charged on your highest income segment) increases. Doing this calculation as tax time approaches will help you compare what your take-home profit would be, so you can decide if you would rather put money back into the business instead.
Since brackets change based on US tax policy, and income levels for each bracket change yearly, we’ll use the following 3 hypothetical tax brackets for this example:
- $0-$50,000 taxed at 10%
- $50,000-$100,000 taxed at 20%
- Over $100,000 taxed at 30%
| Tax Year | Pre-tax Income | Taxes Paid per Bracket | Total Tax Bill | Net After-Tax Income | Take Home Percentage |
| Year 1 | $100,000 |
|
$15,000 | $85,000 | 85% |
| Year 2 | $110,000 |
|
$18,000 | $92,000 | 83.6% |
In this example, even though you made $7,000 more after tax, bracket creep means you’re paying an extra 1.4 percentage points of your pre-tax income in taxes. Instead of taking the extra $7,000 home and paying $3,000 in taxes, you could have spent $10,000 on R&D or made other investments, and your after-tax income would have been the same year over year.
Bracket creep can also change deductions you qualify for. Like with tax brackets, the IRS changes limits for other deductions every year. Here’s another hypothetical situation to show how after-tax income changes if bracket creep causes your business to no longer qualify for the Qualified Business Income (QBI) deduction.
| QBI Qualification Level | Pre-Tax Income | QBI Deduction | Taxable Income | Taxes Paid | Take-Home Income (Pre-Tax Income Minus Taxes Paid) |
| Qualifying Bracket | $197,000 | $39,400 | $157,600 | $28,000 | $169,000 |
| Non-Qualifying Bracket | $248,000 | $0 | $248,000 | $55,000 | $193,000 |
| Difference | $51,000 | $90,400 | $24,000 |
The extra taxable income translates to a difference of about $25,000, which you get to take home because bracket creep pushed you out of the qualifying income limits for the deduction. Making $25,000 more might sound great, but how much more work did that require?
If you charged $100 per hour, you would have worked the equivalent of 63 additional 8-hour days. Working through bracket creep calculations for your qualifying deductions will help you decide if the extra money is worth the extra effort based on your personal and financial circumstances.
Inflation and Bracket Creep
The IRS tries to offset inflation impacts from bracket creep by adjusting income levels for tax brackets and other deductions and provisions every year in addition to the consumer price index (CPI), but the combination of inflation and bracket creep can make you worse off depending on what you spend your money on.
But the CPI is an average of items that span the entire economy whether you buy them or not. When prices rise faster for things you actually buy versus the CPI average, bracket creep can leave you with lower real income (total income adjusted for inflation) than you were expecting.
While inflation isn’t entirely predictable, keeping an eye on monthly CPI releases helps you forecast real income based on the combination of bracket creep together with price changes for things you buy. Then you can decide whether you’re better off investing money in your business before tax for future growth vs. taking it home now.
Using the example from above, here’s how inflation and bracket creep can change your real earnings (take home profits adjusted for inflation) based on the things you actually buy.
| Scenario | Pre-Tax Earnings | Total Tax Bill | Take Home Profits | Inflation Rate for Items You Buy | Real Earnings |
| Year 1 | $100,000 | $15,000 | $85,000 | NA | $85,000 |
| Year 2 (3% Inflation) | $110,000 | $18,000 | $92,000 | 3% | $89,320 |
| Year 2 (5% Inflation) | $110,000 | $18,000 | $92,000 | 5% | $87,619 |
| Year 2 (8.3% Inflation) | $110,000 | $18,000 | $92,000 | 8.3% | $84,949 |
Your real earnings go down as inflation rises on items you buy, and you’re worse off financially if the things you buy go up by 8.3% ($84,949 real income in year 2 vs. $85,000 from year 1).
Small business tactics to manage bracket creep
Planning ahead for bracket creep saves you money because you can make smart tax decisions, and being able to highlight “on-paper” impact to growth rates helps present your business as lower-risk to lenders. Make sure to work with a tax professional on a multi-year tax strategy for your unique business so you get the biggest benefit and stay within the tax laws.
Cash flow from small business loans instead of selling short-term investments
Instead of selling a short-term asset to generate cash, using a small business loan can lower your tax bill and possibly move you to a lower bracket after deducting interest expense. Gains on short-term investments (assets owned less than a year) get added to your regular earnings and are taxed at regular rates.
A business loan can bridge the gap until you sell the asset as a long-term investment, where you pay lower capital gains tax rates and then use the proceeds to pay off the loan. Here’s a scenario to illustrate, using the same tax brackets from the earlier example:
- Tax brackets:
- $0-$50,000 taxed at 10%
- $50,000-$100,000 taxed at 20%
- Over $100,000 taxed at 30%
- Baseline pre-tax income is $100,000.
- You need a $25,000 down payment on new machines that will go into service next year, meaning you can’t depreciate them this year.
- You can sell a short-term investment for $50,000.
- A short-term loan for $25,000 costs $1,000 in interest that you deduct this year.
| Option | Pre-Tax Income | Taxes Paid per Bracket | Total Tax Bill | Net After-Tax Income |
| Baseline | $100,000 |
|
$15,000 | $85,000 |
| Asset Sale | $150,000 |
|
$30,000 | $120,000 |
| Loan | $99,000 |
|
$14,800 | $84,200 |
| Capital Gains Next Year | $50,000 |
|
$7,500 | $42,500 |
Using the loan lowers this year’s after-tax profit by only $800 but you’ll pay only $7,500 capital gains tax next year when you sell the asset versus $15,000 this year due to bracket creep and short-term investment being taxed as regular income.
Presenting financials for lenders
Bracket creep can artificially lower your on-paper growth rate, but you can highlight the impact of bracket creep to show lenders that you’re a lower-risk borrower than it might appear at first. Take the previous example where bracket creep caused your business to no longer qualify for the QBI deduction:
| QBI Qualification Level | Pre-Tax Earnings | QBI Deduction | Taxable Income | Taxes Paid | Take-Home Earnings (Pre-Tax Minus Taxes Paid) |
| Year 1 — Qualifying | $197,000 | $39,400 | $157,600 | $28,000 | $169,000 |
| Year 2 — Non-Qualifying | $248,000 | $0 | $248,000 | $55,000 | $193,000 |
| Growth | $51,000 | $90,400 | $24,000 | ||
| Growth Rate | 25.9% | 14.2% |
If this took place over 2 years, then your take-home income grew by $24,000, about 14% year-over-year. The $51,000 difference in pre-tax income is a better reflection of your true 26% growth rate, because it’s not skewed by the deduction. Highlighting this for lenders will make your business more appealing by showing them you’re less likely to miss payments on a loan.
Deciding how to depreciate business assets
The IRS lets you choose how to depreciate assets, and your choice will help you forecast impacts from bracket creep. You can offset a one-year income bump or minimize bracket creep impact across multiple years by spreading out depreciation deductions.
Bonus depreciation and/or the Section 179 deduction can offset bracket creep from a big bump in income this year, by letting you deduct up to 100% of an asset the year you buy it. With bonus depreciation, you can even create a net loss for the year that you can carry forward to help offset bracket creep in future years.
Straight-line depreciation, on the other hand, spreads out depreciation expense across years, so you have the deduction to offset bracket creep from future income growth.
Make sure to discuss options with your tax professional to stay compliant with rules for depreciation.
Higher business profits can pass through to you as an owner and come with higher taxes, but using these tactics to manage bracket creep will help keep your tax bill as low as possible. Working with a tax professional to identify the full list of deductions and tax provisions you qualify for can help you make the right decisions for your business and help you make the best choice for you regarding whether creeping into the next bracket is worth the extra work required.
National Funding does not provide tax, legal or accounting advice. This material has been prepared for informational purposes only. You should consult your own tax, legal and accounting advisors.
