December 18, 2017 Senate and House conferees adopt passthrough deduction proposal and excess loss limitation for individuals On December 15, 2017, House and Senate conferees to the "Tax Cuts and Jobs Act" (H.R. 1) signed and released a Conference Agreement that is expected to be considered by the full House and Senate this week. The Conference Agreement contains proposed statutory text, which includes major changes to the taxation of corporations, individuals, and passthrough entities (passthroughs include S corporations, partnerships, and sole-proprietorships). The expectation is that President Trump will sign the bill prior to the Christmas holiday. The Conference Agreement reflects compromises by the conferees in a host of areas, including a 21% corporate tax rate that will be effective in 2018 — up from 20% in the bills passed by the House and the Senate — and a 37% top individual income tax rate that would apply to joint filers with annual incomes over $600,000. Importantly, for passthrough business owners, the Conference Agreement proposes: (1) a reduction of the highest marginal income tax rate for individuals from 39.6% to 37%; (2) a reduction of the highest marginal income tax rate for corporations from 35% to 21%; (3) a new deduction for individuals, trusts and estates equal to 20% of domestic "qualified business income" from a partnership, S corporation, or sole proprietorship; and (4) a limitation on the ability of persons other than C corporations to claim losses from active trades or businesses. These changes mean that individuals could, in effect, have a top marginal income tax rate of 29.6% if they can take advantage of the full amount of the 20% deduction (the individual's income less the 20% deduction times the top rate of 37%). The Conference Agreement 's changes to the taxation of passthrough entities differs in many ways from the Senate bill passed on December 2, 2017 (the Senate Bill) and the House bill passed on November 16, 2017 (the House Bill). See Tax Alerts 2017-1927 and 2017-1931 for a discussion of the Senate's proposals relating to the passthrough and partnership provisions, respectively, and Tax Alert 2017-1847 for a discussion of the House's proposals. Special 20% deduction for passthrough income The Conference Agreement would add a new Section 199A, which grants individuals, trusts and estates a 20% deduction on certain passthrough income. Special limitations would apply to income from "specified service businesses" and businesses that do not pay a certain amount of W-2 wages. With the reduction of the C corporation income tax rate to 21% and the presence of a significantly higher top individual income tax rate of 37%, the application of the 20% deduction will be an important factor in determining whether individuals should conduct business through a passthrough (where the entity does not pay federal income taxes but the owners do) or through a C corporation (where the entity pays federal income tax and the owners also pay tax on dividends or stock sales). The provision would be effective for tax years beginning after December 31, 2017, and before January 1, 2026. General rule An individual, trust and estate would be allowed to deduct 20% of domestic qualified business income (QBI) from a passthrough. At the proposed top rate of 37%, if an individual's sole income source is domestic QBI, the individual's effective top tax rate on the domestic QBI would be 29.6% if the individual could claim the full 20% deduction. The deduction would not be allowed against adjusted gross income, but rather would be a below-the-line deduction to taxable income. The Conference Agreement: (1) contains a cap on the amount eligible for the 20% deduction that is based on the W-2 wages paid by the business, plus in certain cases, the "unadjusted basis" of certain property used in the business; and (2) limits the availability of the deduction for individuals with income from certain "specified service businesses." These limits would not apply to individuals with income below certain thresholds (the Thresholds — $157,500 for individuals, and $315,000 if married filing jointly, indexed annually). Qualified business income QBI for a tax year would mean the "net amount of qualified items of income, gain, deduction, and loss" from a taxpayer's qualified trade or business. For this purpose, "qualified items of income, gain, deduction, and loss" are such items to the extent they would be effectively connected with the conduct of a trade or business within the United States (within the meaning of Section 864(c) — i.e., they arise from regular, substantial and continuous business activities in the United States). Qualified REIT dividends, qualified cooperative dividends, and qualified publicly traded partnership income would not be taken into account in determining QBI, but instead would be separately eligible for a deduction without regard to the wage or property limitation mentioned above and discussed below. Thus, for example, 20% of qualified REIT dividends and 20% of qualified publicly traded partnership income may be included in the amount eligible for a deduction under Section 199A. QBI would not include reasonable compensation paid by a qualified trade or business (including such compensation paid by an S corporation), any amounts paid by a partnership to a partner that are "guaranteed payments" under Section 707(c) with respect to the trade or business, or (to the extent provided in regulations) payments to partners for services described in Section 707(a) with respect to the trade or business. It also would not include certain "investment items," such as interest income not properly allocable to the trade or business and any capital gain or loss. In that regard, it is not clear if gain under Section 1231 treated as a long-term capital gain is an amount excluded from the QBI computation. Generally, property that generates Section 1231 amounts is not considered investment property. 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. It is not clear how or whether a net loss from qualified publicly traded partnership income affects the amount of the Section 199A deduction as it appears that the computation of the amount of the potential deduction under Section 199A nets the 20% or wage/property limited QBI amount with 20% of qualified publicly traded partnership income (along with 20% of qualified REIT dividends). As such, if the qualified publicly traded partnership income is a negative amount for a tax year, it is possible that such loss may reduce a taxpayer's total deduction under Section 199A. W-2 wage limitation In general, the amount of qualified trade or business income eligible for the Section 199A deduction would be the lesser of: (1) 20% of the taxpayer's QBI from such trade or business; or (2) the greater of (i) 50% of the W-2 wages of such trade or business, or (ii) the sum of 25% of the W-2 wages of such trade or business plus 2.5% of the unadjusted basis immediately after acquisition of all "qualified property" of such business. Qualified property would include depreciable tangible property (not intangible property) that is used in the qualified trade or business. For taxpayers whose taxable income does not exceed the Thresholds, the W-2 wage and qualified property limitation would not apply. For taxpayers whose taxable income exceeds the Thresholds, the W-2 wage and qualified property limitation would be phased in over the next $50,000 of income for individuals and $100,000 of income for married filing jointly taxpayers. Special limitation for specified service businesses The deduction would not apply to income from "specified service businesses" unless the taxpayer's income is below the Thresholds, and would be phased out over the same income ranges used for the W-2 wage and qualified property limitation. A "specified service business" means any trade or business activity involving the performance of services in the fields of health, law, accounting, actuarial sciences, performing arts, consulting, athletics, financial services, brokerage services, investment management, trading, dealing in securities, partnership interests or commodities, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its owners or employees. Engineering or architecture trades or businesses are not treated as specified service businesses. The deduction also would not apply to the trade or business of performing services as an employee. The provision would be effective for tax years beginning after December 31, 2017 and before January 1, 2026. Limitation of excess business losses of noncorporate taxpayers The Conference Agreement would add a new Section 461(l) that would limit the ability of taxpayers other than C corporations from using an "excess business loss" against other income. An excess business loss is the excess of aggregate deductions of the taxpayer attributable to trades or businesses, over the sum of aggregate gross income or gain of the taxpayer plus $250,000 for individuals and $500,000 for married individuals filing jointly. For a partnership or S corporation, the proposal would apply at the partner or shareholder level. Each partner's or S corporation shareholder's share of items of income, gain, deduction, or loss of the partnership or S corporation would be taken into account in applying the limitation. The disallowed amount would be treated as a net operating loss carryover to the following tax year under Section 172. The provision would be effective for tax years beginning after December 31, 2017 and before January 1, 2026. The loss limitation provision would apply after application of the passive loss rules under Section 469. The Conference Agreement does not provide ordering with respect to application of certain other loss limitation provisions, including Sections 704(d), 465 and 1211. Deductibility of state and local taxes imposed on a passthrough In the Conference Agreement, passthrough entities would retain the ability to deduct entity level state and local property and sales taxes presently allowed on individual taxpayers' Schedule C, Schedule E and Schedule F. Certain implications of individual and C corporation rate disparity As with the Senate Bill and the House Bill, the Conference Agreement would cause certain passthrough owners to consider conversion to C corporation form. An individual's top effective marginal tax rate would be 29.6% for passthrough income under the Conference Agreement, assuming a top marginal rate of 37% and eligibility to use the full 20% Section 199A deduction. For an individual, the effective income tax rate on C corporation earnings would be approximately 36.8%, after considering double-taxation on corporate earnings and assuming distributions are treated as qualified 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 39.8%. For example, on $100 of income, the C corporation would pay $21 of income tax, and if it distributed the remaining $79 to an individual as a dividend, the individual would pay $15.8 of income tax (20% of $79) and $3.0 of net investment income tax (3.8% of $79), leaving the individual with after-tax proceeds of $60.2 for an effective tax rate of 39.8%. This means that the effective tax rate resulting from double-taxation on C corporation earnings is only approximately 7.2% (or 10.2% also 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 20% 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 29.6% only if the entirety of such earnings is eligible for the 20% deduction. The exclusion of many types of service business income from the list of eligible income would limit the benefit of the 20% deduction for many individuals. The W-2 wage and qualified property limitation will also reduce the benefit of the 20% deduction for eligible passthrough income, closing the gap in effective tax rates between C corporations and passthroughs. The new loss limitation rule might also make operating in passthrough form less attractive than currently, given that such rule prevents non-C corporations from using business losses against other income. ———————————————
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