The latest version of the Senate tax reform bill, which cleared the Finance Committee late last week, would give owners of pass-through businesses a 17.4 percent deduction of “domestic qualified business income” from a partnership, S corporation sole proprietorship or similar entity (excluding some services companies) while cutting the corporate rate to 20 percent from 35 percent.
The potential deduction, however, means your high-net-worth client who owns a high-profit pass-through might eventually pay an effective top tax rate higher than 30 percent.
Sen. Ron Johnson (R-Wis.) said the proposed Senate plan would work against many closely held businesses relative to major corporations (C corps). Although pass-through entities, including investment advisors and their small-business customers, would benefit from the 17.4 percent rate, at the back end pass-throughs will pay ordinary income rates on retirement plan distributions.
The House also passed its version of the tax bill late last week, but “the House and Senate have vastly different proposals regarding flow-through income, and some of the Senate provisions do not follow the House provisions,” said Diane Nienow, CPA and senior manager/tax in Madison, Wis. “They’ll need to come to a compromise if they want to pass a bill through both chambers.”
What to tell potentially affected HNW clients? Like everyone else, tax specialists wait on Washington. “The absence of detailed advance information makes it difficult to provide robust guidance,” said Judith Herron, CPA with Markovitz Dugan & Associates in Pittsburgh and a member of the Pennsylvania Institute of CPAs. “Even though the summaries of the bills in the House and Senate talk about reduced tax rates, it’s not a slam dunk that every recipient of pass-through income is going to see a reduction in taxes.”
Potentially affected clients such as owners of pass-throughs and heads of C corp multinationals “are very interested in receiving advice right now,” said Ryan Losi, shareholder and executive vice president at Piascik CPAs in Glen Allen, Va. “Business owners want to know if they should push more income into 2018, and the multinationals want to know if they should defer repatriating foreign earnings via dividends into 2018.”
Also downplayed in the reform wrangling, according to Losi: A proposal for S corp income (in the form of a portion of K-1 income) becoming potentially subject to self-employment tax.
Republicans are not expected to push major tax cuts through Congress this year, according to a majority of economists in a recent Reuters poll. Whatever reform eventually does do to corporate rates and pass-throughs, a drastically lower tax rate for one form of entity over another will ignite a migration to the lower-taxed business entity, much like when Subchapter S became the entity of choice after the last major reform in 1986, Losi predicted.
“If we have a wide disproportion between the highest corporate income rate and the business rate, you will see a sizable migration back to C corps for small business,” he added. “Tax rates should not dictate the type of legal entity a business operates through.”
“One of the tools accountants use to make choices on tax positions is the history of how the IRS has handled a matter in the past, and how the courts have treated the IRS approach in a particular matter. The calculations associated with identifying the character of income for pass-through entities under the proposed new laws are untested in this sense,” Herron said.