***This blog has been updated on December 21, 2017 to reflect the tax bill passed by Congress***
In the past month, the House and Senate have both voted along party lines to approve their own versions of comprehensive tax reform legislation. In order to gather the necessary votes to pass their respective chambers, Republican leaders made some significant modifications during the process. In a series of blog posts, we will cover the major pieces of both bills and compare them to current law. You can see all tax reform 2017 related blogs here.
This blog will cover the topic of taxation of pass-through businesses. The changes included in both bills result in a reduction in taxes for many business owners, however they tend to favor passive investors, not owner operators. Business owners should evaluate their tax burden under the new laws (when passed), to determine if tax planning or changes to their business structure are advantageous.
CONFERENCE COMMITTEE APPROVED BILL
An individual taxpayer would be allowed to deduct 20% of qualified business income from a partnership, S corporation, trust, or sole proprietorship classified as a U.S. trade or business. Qualified business income does not include reasonable compensation or guaranteed payments paid to the taxpayer for services.
The 20% deduction would generally not apply to specified service businesses, unless the taxpayer’s taxable income is less than $315,000 for MFJ taxpayers or less than $157,500 for all other taxpayers. The benefit of the deduction for service businesses is then phased out over the next $100,000 of taxable income for MFJ taxpayers or $50,000 for all other taxpayers. A wage limit also applies to the 20% deduction.
The wage limitation is the greater of (a) 50% of W-2 wages paid, or (b) the sum of 25% of the W-2 wages with respect to the qualified trade or business plus 2.5 percent of the unadjusted basis, immediately after acquisition, of all qualified property.
The deduction would be effective for taxable years beginning after December 31, 2017. The deduction would expire after 2025.
This provision would create a top tax rate for pass-through income of approximately 30%
CURRENT LAW
Pass-through income is currently taxed at individual tax rates. Taxpayers, regardless of industry, receive the same rates. Shareholders in an S-Corporation do not pay self-employment taxes on distributions, but are required to pay themselves reasonable compensation.
HOUSE TAX REFORM BILL
Partnership or S corporation business income would be reduced as low as 25%. This is a significant reduction when compared to the current maximum individual tax rate of 39.6%. The 25% rate would apply to pass-through income when the partner or shareholder is a passive investor in the entity as determined under the current passive-activity loss rules. If the partner or shareholder is active, then the 25% rate would only apply to 30% of the business income with the remainder 70% taxed at regular individual tax rates. Partners or shareholders in service businesses would generally not qualify for any reduced rate.
The bill amendments provide for a reduced 9% tax rate in place of the 12% rate for the first $75,000 ($37,500 if unmarried) in net business taxable income for an active owner earning less than $150,000 ($75,000 if unmarried) in taxable income. When taxable income exceeds that threshold the 9%-rate begins to phase out until $225,000 of taxable income, where it is completely eliminated. This 9% rate is phased in to the tax code over a five-year period.
SENATE TAX REFORM BILL
An individual taxpayer would be allowed to deduct 23% of qualified business income from a partnership, S corporation, or sole proprietorship classified as a U.S. trade or business. The deduction is not eligible to be used for trust or estate income. Qualified business income does not include reasonable compensation or guaranteed payments paid to the taxpayer for services.
The amount of the deduction is generally limited to 50% of the taxpayer’s allocable share of W-2 wages. The W-2 wage limit will not apply to a taxpayer with taxable income not exceeding $500,000 for married filing jointly (MFJ) taxpayers or $250,000 for all other individual taxpayers. When the taxpayer’s income exceeds that threshold, the W-2 limit is phased out over the next $100,000 of taxable income for MFJ taxpayers or $50,000 for all other individual taxpayers. Depending on the taxpayer’s industry and business structure, this limitation could significantly reduce the benefit of this deduction.
The 23% deduction would generally not apply to specified service businesses, unless the taxpayer’s taxable income is less than $500,000 for MFJ taxpayers or less than $250,000 for all other taxpayers. The benefit of the deduction for service businesses is then phased out over the next $100,000 of taxable income for MFJ taxpayers or $50,000 for all other taxpayers.
The deduction would be effective for taxable years beginning after December 31, 2017. The deduction would expire after 2025.
This provision would create a top tax rate for pass-through income of approximately 30%, which is higher than the house proposal (25%), but lower than the current top individual rate (39.6%).