Nov. 14 update: 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). (See the details of the original proposal below.) 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 income. Otherwise, the maximum 25% pass-through rate only provides tax relief in the 35% and 39.6% brackets. It’s not clear if a trading company, eligible for trader tax status and using Section 475 ordinary income, has “business income” and may qualify for the pass-through tax rate.
Most small business owners who saw the aggressive advertising about tax reform thought they would receive a significant tax cut on pass-through entity (PTE) business income, but now that the House released its tax cut bill (Tax Cut & Jobs Act), we see the savings will be far less than expected. Additionally, the bill extends self-employment taxes to owners of S-Corporations, limited partners, and on rental income.
The 25% PTE rate only applies to the “capital percentage,” which by default is 30% for non-service businesses and 0% for service businesses. It does not apply to the remaining “labor percentage” attributed to the officer/owners. PTEs may use an “alternative capital percentage based on the business’s capital investments,” but for many, that may not improve the results by much.
Assume an active owner of a non-service business is in the 35% ordinary tax bracket. His actual PTE rate is 32%, calculated as follows: 70% labor percentage multiplied by the 35% ordinary rate; plus 30% capital percentage multiplied by the 25% PTE rate. The blended rate is just 3% less than the 35% ordinary rate — not a significant tax saving.
The bill’s Section-by-Section Summary (page 3) states, “Under the provision, a portion of net income distributed by a pass-through entity to an owner or shareholder may be treated as “business income” subject to a maximum rate of 25 percent, instead of ordinary individual income tax rates. The remaining portion of net business income would be treated as compensation and continue to be subject to ordinary individual income tax rates.”
The bill disfavors service companies probably related to the anti-abuse provision to prevent people from reclassifying employee wages as service company revenues. Service companies have a 0% default capital percentage, so zero business income is subject to the lower PTE rate.
The bill permits PTEs to use an “alternative capital percentage based on the business’s capital investments.” Manufacturers have significant business capital investments, but many service companies do not. If a service business operates virtually in the cloud, it may not have much capital investment in equipment. Service companies with significant capital equipment may receive some tax benefits from the PTE rules, but the savings won’t be substantial.
Trading vs. investment management businesses
The bill treats trader entities with trader tax status (TTS) and investment managers as service companies, but there is a critical difference. In a trading company, trading and investment income do not constitute “business income,” so a trading company may not use the 25% PTE rate, even if it has an alternative capital percentage.
Conversely, an investment manager’s advisory fees are business income, but the profit-allocation (carried interest) of trading and investment income are not business income. The investment manager with net business income may utilize the 25% PTE rate if it has an alternative capital percentage. Investment managers may have trading workstations and high-frequency trading equipment that may deliver a decent alternative capital percentage.
The bill expressly excludes trading and investment capital from the business capital investment, and it states that trading and investment income are not business income.
The bill states, “SPECIFIED SERVICE ACTIVITY.—The term ‘specified service activity’ means any activity involving the performance of services described in section 1202(e)(3)(A), including investing, trading, or dealing in securities (as defined in section 475(c)(2)), partnership interests, or commodities (as defined in section 475(e)(2)).”
Limited partners get the PTE rate
The bill treats a limited partner’s entire distribution of business income as a capital percentage subject to the favorable maximum 25% PTE rate. The bill states, “Net income derived from a passive business activity would be treated entirely as business income and fully eligible for the 25% maximum rate.” Limited partners do not have a labor percentage since they are passive-activity owners. Some limited partners perform minor services, but not enough to satisfy the material participation standards in Section 469. The bill also subjects limited partner income to self-employment (SE) tax in Section 1402(a).
The bill expands self-employment income
Taxpayers calculate SE taxes based on self-employment income (SEI). It’s essential to understand SEI included vs. excluded items. SE taxes include Social Security and Medicare taxes. Social Security taxes are 12.4% up to the social security base amount ($128,700 for 2018) and 2.9 Medicare tax without an income limit. Obamacare added a 0.9%-Medicare surtax on earned income for people with AGI incomes over $200,000 single and $250,000 married.
The bill significantly expands the base of Section 1402 SEI for assessing SE tax. Tax writers did not mention this in earlier blueprints.
The bill adds these items to Section 1402(a):
• Labor percentage and capital percentage for PTEs.
• “Adjustment For S Corporation Wages – For purposes of this subsection, proper adjustment shall be made for wages paid to the taxpayer with respect to any trade or business carried on by an S corporation in which the taxpayer is a shareholder.”
• Application to rental income – Strikes Section 1402(a)(1), which had “excluded rentals from real estate and from personal property leased with the real estate.”
• Application to limited partners – Strikes Section 1402(a)(13), which had “excluded the distributive share of any item of income or loss of a limited partner.”
The bill does not add investment and trading income to SEI. That would be contrary to Republican tax policy; the GOP is trying to repeal the Obamacare 3.8% Medicare surtax (net investment tax) on investment and other unearned income.
The bill closes the S-Corp SE tax reduction loophole
Under current law, S-Corps do not pass SEI to owners. The IRS requires S-Corps with underlying earned income to have “reasonable compensation” for officer/owners. Industry practice for determining reasonable compensation in an S-Corp is 25% to 50% of net income before officer compensation.
The bill enshrines a labor percentage for S-Corps in Section 1402(a). Accountants should be able to use an S-Corp’s labor percentage, adjusted for office compensation paid, for determining SEI from the S-Corp.
For example, assume a non-service business S-Corp with a 70% labor percentage has $200,000 of income before officer compensation. It pays the officer $50,000, resulting in a net income of $150,000. The labor percentage amount is $140,000 (70% labor percentage multiplied by $200,000 income before officer compensation). SEI is $90,000 (labor percentage amount $140,000 less $50,000 officer compensation.)
For a non-service business S-Corp officer/owner, it’s an SE tax hike from 25% to 70% of income. For a service business, its a hike to 100%.
A trader tax status (TTS) S-Corp does not have business income; it has investment income on capital assets. The bill summary expressly states, “Certain other investment income that is subject to ordinary rates such as short-term capital gains, dividends, and foreign currency gains and hedges not related to the business needs, would also not be eligible to be recharacterized as business income.” I assume Section 475 MTM ordinary income fits the catchall “certain other investment income,” since it’s trading income on capital assets.
The IRS should not apply a labor percentage to a TTS trader S-Corp or partnership since the entity does not have business income. Currently, the IRS does not require a TTS trading S-Corp to have “reasonable compensation” for officer/owners because there is no underlying earned income.
Trader S-Corp retirement plan deduction in 2018
Assume a TTS trader S-Corp makes $200,000 in net income before officer compensation and employee benefit deductions. Assume the IRS does not assess a labor percentage on a trading S-Corp. Assume the S-Corp pays officer compensation of $19,000 to create some earned income. That unlocks a 100% deductible Solo 401(k) elective deferral deduction of $18,500, the maximum limit for 2018. (The bill does not change 401(k) limits).
The trader owner saves income taxes on the $18,500 deduction, figure at 30.3% for federal and state, and pays payroll taxes of 15.3% on $19,000. The owner enjoys a 15% tax savings on $18,500, which is $2,775. The owner could also do the maximum 25%-deductible profit sharing plan of $36,500 on wages of $146,000. That increases the net tax savings of income tax savings over payroll tax costs.
With no labor percentage applied in a TTS trading S-Corp, the officer/owner retains control over compensation and retirement plan choices.
Alternative structures for TTS traders
If the IRS insists on 100% self-employment income for a trading business S-Corp, then traders should consider alternative arrangements. I don’t think the IRS will require SEI for a trading S-Corp, and the bill has a long way to becoming law.
A TTS trader can be a sole proprietor using a Schedule C or a trading partnership and pay a C-Corp management company reasonable administration fees. The C-Corp can deduct health insurance, a retirement plan contribution, and fringe benefit plans, including a health reimbursement arrangement. The management company would be deemed a “personal service C-Corp,” with a 25% rate in the bill, not the 20% rate for other types of C-Corps.
The TTS trader could skip employee benefits and remain a sole proprietor. If married, the sole proprietor trader could hire their spouse, and the spouse could have a health insurance deduction for family coverage (HSA and HRA). The spouse could also have a tax-deductible retirement plan contribution. A sole proprietor may not pay himself as an employee. Trading gains are not SEI, so these machinations are required for employee benefit deductions.
We are looking into whether a C-Corp can be a good option for some traders, so stay tuned.
Alternative structures for companies with business income
The PTE rate deal is disappointing, and S-Corps face an SE tax hike with a 70% to 100% labor percentage. Some small businesses may want to consider changing to a C-Corp for the 20% rate, or 25% rate on personal service corporations.
LLCs taxed as S-Corps may consider revoking the S-Corp election to convert to a C-Corp. Consult with a tax advisor to avoid pitfalls on certain types of reorganization, which could result in taxation. You should consider a tax-free reorganization. If you have a personal service company C-Corp with a 25% rate, plus a qualified dividend rate of 20%, the total federal tax rate would be 45%. C-Corps also must contend with the 20% accumulated earnings tax, which may apply if you avoid paying sufficient qualified dividends. Don’t forget to factor in state double-taxation.
Our firm is considering various options for traders and other business for 2018 so stay tuned. The bill would take effect in years after Dec. 31, 2017, except for a few provisions like increased expensing and the change in mortgage deduction.
See my other blog post, How The House Tax Cut Bill Impacts Traders And Investment Managers.
If you have any questions, contact us soon.