House Tax Reform Proposal and Pass-Through Entities: Our First Read
Note: These provisions have been significantly modified by the Chairman's second amendment. In particular, the SE tax modifications have all been removed in the Bill that passed out of the Committee. A lower bottom threshold rate was also added for small pass-through businesses. Read new summary of current proposals here.
The 429-page tax reform proposal released by the House on Thursday is touted as simplifying the tax code. Not surprisingly, there’s very little simple about it, especially when it comes to its application to small businesses. Despite its complexity, the bill includes changes that could produce significant savings for some in the agricultural community.
Currently, income received by an S corporation shareholder, a partner in a partnership, or a sole proprietor is taxed to the individual at individual income tax rates, which can climb to 39.6%. Generally, sole proprietors must also pay SECA tax on their income, and general partners must pay SECA tax on their guaranteed payments and distributive share income. Limited partners do not pay SECA on distributive share income. S corporation shareholders, on the other hand, pay FICA tax on “reasonable compensation” they must receive. The rest of their S corporation income is not generally subject to self-employment tax.
Lower Rate for Pass-Through Businesses
The Proposal would significantly change the status quo.
The Proposal provides that “qualified business income” of an individual from a partnership, S corporation, or sole proprietorship would be subject to federal income tax at a rate no higher than 25 percent. The law contains complex provisions to ensure that taxpayers aren’t shifting wage income to business income to take advantage of this new preferential rate.
Under the proposal, “qualified business income,” the income that is taxed at the preferential rate, includes all net business income from passive business activity. The term “passive business activity” means “any passive activity as defined in section 469(c),” which is the “conduct of any trade or business in which the taxpayer does not materially participate.” It also includes any rental activity, except for that conducted by real estate professionals. Under this definition, qualified business income would appear to include cash rental income and limited partners’ distributive share income.
Note that the statute refers to “passive business activity,” not passive income for purposes of defining “qualified business income.” As such, it would seem that rules re-characterizing certain income from passive activities as non-passive (i.e. self-rental) should not change the character of that activity for purposes of defining “qualified business income.” It is not clear, however, how this provision would be implemented.
“Qualified business income” also includes the “capital percentage” of net business income stemming from active business activity (reduced by certain losses). The bill establishes a default capital percentage for most active businesses of 30 percent. This means that 30 percent of the business income would be taxed at the preferential rate, while 70 percent would be taxed under ordinary individual income tax rates (maximum 39.6%). This capital percentage can be adjusted upward pursuant to a complex formula (via a five-year election) depending upon facts and circumstances. Services businesses such as law and accounting are considered to have no capital percentage. In other words, absent showing that the default rule should not apply to them, they would be unable to take advantage of the preferential rate for any portion of their income.
The proposal would also make significant changes to the calculation of self-employment tax for pass-through businesses. IRC § 1402(a) would be amended to provide that net earnings from self-employment would be based upon the “labor percentage” of earnings, less deductions. The term “labor percentage” means, “with respect to any income or loss, the excess (expressed as percentage) of 1 minus the capital percentage (expressed as a decimal) with respect to such income or loss.”
In other words, using the default capital percentage of 30 for a general partnership, the labor percentage would be 70%. By contrast, the default labor percentage for a services business would be 100%
Bottom line, it would appear that, absent a special election, 70 percent of a general partner’s distributive share income (up to the SE tax income limit, which is $127,200 in 2017) would generally be subject to self-employment tax under the House proposal. Guaranteed payments could change that equation a bit.
The calculation for an S corporation is more complex because an adjustment must be made for the wages paid for services. The Joint Committee on Taxation, in an excellent review of the proposed law, provides this helpful example:
An S corporation shareholder is paid wages of 20 with respect to a trade or business conducted by the S corporation, and after the deduction for wages, and has a pro rata share of income from the S corporation of 100. Assume the labor percentage is 70 percent. In determining net earnings from self-employment, the 20 of wages is added to the 100 pro rata share before applying the labor percentage of 70 percent (120 x .7 = 84). The 84 amount is then reduced by the wages of 20, yielding net earnings from self-employment of 64. Present-law rules imposing FICA tax on the wages of 20 are not changed by the provision.
Because the imposition of self-employment tax under the proposal would be based upon a labor percentage, two provisions in the current self-employment statute would be repealed. Would-be repealed provision IRC § 1402(a)(1) generally excludes “rentals from real estate and from personal property leased with the real estate” from inclusion in self-employment income. Would-be repealed provision IRC § 1402(a)(13) excludes from self-employment income “the distributive share of any item of income or loss of a limited partner.”
This repeal, while not automatically creating new SE tax liability, does introduce the possibility of SE tax for S corporations, LLC investors, limited partners and renters, based on their participation level. It would no longer be beneficial, for example, to create a “manager-managed” LLC structure to limit SE income.
Early analysis suggests that this proposal could be quite beneficial to many small businesses. It would also appear to upend some current entity planning strategies. In particular, the proposal would appear to eliminate some self-employment tax advantages currently offered by S corporations. It should be noted that grouping elections would need to be evaluated in light of the Proposal. There would no doubt be different opportunities for maximizing savings through grouping business activities.
There will be much more to come as the Ways and Means Committee begins its markup and the Senate evaluates its own proposals. We will also write separately regarding the individual tax provisions in the Proposal. It is certain to be an interesting month.
The Center for Agricultural Law and Taxation does not provide legal advice. Any information provided on this website is not intended to be a substitute for legal services from a competent professional. The Center's work is supported by fee-based seminars and generous private gifts. Any opinions, findings, conclusions or recommendations expressed in the material contained on this website do not necessarily reflect the views of Iowa State University.