As Larry Elkin recently wrote in this space, business taxation may be the stumbling block that keeps congressional Republicans from getting their tax plan across the finish line. But many taxpayers remain confused over what that fight is about, and what it would mean for business owners if the Republican tax plan passed.
The objections recently posed by Sen. Ron Johnson, R-Wis., have to do with the differences in tax treatment for corporations and pass-through entities, such as limited liability companies and partnerships. These structures “pass” business income through to the entity’s owner or owners, and it is taxed as individual income at whatever rate applies. Pass-through entities account for over 90 percent of U.S. businesses and more than half of U.S. business income by some measures, making the question of fairness no small matter.
The passed House bill and the not-yet-passed Senate bill both permanently reduce the corporate tax rate from 35 percent to 20 percent, though the timing of the reduction differs slightly. The two bills diverge more abruptly in their proposals for pass-through tax treatment, however. Because pass-through income is subject to income tax at the individual level, this income can be subject to a maximum tax rate of 39.6 percent. The House bill caps this maximum rate at 25 percent, while the Senate proposal would allow a deduction for 17.4 percent of pass-through income.
When discussing fairness and business taxes, it’s crucial to look further than simply comparing the corporate tax rate to the individual income tax bracket. That’s because corporations face double taxation that pass-through entities avoid. Businesses that are subject to the corporate income tax (known as C corporations) pay tax on business income, but then the remaining income is taxed again when the corporation distributes it to shareholders in the form of dividends. This can result in the government collecting over 50 cents of every dollar that C corporations generate under the current rules. A lower corporate tax rate could make things fairer, depending on how it’s implemented.
There is yet another wrinkle in the tax reform under consideration. In the House bill, the 25 percent rate for pass-through income applies only to the business’s “capital percentage,” which defaults to 30 percent for nonservice businesses and 0 percent for service businesses – a category that includes lawyers, consultants, accountants, architects and an array of other types of small businesses or sole proprietorships. The capital percentage is the portion of income the law assumes comes from capital invested in the business, as opposed to from the labor contributed by the owners. In other words, the law attempts to distinguish between true business profits and wages paid to active owners in a pass-through structure, and assumes that service businesses generate only the latter.
As a tax professional, I worry about how the capital percentage rule would apply to the inevitably large gray area left between “service” and “nonservice” businesses if something like the House bill becomes law. The distinction comes from the existing tax code, but ambiguity remains. For instance, Palisades Hudson Financial Group seems squarely a service business, but what if we decide to diversify our revenue streams by acquiring a factory? More realistically, what if an architect starts printing, framing and selling her blueprints as art to supplement her income? What if a nutritionist starts making and selling his own brand of granola?
In theory, the reason service businesses are shut out is as an anti-abuse measure. I also suspect retaining the exception for service businesses reflects, at least in part, lawmakers’ wishful thinking about the return to a manufacturing economy that simply does not reflect the way most Americans work today. Regardless, if it becomes law, this exception means that many pass-through businesses will not receive any tax cut, except from potential changes to the owners’ individual tax bracket unrelated to their business.
The Senate proposal originally excluded these same service businesses, but later changed course. In its most recent version, within some limits, all pass-through entities can take advantage of the available deduction.
So what is actually fair? Johnson has proposed essentially jettisoning C corporations altogether, or at least eliminating the differences in how they are treated. Johnson’s plan would eliminate the corporate tax outright and, with it, double taxation. Instead, business income would be passed through to shareholders when they pay tax on dividends. Even Johnson, however, admits that it is too late to push for such a major change at this point.
Assuming the Republicans are able to pass tax reform at all, they would be better served to focus on what a level playing field really looks like when double taxation remains a fact of American business.
Earlier in 2017, President Trump proposed that all business income be taxed at 15 percent, for corporations and pass-through entities alike. As Larry Elkin observed at the time, this makes rhetorical sense, but no logical sense. It ignores double taxation and all but invites abuse. It would also mean the Internal Revenue Service would need to somehow determine what proportion of a pass-through owner’s income was a salary, and thus taxable at the individual income tax rate, as compared to the lower pass-through rate. Given how many American businesses are pass-throughs, a major chunk of business taxation would become a deeply unpleasant guessing game. And if the IRS stuck to the capital percentage rules, many businesses wouldn’t benefit from a lower rate at all.
Steven M. Rosenthal, a former member of the Joint Committee on Taxation and a fellow at the Tax Policy Center, told The New York Times of the House bill: “The pass-through section is the worst piece of legislation I’ve seen in 30 years.” And the proposed staggering of certain provisions taking effect could lead to confusion and frustration for business owners.
Lawmakers could align the top individual income tax rate with the blended tax rate from corporate tax combined with the tax on dividends. This would mean that most business owners, in theory, would be paying the IRS roughly the same percentage of their income, regardless of how they organized the company – what Johnson and others like him say they want.
Until a law passes, of course, all of this is speculation. But for business owners, the ultimate result of Congress’ process could have a major impact for years to come.