How to Stop Taxpayers From Gaming a Lower Passthrough Rate

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By Laura Davison

Lowering taxes for passthrough entities would force lawmakers and the Trump administration to decide how to prevent small and mid-sized businesses from taking advantage of those new rates.

Economists and tax accountants note that taxing passthrough income at rates distinct from the individual income scale would open up incentives for taxpayers to route their income through the lowest rate path. Treasury Secretary Steven Mnuchin recently said tax reform legislation would include rules to prevent people from gaming the tax rate meant to spur business investment.

The House tax plan, released almost a year ago, would open up an 8-percentage-point spread by taxing passthrough income at 25 percent and wage income at 33 percent for the highest earners. The Trump plan would tax passthrough income at 15 percent, a full 20 points lower than the top individual rate.

“As soon as those lines get drawn, the lawyers will start getting busy,” said Joe Rosenberg, a senior research associate at the Urban-Brookings Tax Policy Center.

Heavy Lift?

Passthrough income is taxed using the graduated individual rates under current law. Distinguishing between business profits and income tied to labor will likely be a heavy lift as lawmakers seek to develop rules that accurately classify business income and wages and are administrable for the Internal Revenue Service.

Special rates for passthrough businesses aren’t favored by many economists, who prefer that all income be taxed at a single rate. But these passthrough rates allow lawmakers to lower taxes for small and medium-sized businesses without the huge revenue hit that would result from lowering the top individual tax rate.

“Whatever rules you design to stop taxpayers from gaming a lower rate are not going to be perfect,” said Scott Greenberg, an analyst at the Tax Foundation.

S Corporation Inspiration

The reasonable-compensation rules, which currently govern S corporations, are one framework already in the tax code where lawmakers could look for inspiration. But these rules, which require S corporation owners who also work in the business to pay themselves a “reasonable” wage and the associated self-employment taxes, probably are too subjective to prevent aggressive tax planning.

The reasonable-compensation standard is “a tax litigator’s dream,” Don Susswein, a principal at RSM US LLP, said.

Owners of S corporations are incentivized to minimize the amount they pay themselves, so they can avoid the self-employment taxes. The reasonable-compensation standard became well known after former House Speaker Newt Gingrich and former Sen. John Edwards reportedly minimized their income to avoid taxes.

“It would certainly be hard to enforce and be open to manipulation,” Rosenberg said.

Hard-and-Fast Rules

Policy makers could also look to numerical rules to divide the business profits from the compensation. Former Ways and Means Chairman Dave Camp (R-Mich.) included a 70-30 rule in his 2014 tax reform legislation. The provision, which would have subjected 70 percent of passthrough income to payroll taxes, was panned by many passthrough business interests.

“That doesn’t make so much theoretical sense,” Greenberg said. “Every business is different and has a different rate of return.”

However, this would be a way to scale back the availability of the special rate, making it less costly to the federal government. Mark Warren, tax counsel for Senate Finance Committee member John Thune (R-S.D.), said at an American Bar Association tax conference earlier this month that the tax-writing committees will likely look to write more mechanical rules, like 70-30, and steer away from subjective tests, such as reasonable compensation, so that their proposal won’t lose excessive revenue in Joint Committee on Taxation estimates.

The JCT has not yet released the cost of a 15 percent or 25 percent passthrough rate, but the Tax Policy Center found that the special rate could lose between $410 billion and $1.95 trillion, depending on the rate and how passthrough income would be defined in the law.

Another way lawmakers could scale back the cost of a special passthrough rate is to make it unavailable to service partnerships, such as law firms or medical practices, where most of the income is tied to compensation for labor.

Supernormal Returns

Congress could also seek to classify passthrough income based on the rate of return, Rosenberg said. Investments with normal returns, calculated based on basis in the partnership, could be subject to the special passthrough rate. And then above-average returns could be deemed labor compensation or excess profits that would be subject to ordinary tax rates.

There are two reasons for this, Greenberg said: “No. 1, if the returns are supernormal the suspicion is that it is actually labor income disguised. No. 2, if those investments are so profitable they don’t need to be encouraged with a lower rate because they would be made anyway.”

Rules based on rates of return would be relatively simple to include in the statute, which means they would be scored by the JCT, so lawmakers could get a sense of their effectiveness, Susswein said. It’s also much easier to implement than reasonable compensation rules, he said.

However, defining particulars of a reasonable rate of return for specific industries is something that will likely get put off until regulations are written, and they won’t get included in the legislation, said Steven Schneider, a partner at Baker & McKenzie LLP. Reasonable rate of return will depend on what the capital is used for and what the risk is, which will likely take more time to calculate than the House Ways and Means and Senate Finance committees have, if they plan to pass legislation this year.

“No matter what, this is going to be really messy,” Schneider said.

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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