The Impact on Taxation of Pass-Throughs if House's "Tax Cuts and Jobs Act" Passes

Tax Law Update | November.08.2017

On November 2, 2017, the House of Representatives (the "House") introduced the Tax Cuts and Jobs Act ("H.R.1"). This bill, if passed, would make fundamental changes in the taxation of businesses operated in pass-through form.

Most notably, H.R.1:

  • Would drop the tax rate on income received by owners of partnerships, limited liability companies (LLCs), S corporations and sole proprietorships to 25%.
  • Would restrict the use of the 25% rate to businesses other than professional services, such as accounting, law, medicine and consulting.
  • Would not eliminate carried interests in pass-through entities, which benefit private equity and hedge fund owners, but would restrict carried interests to interests in underlying assets with a three-year holding period (by amendment introduced November 6).   

Rate on Income from Pass-Throughs Is Cut to 25%

The drafters of the bill recognized that owners of businesses in pass-through form would be disadvantaged as compared to businesses in C corporation form if the C corporation rate were reduced significantly (which they do propose to reduce to 20%) without a comparable rate drop for pass-throughs. Therefore, the bill offers a special tax rate of 25% to business income received by taxpayers from a pass-through entity.

Background

Under current law, businesses organized as partnerships, most LLCs, S corporations and sole proprietorships are generally treated for federal income tax purposes as "pass-through" entities that are subject to tax at the individual owner or shareholder level rather than the entity level. The owners then report the income on their own returns and pay tax (generally) at ordinary income rates, the top current rate being 39.6%.

Owners Active in the Pass-Through Business Apply the 25% Rate to Only Part of Their Income

Each owner would separately determine its proportion of business income received from the pass-through entity.  If the income is derived from a passive business activity it would be treated entirely as business income and all subject to the 25% rate. If the income is considered to be active income, and thus raises a question as to the appropriate amount to be treated as compensation and subjected to regular rates, then only a portion of the income would be eligible for the 25% rate. As a default rule, 30% of the income would be subject to the 25% rate, while the other 70% would be treated as wages or compensation and taxed at regular, graduated ordinary income rates.  

A higher percentage of such active income could be subject to the 25% rate, depending on a deemed return calculation.  In the deemed return calculation, the taxpayer would apply a rate of return (the federal short-term rate plus 7%) to the cost basis of the assets of the business as of the end of the tax year. That amount of the taxpayer's total income from the pass-through would be subject to the 25% rate. Depending upon the asset base and the rate applied, the percentage of total income receiving the benefit of the 25% rate could exceed the default percentage of 30%. The effect of such a provision would be that those businesses in pass-through form that are heavily invested in equipment or other assets, such as manufacturers, would generate income that is taxed to their active owner recipients at a significantly lower rate.  However, assets that have been expensed under the new rules under H.R.1 would not provide any cost basis for purposes of this rule.

Professional Services Businesses Continue to Pay at Ordinary Rates

The 25% rate would not be available to taxpayers who receive their pass-through income in exchange for the performance of professional services, such as law, accounting, medicine and consulting. However, such businesses would have the option of determining the deemed return on their asset base and if the deemed return exceeds 10% of the income from the pass-through (less interest expense), then the deemed return amount is eligible for the 25% rate.  Most service businesses would not have a significant enough investment in assets to make the 25% rate available. One exception might be medical practices that invest heavily in equipment, such as radiology or surgery practices. 

Preferential Treatment of Carried Interests Tightened

Interestingly, the long-expected eradication of carried interests, that would increase the tax on partners in partnerships formed by private equity managers, venture capitalists and hedge fund managers, would not be implemented by H.R.1. Currently, such businesses are frequently structured so that their income flows through to their owners as capital gains, which are taxed at rates lower than ordinary income. H.R.1 would change the tax rate on income flowing through partnerships to 25% but does not change income that flows through as capital gains into ordinary income and does not change the tax rate on capital gains.  Since the capital gains rate currently is 23.8% for capital assets held for greater than one year (the 20% income tax rate plus the 3.8% Medicare tax, if income exceeds certain thresholds), a carried interest structure would still deliver a benefit as compared to the new 25% rate applied to partnership ordinary income. On Monday, November 6, Ways and Means Committee Chair Kevin Brady (R-Texas), introduced an amendment to H.R.1 which includes a change that will tighten the availability of preferential treatment for carried interests. Under the bill as amended, carried interests would only be eligible for capital gains treatment to the extent the underlying investments satisfy a three-year holding period, rather than the currently applicable one-year holding period. 

Preferential Rate would Apply to Certain Dividends from REITs

Under H.R.1, certain dividends from real estate investment trusts ("REITs") also would be eligible for the preferential 25% rate for income from pass-through entities. The 25% rate would not apply to dividends of capital gains and qualified dividends from REITs, to which the capital gains rates would apply.

Technical Termination Repeal

H.R.1 would repeal the technical termination rules of section 708. This provision required that a partnership file a short-year return and, usually, restart the life over which it depreciated its assets, if 50% or more of the interests in the partnership were transferred within a 12-month period. This rule has been a technical hindrance in many partnership transactions and its repeal is a simplification effort. 

Publicly-Traded Partnerships

The treatment of publicly-traded partnerships as pass-throughs (rather than as corporations) would not change under H.R.1. The taxable income of the unitholders, as passive investors, would be entirely subjected to the 25% rate as to ordinary income and the long-term capital gains rate (lower) to the extent of any capital gains. 

By Barbara S. de Marigny