Tax Reform Overview

From the corporate perspective, the early returns on the new tax bill are promising.  The markets certainly like the lower corporate tax rate and dozens of public companies have announced tax-cut related investments, wage hikes, and bonuses.  For the corporate world, the new law appears to be doing exactly what its authors hoped for.

But what about Main Street businesses?  Will they benefit from the new law?  There, the outlook is much more complicated.  C corporations got a rate cut.  Pass-through businesses got a 20-percent deduction.  The deduction is helpful, but it is smaller than the rate cut and it raises numerous technical challenges that a simple rate cut would have avoided (see our full list of technical concerns with the new law here).  Moreover, deductions are viewed differently than rate cuts – they are more susceptible to scrutiny and limitations.  It’s a deduction, after all.

The new “guardrails” accompanying the pass-through deduction are a good example.  The C corporation rate applies to all corporate income, regardless of who earns it or how it’s earned.  The pass-through deduction, however, is limited by both through a series of increasingly complicated rules designed to ensure the deduction applies to profits and not wages.  As Marty Sullivan pointed out:

…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.

Interesting is one way to put it.

This complexity is compounded by the fact that the new law preserved the Obamacare Net Investment Income Tax, took away the ability of most pass-through businesses to deduct their state and local income taxes, and excluded international income from getting the deduction.  The result is pass-through businesses will be taxed at different rates based on their industry, payroll, investments in depreciable capital, participation levels of their owners, where they are located, and where their sales take place.  The resulting matrix of applicable top tax rates is mind boggling.

For the next few years, some S corporations will do well under the new law, with modest reductions in their overall tax burden.  Others will see their taxes go up.  All of them face tax hikes in 2026 with the sunset of the deduction and the rest of the individual tax provisions.  It will be similar to the 2012 “fiscal cliff” only worse — the potential rate hike is larger and the deduction isolates business income from wage earners, making the politics that much more difficult.

The sunset makes business planning now “interesting” too.  Should S corporations utilize the new expensing provision if the result just shifts income into years after the deduction has sunset?   How do you forecast the long-term return on an investment when the tax rules are so unstable and temporary?

The law does include friendly new rules for converting to C corporation, but only if you convert in the next two years.  So the clock is ticking for pass-through owners.  They need to figure it all out now, based on rules that are complicated and temporary, and they need to figure it out fast.

It could have been worse.  The original bill included a smaller business deduction that did not apply to trusts and estates, which meant that large family-owned businesses would be excluded.  Thanks to the efforts of Senators Johnson (R-WI), Daines (R-MT) and Inhofe (R-OK), the final bill included a larger deduction that includes trusts and estates.  Those changes made it possible for some large family businesses to continue to be organized as pass-throughs, for now.  Their longer-term prospects depend entirely on the actions of Treasury and future Congresses.

So that’s the new law from the pass-through perspective – complicated, uneven, and temporary.  What does the Main Street community plan to do about it?  First, the pass-through deduction needs to be clarified and strengthened.  S-Corp is going to work with its allies on three specific steps:

  1. Clarify the new rules and make them as business-friendly as possible, including specific improvements to the international rules affecting pass-through businesses;
  2. Broaden the deduction while simultaneously identifying and closing loopholes that allow non-business income to get the deduction — the deduction should be reserved for real business profits only; and
  3. Make it all permanent.

At the same time we work to solidify the deduction, S-Corp will continue to press for parity between S corporations and C corporations, including working at the Federal and State level to expand the ability of S corporations to deduct state and local income taxes.  Finally, S-Corp will continue to support repealing the Net Investment Income Tax, either as part of health care reform or another vehicle.

So to sum up, tax reform is a mixed bag for pass-through businesses.  The deduction is helpful, but the results are uneven and the rules are unclear.  Every S corporation we know is consulting with their tax advisors to analyze how they should be organized moving forward.  For many, the choice on whether to convert is a close call that will be influenced by how Treasury addresses the dozens of technical questions raised by all the new rules.  For all of them, the sunset of the deduction means that whatever decision they make now will have to be revisited in a few years.

All this uncertainty detracts from the pro-growth aspects of the new law.  Decisions on how to organize and whether to sell do not mix well with decisions to hire and invest.  Something to consider as we move on to the next stage in tax policy.

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