Need for Special Passthrough Rate Depends on Corporate Tax Cut

By Laura Davison

The business community has long held a simple idea when it comes to lowering taxes: If you cut rates for corporations, you also need to do something for passthrough entities.

House Republicans addressed that request in their 2016 tax reform blueprint, which would cut the corporate tax rate to 20 percent and the rate for passthroughs to 25 percent. Because corporate profits distributed as dividends are also taxed, most in the business world would accept a slightly higher rate for partnerships and limited liability companies, which can range from mom-and-pop convenience stores to hedge funds.

That 20 percent corporate rate is now in question. President Donald Trump is pushing for 15 percent. House Speaker Paul D. Ryan (R-Wis.) revised his goal upward to 22.5 percent. House Republican aides are privately saying it will be difficult to get the rate below 28 percent. Without a big corporate rate cut, a preferential passthrough rate might not be possible.

“The less a tax bill cuts the corporate rate, the more viable it is to just cut the top individual rate rather than establish a new rate regime for passthroughs,” Scott Greenberg, a senior analyst at the Tax Foundation, told Bloomberg BNA Sept. 7.

A corporate tax rate in the high 20s doesn’t give lawmakers much room for a preferential passthrough rate, especially if they cut individual rates. Taxes for passthroughs and individuals top out at 39.6 percent, but Republicans have suggested lowering the top rate to the low- to mid-30s.

Equivalent Rate Cut

“My goal—and we are still in these discussions—is to, from a percentage standpoint, lower taxes equally whether you are a passthrough or structured as a corporation,” House Ways and Means Committee Chairman Kevin Brady (R-Texas) told reporters Sept. 7.

People often forget about the second layer of taxes that corporations pay, said Joseph Rosenberg, a senior research associate at the Urban-Brookings Tax Policy Center. Tax rates on passthroughs can be higher because these entities only have a single level of tax and are relatively tax-favored under the current system, he told Bloomberg BNA.

“From an economic perspective, you could reduce the corporate rate some without needing to do anything for passthroughs,” Rosenberg said. “But that creates political problems even if you modestly reduce the corporate rate and don’t do much for small businesses.”

Cutting the corporate rate to the low 20s would require eliminating credits and deductions that benefit passthroughs and individuals. Greenberg modeled in June that the corporate rate could only be cut to 28.5 percent if 54 of the main corporate tax provisions were eliminated.

New Problems Created

Establishing a preferential passthrough regime that is separate from individual rates has been criticized by some tax lawyers and economists who say it would create an opportunity for people to game the system by routing what should be classified as wage income through a lower-taxed business entity, such as an LLC.

Distinguishing between business profits and income tied to labor would likely result in complicated regulations that could be difficult for taxpayers to follow and for the Internal Revenue Service to administer. It’s simpler to keep passthrough rates aligned with the individual rates than to create a whole new regime, Rosenberg said.

“Even if you are solving one problem, you are creating a host of new problems,” he said.

A smaller spread between any passthrough rate and the top individual rate would reduce the incentive for taxpayers to misclassify income or change the type of entity that they are. And any changes to the rate structure would be unlikely to cause a big wave of businesses opting to be corporations. Partnerships have become increasingly popular in recent years because of their flexibility and the single layer of tax, said Michael Grace, consulting counsel at Wiley Rein LLP.

“Partnerships are very pragmatic,” he told Bloomberg BNA. “They are basically saying, ‘Look, I don’t think the administration has the political clout to push through a 15 percent rate. Even if it’s higher than 15 percent but lower than the combined corporate rate, I’m still better off in the passthrough regime than as a corporation.’”

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