United States

Tax reform framework may have bad news for service businesses

Passthroughs may be excluded from preferred tax rate

TAX ALERT  | 

Congressional leaders and the Trump administration have indicated that they plan to release their much anticipated tax reform framework the week of Sept. 25. This framework should give the public additional insight into the direction that tax reform legislation may take later this fall.   It appears, however, that at least one group may be unhappy with the contents – the accounting industry.

The reason relates to the administration’s desire to give pass-through businesses a tax break, while limiting service businesses’ ability to convert compensatory income (taxed at normal rates) into passthrough income (potentially taxed at preferred rates).

Background

A cornerstone issue in the recent reform discussions has been the desire to reduce the corporate tax rate. The Trump administration has proposed a top rate of 15 percent, House Republicans have suggested a top rate of 20 percent and others have floated various alternatives. The passthrough community has voiced its concern, however, that S corporations and partnerships, whose income is generally taxed at individual income tax rates, should also enjoy a similar rate reduction to avoid being put at a competitive disadvantage. For this reason, both the administration and Congressional Republicans have outlined proposals that would provide a preferred tax rate for passthrough income in order to address this issue.

The complication of these proposals, however, is that the preferred rate is meant to apply to business income, not compensatory income. As a consequence, there has been significant discussion surrounding finding ways to identifying mechanisms to ensure that passthrough businesses cannot shift compensatory income, e.g. wages and guaranteed payments for services, that would otherwise be taxed at the normal graduated income tax rates, into passthrough income, that might enjoy this new preferential tax rate.

Recent Statements

Recent statements from the administration suggest that they are concerned that certain industries are more susceptible to this temptation, leading Treasury Secretary, Steve Mnuchin, to recently indicate that a reduced passthrough rate would not apply to passthrough service businesses, such as accounting firms.

Although Mnuchin singled out the accounting industry, his statement is an indication that the tax reform framework may identify other service businesses to be excluded from the preferred rate, with the most likely candidates being businesses in the fields of law, accounting, consulting, engineering and health. Taxpayers in those industries should have special interest in the details that we hope will be included in the framework.

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