Many American businesses are organized as pass-through entities. These companies account for roughly 30 million entities or 90 percent of all enterprises in the United States. The business income of the owners of such firms operating as sole proprietorships, partnerships and S corporations are currently taxed at individual taxpayer rates.
Lawmakers are hard at work with a goal of delivering a tax reform bill to President Donald Trump by year end. The provisions affecting pass-through businesses are still being developed, with the House and Senate proposals containing noticeable differences.
The House calls for a maximum rate of 25 percent for pass-through income treated as “qualified business income,” which is limited to 100 percent of passive business income and a portion of active business income (generally 30 percent or less) as defined under Section 469. If the business is a service business, the special 25 percent rate is generally unavailable, unless the business is capital-intensive. Passive owners may be able to apply the 25 percent rate to all of their passive pass-through business income.
In the Senate proposal, individual taxpayers would be eligible for a deduction equal to up to 23 percent of the taxpayer’s combined qualified business income, which generally includes non-service-business income as well as certain other qualified income earned in the United States. One part of this proposal generating significant attention is the apparent exclusion for trusts and estates from being eligible for the 23 percent deduction.
The 23 percent deduction is generally limited to 50 percent of the owner’s allocable share of W-2 wages with respect to the business. For individuals having taxable income under a threshold, service income is also eligible for the deduction, and the wage limit does not apply. Under the current Senate proposal, however, once single filers meet a $250,000 threshold ($500,000 for married, filing joint), pass-through owners would be quickly phased out over the next $50,000 or $100,000 of taxable income, respectively, and would be unable to benefit from the 23 percent deduction with respect to their allocated service business income. A proposed “phase-in” of the W-2 wage limitation commencing at the same dollar thresholds could also limit the benefit of the deduction for non-service businesses with no wage expenditures.
As the specifics on deductions, rules on profits, and guidelines on corporate rates take shape, scenario modeling is prudent way that tax and business professionals can plan for potential tax changes.
Pass-through entities can take a few steps to accomplish this:
- Evaluate current tax accounting methods. Many companies are evaluating their tax accounting positions to identify approved methods to defer income and accelerate deductions into the tax year preceding the effective date of the enactment of tax reform. To the extent a company can defer taxable income into a tax year after the law change occurs or accelerate deductions to a tax year before the law change occurs, the overall income tax liability to the business owner may be reduced as the income could be taxed at a lower rate.
- Prepare for new international tax regimes. Another “what-if” scenario for multinational companies involves tax differences across jurisdictions. If lawmakers settle on a shift to a territorial system in which domestic companies pay tax only on domestic income – something widely expected -- companies should assess their current supply chain to determine the ultimate income tax implications to the owners.
- Evaluate status as a pass-through entity. In the current debate over changes to both the corporate rates and pass-through provisions, companies should consider modeling whether remaining a pass-through entity is the right structure for the business in the future. For example, many boards, owners and company executives are now assessing whether their organizations are structured correctly to increase their after-tax profitability as a matter of good governance.
There are other potential changes that would affect pass-through entities. Both bills reduce individual taxes overall (with the House bill proposing a reduction in income brackets from seven to four, along with a 6 percent bubble rate on certain high-income taxpayers) and would allow U.S. companies to earn future foreign profits free of incremental U.S. tax. The House bill also calls for the repeal of the technical termination rules.
In addition, both the House and Senate versions of the bill retain last-in-first-out (LIFO) accounting provisions, reflecting the values of the most recent inventory acquired, which tends to carry a higher cost for the sake of deductions. To offset the cost of the retention of these benefits, both bills call for a repeal of the manufacturing deduction under Section 199, although with differing effective dates. While each bill limits net interest deductibility to corporations and partnerships at 30 percent of income, a meaningful deviation from the current 100 percent potential deduction, both vary in their approach to determining taxable earnings. The House version, for example, allows businesses to add back depreciation and amortization to compute adjusted earnings. This subtlety can have a significant impact on allowable interest deductions, particularly for companies with high debt levels.
There are also provisions surrounding foreign business activity. Offsets provided by the House bill include a 20 percent excise tax on payments by domestic companies to related foreign corporations – an important consideration as middle market and privately-owned businesses become increasingly global in nature.
Still, the political prospects for passage are less than 100 percent. In addition to political and policy differences surrounding issues including alternative minimum taxes and individual healthcare mandate penalties, lawmakers from some higher-tax states are pushing hard to allow individuals to deduct more of their state and local tax payments. Furthermore, some small businesses have challenged the language in the House bill on pass-through income as unfair to many companies with predominantly active business income that wouldn’t qualify for the lower 25 percent rate.
What might a potential scenario look like for your clients? Unfortunately, the answer will depend upon the operations of the company, the make-up of its ownership and where it does business.
A top priority for companies and their owners is minimizing the burden of taxes. As evidenced by two separate Deloitte polls of more than 5,000 participants each, 42 percent of respondents called tax rate reduction the most important outcome of tax reform.
As Congress works to get a plan to President Trump, pass-through companies need to consider the angles. Even in times of uncertainty, they can gain confidence by making sure their financial data and systems are tuned up and ready to go when changes hit.
© 2017 Deloitte Development LLC