The Wall Street Journal featured S-Corp Board member Clarene Law last week in a story focused on the new tax rates for pass through businesses in the House tax reform plan. As the story notes:
Clarene Law said a lower tax rate on pass-throughs would free up capital to add rooms to her hotels in Jackson, Wyo. or buy new air conditioners and washing machines.
“25% if it’s pure, not all cobbled up with a bunch of surtaxes, it would be a great benefit,” said Ms. Law, chief executive officer of Elk Country Motels Inc. Her businesses own more than 400 hotel rooms and generate revenue of more than $10 million a year, she said.
What does Clarene mean by a “pure” 25-percent rate? The priority of the pass through community is making certain that the new, 25-percent rate is real and robust. It should apply to all forms of active pass through business income just as the new 20-percent rate applies to all forms of active corporate income.
The concern here is twofold. First, when Congress has considered special rates for closely-held businesses in the past, they typically have limited the application of the new rate or deduction based on industry and income. For example, back in 2012, the House considered a special, 20-percent deduction for small business income, something you would expect the Main Street community would support.
However, the legislation included several carve-outs – various versions of it imposed limit on revenues, a cap on the number of employees, and excluded certain industries from the deduction. In the end, most of the business community chose not to support the effort.
So for the new, 25-percent rate, how Congress defines the tax base is extremely important. In our communications with Members of Congress, we have emphasized that the pass through tax rate base should:
- Target active business income, rather than active shareholders. Previous efforts to create a separate, pass through tax rate defined the tax base by looking at the shareholder, rather than the business. That’s the wrong approach. If a business makes income manufacturing steel, the income is the same regardless of whether the shareholder is active or passive. The base needs to be broad, and focused on the income, not the shareholder.
- Not be limited by industry or income. Some early versions of a lower pass through rate would have excluded financial services companies from the lower rate. This approach is also wrong – there is no valid policy reason to exclude pass through businesses operating in the financial services area. The tax base for the pass through rate should mimic the C corporation tax base, avoid excluding certain industries, and be as broad as possible.
The second challenge is how does Congress prevent cheating without undermining the value of the new 25-percent rate? Under the Brady plan, the top tax rate on salaries and wages will be 33 percent, while the top rate for pass through businesses will be 25 percent. For owners that also work at the business, there will be an incentive to allocate as much of their total income as possible as business profits rather than wages and salaries.
This is an old issue – it dates back to 1993 when Congress removed the salary cap on Medicare Payroll taxes – and we have addressed it many times in the past. The larger rate differential in the House plan, however, raises the stakes, and lawmakers are eager to find a solution.
The challenge is how exactly do you distinguish between business income and wage income for active business owners? Here’s the JCT on the existing rules:
A shareholder of an S corporation who performs services as an employee of the S corporation is subject to FICA tax on his or her wages, but generally is not subject to FICA tax on amounts that are not wages (such as distributions to shareholders). Nevertheless, an S corporation employee is subject to FICA tax on the amount of his or her reasonable compensation, even though the amount may have been characterized as other than wages.
A significant body of case law has addressed the issue of whether amounts paid to shareholders-employees of S corporations constitute reasonable compensation and therefore are wages subject to the FICA tax, or rather are properly characterized as another type of income that is not subject to FICA tax.
In the past, S-Corp has maintained that any attempt to legislate in this area should pass a simple test – are the new rules clearer, more accurate at differentiating wages from profits, and more enforceable than the existing rules? If not, then the new approach should be rejected. To date, all the proposed solutions have failed this test.
So, as the Committee is working through these issues, the S Corporation Association and its allies are up on the Hill, educating members about the importance of addressing both these challenges fully and appropriately. With lower rates, estate tax repeal, AMT repeal, expensing, and territorial on the table, the Brady bill has the potential to completely re-craft how pass through businesses pay tax, so it’s definitely worth the pass through business community’s time to help get this right.
Expect lots more on this in the coming weeks.