United States

Pass-throughs holding breath for House tax bill

TAX ALERT  | 

More than any other business segment, domestically based pass-through entities are holding their breath to see what the House Republican tax plan will unveil on Wednesday. The Unified Framework announced by the White House and Congressional Republican Leadership suggested that major changes could be in store for owners of partnerships, LLCs, S corporations and sole proprietorships, but left the details to the tax-writing committees. There is a wide range of possible outcomes, with perhaps more at stake for domestically based pass-throughs and their owners than other segments of the economy.  

The three main issues of concern are the proposed 25 percent top rate for “pass-through income,” a term that is still undefined, the possible limitation of business interest deductions for pass-through entities and the future of “carried interest” and profits interests generally. These issues are closely related, both technically and policy-wise.

Here are the main issues the House tax bill must apparently take a position on in the next few days:

Pass-through rate

Although it has not been widely discussed, the new reduced rate will likely not apply to income derived from “portfolio” assets, such as interest or gains from the trading of financial instruments and commodities. As under current law, such income will presumably be “separately stated” and taxed under current law rules.

After that, purely passive investors in a business or business-like activity should have no issues. Their entire income should be eligible for the reduced rate. But there will be an issue of how to exclude the portion of income from a business from the low rate, such as a restaurant, medical practice or asset-management firm, that is compensation for the personal services provided by an owner-operator, such as an investor who doubles as a chef, physician or financial consultant.   

Ideas widely endorsed by the business community include allowing the owner-operator to enjoy the reduced rate, at least on amounts he earns on investments that are made on the same terms as independent, passive investors. Examples include the passive investment returns earned by a limited partner who also happens to be running the company as its general partner, or if there are no independent investors, to the extent of a statutory rate of return, like 12 percent, on his or her actual invested capital, with the rest taxed as compensation at normal graduated rates. For example, with $1 million of invested capital in a sole proprietorship earning $500,000, that “return on investment” rule would allow $120,000 to be taxed at the reduced rate, with the remaining $380,000 taxed as if it were a salary at normal graduated rates.  

Other ideas include requiring proof that “reasonable compensation” was paid to the owner-operator, or automatically treating 70% of an owner-operator’s pass-through income as “reasonable compensation” with the remaining 30% treated as eligible for the reduced 25 percent rate. As with all proposals of this nature, transition rules will be very important. 

Another issue is what will happen to losses (active and passive) from activities eligible for the 25 percent rate. Will they be allowable against income taxed at 35% or higher, or will restrictions beyond the passive loss rules be imposed?  

Carried interest

Closely related to the issue of the pass-through rate is whether full capital gains will continue to be available to individuals who have mainly “sweat equity” in the business with little or no actual capital investment of the type that may be required to enjoy the reduced pass-through rate, but who participate under the terms of their agreements in capital gains when the business or its assets are sold. This is an issue for managers of alternative investment funds (hedge funds and private equity), real estate projects and real estate private equity, as well as for holders of profits interests in more traditional operating businesses. The White House has indicated an intent to close the “carried interest” loophole, but it is unclear what, if anything, will be included in the House bill.   

Past proposals have included partial denials of capital gains treatment and rules that apply either across the board to all partnerships, only to investment partnerships or only to certain industries.  

Interest deduction limitations

There will clearly be a limitation on corporate interest deductions, based on the theory that corporate income is supposed to be subject to a two-level tax that can be avoided when corporate income is “passed-through” as interest on corporate indebtedness. It is unclear whether the same idea will be applied to pass-through entities. Individuals are taxed once, and only once, whether they hold debt or equity interests in a pass-through entity. Thus, those entities don’t present the same “double taxation” issue. Still, Congress may be looking to raise revenue to help “pay for” the pass-through rate reduction or other provisions, giving pass-through businesses more accelerated depreciation or expensing benefits.  

It may be quite difficult to arrive at a consensus for a reasonable restriction on business interest of pass-through entities, since their operations are often so different from the large, multinational corporations that have been the focus in the development of the corporate proposal. The corporate proposal is expected to limit deductible interest to no more than approximately 30 percent of corporate earnings before interest, taxes, depreciation and amortization (EBITDA), possibly with various carryforwards. It is unclear how that would or should apply to pass-throughs.  

Particular concerns exist in the real estate industry where the level of “earnings” in EBITDA are lower and more stable than earnings in many other industries, but leverage is typically higher because of that fact. Some may argue that real estate rents should be treated more like interest received by financial institutions, who are expected under the bill to be able to deduct interest that does not exceed their net interest income. In these and many other cases, the EBITDA rule that may make sense for multinational corporations may not make sense for many pass-through entities. And there is also the fundamental argument that interest disallowance should not apply to pass-throughs, since they are not supposed to be “double-taxed” like C corporations.  

One would strongly hope that no one would face a worse result than current law, under the combination of the reduced pass-through rate and the possible limitation on pass-through interest deductions, but that is certainly possible depending on how the rules develop.

Potential effects for lenders

Another concern, even if the rules limiting interest deductions make sense as a policy matter, is the sheer disruptive effect on the economy of changes like this. The idea of limiting interest deductions for corporations has been under discussion for several years, but not so for pass-through entities. Banks and financial institutions that make loans to pass-through entities may have to prepare for a brave new world.  

Takeaways

With the House Republicans set to unveil their tax bill this week, domestic pass-through entities will soon have more details on how their businesses may be affected if tax reform moves forward. Whether the news is good, bad or mixed, this is still only the first or second inning in a long legislative game. The positions of the House, the Senate and the White House may still evolve, particularly if they hear from constituents, trade associations or lobbyists that particular proposals are viewed as problematic or potentially disruptive to the economy. Accordingly, affected taxpayers should continue to closely monitor major developments in the legislative process. They should also consider making their views or concerns known to their elected officials.

More information regarding tax reform and the tax reform process can be found at our Tax Reform Insight Page.

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