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Senate Version May Be Preferred Passthrough Proposal

Posted on November 28, 2017 by Matthew R. Madara

Lawmakers will have to reconcile two drastically different proposals intended to lower tax rates for passthrough businesses if the Senate is able to pass its version of the Tax Cuts and Jobs Act, which may be the more administratively workable proposal.

The House passed the Tax Cuts and Jobs Act (H.R. 1) November 16 in a mostly party-line vote that included a proposal that would subject qualified business income to a maximum 25 percent rate. Income that isn't qualified business income would be taxed at ordinary individual income tax rates, which are also being overhauled by the legislation.

Under the House legislation, income derived from active business activity would be treated as 30 percent business income and eligible for the 25 percent rate. The remaining 70 percent of income from an active business activity would be treated as compensation. The legislation permits taxpayers to rebut this presumption for active business activities using a facts and circumstances formula. 

The Senate proposal provides a 17.4 percent deduction on domestic qualified business income for passthrough businesses, according to a description (JCX-51-17) of the proposal released November 9 by the Joint Committee on Taxation. The Senate Finance Committee released legislative text of the Tax Cuts and Jobs Act November 20.

Richard M. Lipton of Baker McKenzie said “the Senate approach may be more administratively easy, but the House approach is more favorable and more closely resembles the intent, which was a lower rate on passthrough income.” 

Likewise, Eric B. Sloan of Gibson, Dunn & Crutcher LLP, called the Senate approach "more elegant and more workable.”

“The House’s approach to giving a lower rate on passthrough income is exceedingly complicated,” he said, adding that his view isn't based on policy considerations.

The House and Senate legislation both include similar carried interest proposals that would impose a three-year holding requirement for qualification as long-term capital gain with respect to some partnership interests received in connection with the performance of services. “There are five or six obvious gaps or ambiguities in that legislation,” Sloan said. 

According to Sloan, “requiring a longer holding period to be eligible for the capital gains tax rate is a very different approach from earlier proposals,” which were “largely unworkable and couldn’t be fit onto the Internal Revenue Code very easily.”

The carried interest proposal in the Senate and House legislation “definitely needs tweaks, clarifications, and fixes,” he said, but added that they are “nicely thought out and elegant.”

“I’m not saying it's good tax policy,” but from an administration standpoint it's good tax administration and “relatively easy to administer,” Sloan said.