Simplification claimed by ‘tax reform’ a mirage
The Republican “tax reform” proposals have established one thing as the centerpiece of the legislation — the 20 percent tax rate for regular corporations. This rate is said to benefit business.
Unfortunately, the number of businesses operated as “passthrough” entities, which include partnerships and S corporations, is five times the number of regular corporations.
Not to worry — the Congress has reserved a special 25 percent tax rate for the business income of a pass-through entity. Such entities do not themselves pay tax, so the special rate will apply to the individual who owns the entity.
Now, this is a maximum rate, so any individual who would otherwise pay a rate of 25 percent or below will not benefit from the maximum rate. The House bill requires a married couple to have more than $260,000 to be in a rate bracket above 25 percent. The threshold is $200,000 for a single person.
We are told “tax reform” will simplify things. So let’s take a short trip through this simplification for the special 25 percent rate for business income of a passthrough entity.
First, the special rate will not apply to a service activity. This includes activities such as law, medicine, accounting, and so on.
But there is an exception. If the service business has at least 10 percent of its income from capital, rather than from services, then the share of capital income qualifies for the special rate.
But the income computation for the special rate must add back the wages or guaranteed payments made to the owners. Then a maximum income from capital can be computed.
Let’s say the service business makes $200,000 of income but pays the owner $120,000 in wages. The net income of the business is then $80,000 because the salary is deductible.
But the salary must be added back to the net income to get the gross of $200,000. Since 60 percent of that income ($120,000) is paid as salary, then only 40 percent of the income can possibly qualify for the 25 percent tax rate for capital.
But the capital share can also be lower than 40 percent. Capital share income can be calculated by multiplying the business “gross asset value” by the “federal short-term rate” plus 7 percent.
Oh, this income share must then be reduced by any deductible interest allocable to the activity. And I forgot to mention that the business has to determine how many activities it has using the regulations that apply to “passive activities.” The test applies activity by activity.
That’s just for a service business. Other businesses may qualify for the 25 percent rate provided the owner does not materially participate in the activity — that is, the rate may apply only to passive income.
If the owner is active, then the special rate applies to a deemed capital share of 30 percent. But the owner may elect another share of capital subject to the special rate.
The elective rate of capital needs proof. Once the special rate is elected, it applies for the next four tax years.
Capital gains and “qualified” dividends are taxed at an even better rate than 25 percent. So those items must be separated from the general business income before the share subject to 25 percent can be determined.
If the pass through entity happens to be an S corporation, the business income may be subject to the self-employment tax (sort of like payroll taxes for the self-employed) for the first time.
The S corporation shareholder’s share of income is increased by his or her salary, and then 70 percent of this figure is deemed to be from labor and therefore subject to payroll (or self-
employment) tax.
Let’s say the S corporation has $600,000 of business income and pays the sole shareholder $100,000 for wages. The owner and the business pay payroll taxes on the $100,000.
Now the owner takes the $100,000 salary, plus the $500,000 income after the salary deduction, which is $600,000, and multiplies that by the 70 percent labor share. This is $420,000.
The $420,000 total labor share is then reduced by the $100,000 salary share, and the $320,000 is subject to self-employment tax.
Got it? After all, simplification means you’ll no longer need an accountant to explain the law to you.