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Passthroughs and the Unified Tax Reform Framework

David: Welcome to the podcast. I'm David Stewart, editor in chief of Worldwide Tax Daily. Joining me in the studio this week is Tax Notes Today reporter Jonathan Curry. Jonathan, welcome.

Jonathan: Hi, David.

David: In their recent outline of tax reform proposals, Republican leaders have suggested a special tax rate on passthrough businesses. This idea started out as one of President Trump's campaign pledges and will now factor into negotiations on Capitol Hill, as lawmakers attempt to overhaul both the business and personal income tax systems. Jonathan, I guess the first question to ask is, what is a passthrough?

Jonathan: Sure. A passthrough is a business that is taxed at the individual level. So you're talking about sole proprietorships, LLCs, partnerships, and S corporations. And for example, if you sell crafts on Etsy, that's passthrough income. If you're a lawyer working at a private practice, your income is also most likely passthrough income. And what that means is that even though this is “business income,” you're taxed under the individual income tax code rather than the corporate tax code.

David: What is being proposed for passthroughs?

Jonathan: Well, like you said, this idea initially began during President Trump's campaign as a unified business tax rate. What he wanted was 15 percent for both corporations and small and medium-size passthrough businesses, and that was a huge tax cut any way you look at it. The current federal corporate tax rate is 35 percent, and the top marginal individual income tax rate is 39.6 percent. President Trump wanted to essentially bring them both down to 15 percent. Now since then, after months of negotiations, the Big Six Republican leaders settled on a corporate tax rate of 20 percent and a passthrough rate of 25 percent. Not quite unified, but it's still a big tax cut either way.

David: Now whenever people talk about a special rate for passthroughs, Kansas comes up. What happened there?

Jonathan: So in 2012 and 2013 Kansas enacted major tax cuts, which included an exemption from income taxation for passthrough entities. The idea here was that small businesses are typically passthroughs, so by zeroing out that rate, small businesses would expand and create more jobs.

David: Okay it's been a few years; what happened?

Jonathan: Well there are a lot more passthrough entities, but few new jobs were actually created. Instead, a budget deficit crisis has persisted even though they've cut state spending. The state's credit rating was downgraded, and it had the fifth worst job growth in the nation in 2016. Now of course there are plenty of other economic factors at play here. But the generally agreed upon takeaway is that the tax cuts fell short of their objective.

David: Have state lawmakers done anything in response?

Jonathan: Yeah, things kind of backfired. Earlier this year, the Republican-controlled legislature rebelled, passing a major rollback of the governor's tax cuts and the passthrough exemption. Even mustering enough support in both chambers to override the governor's veto. And as for how this relates to the passthrough tax proposal, a phrase I've often heard is that it would be Kansas on steroids.

David: But they are not talking about eliminating the taxes right?

Jonathan: Right, they're not necessarily the same. Passthroughs would still be taxed under this new tax plan. But the Kansas state income tax was only at around 5 percent on passthroughs, and that was enough to convince a lot of people to become a passthrough.

David: How would this play out on the federal level?

Jonathan: What you're talking about is a proposal that has a top individual income tax rate of 35 percent with a potential, if you're clever, to slash that all the way down to 25 percent, at a 10 percentage point difference.

David: Now what would this clever taxpayer do to take advantage?

Jonathan: Well let's say I'm one of those clever taxpayers. I'm a reporter for Tax Analysts, making $300,000 a year in wage income, and then the Republican tax plan gets enacted. I could either face a 35 percent marginal rate in taxes on that wage income, or I could quit Tax Analysts, form my own business called Jonathan Curry Reporting LLC or something like that, and then get hired back by Tax Analysts as a contractor at the same exact pay. Only now I'd owe 10 percent less in taxes on what's now technically considered business income, and that's a huge difference. The recent Republican tax reform framework proposed three tax brackets, 10, 25, and 35. And they left open the possibility for a fourth rate on the super wealthy. So anyone in those top two brackets would still have a huge incentive to try to game the system. We are still of course waiting to find out what the income thresholds for those tax brackets would be, but it also raises the possibility of exacerbating existing controversies, like those dealing with reasonable compensation.

David: Reasonable compensation sounds to me like a term of art; what does it mean?

Jonathan: So, reasonable compensation has to do with the ratio of how much profit is distributed to shareholders of an S Corp, a type of passthrough entity, as either wage income or as dividends from the business's profits. The wage portion is subject to self-employment tax, while the dividends are not. Naturally, there's a strong inclination for S Corp shareholders to prefer more of the income to be treated as business income, in order to avoid that self-employment tax. So there's a constant tension between the IRS and businesses to determine what a reasonable amount of compensation is.

David: What's the plan from preventing this from becoming a huge new loophole?

Jonathan: So that's still a big unanswered question. Republicans say they will come up with rules, and during the presidential campaign, one of Trump's economic advisers, Wilbur Ross, who is now his commerce secretary, he famously said that if all the lawyers and tax experts in Washington can't figure out a “simple” thing like that, they ought to just quit. But most tax experts and lawyers I talked to really don't think it's going to be that simple.

David: Are there any indications of what they might do?

Jonathan: Yeah, there are a couple of ways the Republicans could try to approach this. For passthroughs, they could take a harsh bright line approach, and that would be where they deem a certain ratio of income to be either wage or salary income. And then the rest would be considered distributed shares of the profit at a, say, 70/30 split. That's something that former House Ways and Means Committee Chair David Camp included in his famous 2014 tax reform draft. And while it might be pretty good at stopping a lot of the gaming, it's definitely a sledge hammer approach and a lot of businesses would get upset by this. They could maybe try to mitigate that harshness a bit by setting what's called safe harbor income ratios for different categories of businesses. So for example, a lawyer might have a different definition of what constitutes reasonable wage compensation or distributive share than, for example, a dentist or a professional athlete.

David: Are there any other ways they might approach it?

Jonathan: Yeah, they could try to limit the special passthrough tax rate to the types of businesses that were considered main street businesses, and that's not unheard of. There are already tax regulations in the code that make distinctions between types of businesses, but even that runs into complications. If you exclude, for example, doctors who make big salaries, do you also exclude small town rural doctors who operate a smaller clinic? They could also come out with a cap on a business’s net income or net assets on what would be considered a small business, and set it at something like $10 million.

David: A cap would be pretty easy to administer, I'd imagine, and wouldn't require picking favorite industries. Is there any reason that might not work?

Jonathan: Yeah, the danger of that last approach is that a business could fall in or out of this definition of small business from one year to the next as its income fluctuates. And then it could face a massive change in tax rates flipping from 25 percent to 35 percent from one year to the next. If you're worried about the tax code being economically disruptive, then you can imagine a lot of small businesses that are close to that cap are working hard not to make profit or invest more in their business’s assets if there's a massive tax hike on that extra income. That's not economically efficient and it's definitely not pro-growth, which is one of the main objectives Republicans have been talking about through this whole process.

David: It sounds like there's no simple solution; who's going to have to make that decision?

Jonathan: So there are two basic ways to approach this. One is you could write clear rules into the bills so that they become part of the statute, or you could give the Treasury and IRS broad rule-making authority. And just about everyone thinks it'd be preferable for lawmakers to come up with the rules themselves. That way there's a lot less ambiguity, and there's less uncertainty and delay when it comes to implementing the rules. If it's left up to Treasury, they would have to go through lengthy and time-consuming notice and comment periods. And then they'd run the risk of facing blowback from industry groups or lawmakers if the rules that they do come out with are perceived as unfair or unnecessarily harsh. It's also a process that could take years to conclude.

David: Is there any indication on which way they might go?

Jonathan: So far, Treasury Secretary Steven Mnuchin has said before that the rules would be codified. And other officials like National Economic Council director Gary Cohn, he said recently that the passthrough question is something that they've given an enormous amount of thought to. So they're definitely aware that this is an issue they're going to have to reckon with. Now, whether hard and fast rules do end up in legislation is something big to watch for whenever tax reform legislation does get released.

David: I'm sure you'll keep us updated as the picture becomes clearer. Jonathan, where can listeners find you online?

Jonathan: You can follow me on Twitter @JTCurry005.

David: Thank you for joining me. That's it for this week. My guest was Tax Notes Today reporter Jonathan Curry. If you'd like to hear more on the Kansas experiment, check out our bonus episode on the subject. You can follow me on Twitter @TaxStew. That's S-T-E-W. If you have any comments, questions, or would like to suggest a topic for a future episode, you can email us at podcast@taxanalysts.org. Thank you for listening. Be sure to subscribe on iTunes, Google Play, or wherever you find your podcasts, to make sure you get the next episodes of Tax Notes Talk.
 

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