November 14, 2017 Passthrough deduction proposal by Senate Finance Committee Chairman On November 9, 2017, the Senate Finance Committee released the Chairman's Mark of the Tax Cuts and Jobs Act (the SFC Chairman's Mark). The SFC Chairman's Mark describes changes to the Internal Revenue Code that, if enacted, will have meaningful consequences to passthrough entities and their owners. The SFC Chairman's Mark proposes: (1) a reduction of the highest marginal income tax rate for individuals from 39.6% to 38.5%; (2) a reduction of the highest marginal income tax rate for corporations from 35% to 20%; and (3) a new deduction for individuals equal to 17.4% of "domestic qualified business income" from a partnership, S corporation, or sole proprietorship. These changes mean that individuals could, in effect, have a top marginal income tax rate of 31.8% if they can take advantage of the full amount of the 17.4% deduction (the individual's income less the 17.4% deduction times the top rate of 38.5%). The SFC Chairman's Mark and the Ways & Means Committee bill differ in significant ways. See Tax Alert 2017-1847 for an overview of the Ways & Means Committee bill as it applies to passthrough entities and their owners. Process summary and background The staff of the Senate Finance Committee released a section-by-section explanation of the SFC Chairman's Mark on November 12, 2017 (the SFC Mark Explanation). The Senate Finance Committee began marking up the SFC Chairman's Mark on November 13, 2017. The Tax Cuts and Jobs Act, originally released on November 2, 2017, by Ways & Means Committee Chairman Brady, was amended on November 3, 6, and 9 (the original bill jointly with its amendments, the W&M Bill). The House Ways and Means Committee approved the W&M Bill on November 9, 2017. The W&M Bill is expected to be considered by the full House of Representatives. Special 17.4% deduction for passthrough income The SFC Chairman's Mark would provide individuals with a 17.4% deduction on certain passthrough income. Special limitations would apply to income from "specified service businesses." General rule An individual would be able to deduct 17.4% of domestic "qualified business income" (QBI) from a partnership, S corporation, or sole proprietorship (qualified businesses). At the proposed top rate of 38.5%, if an individual's sole income source is domestic QBI, the individual's effective top tax rate on the domestic QBI would be 31.8%. The SFC Mark Explanation of the proposal describes a cap on the amount eligible for the 17.4% deduction that is based on 50% of the W-2 wages paid by the S corporation or partnership (but not a sole proprietorship), including wages "of both employees and owners/shareholders" but excluding Section 707(a) and (c) payments. Qualified business income QBI for a tax year would mean the net amount of domestic qualified items of income, gain, deduction, and loss with respect to a taxpayer's qualified businesses, which would include any trade or business other than specified services trades or businesses (as defined in this Alert). In determining a taxpayer's qualified items of income, gain, deduction, and loss, items would be taken into account only to the extent included or allowed in the determination of taxable income for the year. REIT non-capital gain dividends and certain cooperative dividends would be considered qualified items of income for this purpose. QBI would not include reasonable compensation of an S corporation shareholder, or amounts paid by a partnership to a partner that are Section 707(c) or Section 707(a) payments for services. It also would not include certain investment-related items. If the computation of QBI results in a loss for a tax year, the amount of the loss would be carried forward and treated as a loss from a qualified business in the next tax year. Special limitation for specified service businesses The 17.4% deduction would not apply to "specified service businesses," except for taxpayers whose taxable income does not exceed $150,000 (if married filing jointly) or $75,000 (for other individuals). The benefit of the deduction would phase out for these individuals over a $50,000 range for taxable income exceeding the aforementioned thresholds. The SFC Mark Explanation refers to Section 1202(e)(3)(A) in describing the specified service businesses. The proposal would be effective for tax years beginning after December 31, 2017. According to the JCT, the provision would reduce revenues by $459.7 billion from 2018 through 2027. Comparison to W&M bill The W&M Bill would add a new maximum income tax rate of 25% for individuals (and 9% for certain lower-income individuals phased in from 2018 through 2022) on certain QBI (the definition of which differs from the SFC Chairman's Mark definition) from passthrough entities, after the exclusion of net capital gain. Passive income If all of an individual's income from a passthrough entity is net business income from a passive activity that is treated as QBI, the individual's effective tax rate under the W&M Bill would be 25%, significantly lower than the 31.8% rate under the SFC Chairman's Mark (assuming full use of the 17.4% deduction). Active income If the individual's income were instead net business income from an active activity (an activity in which the individual is active) that is treated as QBI, the individual's effective tax rate under the W&M Bill would be 35.2% (assuming the highest marginal tax rate), which is higher than the rate that would be applicable on the same income under the SFC Chairman's Mark of 31.8% (assuming full use of the 17.4% deduction). The 35.2% rate under the W&M Bill consists of a 25% rate on 30% of the active business income and a 39.6% rate on 70% of such income. QBI QBI under the W&M Bill would generally be 100% of "net business income" derived from a passive business activity and 30% of any net business income derived from an active business activity. The W&M Bill would use the Section 469 regime to group activities and to determine passive or active status. The SFC Chairman's Mark does not appear to differentiate between active and passive activities in describing the 17.4% deduction. Service activities The W&M Bill would reduce the 30% default capital percentage to 0% for "specified service activities." The description of excluded service activities in the SFC Chairman's Mark appears consistent with the definition of such activities in the W&M Bill, which cross-references Section 1202(e)(3)(A). An individual engaged in a specified service activity may attempt to support an "applicable percentage" higher than the 0% default capital percentage under the W&M Bill. The SFC Chairman's Mark seems to exclude income from specified service businesses (except for individuals who meet the taxable income requirements described above) from the 17.4% deduction regime. Revenue estimates The JCT estimated a $448.0 billion loss of revenue over 10 years for the W&M Bill's 25% passthrough income tax rate, an amount very close to the loss of revenue estimate of $459.7 billion for the SFC Chairman Mark's 17.4% deduction for certain passthrough income. Certain implications of individual and C corporation rate disparity The SFC Chairman's Mark could cause certain passthrough owners to consider conversion to the C corporation form. An individual's top effective marginal tax rate would be 31.8% for passthrough income under the SFC Chairman's Mark, assuming a top marginal rate of 38.5% and full use of the 17.4% deduction. For an individual, the effective income tax rate on C corporation earnings would be 36%, after considering double-taxation on corporate earnings and assuming distributions are treated as dividends, but excluding the 3.8% net investment income tax on dividends. With the 3.8% net investment income tax on dividends, the aggregate effective tax rate would be 39.04%. For example, on $100 of income, the C corporation would pay $20 of income tax, and if it distributed the remaining $80 to an individual as a dividend, the individual would pay $16 of income tax and $3.04 of net investment income tax, leaving the individual with after-tax proceeds of $60.96 for an effective tax rate of 39.04%. This means that the effective tax rate resulting from double-taxation on C corporation earnings is only 4.2% (or 7.2% taking into account the net investment income tax) higher than that on passthrough earnings (if all such earnings are domestic QBI and eligible for the full 17.4% deduction). In certain cases, C corporation owners have the ability to defer the second level of tax by monitoring the timing of distributions. Moreover, the effective income tax rate for passthrough owners will be as low as 31.8% only if the entirety of such earnings is eligible for the 17.4% deduction. The apparent exclusion of certain service business income from the list of eligible income would limit the benefit of the 17.4% deduction for many individuals. The 50% of W-2 wages limit might also reduce the benefit of the 17.4% deduction for eligible passthrough income, closing the gap in effective tax rates between C corporations and passthroughs. ———————————————
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