Passthrough Gaming Solution Eludes GOP as Tax Bill Release Nears

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By Laura Davison

Republicans are struggling to decide how to prevent passthrough entities from gaming a lower tax rate as they put the final details on their tax legislation.

The plan calls for a 25 percent tax rate for partnerships, limited liability companies, and S corporations. But for businesses where an owner is also actively engaged in running the business, the law will need to distinguish wage income, subject to individual tax rates and payroll taxes, from business profits.

Some House and Senate tax staff members have touted a simple formula: 70 percent of the income stream would be treated as compensation and 30 percent would be subject to the preferential passthrough rate. But many business owners dislike this idea, saying it doesn’t reflect the economic reality of what is a fair-market-value wage and what is profit.

“Tax writers are eager for any ideas that help ensure the pass through rate is reversed for profits only,” Brian Reardon, president of the S Corporation Association, told Bloomberg BNA. “The key is to find some approach, or a combination of approaches, that would prevent cheating while preserving the value of the lower rate for real profits.”

A tax lobbyist, who requested anonymity to protect client interests, called the process a mess. Members don’t like the 70/30 test, but a more nuanced approach is difficult to administer, the lobbyist said.

Bright-Line Avoidance

Still, lobbyists and lawmakers are searching for ways to avoid the 70/30 test. Options being floated include an employee wage test that would tax a higher percentage of income as business profits as the payroll increases. Another option is to tie the profits to how much the owner invested in the businesses versus what he or she took out. Yet another is to have a third party certify the wage amount so the owners are taking a fair wage and subjecting the remainder to the lower passthrough rate.

House Ways and Means Committee staff members favor the 70/30 approach, but they are becoming more open to alternatives as the lack of support for the approach among lawmakers and the business community becomes clearer. Rep. Vern Buchanan (R-Fla.), a Ways and Means member, said the committee is still figuring out what the guardrails will be.

Startups are worried that the special passthrough rate could invite more Internal Revenue Service scrutiny, Raymond J. Keating, chief economist for the Small Business & Entrepreneurship Council, said. If 70/30 were an option, some businesses could choose that to be sure they are complying with the rules, he said.

“Small businesses could be open to 70/30 being a safe harbor if it truly is a safe harbor,” Keating said. “They don’t want it to get any worse than it already is in terms of the IRS.”

Considering how much a company pays in wages is a broader measure of the value of the business than just counting machinery and land, Liam Donovan, a lobbyist with Bracewell LLP, said. That could be one way of determining profits versus wages. The trick is also targeting enforcement on situations where there is more opportunity for abuse, such as family businesses where people have control over the company and their compensation levels, he said.

S corporations with multiple unrelated owners aren’t in a position to game the system and should get the lower rate, Reardon said.

Income-Focused Approach

Wage certification, where a third party determines an owner’s fair market value wage based on location, duties, industry, and organization size, could be another way to distinguish compensation from profits, Mel Schwarz, director of tax legislative affairs in Grant Thornton LLP’s National Tax Office, told Bloomberg BNA. This could be an alternative to 70/30 for passthrough owners who want to undergo the additional paperwork and expense of getting the compensation certified.

The infrastructure is already in place for companies to provide wage certification, James Sillery, a principal at Conduent HR Services in Chicago, said. This type of compensation consulting is already being done for management at publicly traded companies and executives at tax-exempt organizations, he said. Aon Hewitt LLC, Mercer Inc., and Willis Towers Watson Plc are companies that are already offering this type of compensation analysis, Aaron Taylor, a director at Grant Thornton, said.

Grant Thornton, which has a compensation consulting business, would also stand to benefit from this proposal.

“There is a logic to it and a lot of people already do that,” Donovan said. “It would be a boon to the Grant Thorntons of the world, so people do roll their eyes a little bit, but it could be part of the solution.”

The Ways and Means Committee is planning to release a bill shortly after the House and Senate agree to a budget resolution, which could come as soon as the end of the month. That gives tax-writers a matter of weeks to coalesce around a plan.

“70-30 is a non-starter for a lot of groups. That would be the quickest way to hit a snag in this plan,” Donovan said. “Congress is put in a tough spot of finding the least-bad solution.”

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 mshreve@bna.com

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