Big Six’s Framework for Tax Reform Is Light on Details for Pass-Through Entities

The  “Unified Framework for Fixing Our Broken Tax Code” included several goals for reforming the tax provisions that affect pass-through entities and noted that small businesses drive our economy and our communities. Roughly 95% of U.S. businesses, from small businesses to massive hedge funds, are subject to pass-through taxation. A small number of large businesses account for the majority of pass-through income and activity in the economy. Thus, the proposals discussed below will have wide-spread impact on small and large businesses if passed into law. For a full analysis of the ‘framework’ see this special report, How the ‘Unified Framework’ Would Change Current Law.

25% Tax Rates for Pass-Throughs

Pass-through entities get their name because the income from the entity is currently passed through and taxed to its owners under the individual tax rate (currently between 10% and 39.6%). The framework would instead apply a flat 25% tax rate to the business income of partnerships, S corporations, and sole proprietorships.

The framework would also reduce seven individual tax brackets (10% to 39.6%) into three brackets (12%, 25% and 35%), while leaving open the possibility for an additional top rate for the highest-income taxpayers. Thus, it is unclear whether the current top individual 39.6% tax rate would be reduced. A flat pass-through rate has been criticized as creating an opportunity for high-income individuals to shelter wage income that would be subject to the top individual tax rate by classifying it as business income. Anticipating the need to prevent such gaming of the system, the proposal tasks the legislative committees to adopt measures to prevent the recharacterization of personal income into business income.

Treasury Secretary Steven Mnuchin recently suggested that partners in service partnerships should be excepted from the 25% tax rate for pass-through business income.

“Services companies that are passthroughs will not get the benefit of the rate,” Mnuchin said. “If you're a business that's creating manufacturing jobs, you will get the benefit of that rate because that is income that will be passed through to help create jobs and better wages.”

This exception was not included in the framework. Such an exception or other measures to curb gaming of the system may result in complex regulations and complicate IRS administration of the new system.

The 25% rate for pass-through entities would be slightly higher that the proposed 20% corporate tax rate included in the framework, presumably reflecting the double taxation of corporate earnings.

Questions remain for owners of pass-through entities until a draft of tax reform legislation is released, including:

  • What measures will be taken to prevent gaming of the system?

  • Will the special reduced rate for carried interest survive?

  • What pass-through business deductions and credits will remain?

  • Will there be changes to the partnership audit rules?

  • Will legislation have retroactive effect to the beginning of 2017?

Meant to serve as a template for the legislative committees that will develop any future tax reform, the framework leaves the heavy lifting to Congress. The devil is in the details, and the details of a tax reform bill are sure to create many more questions.