House Tax Reform and S Corps, Part II

The Ways and Means Committee is likely to wrap its tax reform markup today.  The bill presents many challenges to pass-through businesses that are unlikely to be fixed today.  Here are some quick hits on what we’re seeing.

Reality v. Rhetoric

We continue to hear from S corporations who believe they will get a 25 percent tax rate under this bill.  As we reported earlier this week, most businesses won’t see anything even close to the 25 percent rate.  Part of the confusion is the rhetoric coming out of Congress.  For example, here’s one description from the House:

That’s not all.  In order to ensure that small businesses continue to expand and raise wages, the Tax Cuts and Jobs Act includes a small business provision: a 25 percent cap on how much small businesses can be taxed.

That means, a small pass-through business bringing in one million dollars will not be taxed at 39.6 percent, but rather will be able to take advantage of the new small business income tax of 25 percent.

This is simply not accurate for the majority of S corporations and other pass-through businesses.  You can read the full explanation here, but the bottom line is only small minority of pass-through businesses will get the 25 percent rate.  The simple metric is:

  • Millions of professional services pass-through businesses – doctors, lawyers, accountants and other professionals – are precluded from the lower rate and would, in many cases, see a tax hike under this legislation.
  • Other pass-through business owners who are active in operating their businesses would see their profits subjected to an arbitrary 70/30 separation of wages and profits, resulting in a melded marginal rate above 35 percent, or more than 15 points above the C corporation rate. Coupled with the base broadening in the bill (including the SALT deduction repeal), some of these owners could see modest tax hikes under the mark.
  • Manufacturers and other capital-intensive industries could elect the return on capital option in the bill, applying a set rate of return (around eight percent in the current draft) to a defined measure of capital and see if they do better than the 70/30 rule. Some of our members who have run the calculation did better under this option, but none got close to the promised 25 percent rate.

So don’t be confused about the 25 percent rate – it only applies to a small minority of pass-through businesses.

S Corps & SALT

One major area of confusion was whether the repeal of the SALT deduction applies to pass-through profits.  Richard Rubin in the Wall Street Journal has an excellent piece in the WSJ on it:

There’s a bit of a mystery hanging over the House Republicans’ tax bill.

Here’s the question:  Can pass-through businesses deduct state and local taxes from their federal income?  And to what extent?

It’s clear under the House bill that individuals can’t deduct state and local income taxes and only up to $10,000 in property taxes.

It’s also clear that corporations can deduct state and local taxes as ordinary business expenses, just as they do now.

But it’s fuzzier when it comes to pass-throughs, the partnerships and S corporations that pay taxes through their owners’ individual returns and are getting a new tax regime with a 25% rate.

The reason was a mystery is that while the Committee’s descriptive language of the bill says that pass-through businesses would be able to deduct SALT on their profits, the legislative text appears to say no.

We alerted the Committee to this concern earlier this week, but apparently they rejected our fix and decided to apply the SALT deduction repeal to pass through businesses.  Here’s the letter the Chairman released today:

We have discussed the italicized language with the JCT staff, and they have confirmed that this language was in error.  We intend to correct this mistake in the Committee Report…. State and local income taxes paid by an individual owner of such business would not be deductible on the individual’s tax return.

Needless to say, C corporations will continue to be allowed to deduct SALT under the bill.

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