Pass-through taxation, part 2: The Senate tax reform bill

Republicans continue to work on their tax reform bills. The House plans/hopes to vote on its bill this week, while the Senate's version, released Nov. 9, is still being analyzed.

One area getting a lot of attention is the two bill's differing treatments of pass-through entities. Income from these businesses — which include sole proprietorships, partnerships, limited liability companies (LLC) and S-corporations — is passed through to the business owners, who then report it on their personal tax returns.

The issue confronting lawmakers is that these earnings currently are taxed at ordinary income tax rates. Under the new tax reform bills, that could be more than the corporate tax rate both legislative chambers propose lowering.

Both the House and Senate bills call for a 20 percent corporate tax rate, but on differing timetables. The House's business tax cut from the current 35 percent rate would be immediate. The Senate's flat 20 percent corporate tax rate wouldn't kick in until the 2019 tax year.

Pass-through pas de deux: To pacify worried pass-through owners, House and Senate tax writers have done some jiggling with their proposed taxes on these companies.

The House bill, H.R. 1 or the Tax Cuts and Jobs Act, proposed in its original form that pass-through entities pay tax at 25 percent on 30 percent of business income. The remaining 70 percent of business income would be taxed as it is now, at the owner's individual tax rate.

Any individuals earning more than $200,000 a year (or $260,000 annually for couples) would pay the rest of their taxes at a rate of 35 percent.

During markup of the bill last week, the House Ways and Means Committee approved an amendment that would apply a 9 percent tax rate instead of the bill's lowest 12 percent rate to the first $75,000 in net business taxable income of an active owner or shareholder earning less than $150,000 in taxable income through a pass-through. The 9 percent rate is phased in over five years. It also would phase out at $225,000.

The Senate bill calls for a 17.4 percent deduction for pass-through business income. The deduction would be against domestic qualified business income from a partnership, S corporation or sole proprietorship.

This would effectively reduce tax rates on all pass-throughs, whether owned by richer taxpayers or the middle-class that the GOP is wooing.

Certain services businesses, however, wouldn't be eligible for the deduction if earnings exceed $75,000 for single taxpayers or $150,000 for married couples.

More business buy-in, but…: The Senate's bill and the changes to the House's original proposal have mollified some business groups, notably the National Federation of Independent Business. The business group slammed H.R. 1 when it was introduced, but praised the pass-through amendment.

However, there's still the matter of complexity.

"Both approaches will generate lots of extra complexity — and create a variety of loopholes and glitches," Steven M. Rosenthal of the Urban-Brookings Tax Policy Center told Tax Notes. "The tax relief is silly; any pass-through business that wanted the lower corporate tax rate could convert, tax free, to a corporation."

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