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Proposed Tax Reform Jeopardizes Pass-Through Entities

In Washington, DC, Tax Reform is on the menu.

An area of consensus, at this writing, is ensuring a new low top rate on pass-through businesses partnerships (S Corporations, sole proprietorships).  But, separating business and individual rates brings its own challenges.

  • Pass-through income is derived from businesses which is claimed on individual tax returns, i.e., it “passes through” to the business owners and is taxed at the owners’ individual tax rates.
  • Lawmakers looking to lower taxes for small and medium-sized businesses often look to these pass-through rates to keep their tax cut pledges without incurring the huge revenue hit that would result from lowering the top individual tax rate.
  • Distinguishing between business profits and income tied to labor will likely be a heavy lift as lawmakers seek to develop rules that classify business income and wages.
  • For better or worse, Congress appears stuck on applying an arbitrary 70/30 rule on pass-through income. The idea would is to subject 70 percent of pass-through income to payroll taxes.
  • The arbitrary 70/30 rule would unfairly disadvantage pass-throughs as this chart comparison illustrates, by allowing C-corporations to be taxed at a blended differential of approximately 25 percent while pass-throughs would be taxed at approximately 30 percent on the same amount of net profits.

Why it’s important: Many ISRI member companies are pass-through entities currently, and this tax proposal, if enacted, could force some to incur the trouble and unproductive cost of converting to C corporation status in order to remain competitive.

  • With the potential to turn a proposed tax cut to a tax hike for many pass-through businesses, the arbitrary 70/30 rule is an incredibly damaging proposal.
  • It is not easy to distinguish returns from an owner’s personal labor and his/her investments in capital and employees, and getting it wrong has the potential to completely undo the benefits of tax reform. Contact Danielle Waterfield with any questions.

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