Kansas Passthrough Exemption on Life Support

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By Christopher Brown

A controversial income tax break came back from the dead in the Kansas Legislature Feb. 22, but it appears to have little chance of ultimately surviving the current legislative session.

The passthrough exemption, which applies to non-wage income from partnerships, LLCs, sole proprietorships and S-corporations, was targeted in a bill ( H.B. 2178) that also would have raised income tax rates and created a third tax bracket for higher income taxpayers.

The debate over the passthrough exemption in Kansas has taken on a new salience since the election of President Donald Trump, who is working with Republicans in Congress on a variety of tax cut proposals, including one that would tax income from passthrough entities at 25 percent, well below the proposed 33 percent top income tax rate.

Brownback Veto

Gov. Sam Brownback (R) vetoed the bill late Feb. 21, and an override attempt failed in the Senate the next day after succeeding in the House that morning. But even senators who voted to sustain the veto said Feb. 23 that eliminating the passthrough exemption will almost certainly be part of any legislative package aimed at addressing the state’s budget problems and restoring fairness to its tax code.

Senate Majority Leader Jim Denning (R) said the debate over H.B. 2178 in the Senate showed that the state has a structural imbalance of $400 million a year and that eliminating the passthrough exemption is needed to restore the balance.

“Our tax cuts in 2012 and the other changes that we’ve made since then have left us about $400 million short,” he told Bloomberg BNA. “And the way forward will have to include ending the passthrough exemption and increasing our income tax rates.”

Structural Fix

Senate President Susan Wagle (R) also voted to sustain the veto, but said in a statement that her vote didn’t represent a defense of current tax and budget policy.

“I’m optimistic that legislators maintain their commitment to rejecting business as usual,” Wagle said. “I’m confident that debating this proposal got us closer to a compromise for a structural fix, and I am confident that we’ll soon come to a thoughtful, bicameral agreement that does right by Kansas families.”

Wagle’s statement didn’t mention the passthrough exemption, but her spokesman told Bloomberg BNA Feb. 23 that she expects that “closing the loophole will be part of the final package.”

Retroactive Increase

Denning said he supported Brownback’s veto because he strongly opposed a provision in the bill that imposed retroactive tax increases on ordinary income in addition to passthrough income.

Those increases were unfair and politically unsustainable and “will have to be stripped out,” Denning said.

“I did some calculations on the retroactivity provision in the bill, and it would have increased the effective tax rate for this tax year to 6.3 percent, which compares to the rates in our current brackets of 2.7 percent and 4.6 percent,” he said. “And that is just too big a retroactive adjustment.”

Follow-On Bill

The problem was so obvious that there was already talk during the veto debate of a follow-on bill that would have stripped the retroactivity provision from H.B. 2178. But that maneuver would have recreated the budget problems that the bill was designed to address, Denning said.

“Without retroactivity, you end up with a $100 million budget gap for fiscal year 2018 because the income tax increase doesn’t kick in until halfway through,” he said. “But with it, you putting an unfair increase on ordinary earners.”

The solution, Denning said, was to sustain the veto, and then address that $100 million gap from the spending side at the same time that a tax bill was being drawn up without retroactivity for W-2 income.

The most likely candidate for spending cuts is K-12 education, which hasn’t yet felt the budget knife during the current budget cycle, he said.

“The schools have known this was probably coming, and they’ve been preparing,” he said. “And there are ways we can soften the blow. But K-12 cuts will have to be part of it.”

Brownback also called on the Legislature to look to spending cuts in a statement he released after the failed override effort. “I encourage [legislative leadership] to find savings in the state’s budget before asking Kansans to find savings in theirs.”

Hopeful for Compromise

In the House, Rep. Steven Johnson (R), chairman of the Taxation Committee, expressed disappointment that the veto override had failed, but said he was prepared to work with Brownback and the Senate to find a compromise.

“I was glad to see that the House stood strong in overriding the veto and sending a message that the time for tax reform is now,” he said. “But we’re willing to look at any viable plan that addresses our budget’s structural problems.”

Johnson said he had been present during the Senate’s discussion of H.B. 2178 prior to the override vote, and had taken note especially of the objections raised by Denning and other senators to the retroactivity provision.

“They are right that it’s a terrible choice to have to make, and we can talk about that,” he said. “But I fear that the alternative may be even worse.”

Trio of Bills Teed Up

Johnson also expressed doubt about the wisdom of squeezing K-12 funding as part of a budget solution. “Among other things, we can’t be sure how the courts are going to look at that,” he said, referring to ongoing litigation before the state Supreme Court over the adequacy of school funding.

As for next steps in the House, Johnson said he had three bills teed up in his committee, including one containing Brownback’s tax and budget proposals ( H.B. 2315).

“We’ll take a look at that to see if there are any pieces that we can use, and look at a couple of other bills to see where we’re going here,” he said.

The result will probably be a bill that’s “a couple of steps to the right” of H.B. 2178, he said. “It looks like that’s what we need to do to pick up enough Senate votes to override a veto.”

To contact the reporter on this story: Christopher Brown in St. Louis at ChrisBrown@bna.com

To contact the editor responsible for this story: Ryan C. Tuck at rtuck@bna.com

For More Information

Text of H.B. 2178 is at http://src.bna.com/mhj.

Text of H.B. 2315 is at http://src.bna.com/mrT.

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