A solution to the tax reform pass-through problem
Tax reform under any of the proposals thus far released contemplates a significant rate cut for C corporations, and a smaller rate cut for individuals. But pass-through entities like S corporations, which comprise 90 percent of all U.S. businesses, pay taxes through the individual returns of their owners. There is already a rate gap between the current corporate rate of 35 percent and the highest individual rate of 39.6 percent, but under any tax reform plan, that gap would increase.
“One of the reasons for tax reform is the competitive disadvantage faced by U.S. multinationals compared to their foreign counterparts, but it doesn’t make a lot of sense to address one disparity caused by the Tax Code to create a new disparity caused by the Tax Code,” said Mel Schwarz, tax-policy advisor in Grant Thornton’s Washington National Tax Office. “That’s what will happen if you significantly reduce the corporate tax rate and do not also provide an equivalent rate cut for pass-throughs.”
“Pass-throughs do have a benefit in that they are only subject to a single level of tax, but there’s a good argument that the current difference between the corporate rate and the highest individual rate – 4.6 percent – is a pretty accurate measurement of what that benefit is,” Schwarz said.
One of the tax reform proposals would lower the corporate tax rate from 35 percent to 20 percent while lowering the top rate on individuals from 39.6 percent to 33 percent, Schwarz noted. “In addition, it would establish a new tax rate for a portion of pass-through profits, at 25 percent.”
The upshot is that rather than facing a nearly five-percentage-point difference in tax rates, the gap would expand to as much as 13 percentage points, depending on how much pass-through business profits are eligible for the 25 percent rate, Schwarz indicated.
Moreover, individual owners, faced with the choice of paying taxes on their salary at an individual rate of 33 percent, will be tempted to reclassify at least a portion of their salary so as to use the lower 25 percent rate.
FIXING THE PROBLEM
One solution that has been advanced is the “70/30” test, which would arbitrarily tax 70 percent of pass-through income as if it were wages, while taxing the remaining 30 percent at the lower rate. “But this method is extremely arbitrary and in many cases would be extremely unfair,” said Schwarz. “For example, some pass-through entities are capital-intensive. Why should 70 percent of profit at a manufacturing company be treated as wage income if machines are doing most of the work?”
A better solution would be to have third-party certification that a pass-through entity is paying appropriate wages, which would then be taxed at the new wage rates before distributing business profits to owners. “This would avoid a rough-justice rule, close the potential wage-profit loophole and deliver a tax rate on business income close to that paid by corporations,” said Schwarz.
Although some businesses might prefer to use a simple ratio so they can easily process their tax returns, more complex pass-throughs could use the third-party certification process to ensure that business profits are not misclassified as more wage income, he suggested.
The beauty of this proposal is that the mechanism is already out there, Schwarz observed. “Many businesses have studies done to make sure that the compensation they offer is competitive. There’s a whole group of people who are specialists in this area.”
“The hard details will be to make sure that tax law appropriately captures what is and isn’t business income from all pass-through entities and taxes it at a low and uniform rate, and to establish standards and enforcement rules to reduce the ability of business owners to recategorize their wages as business income,” Schwarz said.