How pass-through tax reform proposals differ in House and Senate
Competing bills have fundamentally different policy approaches
TAX ALERT |
UPDATE (11/21/2017): The release of the text of the Senate Finance Committee bill seems to clarify two aspects of that proposal. The Senate bill (other than for taxpayers with income below the $500,000/$250,000 threshold) excludes "any trade or business involving the performance of services described in section 1202(e)(3)(A), including investing and investment management, trading, or dealing in securities (as defined in section 475(c)(2)), partnership interests, or commodities (as defined in section 475(e)(2)).”
This language appears to clarify that, for example, a manufacturing business making hand-made guitars would not be excluded because its principal asset was its skilled workforce. Such a business would not involve ‘the performance of services.’ However, it is still unclear whether the excluded service business are limited to those in the statutory list of forbidden fields (health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, or brokerage services) or also include any trade or business involving the performance of services in, "any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees." Examples might include culinary arts or services or construction. It is also unclear what is meant by an ‘employee’ and how one would value, as an asset, the skill of one's employees. The Senate bill also appears to provide that real estate investment trust (REIT) dividends are automatically eligible for the 17.4 percent deduction without regard to whether any wages are paid by the REIT or any other person. For some real estate rental activities, REITs may be a work-around but they contain many restrictions and generally require a substantial number of distinct individual investors holding relatively small percentage interests.
(11/20/2017) The House and Senate tax plans would both reduce taxes on certain business income earned by owners of pass-through entities or sole proprietors. But the differences in their approaches are stark. In addition, there is still substantial uncertainty regarding how the Senate’s conceptual plan will be turned into actual legislative language. Here are some illustrations of the main differences, and areas of uncertainty.
House bill for passive investors
For purely passive investors, the House bill is simple. The top rate on business income is reduced to 25 percent. This is a big reduction from the otherwise applicable top rate of 39.6 percent. If one includes the 3.8 percent net investment tax on passive business income, the top combined rate would be 28.8 percent – down from 43.4 percent today – a major reduction that many hope will help attract investment capital to non-publicly traded businesses.
A taxpayer’s active or passive status is determined using the complex passive activity loss rules. But for an investor in a single, stand-alone business who only contributes money or property, who does not work for the entity currently and has never done so, achieving passive status is simple. Where the taxpayer has multiple investments or activities, the potential ‘grouping’ or aggregation of entities must be taken into account.
A classic example would be a passive investor with $1 million of salary income who buys an empty lot for $1 million, paying $200,000 of cash and borrowing $800,000 at 5 percent interest, who uses it as a parking lot that generates fees of $200,000. After paying $40,000 to an independent contractor to manage the lot, and $20,000 for insurance and $40,000 of interest, there is $100,000 of net income. 100 percent of that income would be taxed at a top 25 percent rate, while his normal salary would be taxed at normal, graduated rates.
In general, this broad, liberal approach to passive investors would also apply to investors in REITs.
Passive investors under the Senate plan
The Senate approach is much less generous than the House bill even for cases when it clearly applies. The Senate provides a deduction – equal to 17.4 percent of income determined before that deduction – rather than a rate cut. That only reduces the top 38.5 percent rate to approximately 31.8 percent – well above the 25 percent rate of the House bill (and the Unified Framework which both bills were supposed to implement).
Perhaps more importantly, in many cases the Senate plan will not apply at all. For example, no benefits at all would apply to this previously described passive, parking lot entrepreneur. Why is that?
For one thing, to qualify for Senate benefits the $40,000 paid to an independent contractor would need to be paid as wages. The Senate plan generally provides benefits only if a specified amount of W-2 wages are paid.
If the business replaced its independent contractors with employees – which might not otherwise be good business for a variety of reasons – then the 17.4 percent deduction would apply, allowing $100,000 of income to be reduced by $17,400 to $82,600 before applying the Senate’s proposed tax rates. Again, the Senate bill allows a deduction of $17,400 only because at least twice that amount is paid in wages. Here, with $40,000 of wages the full $17,400 deduction may be claimed.
Note that if income began to grow faster than the wages of its parking attendants, and more wages were needed solely for tax purposes, the business might have to ‘in-source’ other services, like hiring a part-time lawyer or accountant as an ‘employee’ rather than using a local firm that is otherwise more proficient and more economical. It is also quite possible that the IRS would challenge the ‘employee’ status of some of these service-providers. (See below for situations where the IRS would argue the opposite under the Senate bill – that purported independent contractors were actually employees.)
If all goes well, the benefits for the parking lot investor otherwise in the top Senate tax bracket of 38.5 percent would be 38.5 percent of $17,400 or $6,699. That is slightly more than half of the $13,500 of tax savings that would arise from lowering the top Senate tax rate from 38.5 percent to 25 percent (13.5 percentage points) and applying that reduced rate to $100,000.
But note that if the parking lot were associated with a hospital, or a sports arena or stadium, it might be considered to part of a business providing services in the forbidden field of ‘health’ or ‘athletics.’ In that event, no benefits at all would be allowed under the Senate bill.
For passive investors in higher brackets, the House bill is more generous and relatively simple to apply. It does not have any wage requirement or any exclusions of particular industries.
One particularly opaque rule in the Senate proposal extends the ‘forbidden service business’ rule to ‘any trade or business where the principal asset of such trade or business is the reputation or skill of 1 or more of its employees.’ It is unclear whether this is applicable only to service businesses, or would also apply – as the IRS has privately indicated applying similar language – to a non-service business relying on skilled employees as its ‘principal asset.’ An example might be a manufacturer of hand-made guitars or motorcycles. It is also unclear how one would measure – as an ‘asset’ – the skill and reputation of employees who are theoretically free to leave the employ of the firm – and whether ‘employees’ includes owners or partners who provide services to the firm in a non-employee capacity.
The Senate bill also has a special rule for REIT owners, but it is difficult to tell at this point what it is intended to do.
House bill for active owners
The House bill is responsive to the concern raised by many critics of the proposed Republican tax reforms that a reduced tax rate for pass-throughs would allow individuals to convert their personal services income to low-rate ‘business’ income. Accordingly, the theory of the House bill is that one must distinguish an owner’s return on capital–which is obviously 100 percent of income in the case of a purely passive investor–from returns that reflect the personal services of an active owner.
Where the business is not itself providing personal services in certain listed fields (health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, or brokerage services – but apparently excluding construction, food preparation or service, transportation services, writing books or magazine articles, and many other activities), 30 percent of total business income is deemed a return on capital and eligible for the 25 percent rate with the rest taxed at normal graduated rates.
For example, if our parking lot owner in the original example were active in the business – running it himself instead of paying $40,000 to an independent contractor – the total income would be higher by $40,000. It would be $140,000, not $100,000. Under the House bill’s 30 percent rule, the active partner could treat 30 percent of $140,000 or $42,000 as income eligible for the top rate of 25 percent. The remaining $58,000 would be taxable at normal ordinary income rates.
Alternatively, an active owner can look at his tax books to determine his share of the adjusted basis of the entity’s ‘trade or business’ assets at year end, and multiply that by around 8.5 percent – technically, the prevailing short-term Treasury borrowing rate plus 7 percentage points. If the assets are debt financed, that number is further adjusted by subtracting deductible interest on the debt.
For example, using the same active parking lot owner with $140,000 of net income, his capital investment would be $1 million. Multiplying that by 8.5 percent would yield $85,000. Since the investment was debt-financed, the taxpayer would subtract $40,000 of interest to produce $45,000. That $45,000 would be the portion of the taxpayer’s $140,000 of total business income that would be eligible for the reduced tax rate under the House bill.
As these examples illustrate, exactly how much benefit is obtained by an active owner is a function of how much in the way of business assets are held by the business and how those assets are financed. In this case, the 30 percent rule and the rule based on actual capital invested produce similar results. Here’s another example involving a depreciable asset, not land.
Assume that a taxpayer borrowed $40,000 to purchase a $50,000 automobile that was depreciated to $40,000 in its first year, and was actively used by the owner in a limousine business that produced $5,000 of net income, after $2,000 of interest expense.
Under the 30 percent rule the 25 percent top rate would apply to 30 percent of $5,000 or $1,500.
Alternatively, using the capital investment formula, the income subject to the 25 percent rate would be (8.5% x $40,000 = $3,400) less $2,000 or $1,400.
And if the automobile was purchased entirely for cash, the capital investment formula would allow $3,400 of the active owner’s $5,000 of income to be taxed at the top rate of 25 percent under the House bill.
Note that if the identical business was providing ambulance services – not limousine services – it might be deemed to be a personal service business in the field of health. In that event, the 30 percent rule would be unavailable, but the taxpayer could generally still get $1,400 taxed at the reduced rate based on his debt-financed investment in the vehicle or $3,400 if the vehicle were purchased entirely for cash.
As this example suggests, the service business limitation of the House bill is mainly designed to prevent the use of the reduced 25 percent rate – and the automatic 30 percent rule – by lawyers, physicians, accountants, and other professional firms that do not have very much in the way of capital investment. But a radiologist, for example, with a substantial investment in expensive medical imaging equipment might be able to get a good result using the return-on-capital rule.
House bill for small, active businesses
The House bill has a special 9 percent rate, instead of the otherwise applicable 12 percent rate, that also waives the personal service business limitations and avoids any need to show a capital investment. This provision is intended for ‘mom-and-pop’ service providers, generally applies only to the first $75,000 of such income for joint filers, less for single filers, obviously applies only at a low tax rate, and is also phased-out. Thus, the fact that some of this income may be ‘personal service’ income is not as much of a concern as under the Senate approach which makes a similar benefit available virtually to anyone who is not part of the ‘top 1 percent’ of taxpayers.
Senate bill for active professionals not in the top 1 percent
In an unusual turn of events – considering the earlier clamor against applying a reduced tax rate to personal services income – the Senate Finance Committee included a last-minute change to its rules. As long as a taxpayer has total income under $500,000 on a joint return or $250,000 for single filers – the traditional boundaries of the ‘top one percent’ – none of the Senate’s ‘wage’ requirements and none of its rules blacklisting certain businesses will apply.
Thus, for example, a member of a professional firm or practice in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, or brokerage services – as well as any other profession or service line – can get the 17.4 percent deduction without limitation, as long as their total income does not exceed the $500,000/$250,000 limits. They are not required to have any employees or pay any amount of wages. At a tax rate of 35 percent, a deduction equal to 17.4 percent of $500,000 would produce a tax cut of over $30,000.
The benefits of this rule are very quickly phased out as income rises from $500,000/$250,000 to $600,000/$300,000. But many highly successful lawyers, physicians, dentists, accountants, and other professionals – perhaps the vast majority of those professionals in certain areas of the country – will be able to enjoy the resulting tax cut – as much as $30,400 – as long as their income stays below $500,000/$250,000. Obviously, in many cases this income will be entirely a return on the personal services of these professionals, since they will have minimal capital invested in the business.
One can also imagine that many salaried professionals will be encouraged to become, or try to become, independent contractors rather than employees, in order to enjoy these benefits. A salaried CFO or General Counsel of a corporation, for example, might rejoin their former accounting or law firm, but only to serve one client, their former employer.
As can be seen, the IRS will be arguing for ‘employee’ status in cases like this, but arguing for ‘independent contractor’ status if the client is a pass-through entity seeking to maximize its ‘wages’ under other provisions of the Senate plan.
Some critics have argued for changes to both bills.
The first question for analysis is whether either bill fulfills the goal of the Unified Framework which promised to limit, “the maximum tax rate applied to the business income of small and family-owned businesses conducted as sole proprietorships, partnerships and S corporations to 25%.”
For passive investors, the House bill seems to do that far better than the Senate proposal both because of its larger benefits, and because of its application to virtually any type of business, irrespective of its industry or the level of capital or labor it uses. Indeed, according to the revenue estimators, the Senate pass-through deduction will provide tax benefits with a ten-year cost of $362 billion, while the reduced rate of the House bill provides tax benefits costing almost $600 billion.
The second part of the Unified Framework was a promise to include, “measures to prevent the recharacterization of personal income into business income to prevent wealthy individuals from avoiding the top personal tax rate.” Obviously that issue does not arise for passive investors, as there is no compensation element for a purely passive investor.
For active investors, the House bill contains ‘guardrails’ that some have criticized as too restrictive, particularly for many existing businesses. If the basic House approach is followed, some have suggested that an ‘active’ investor, who also holds investor-class securities, should be able to qualify his ‘passive’ earnings from investor-class securities for the reduced rate, as long his ‘passive’ earnings were the same as those earned on investor-class securities of the same class that were held by a substantial number of unrelated passive investors, providing a ‘benchmark’ for an arm’s length return unrelated to any personal services of the owner. The theory is that no disguised compensation is likely to arise in such cases because it would need to be shared with unrelated passive investors. But long-held, family-owned businesses might find the ‘related party’ requirements problematic and unfair. Another idea would allow manufacturers and others to include inventory or work-in-progress in the definition of assets or capital investments that increase the amount of reduced-rate income. Still others argue that the allowed ‘rate of return’ on assets of 7 percentage points over the short-term Treasury borrowing rate is too low for a reasonable, equity-like return.
On the other side, there are also those who criticize the 30 percent allowance of the House bill as arbitrary – arguing that only demonstrable capital investments should give rise to benefits. Others defend the 30 percent rule as a helpful transition for many existing businesses, and as a way to avoid thorny disputes over ‘reasonable compensation.’
The Senate bill seems to have no guardrails at all – other than for taxpayers in the top one-percent with joint incomes over $500,000 or single-filers earning more than $250,000. Lawyers, accountants, physicians, dentists and similar professionals with family income below those limits can apparently treat all of their personal services income as ‘business’ income qualifying for the 17.4 percent deduction. But even for higher income taxpayers with income above those limits, if the taxpayer is the sole proprietor and full-time CEO of a manufacturing business that meets the wage and industry requirements of the Senate bill, there does not seem to be any rule against converting the professional’s personal services income – what might otherwise be a CEO salary – into business income that qualifies for the 17.4 percent deduction.
The technical challenges raised by these provisions may be causing some policy makers and observers to reconsider their prior views of the progressive income tax.
There is a certain amount of sympathy – even on the part of those who generally favor highly progressive taxes on ‘the rich’–for entrepreneurs who contribute only their ‘sweat equity’ and who would not get any tax relief here if the provision required them to show a capital investment. Ergo, the 30 percent rule of the House bill, even for active owners who invest no capital. Yet it is difficult to economically distinguish those entrepreneurs from professionals in the forbidden service industries (law, accounting, medicine, etc.) who invest in their own professional skills and expertise – who many say should not get any benefits on account of their ‘sweat equity.’ And, ironically, after all of the clamor on this issue, the Senate bill gives that group very large benefits, as long as the taxpayers are not in the ‘top 1 percent’ of taxpayers.
Some policy makers and observers are also ambivalent about ‘passive’ investors. Traditionally, ‘active’ is good and ‘passive’ is bad. But if benefits are provided to passive investors, that should reduce the cost of capital for an active entrepreneur – which is particularly important if they are getting little or no benefits for the returns on their ‘sweat equity’ because that is viewed as ‘labor’ that should be taxed under highly progressive rates. It would seem to be hard to argue logically that the active investors should not get any benefits, and that the passive investors should also not get any benefits. In short, it is getting harder to know who should be considered the ‘heroes’ of the American economy and who should not – those who are highly creative, efficient, and productive with their labor and entrepreneurial efforts, or those who remain passive, but choose to invest their discretionary income in productive new enterprises managed by others. If both are to be discouraged, it is hard to see how economic growth can be encouraged.