Tax Reform Loophole

Potential Pass-Through Entity Loophole in Tax Reform

● The Tax Cut and Jobs Act proposes setting a maximum tax rate of 25% on pass-through business income. While lawmakers intend to benefit small business owners with the new, lower tax rate, many are concerned that certain individuals will abuse the provision by re-categorizing wage income taxed at a maximum 39.6% rate as pass-through business income taxable at the lower 25% maximum rate.

Tax Reform Loophole● How will the Act prevent individuals from re-categorizing their wages as pass-through business income taxable?
To prevent this from happening, the House Ways and Means Tax Plan includes anti-abuse rules:

  1. The lower rate will only apply to a default rate of 30% of the pass-through entity’s business income with certain exceptions.
  2. The lower rate will not apply to professional service businesses. In other words, the default rate for these entities equals 0%.
  3. The lower rate will apply to 100% of the business inco me passed through to limited partners. In other words, the Act recognizes that limited partners as passive investors by definition do not contribute a material amount of labor to the business enterprise.
  4. However, both service and non-service pass-through entities can establish a higher rate based on a presumed annual return on invested capital. An entity calculates this amount by multiplying the adjusted basis of its depreciable assets by the Applicable Federal Rate (“AFR”) plus 7%. If this amount exceeds the default rate multiplied by its business income for the year that higher amount will qualify for the maximum 25% tax rate.
    The above exception to the default rates assumes that this income is generated by invested capital rather than by the owners’ labor.

Example: A pass-through entity has business income of $100,000. It would otherwise qualify for the 25% tax rate on $30,000 of the $100,000 in business income at the 30% default rate. The adjusted basis of its depreciable assets equals $1,000,000 (without the application of the 50% bonus or Section 179 deductions). The AFR plus 7% equals 8%. The pass-through entity therefore calculates a return on its net depreciable assets of $80,000 ($1,000,000 x 8%). The maximum 25% tax rate therefore applies to $80,000 of the pass-through business income.

● Owners of pass-through entities should also keep in mind that the Act expands the types of pass-through income subject to self-employment tax. For example, it will repeal the provision exempting limited partners from owing self-employment tax on their pass-through business income.
You may explore more on this section of the Tax Cuts & Jobs Act in Section 4 of the Act.

About The Author

Richard O'Brien

Richard O’Brien of Kurtz & Company, P.C. in Dallas Texas.