The House tax reform bill to be considered this week has a headline top rate of 25 percent for S corporations and other pass-through businesses, but in many cases the real rate is significantly higher.  S corporation owners need to pay attention.

Here are some of key details:

  • Professional Services: First, the 25 percent rate doesn’t apply to professional service businesses.  Specifically, the bill excludes businesses engaged in “the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees, or investing, trading, or dealing in securities, partnership interests, or commodities.”

As you can see from the attached breakdown of S corporations by industry, this exception would preclude a large percentage of S corporations from the lower 25 percent rate.  These businesses range from one-man accounting firms (whose income is due to their personal labor and probably should not get the lower rate) all the way up to large engineering and consulting firms with worldwide operations and thousands of employees.  It’s a remarkably broad exclusion.

The resulting top tax rate on these businesses (including state taxes) would be the new individual income tax rate schedule prescribed in H.R. 1, amplified by the loss of the State and Local Tax deduction plus the expansion of Payroll Taxes to now include all of their S corporation profits.  The actual rate depends on what state the business resides in, but for the majority of states, this top rate is going up.

For example, the current top marginal rate (including state taxes) on income in Wisconsin is 45.4 percent:

  • (39.6% * 1.03) + [(1- 39.6%) * 7.65%] = 40.788% + 4.62% = 45.4%

Under the new rules, accounting for the loss of the State and Local Tax Deduction and the new application of SECA taxes to S corporation profits, the new top rate would be significantly higher – more than 50 percent:

  • 6% + (92.35% * 3.8%) + 7.65%) = 50.8%

This is just a marginal rate calculation, and it doesn’t include the other base-broadening measures included in the bill.  For many businesses, the net result will be a significant increase in taxes.

  • 70/30: Second, for the active owners of non-professional services corporations, the bill imposes a separate limitation on the 25 percent pass-through rate.  It would cap an active owner’s profits at 30 percent of the sum of their wages and profits from the business.  It works like this — if the owner of a successful printing shop pays himself a market wage of $300,000 and has additional profits of $700,000, for total business income of $1 million, the bill would recharacterize 70 percent of that total as wages subject to the higher individual rates and treat just $300,000 of his income as profits eligible for the lower rate.

The top rate that would apply to this mixture of wages and profits varies depending the state, but it appears to be about the same as the top rate under current law.  Using Wisconsin again as the example (current combined top rate is 45.4 percent), the new top rate under H.R. 1 using the 70/30 mix is 45.3 percent.

  • {70% * [39.6% + (92.35% * 3.8%) + 7.65%]} + {30% * (25% + 7.65%)} = 70% * 50.7593% + 30% * 32.65% = 35.53151% + 9.795% = 45.3%

You’ll notice the rate calculation just got really complicated, and that the difference between current law and H.R. 1 is the loss of the State and Local Tax Deduction combined with the expanded application of Payroll Taxes (the Obamacare .9% surtax).  The net result of all these changes is that the top marginal rate on this business is not going to be significantly different than it is today, because of the limited application of the lower 25 percent rate.

Depending on the amount of base broadening that this business is subject to, its total tax hit could be lower, the same, or higher than what the business pays under current law.  For higher income tax states, the top marginal rate will go up significantly, even with the lower headline 25 percent rate.  In no respect, however, will it be comparable to tax reduction applied to C corporations, who get a flat 20 percent rate with no guardrails.

  • Return on Capital Option: Third, H.R. 1 offers S corporations an alternative to the 70/30 rule for their active shareholders, but it will be of little help to most taxpayers.  This calculation takes into account a portion of the capital an owner has invested in the business and establishes a target rate of return.  Active owners of S corporations who don’t like the result they get from 70/30 can elect to use this formula instead.  As described by KPMG:

The alternate method essentially would allow the 25% rate to apply to a deemed return (short-term AFR plus 7%) multiplied by the owner’s share of the adjusted tax basis of any property described in section 1221(a)(2) which is used in connection with the business…

As of today, this deemed return rate would be 8.38%.  The actual definition of property that would be included has been a moving target over the last couple of days, but as of Friday it doesn’t appear to include inventory and accounts receivable. The above language may include intangibles, but that’s unclear.  For a few businesses – those with high capital costs and low margins, for example – this alternative may get them close to the promised headline rate of 25 percent.  But for many others, it will obviously fall short.

Looking at the formula from the standpoint of policy, several things seem clear.  First, the higher return a business earns, the worse it does under this formula.  So, businesses engaged in high tech or other cutting edge industries would do worse, while franchises and other high capital, low return businesses may do well.

Second, a business’s investment in its human capital is valued at nothing.  Many of the most valuable businesses created within the last two decades would be penalized because their primary investment is in people, not things.  This policy comes at a time when everyone recognizes that economic activity is moving towards service businesses.

Third, it appears that intangibles are or could be included in the measure of capital.  But first generation businesses still run by their original owners don’t have intangibles, since they have never been priced into a sale.  So those businesses would be penalized.

Finally, the true measure of an owner’s “investment” in a business is the value of the business as a whole to a prospective buyer.  This is the value that would be taxed under the gift and estate tax rules, and that’s the opportunity cost the owner is incurring by not selling the business and using the capital for another purpose.  Any measure of capital less than the value of the entire business is obviously short-changing the owners.

  • Single Class of Stock Rule: Finally, S corporations are allowed just one class of stock, which means that all distributions of income or loss must to proportional to ownership shares.  In practice, this means that any S corporation distribution to shareholders must be pro-rata, even those distributions made to cover the tax liabilities of the business.

As a matter of practice, most S corporations make tax distributions equal to the marginal tax of their highest taxed shareholder.  The interaction of the single class of stock rule with the 70/30 rule means that any business with a combination of active (70/30) and inactive (25 percent) shareholders will have to make distributions equal based upon the highest tax rates, draining money from the business as if all the shareholders paid the high rates.  This fact dramatically reduces the benefit of the 25 percent rate to multi-shareholder S corporations.

So, for S corporation owners, depending on what state you live in, your company’s industry, whether you work in the business or are a passive owner, and whether your co-owners do the same, your taxes under H.R. 1 could go up, down, or stay about the same.  That is a significant challenge by itself, but it’s compounded by the fact that all C corporations, regardless of industry or their ownership makeup, are getting significant rate cuts in this bill, resulting in a general reduction in their overall tax burden and lower marginal effective tax rates on their investments.

H.R. 1 is just at the beginning of the legislative process and there will be opportunities for change, but with so much room for improvement and a short legislative window, it needs to come quickly.