Now that both chambers of Congress have passed their versions of Tax Reform, a conference committee will endeavor to reconcile the differences between the two bills.
One of the areas of divergence in the House and Senate plans relates to tax relief for so-called “pass-through entities.” These provisions apply to business income of individuals from sole-proprietorships, partnerships, LLC’s, S-corporations and REITS. As discussed below, these provisions are complicated in their application, but can provide significant tax benefits for certain taxpayers.
Under the House version, the business income of individuals will be taxed at a maximum rate of 25%, rather than the maximum tax rate of 39.6% (for those taxpayers subject to higher rates). However, this 25% preferential rate does not apply to all the taxpayer’s business income. Under some rather complicated provisions in the House bill, the 25% rate only applies to 30% of the business income from the taxpayer’s active businesses based on a presumed “capital percentage” defined in the new law. The taxpayer can elect to determine a higher capital percentage for capital-intensive businesses (such as real estate, manufacturing and transportation businesses) based on a statutory calculation of “return on capital” of the business.
There is a further limitation to active business income entitled to the preferential 25% tax rate based on wages, guaranteed payments and director’s fees, if any, received by the taxpayer from the business activity, in comparison to the total business income of the activity.
On the positive side, the 25% maximum rate applies to all the taxpayer’s passive income from business activities, including rental income and income from Real Estate Investment Trusts (REITS).
The Senate plan takes a somewhat different approach. Instead of reducing the tax rate for an individual taxpayer’s business income, it provides a deduction of up to 23% of the taxpayer’s taxable income less capital gains. However, in another set of complicated calculations, the 23% deduction can’t exceed 23% of the taxpayer’s qualified business income or (if the taxpayer’s taxable income exceeds $250,000 or $500,000 for a joint return) 50% of W-2 wages paid by the taxpayer’s qualifying businesses. If the taxpayer is in the highest income tax bracket, this deduction results in an effective tax rate of about 30% for the taxpayer’s qualified business income. The Senate provision expires at the end of 2025.
Notably, both the House and Senate versions deny this tax relief to service businesses 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 1 or more of its employees, and securities dealers and traders. Under the Senate plan, this prohibition is phased-in based on the taxpayer’s taxable income between $250,000 and $300,000 (double these amounts for a joint return).
While these rules may afford meaningful tax relief to businesses owned by individuals, the biggest beneficiaries will be real estate businesses and other capital-intensive companies such as manufacturers and transportation businesses. We recommend that business owners seek guidance on the implications of these pending rules on their own unique tax situation.