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Economic Analysis: Your Easy Guide to Passthrough Rules in the Conference Report

POSTED ON Dec. 19, 2017

In its much-debated, highly complex, and entirely new tax break for passthrough businesses, the conference agreement for the Tax Cuts and Jobs Act (H.R. 1) — released at 5:30 p.m. on December 15 — generally follows the Senate bill, but with a few changes. Before we get into the legal gobbledygook, let’s take a moment to talk about what Congress intends this historic legislation to do for passthrough businesses.

The bill would let some owners of passthrough businesses deduct 20 percent of certain types of income earned by those businesses. The idea is to provide tax relief to noncorporate businesses that parallels the rate cut the new law will give C corporations.

Salaries that are "reasonable compensation" paid to owners would not be eligible for the deduction. Only earnings from capital (and not wages) are meant to get relief, just as only profits (and not wages) of corporations would get relief from the corporate rate cut.

Passive investment income received by passthrough businesses would also be ineligible for the deduction, to stop business owners and investors from using passthrough entities as tax shelters.

If an owner's taxable income is too large, the deduction becomes subject to several limitations. Under specific conditions, the deduction phases out for joint filers with taxable income between $315,000 and $415,000, and for individual filers earning between $157,500 and $207,500. 

Taxable income above those limits will not qualify for the deduction if it comes from a firm providing services in law, accounting, medicine, or any of several other specified professional activities.

You'll look in vain (or I have, anyway) for a policy justification for this line-of-business disqualification, except maybe — and this is a stretch — that Congress wants to incentivize tangible capital formation, and these service-oriented firms may be less capital-intensive.

But even if the income comes from a source other than those disfavored professions — say, from a manufacturing operation organized as an S corporation with high-income shareholders — the deduction may still be limited by a cap computed for each line of business. That cap is designed to limit abuse by tying the benefit to indicators of real business activity — namely, employees and tangible capital.

Some Details and Commentary

The provision (new code section 199A) would be temporary because the legislation must satisfy the portion of the Byrd rule that forbids a reconciliation bill from losing any revenue beyond the 10-year budget window. The deduction would be available to taxpayers in tax years beginning after December 31, 2017, and before January 1, 2026.

Under current law there are seven individual income tax rates: 10, 15, 25, 28, 33, 35, and 39.6 percent. Under the conference agreement there would still be seven rates, but the standard deduction would increase, personal exemptions would be repealed, the breakpoints between rates would shift, and the rates would change to 10, 12, 22, 24, 32, 35, and 37 percent. (These provisions would also be temporary and would expire at the end of 2025.) With a deduction of 20 percent, the effective rates for income qualified for the passthrough deduction would be 8, 9.6, 17.6, 19.2, 25.6, 28, and 29.6 percent. As under current law, the 3.8 percent net investment income tax would also still apply to upper-income taxpayers.

Income that would qualify for the new deduction is not only from the "usual suspect" passthrough entities — that is, not only from sole proprietorships, partnerships, and subchapter S corporations. An individual taxpayer could also deduct 20 percent of qualified dividends paid by real estate investment trusts, qualified publicly traded partnership income, and qualified cooperative dividends. Special rules would apply to specified agricultural or horticultural cooperatives. Also, in a conference agreement modification sought by the S Corporation Association, estates and trusts (in addition to individual filers) would be eligible to claim the deduction.

Qualifying income must be from domestic sources, including Puerto Rico. This last feature is notable because Puerto Rico is generally considered foreign for tax purposes even though it is a territory of the United States.

Under the conference agreement, you don’t want to be a "specified service business." Although long and tortuous, the official definition of the term is worth quoting:

"A specified service trade or business means any trade or business involving the performance of services in the fields of health, law, consulting, athletics, financial services, brokerage services, 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 employees or owners, or which involves the performance of services that consist of investing and investment management trading, or dealing in securities, partnership interests, or commodities."

The engineering and architecture lobbies were successful in getting their professional activities dropped from that list.

It will be interesting to see how taxpayers and the IRS determine when a trade or business's principal asset is its owners' or employees' reputation. This, in addition to the line between salary and profits, will be hard for an understaffed IRS to police. Several commentators have already highlighted one possible way tax planners could circumvent the specified trade or business limitation: splitting one company into separate specified and non-specified businesses, and then shifting profits to the tax-favored, non-specified business. This could be done by having the specified business borrow from its tax-favored sibling and pay above-market prices for rentals and services the non-specified business provides.

This is only an introduction to the new passthrough provisions; there are more special rules in the statutory language, and more to come in regulations that are eagerly awaited by the passthrough community. Tax relief for passthroughs is a political necessity for the Republicans crafting this bill. But it is also, unfortunately, an administrative and compliance nightmare, and obviously it moves in the opposite direction of small business simplification. From an economic perspective it also is lacking, given the considerable incentives it provides for businesses to inefficiently change behavior and to waste otherwise productive resources to maximize tax benefits.

Author’s note: For further discussion of passthrough and other provisions in the new legislation, see Michael L. Schler, “Reflections on the Pending Tax Cut and Jobs Act,” forthcoming in the December 18 edition of Tax Notes and appearing in Tax Notes Today during the week of January 2.