Update Nov. 15: In its Nov. 14 modified mark of the tax cut bill, the Senate committee made two significant improvements in the deduction for pass-through businesses for taxpayers with taxable income up to $500,000 married, and $250,000 for other individuals. Under this upper-income threshold, the Senate committee removed the 50% wage limitation and allowed specified service businesses to use the 17.4% pass-through deduction. There are phase-out rules over the limit, $100,000 married and $50,000 for other individuals.
Update Nov. 14: The House improved HR-1′s pass-through entity provisions with RULES COMMITTEE PRINT 115–39, scrapping the original bill’s expansion of self-employment income (SEI). The modified House bill helps middle-income taxpayers by adding an 11% maximum pass-through tax rate, phasing down to 9%, on the first $75,000 of business income, which phases out between $150,000 and $225,000 of married income.
After the release of the Senate’s tax plan summary on Thursday (Nov. 9), the media has been dissecting the language and comparing it to the House bill and the current law. But what plan is better for pass-through businesses? The Senate seems to deliver more tax savings to a non-service business with its 17.4% pass-through deduction vs. the House’s 25% pass-through (PTE) rate.
The Senate’s pass-through deduction for non-service businesses works well in all brackets, whereas, the House doesn’t seem to deliver savings in brackets under 25% ordinary rate. Furthermore, the House’s 25% PTE rate is misleading — in the 35% ordinary bracket, the blended PTE rate for an active owner of a non-service business is 32%, providing just a 3% rate savings. In my below example, the non-service business owner lowers his federal tax rate by 6% with the Senate proposal. Also, the Senate pass-through deduction could save taxes on state income tax returns (unless a state decouples from the federal rules). The House PTE rate does not deliver tax savings on state returns, just like a long-term capital gain rate is not reflected on the state level.
The Senate allows service companies to use the pass-through deduction providing they are middle-income taxpayers with taxable income under the phase-out range. The House bill provides service companies to use the PTE rate only if they have an “alternative capital percentage.” Increasingly, many service businesses invest in automation, robots, and other equipment. (See my blog post, Why The House Tax Cut May Disappoint Owners Of Pass-Through Entities.)
Traders with trader tax status have trading and investment income, including capital gains and Section 475 ordinary income, and therefore are excluded from the Senate’s pass-through deduction since only business income qualifies. Traders in a middle-income bracket might want to consider a dual entity solution: A trading partnership and S-Corp management company, with the S-Corp qualifying for a service company pass-through deduction. The House excludes trading income from the PTE rate.
The Senate requires a business loss to be carried over to the subsequent tax year to reduce the pass-through deduction in that year. Also, the Senate proposes an “excess business loss” limitation. The House bill does not have these two provisions. (See How The Senate Tax Bill Disallows Excess Business Losses In Pass-Throughs.)
The House bill extends self-employment taxes to non-passive owners of S-Corps, limited partners, and on rental income. The Senate summary does not mention changes to self-employment income or SE taxes.
The Senate’s Bill
I have included some of the text from the summary below and my thoughts. (See The Chairman’s Mark Of The “Tax Cuts And Jobs Act”)
Senate plan: “An individual taxpayer generally may deduct 17.4 percent of domestic qualified business income from a partnership, S corporation, or sole proprietorship.
“The deduction does not apply to specified service businesses, except in the case of a taxpayer whose taxable income does not exceed $150,000 (for married individuals filing jointly; $75,000 for other individuals). The benefit of the deduction for service providers is phased out over a $50,000 range (for married individuals filing jointly; $25,000 for other individuals). The phase-out applies for taxable income exceeding $150,000 (for married individuals filing jointly; $75,000 for other individuals).
“In the case of a taxpayer who has qualified business income from a partnership or S corporation, the amount of the deduction is limited to 50 percent of the W-2 wages of the taxpayer. W-2 wages of a person is the sum of wages subject to wage withholding, elective deferrals, and deferred compensation paid by the person during the calendar year ending during the taxable year. Only those wages that are properly allocable to qualified business income are taken into account.”
Robert Green: Partners don’t have wages; they have guaranteed payments, which are similar to salaries. The “50% of wages limitation” is the Senate’s way of incentivizing owners of S-Corps and partnerships to have “reasonable compensation” for active owners. Payroll brings payment of payroll taxes including Social Security and Medicare.
Assume a non-service business S-Corp’s net income before officer compensation is $400,000. The S-Corp pays reasonable compensation of 25% of net income ($100,000 wages by industry practice). The “50% of wages limitation” is $50,000. The pass-through deduction before limitation is $52,200 (17.4% multiplied by $300,000 net income). The pass-through deduction is $50,000 since the 50% wage limitation is a lower amount. The owner would likely increase wages to get the full deduction if the accounting was in order before year-end. In a 35% tax bracket, a $52,200 pass-through deduction is worth $18,270 in federal tax savings, plus state tax savings could increase it to about $21,000. Tax savings of $21,000 divided by $300,000 net income is 7%.
The Senate summary does not address the issue of passive owners who do not have officer compensation. Without compensation, the passive owner may face a zero wage limitation, meaning there would be no pass-through deduction for passive owners. In the House bill, passive owners get the entire 25% PTE rate benefit since they do not have a labor percentage. The House bill also subjects passive owners to self-employment taxes. The Senate summary encourages more SE tax with the wage limitation.
Senate plan: “Qualified business income for a taxable year means the net amount of domestic qualified items of income, gain, deduction, and loss with respect to the taxpayer’s qualified businesses (that is, any trade or business other than specified service trades or businesses, defined below).
“If the amount of qualified business income is less than zero for a taxable year, i.e., is a loss, the amount of the loss is treated as a loss from qualified businesses in the next taxable year.
“Qualified business income or loss does not include certain investment-related income, gain, deductions, or loss.
“A specified service trade or business means any trade or business activity involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or 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.”
I hope Congress merges the best features of the Senate and House tax bills to accommodate the essential interests of small business owners, whether middle income or upper income. Service companies have been stellar performers in the U.S. economy for decades, and they outcompete their foreign competition. They hire millions of Americans with good paying jobs and benefits, and they deserve tax relief.