House and Senate plans differ on pass-through tax rates
TAX ALERT |
The 'Unified Framework' for tax reform of the Trump Administration and Congressional Republicans called for a 25 percent tax rate on pass-through business income, with appropriate safeguards to prevent the conversion of salaries and other personal services income into purported 'business' income. Two very different approaches to that objective are taken by the House bill approved in committee on Nov. 9, 2017, and the Senate Republican plan announced the same day. The approaches are so different that it is possible that entirely new ideas may surface to reconcile the differences. Here is an overview of the two approaches, and what may happen next.
1. Reduced tax rate in House vs. special deduction in Senate
For qualifying business income, the House bill reduces the top individual rate to 25 percent. That amounts to a significant reduction from the otherwise applicable top rates of 35 percent or 39.6 percent.
The final language also allows up to $75,000 of business income (less for singles and heads of household) to enjoy a 9 percent rate if it would otherwise be subject to tax at 12 percent, providing a maximum benefit of $2,250. That benefit is available to moderate-income business owners-including professional and personal service firms even if there is no capital investment in the business-although these reduced rates are phased-in over several years, and the tax benefits are phased-out as the overall income of the taxpayer increases. (Note that this nine percent rate would appear to create an incentive for the conversion of salaries, such as the $75,000 salary of a private school teacher, into 'fees' paid to wholly-owned S corporations, unless there is a rule, as some expect there will be, requiring that the 'business' qualifying for this provision have multiple independent sources of revenue (such as five or more substantial customers or clients)).
In contrast, the Senate bill effectively excludes a portion of qualified business income from tax, at whatever rate otherwise applies. By allowing a deduction equal to 17.4 percent of qualified income the applicable tax rate can be computed as the product of 82.6 percent (100 percent-17.4 percent) and whatever tax rate would otherwise apply. For example, if the income would otherwise be taxable at the Senate’s top rate of 38.5 percent, the 17.4 percent deduction makes it subject to tax at a rate of 31.8 percent. If the income would otherwise be taxable at 25 percent, the 17.4 percent deduction makes it subject to tax at a rate of 20.65 percent. Thus, in some cases it is better than the House approach, in other cases worse.
2. Senate 'wage' requirements and 'skilled employee' restrictions
The Senate proposal contains an ambiguous provision that many believe imposes a 'wage' requirement on pass-through businesses. For example, if a car wash business operated as an S corporation with a single shareholder was making $134,800 before wages paid to its employees, and paid $34,800 of wages to its employees, the entity would have $100,000 of taxable income, and would be eligible for a $17,400 deduction under this provision–but only because it had paid $2 of wages ($34,800) for every $1 of this special, final deduction ($17,400).
Another interpretation of this provision is that it could operate as a 'minimum tax' for owner-operators similar to the House approach to active business owners. For example, if the $34,800 of wages were paid instead to an independent contractor who serviced and operated fully automated car wash machinery, there would be $100,000 of net income for the S corporation and no 17.4 percent deduction would be allowed. However, if the sole-owner of this business paid himself wages of $26,000 he might be able to claim a 17.4 percent deduction against the remaining $74,000 of S corporation income–a deduction of $12,876 that would qualify because it was less than 50 percent of the $26,000 of wages paid. That would give the owner total income of $26,000 of wages and $61,124 of S corporation income for a total of $87,124–lower than the $100,000 that would apply without the special deduction. For a taxpayer otherwise in the 38.5 percent bracket the tax savings would be $4,957.26 (38.5 percent x $12,876). This is close to the tax savings under the House bill, if 30 percent of the $100,000 of S corporation income or $30,000 were subject to tax at 25 percent with 70 percent or $70,000 subject to tax at 39.6 percent. The tax benefit there would be $30,000 multiplied by the rate differential (39.6 percent less 25 percent or 14.6 percent) or $4,380.
However, if the owner is entirely passive, the House bill would be better for a low-wage or no-wage business. In this example, 100 percent of the $100,000 would be taxable at 25 percent-a total tax savings of $14,600 on the $100,000 of income.
There is also a provision in the Senate plan that would make its benefits unavailable for any business, “where the principal asset of such trade or business is the reputation or skill of one or more of its employees.” It is not clear how the reputation and skill of employees can be considered an 'asset' of the business, or how that would be measured and compared with other assets, such as machinery. Conversely, it is not entirely clear that the reputation and skill of an active owner who is not technically an 'employee' because he is a partner or a sole proprietor-the IRS position is that partners cannot be employees of their own partnerships and that sole proprietors do not 'employ' themselves-would be covered by this rule, although that is probably what is intended.
In a case where this rule applied, because it was clear that there were no substantial assets other than the skill and reputation of the workforce (such as a business that detailed cars by hand, or a company that manufactured custom-made, hand-made guitars, cigars or bicycles) it is not clear that the Senate intends this provision to apply as it appears to be described. That is because a literal interpretation could cut out hundreds of thousands of businesses in the services industry, and even manufacturing businesses that relied on skilled workers instead of machines. In that fashion, this provision also appears to be working at cross purposes with the 'pro-wage' policy of the wage requirement. Skilled workers with good reputations that enhance business revenues tend to earn higher wages.
It is possible that the Senate only intends this restriction to apply where the skilled 'employees' are also owners of the business, presenting a risk of 'disguised compensation' being converted to low-taxed business income.
3. Rules to ensure 'reasonable compensation' to 'active' owner-operators
From the beginning, even in cases where an enterprise is a bona fide trade or business providing goods or services to multiple clients or customers–and not just a scheme for converting a salary into business income–there has been a concern that the business may not be paying the owner-operator 'reasonable compensation' for his services, and thus might be 'converting' some compensation income into lower-taxed 'business' income. The House bill has extensive provisions to address that concern.
Under the House bill, purely passive owners have no issues. But 'active' owners of non-personal service businesses are allowed to generally treat no more than 30 percent of their income as 'capital' income eligible for the reduced rate. They can use a higher percentage determined by multiplying a statutory rate of return (short-term Treasury borrowing rates plus 700 basis points or around 8.5 percent today) times their actual capital investments in the business, which can sometimes be much more than 30 percent. For 'active' owners of personal services businesses, there is no 30 percent allowance, but they can prove-out their capital investments, such as a radiologist investing in expensive imaging equipment.
In the Senate plan, other than the complete exclusion of service businesses described above which is arguably overbroad and possibly not intended, the Senate proposal has no 'guardrails' of this nature.
If the “skilled employee” rule is intended to serve as the Senate’s guardrail, it seems that the rule is quite vague and difficult to apply, particularly in contrast to the House approach that uses a combination of fixed percentages and the actual basis of assets on the books of the entity.
The Senate bill does not impose the 'skilled employee' exclusion for taxpayers with income below $150,000 (married) or $75,000 (single). Thus, this leaves open the possibility of converting a modest salary into a 'fee' paid to an S corporation to enjoy the Senate’s 17.4 percent deduction.
Consider a single, private school teacher making a salary of $75,000 and claiming the standard deduction–for net taxable income $63,000 and tax of $9,996. He might convert that into a fee to his S corporation of $75,000, pay himself a salary of $20,000 leaving S corporation income of $55,000, deduct 17.4 percent or $9,570 (less than 50 percent of his $20,000 wage), leaving $43,430 of S corporation net income, and then claim a $12,000 standard deduction for a net taxable income comprised of $20,000 of salary plus $43,430 of S corporation income (net of the 17.4 percent deduction), less $12,000 standard deduction for a net taxable income of $53,430-a reduction due to the $9,570 deduction of 17.4 percent of his S corporation income. The tax savings would be close to $2,000 as he would be in the 22.5 percent bracket for amounts above $38,700 and below $60,000.
This might be addressed if there was a requirement that the business receive income from multiple, unrelated clients or customers (such as 5 or more with no single one accounting for more than 20 percent of total revenues).
4. Other ideas that may surface as the process continues
Under either approach, a deduction or a reduced rate, it has been suggested that an 'active' owner in any kind of business, including one relying on the skills and reputation of the owner or others, be permitted to have a dual capacity under a 'benchmarking' concept. That is, even an active owner could receive investment income, fully qualifying for the reduced rate or the deduction, from an investment held on the same terms as purely passive investors holding a substantial investment in the same class of interests or shares. The theory is that no 'disguised compensation' would arise from a failure to pay reasonable compensation, because of the 'leakage' that would necessarily occur to independent, unrelated investors. A similar concept is contained in the proposed regulations for exempting limited partners from self-employment tax, to distinguish 'investment' income that should not properly be subject to that tax.
It is also possible that transition rules, or 'grandfather' rules, might be applied for longstanding family-owned or closely held business that have been diligently paying 'reasonable compensation' to their active owners, and continue to do so, but who cannot meet the 'benchmarking' test and cannot 'prove out' the basis of their business assets (under the House bill) because they largely consist of appreciated goodwill.