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Exempting service partnerships, such as law firms and medical practices, from a special, lower passthrough tax rate could introduce complexity into the tax code, in contrast with Republicans’ stated principles for tax reform.
Treasury Secretary Steven Mnuchin floated the idea of exempting partners in service partnerships from a preferential tax rate for passthrough income during a recent speech.
“Services companies that are passthroughs will not get the benefit of the rate,” Mnuchin said Sept. 12. “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.”
The House has proposed a 25 percent rate for passthroughs and a top individual rate of 33 percent, though discussions are ongoing as lawmakers and Trump administration officials negotiate a final tax plan.
“It’s a good idea to exempt service partnerships because they are the most inclined to abuse it, particularly small partnerships,” Walter D. Schwidetzky, a law professor at the University of Baltimore School of Law, told Bloomberg BNA. “There would still be some gaming on the margins, but it would fix about 90 percent of the problems.”
Creating a carve-out for service partnerships would help prevent compensation from being undertaxed. But it also would create an additional layer of complexity for the Internal Revenue Service to determine how and what portions of partners’ income should be taxed. It also would incentivize some passthroughs to try to not be classified as service partnerships.
The complexity of the House-proposed passthrough rate has been panned by economists and tax lawyers, who say it would incentivize people to misclassify income to save on their tax bill. Opinions are mixed about whether the additional complexity of having to ferret out what partners pay on what income would be workable.
“Taxes should not be focused on particular professions or businesses,” J. Leigh Griffith, a partner at Waller Lansden Dortch & Davis LLP, said in an email. “There should not be a penalty for choosing to work in a passthrough structure and to invest in equipment, personnel, etc.”
Lawmakers looking for a way to define a service partnership that would be excluded from the special rate could look to tax code Section 1202, David Shechtman, of counsel at Drinker Biddle & Reath LLP, said. That definition includes businesses involved in services including health, law, engineering, performing arts, athletics, or “any trade or business where the principal asset of the trade or business is the reputation or skill of one or more of its employees.”
The definition would also exclude some passthroughs in the real estate business, meaning “the Trumps and the Kushners of the world” wouldn’t get the lower rate, Shechtman said.
If the top tax rate is in the 30s and the special rate for passthroughs is 25 percent, “people are going to be very interested in pushing themselves into an included group and not an excluded group,” he said.
Coming up with a definition that seeks to aid capital-intensive businesses could be additionally complicated because there are some service partnerships, such as medical firms, that do invest heavily in equipment.
“I agree with the concept that service pass-through businesses generally employ less capital than manufacturing and retail and that a distinction based on that may make sense,” Griffith said. “However, I would note that law firms, accounting firms and medical practices do hire non-partners, make capital commitments, including leasing office space, and are making significant capital expenditures on computers, software, other equipment and other resources.”
Lawmakers working on the tax bill are conflicted about excluding service partners from a lower rate. House Ways and Means Committee member Tom Rice (R-S.C.), who has worked as an accountant and tax lawyer, said there shouldn’t be carve-outs for any particular industry or type of partnership.
“Those are all conversations that are going on, but remember one of the fundamental goals is simplicity,” said Rep. Tom Reed (R-N.Y.), also on Ways and Means. “As soon as you start carving off industries over other industries and picking that complexity in the code, you’re giving up one of the goals.”
However, exclusion of accountants, architects, and lawyers from the special rate is still under consideration because it would give lawmakers more room to cut tax rates, Reed said.
The debate over how to classify income for tax purposes isn’t a new one. Similar questions have come up with carried interest and determining which payments for service are eligible for capital gains rates, Noel Brock, assistant professor of accounting at Eastern Michigan University, said.
The special partnership rate would likely need to be determined on a partner-by-partner basis, rather than at the entity level, Brock said. Some partnerships, such as private equity firms, have partners who are running the business and some who just put up capital, he said.
“Adding a lower rate for business income, however defined, introduces a third category of income into the mix, in addition to ordinary and capital gains,” Brock said. “You now have to determine which rate folks are subject to. Within one partnership you could have all three rates floating around.”
This added complexity would be likely to create an “administrative nightmare,” Shechtman said. It would probably take hundreds of pages of regulations to determine who is and who isn’t a service partnership, he said.
“You will stop most of the gaming if you exempt service businesses,” Schwidetzky said. “Another way to get rid of that problem is to not have a special rate.”
With assistance from Colleen Murphy in Washington.
To contact the reporter on this story: Laura Davison in Washington at lDavison@bna.com
To contact the editor responsible for this story: Meg Shreve at firstname.lastname@example.org
Copyright © 2017 The Bureau of National Affairs, Inc. All Rights Reserved.
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