In a departure from the House’s tax reform proposal, the Senate Finance Committee’s version of tax reform includes a deduction for passthrough businesses, setting the stage for a necessary reconciliation of the two visions of reform.
In its proposal released November 9 and described by the Joint Committee on Taxation (JCX-51-17), the Finance Committee offered a deduction for passthrough businesses of 17.4 percent of domestic qualified business income from a partnership, S corporation, or sole proprietorship. Specified services businesses would not be eligible for the deduction, except in the case of married individuals filing jointly whose taxable income does not exceed $150,000, or other individuals whose taxable income does not exceed $75,000. The deduction would cost $459.7 billion over 10 years, according to JCT estimates (JCX-52-17).
The proposal includes a limitation on the deduction of 50 percent of the W-2 wages of the taxpayer, taking into account only those wages that are properly allocable to qualified business income. W-2 wages are described in a way that does not include wages of a sole proprietor. Under current law, partners cannot be employees and thus do not receive W-2 wages.
Monte A. Jackel of Akin Gump Strauss Hauer & Feld LLP noted that the proposal does not state whether the deduction is above the line or not. “I think it makes most sense that it is an above-the-line deduction because services as an employee are not qualifying income,” he said.
Under the Senate proposal, qualified business income is defined as the net amount of domestic qualified items of income, gain, deduction, and loss regarding the taxpayer’s qualified businesses. Qualified business income does not include any amount paid by an S corporation that is treated as reasonable compensation of the taxpayer, or any amount allocated or distributed by a partnership to a partner who is acting other than in his capacity as a partner for services. Some investment-related income, gain, deductions, or loss are also excluded.
The committee’s proposal prospectively overrules Grecian Magnesite Mining v. Commissioner, 149 T.C. No. 3 (2017), in which the Tax Court rejected Rev. Rul. 91-32, 1991-1 C.B. 107, and decided that a foreign company’s gain on the redemption of a U.S. partnership interest would not be effectively connected to a U.S. trade or business. The proposal would make gain or loss from the sale or exchange of a partnership interest effectively connected income to the extent that the transferor would have effectively connected gain or loss had the partnership sold all its assets at fair market value as of the date of the sale or exchange. Also, the transferee of a partnership interest would have to withhold 10 percent of the amount realized on the sale or exchange.
The change is not unexpected, practitioners said.
Two additional changes are included in the Senate proposal. First, the definition of substantial built-in loss in the case of a transfer of a partnership interest under section 743(d) would be modified to include situations in which the transferee would be allocated a net loss in excess of $250,000 upon a hypothetical disposition by the partnership of all the partnership’s assets for cash equal to the assets’ FMV. Second, the basis limitation on partner losses would be applied to a partner’s distributive share of charitable contributions and foreign taxes.
The Senate’s approach to passthrough taxation is markedly different from the House’s. The House, in the Tax Cuts and Jobs Act (H.R. 1) introduced a maximum 25 percent rate for the qualified business income of an owner or shareholder of a passthrough entity. The House Ways and Means Committee on November 9 approved an amendment to the bill that would apply a 9 percent tax rate instead of a 12 percent rate to the first $75,000 in net business taxable income of an active owner or shareholder earning less than $150,000 in taxable income through a passthrough. The lower rate would phase out at $225,000 and would be phased in over five years. The amendment also eliminates previously proposed provisions related to the Self-Employment Contributions Act.
Donald B. Susswein of RSM US LLP said the House bill solved most of the problems with passthrough taxation that were originally raised, and that the amendments were good additions. “The 9 percent rate is really a recognition that there are a lot of small businesses, and there is a different type of investment and risk by the start-up business person. It may not be out-of-pocket cash capital invested in plant or equipment, but that person might have quit a secure job to start a small service business. That should be recognized as an important and risky investment,” he said.
Susswein also said it is important that purely passive investments in passthroughs get a break, “because that’s a key source of capital for small businesses.” He noted that the Tax Reform Act of 1986 eliminated the possibility of applying a loss from an investment in a business against other income but gave investors a 28 percent rate, and that rate has increased ever since.
“If it is easier to raise capital because of the tax break on passive investments, that’s good for the new economy,” Susswein said.
Steven M. Rosenthal of the Urban-Brookings Tax Policy Center said that while their approaches differ, both the House and Senate grant generous tax relief to passthroughs. The House bill grants more relief to passive businesses, because they cannot convert wage income to business profits easily, he added.
But overall, Rosenthal was not impressed with the passthrough provisions. “Both approaches will generate lots of extra complexity — and create a variety of loopholes and glitches,” he said. “The tax relief is silly; any passthrough business that wanted the lower corporate tax rate could convert, tax free, to a corporation.”
Emily L. Foster contributed to this article.