PROTECTING SMALL BUSINESS, PROMOTING ENTREPRENEURSHIP

Tax Relief for ‘Pass-Through’ Small Businesses: A Look at the House and Senate Plans

By at 29 November, 2017, 10:57 pm

by Raymond J. Keating-

Clearly, one of the hot topics swirling around the current tax relief effort is the tax treatment of pass-through businesses, such as S-Corps, LLCs, sole proprietorships, and partnerships. These, of course, are overwhelmingly small businesses.

The House and Senate plans both would reduce the individual income tax rate as applied to business profits. The House would cap the top rate for such income at 25 percent, while the Senate supplies a deduction worth 17.4 percent of qualified business income.

A new, handy analysis from the National Taxpayers Union hits on key issues in how each plan handles the issue of defining business income or profits versus wage or salary income. The House combines three approaches, as reported:

● “It dictates that certain professional services, like attorneys, would be unable to benefit from the lower pass-through rate.”

●  “For businesses that are not selectively denied the benefits of the pass-through rate, the general approach is a so-called ‘70-30’ rule, which establishes a bright-line standard that they count 70 percent of income as ordinary wage income (and thus subject to ordinary income tax rates) and 30 percent as business income (and thus subject to the lower pass-through rate).”

● “Alternatively, for businesses that feel a 70-30 rule would unfairly characterize too much income as wage income not eligible for the 25 percent top rate, the bill provides for a ‘facts-and-circumstances’ option which calculates taxability based on a formula relating to capital investments and rate of return.”

For good measure, a new lower tax bracket of 9 percent would be added for pass-throughs. NTU noted that this adds still more complexity, but also tax relief:

“The first $75,000 of pass-through earnings for a taxpayer with less than $150,000 in such income is subject to the 9 percent rate, but the discount phases out approaching $225,000 in income.” Also, the 9 percent rate is phased in over several years.

Meanwhile, the Senate’s 17.4 percent deduction is far simpler than the House’s plan. Somewhat similar to the House, “the Senate bill does not allow certain professional service pass-throughs to claim the deduction, but only if their income exceeds $500,000 for a couple or $250,000 for an individual… Additionally, it restricts the total amount of the deduction to no more than half of the taxpayer’s W2 wages, but again only if income exceeds $500,000/$250,000.”

In comparing the two plans, the Senate bill “also has the effect of distributing its benefits somewhat more consistently, since all qualifying taxpayers would apply the same 17.4 percent deduction. By contrast, the value of the House bill’s preferential top rate accelerates as incomes climb since it protects pass-throughs from high ordinary income tax rates.” In addition, the Senate bill “provides less overall tax relief than the House’s, in part because it is scheduled to sunset (along with several other features) at the end of 2025.”

Finally, as for marginal tax rates (arguably the most important rate, as it is the tax burden that falls on the next dollar of income earned), NTU summed up:

“Under both the House and Senate bills, corporate income faces a top marginal rate of 39.04 percent when accounting for both layers of taxation. Under the House plan, pass-throughs would face a top marginal rate of 35.2 percent, nearly 4 percentage points lower than the combined corporate burden. Under the Senate plan, the top marginal rate for pass-through income would be 31.8 percent, over 7.2 percentage points lower.” And if a rumored 20 percent deduction (up from the 17.4 percent) were to be approved in the final Senate bill, then the marginal rate would further decline to 30.8 percent.

In the end, the key is to reduce tax rates for all, including small businesses that play such a vital role in innovation and economic growth. The NTU report concluded: “It is imperative that any tax reform plan take significant steps to lower [small business] burdens in order to unlock additional growth that is squandered by our current tax code. Though they take different approaches, both the House and Senate tax reform bills would make significant progress toward that goal.”

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Raymond J. Keating is chief economist for the Small Business & Entrepreneurship Council.

Keating’s latest book published by SBE Council is titled Unleashing Small Business Through IP:  The Role of Intellectual Property in Driving Entrepreneurship, Innovation and Investment and it is available free on SBE Council’s website here.

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