House and Senate Bills Decrease Tax on Pass-Through Income for Individuals
This week the full Senate is expected to take action on the Senate Finance Committee tax reform bill. While waiting for that action to begin, the following is a recap of what brought us to this week’s decision point.
With a belief that the economy could be stimulated by decreasing the current tax applicable to income generated by small business organizations, particularly “pass-through” type business entities, both the House of Representatives and the Senate Finance Committee have approved proposed legislation designed to reduce the amount of tax paid by individual owners on their distributive share of income arising from pass-through entities. The Tax Cuts and Jobs Act (“House Act”), passed Nov. 16 by the full House of Representatives, and the version of tax reform legislation approved later the same day by the Senate Finance Committee (“Senate Act”), propose significant changes to the current tax treatment of pass-through income.
Background on Pass-Through Entities
A pass-through entity is a business that operates separate from the owners. It reports taxable activity on a separate tax return, but is not taxed on that income at the business entity level. Rather, the income flows to the owners for taxation at the owner level, thus the name “pass-through.” The usual pass-through entities are partnerships, S corporations and limited liability companies that operate for tax purposes as partnerships.
Under current tax rules, the taxation of pass-through distributable income items reported to owners using Schedule K-1 depends on the nature of the income items being distributed. Therefore, a distribution item could be considered ordinary income to the owner, subject to ordinary income tax rates or a capital investment item subject to capital gain rates. Add in the rules related to the owner being active or passive in the business operations, plus the 3.8 percent net investment income tax, and it gets much more complicated.
The House Act
The House Act introduces a new category of income, termed “business income,” that is subject to a reduced 25 percent tax rate. However, determining the amount of newly defined business income subject to the 25 percent tax depends on an election to be made by an individual pass-through owner. The House Act allows an individual owner of a pass-through entity to use a defined percent of 30 percent, called the “capital percentage,” of their actively generated business income flowing from an S corporation or partnership as being subject to the 25 percent tax rate. The remaining 70 percent will be subject to the owner’s individual income tax rate.
The purpose of providing the two different levels of taxation is to recognize that in a business, there are usually two different things an owner will do. First, they will make an investment in the business—that’s what the 30 percent level covers. Second, they may become actively involved in the operation of the business. If they do, there will be a compensation element, and that’s covered by the 70 percent level. However, it should be noted, individual pass-through owners that are only passively invested in a partnership or S corporation can treat all of their income as subject to the 25 percent tax rate. Thus, passive owners may receive preferential treatment compared to active owners under the House Act—a somewhat controversial result.
Related to the earlier comment about the active or passive loss rules complicating pass-through taxation, the House Act relies upon the longstanding passive activity rules to determine whether a taxpayer is active with regards to a particular trade or business. Additionally, individual owners of certain businesses involved in the performance of services, such as lawyers, accountants, doctors, engineers, consultants, financial service providers, and a few others, are not allowed to use the 30 percent factor in determining the amount of income subject to the reduced 25 percent rate.
In lieu of treating 30 percent of business income as subject to the 25 percent tax rate, individuals actively involved in a trade or business, including some service-based businesses, can elect to determine the percentage of income that is business income, and therefore subject to the 25 percent tax rate, by using a formula based upon the taxpayer’s share of the partnership’s or S corporation’s adjusted tax basis in its assets. For capital intensive businesses, this methodology may allow individual owners of pass-through entities to treat a larger share of their income from a business as subject to the 25 percent tax rate. The Joint Committee on Taxation’s explanation of the House Act provides that only property subject to the allowance for depreciation and real property used in the trade or business can be used for purposes of the asset-based test. It is unclear whether businesses with significant types of intangible assets will be able to use the tax basis of those assets to determine the increased capital percentage.
The House Act introduces a further tax rate reduction for certain taxpayers. Under an amendment by House Ways and Means Committee Chairman Kevin Brady (R-TX), active individual partners and S corporation shareholders can apply a 9 percent tax rate, in lieu of the newly proposed ordinary 12 percent rate, for business income flowing from a partnership or S corporation. There is a phase out schedule for the 9 percent tax rate that makes individual partners and S corporation shareholders with higher overall incomes not eligible for the 9 percent tax rate.
The Senate’s Approach
The Senate Finance Committee took a different approach for reducing individual tax related to pass-through entities. The Senate Act provides that individuals “may deduct 17.4 percent of domestic qualified business income” allocated from a partnership or S corporation. This deduction, however, would be limited for an individual pass-through owner to 50 percent of the wages paid by the pass-through entity allocable to the owner. Consequently, the Senate Act would provide limited relief to owners of pass-through entities with few direct employees. Under a special exception, the 50 percent of wages limitation would not apply in the case of an owner with taxable income of $500,000 or less for married individuals filing jointly ($250,000 for other individuals).
Generally, qualified business income is defined to mean any income from a trade or business, other than “specified service trades or businesses,” which are similar to those certain service businesses listed in the House Act. This provision includes, though, another special exception allowing the 17.4 percent deduction to owners of specified service businesses whose taxable income does not exceed $500,000 for married individuals filing jointly ($250,000 for other individuals). Wages paid to an S corporation shareholder, or guaranteed payments for services paid to partners, do not count as qualified business income and will not be reduced by the 17.4 percent deduction.
The 17.4 percent deduction expires on Dec. 31, 2025, like many of the other Senate provisions affecting individual taxpayers. At that time, the taxation of pass-through income for individuals would revert back to the current rules (unless future legislation extends the deduction beyond 2025).
The House and Senate Acts provide preferential individual tax treatment of business income generated through a pass-through entity. The House Act accomplishes this with a direct, lower tax rate for business income, while the Senate Act provides a deduction for a percentage of business income. Also, both the House and Senate Acts exclude certain service-based businesses from the preferential tax treatment. And, while there are more than individual owners of pass-through entities, the reduced tax rate in the House Act or the deduction provided in the Senate Act, would only be available to individual pass-through owners, effective as of Jan. 1, 2018, but transitional rules may apply.
Several Republican senators have complained the pass-through provisions contained in both the tax reform bills are too complex and do not provide sufficient relief for pass-through business owners in light of the 20 percent maximum tax rate proposed for regular (‘C’) corporations. As negotiations take place among Republican House and Senate leaders and Administration officials, do not be surprised to see substantial changes.
Contact your Eide Bailly professional with questions or for additional information.