Tax Reform Flowing-Through the Guard Rails

Tuesday, October 31st, 2017 at 9:39 pm, by Michael D'Andrea

Goals of Tax Reform

Since the 2016 campaign trail, tax reform continues to seize elevated debate time beyond the public’s historical interest. Whether this is due to Americans deep desire to submit their taxes on a post-card, or due to the anticipation it will be “REFORM THAT WILL MAKE AMERICA GREAT AGAIN” is still up for grabs. Regardless, the President and Republicans in Congress, published several proposals outlining their vision of tax reform. Their purpose, as outlined in the Unified Framework, is fourfold: (1) a simple and fair tax code, (2) to cut taxes for American workers, (3) to attract jobs to the U.S. by “leveling the playing field,” and (4) to repatriate offshore earnings. Current public debate centers on whether the proposals achieve their intended goals, and who will bear the tax burden. This article will identify issues arising from reducing the tax rate on business flow-through income and potential solutions.

Tax Reform Proposal

The Unified Framework highlights two types of taxpayers – individuals and businesses. It reduces individuals’ tax brackets from seven to three or four, doubles the standard deduction, eliminates most itemized deductions and the personal exemption, and increases the Child Tax Credit. The Framework also reduces the federal corporate tax rate to 20%, from approximately 35%, and allows an immediate deduction of some new capital investments. The proposal also intends to “consider methods to reduce the double taxation of corporate earnings,” claims to eliminate incentives to shift jobs overseas, move the U.S. from a worldwide to a territorial tax system, and repatriate foreign held income under a lower rate. The Unified Framework also eliminates the estate tax and AMT. While the Individual and Corporate reforms represent a major aspect of the proposal, this article focuses on issues arising from reduced flow-through business income tax.

Flow-through entities enjoy no federal entity level tax on income. Instead, flow-through entities’ (partnerships, sole-proprietorships, S-Corps, etc.) earnings generally pass-through to owners and are taxed at individual rates – currently the highest bracket is 39.6%. The proposal would limit the rate for business income to 25%.

Implications of the Unified Framework Proposal for Flow-Through Entities

Wages paid to shareholder-employees for labor are included on the individual’s tax return as a salary, and they also offset shareholders business flow-through income as an expense. Generally, under the current tax model, both business income and salary are taxed under the individual rates. The proposal caps the tax rate for flow-through income at 25%, whereas wages and salary remain subject to all individual tax brackets, up to 35% or 39.6%. Thus, the Uniform Framework incentivizes flow-through entity shareholder-employees to reduce the amount they receive as salary, instead allowing the income to pass-through as business income – thereby subject to the reduced maximum 25% tax rate.

The Uniform Framework recognized this issue, stating that it “contemplates that the committees will adopt measures to prevent the recharacterization of personal income into business income to prevent wealthy individuals from avoiding the top personal tax rate.” Treasury Secretary Steven Mnuchin reiterated this in a discussion of the proposal with ABC’s George Stephanopoulos, where he stated “as we change the pass-through rate, it’s very, very important that we have guard rails around those rules so… this isn’t about creating a tax cut for the rich.” However, both the proposal and the Treasury Secretary remain silent on what exactly these “guard rails” will be.

Potential “Guard Rails” to Avoid Abuse

Reasonable Salary Standard

S-Corporations (“S-Corp”, flow-through entity) wrestle with a similar conflict regarding federal payroll taxes. S-Corp wages are subject to federal Social Security and Medicare tax, whereas shareholder business income is not subject to either–as long as the salary is reasonable.[i] The Treasury estimates that tax schemes to avoid contributing to payroll “cost about $25 billion a year. Such schemes tripped up presidential candidates John Edwards in 2004 and Newt Gingrich in 2012. It is now called the Gingrich-Edwards Loophole in their dubious honor.” The IRS issued guidance on what is a reasonable salary. They also have the authority to reclassify payments when they fail to meet the criteria.[ii] A similar reasonableness approach could be used to evaluate salaries and business income benefiting from the proposal’s reduced tax rate; however, the process would be heavily fact-dependent, and therefore subjective and difficult to enforce.

Standard Allocation

Prior proposals to allow a reduced tax rate on business income attempted to correct for this issue. Rep. David Camp (House Ways and Means Chairman R-MI) proposed the following in 2014:

Shareholders who materially participate in the trade or business of the partnership or S corporation would treat 70 percent of their combined compensation and distributive share of the entity’s income as net earnings from self-employment . . . and the remaining 30 percent as earnings on invested capital. . . . For partners and S corporation shareholders who do not materially participate. . . the effect of the deduction would be that no amount would be treated as net earnings from self-employment.

This bright line rule allocates business income in an easily implemented and enforced manner. Conversely, it creates an arbitrary threshold which will fail in most cases to reflect what is truly salary versus business income. Therefore, this rule arbitrarily benefits some and harms others, seemingly at odds with the reform’s intended goals to establish a fair tax code.

Segregation Based on Industry

Other proposals include limiting the type of flow-through businesses that qualify. For example, denying the advantage to personal services businesses (lawyers, accountants, consultants, architects, as defined in Publication 542) would curtail abuse opportunities. While this limits abuse in certain industries, the list of categories will never be so extensive as to cover all opportunities for abuse, and may limit the benefit in areas where it was intended to help.

To Be Determined

Most likely, some combination of the above solutions would be most effective should the proposal become law. Without appropriate “guard rails,” the rate reduction will give rise to extensive abuse and benefit parties that do not further the stated goals of the legislation to benefit American middle-class workers and avoid the Treasury Secretary’s sincerely-held view it not act as “a tax cut for the rich”.

[i] Joly vs. Commissioner, 211 F.3d 1269 (6th Cir., 2000).

[ii] Id.