NATSO ANALYSIS: Treatment of Pass-Through Entities Subject to Debate as Tax Reform Legislation Enters Final Stretch

Determining how to treat businesses organized as pass-throughs has been one of the more controversial components of the tax reform legislation that congressional negotiators are attempting to finalize before Congress breaks for Christmas.

The Senate and House have taken different approaches thus far.

The Senate’s tax reform legislation would exempt the first 23 percent of income from pass-throughs, though this amount phases out for pass-through service businesses if the taxpayer has taxable income over $75,000 ($150,000 for married couples), and phases out for all individuals with taxable income over $250,000 ($500,000 for married couples).

The Senate version contains additional limitations on this deduction if the pass-through is a partnership or S corporation, contains additional rules on taxing gains and losses from partnership sales as well as provisions for calculating taxable income for each type of pass-through business. Importantly, these provisions would expire after 2025 unless Congress extends them.

A number of small business groups contend that when this provision is combined with the loss of deductions the effective rate for pass-through entities will only decrease by a minimal amount.

Additionally, many family businesses will pay higher taxes under the Senate bill because it precludes trusts and estates from using the deduction. Such trusts are designed to help the business survive from one generation to the next. NATSO maintains that it is inappropriate for all of the income of a closely held business to become taxable at a higher rate if an owner unexpectedly passes away and his or her estate then owns the stock. NATSO has argued that trusts and estates should be allowed to benefit from the pass-through deduction in the Senate.

The House tax reform legislation creates a new “pass-through” tax rate at 25 percent. The bill would presume that 70 percent of pass-through income is wage income (subject to the individual income tax rate), while 30 percent is business income (subject to the lower 25 percent rate). It excludes many professional service companies from the preferential rate. Businesses who wish to avoid the 70-30 ratio would be able to demonstrate based on “facts and circumstances” (e.g., capital expenditures) that a greater share of the pass-through income should be subject to the lower 25 percent rate rather than the individual rate.

Under the House version, those who do not work in the pass-through, so-called “passive” owners, will receive the 25 percent rate on all income from the business.

House and Senate conferees continue to negotiate provisions in the bills and therefore are subject to change. NATSO will continue to keep members apprised of all developments on tax reform legislation.


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