Pass-Through Tax Rates

October 18, 2017

The recently released Tax Framework proposes a new tax rate structure for small businesses that “limits the maximum tax rate applied to the business income of small and family-owned businesses conducted as sole proprietorships, partnerships and S corporations to 25 percent.” It also calls for, but does not specify, rules for combating the potential abuse of a top tax rate on pass-through business income that is lower than the top tax rate on ordinary individual income.

It is also clear, however, that the framework envisions the 25 percent rate to apply to only a share of the income of ALL active pass-through business owners. Previous tax reform plans—which appear to be the basis from which tax-writers are working—call for only 30 percent of pass-through income to be taxed at the lower “business” tax rate, with the remaining 70 percent continuing to “flow through” to the higher individual rates. The objective of such a structure is to separate ownership income from compensation for working in the business and taxing those two streams of income separately. Obviously, the structure outlined above would not reflect a correct balance of revenue for a significant number of companies.

And in virtually every case, the total top effective income tax rate for pass-through business owners would be higher than the touted 25 percent rate.

NSBA believes strongly Congress needs to make sure it does not undermine the value of the lower rate to business owners while also not increasing the administrative, record keeping, and IRS audit burdens on smaller businesses. Separating the return on owner’s labor from the return on their investment in the business is not easy. It is important that the new rules are easier to comply with than the existing reasonable compensation rules that the IRS uses today.

The new Framework leaves many difficult policy issues to be resolved by the House and Senate tax committees, including the one related to reasonable compensation. The issue of how and whether to treat business and compensation income differently may ultimately prove to be one of the most difficult and significant ones facing tax reform.

If Congress moves forward with an arbitrary 70/30 rule, or other percentage split, it should only be considered as a potential “safe harbor.” NSBA is still exploring the potential for such an approach, but a safe harbor would allow business owners to use such a formula in order to forego recordkeeping burdens and to avoid costly audits if they so choose, but would leave them free to justify a different income split that better reflects the realities of their businesses.