Explaining the Pass-Through Income Anti-Abuse Rules in the House Tax Cuts and Jobs Act

November 3, 2017

On Thursday, House Ways and Means Committee leadership released bill language for federal tax reform. Our details on the provisions in the package are here. One issue that deserves additional attention is a provision in the plan that lowers the rate on pass-through business income to 25 percent, while the top marginal income tax rate for wage income will remain at 39.6 percent.

For background, business income from traditional C corporations is taxed twice: once in the form of corporate profits in the corporate tax, and then again when profits are paid out to shareholders in the form of a dividend.

However, pass-through businesses (like LLCs, S corporations, and sole proprietorships) are subject to just one layer of taxation, when the income is “passed through” to the owners on their individual income tax return. This single layer of taxation is good policy; read our primer on pass-throughs here.

However, with the House Ways and Means Tax Plan offering a pass-through rate cut to 25 percent but keeping the rate on wage income at 39.6 percent, there is cause for concern that some filers would have strong incentives to recategorize their wages as “business income” to get a substantial rate cut.

How would that work? In a simple hypothetical, an engineer might choose to sell his services to his firm as a contractor rather than a wage-earner, cutting his income tax liability. In this scenario, he would now have to pay both the employer side of the Social Security and Medicare withholding taxes (7.65 percent), but he could likely gross up his contracting fees to adjust for that, and still “cost” the firm the same amount to employ.

This would be a good deal for that engineer, but a bad deal for federal revenues, as tax collections would go down substantially even though no new economic activity has occurred (the engineer is ostensibly still carrying the same workload).

Or consider the case of a sole proprietor. If she worked for an employer, she would receive wages, taxable at ordinary rates. If she could benefit from a lower rate on business income than she does on wage income, however, it would make sense to limit the amount (if any) she receives in wages and instead take more business income. We know that, in theory, some portion of the income she receives is due to her labor (wage income) and some portion is due to her investment/ownership stake (business income), but the pass-through rate provides an incentive to place as much income as possible in the latter basket.

However, lawmakers have made clear that they want to provide a tax cut for all businesses and perhaps particularly small businesses (though many pass-through businesses are actually quite large), and while economists generally agree that pass-through businesses are tax-advantaged compared to double-taxed C corporations, the House Ways and Means Tax Plan pairs corporate rate reductions with a lower maximum rate for pass-through businesses. The challenge, then, becomes how to offer a lower rate for pass-through business income without encouraging substantial recategorization of income.

How should we square this circle to make sure a lower pass-through rate doesn’t lead to abuse and tax avoidance? There are basically three strategies federal lawmakers could employ, each of which solve certain problems but come with drawbacks as well:


Method #1

Use a formula to determine how much income should be categorized as wages on the tax return of a business owner, ensuring some of the income is subject to the wage income tax rates.

The idea is that some portion of income returns to labor, and the other returns to capital—real business profits.

Advantages

This method reduces any incentives to work as a subcontractor for tax purposes, and limits the degree to which business owners can reclassify their earnings from wages to business profits.

Drawbacks

  1. This makes for a tax preference that is less likely to induce recategorization because you still have to pay yourself 70 percent of your income in wages
  2. Any such rule is a necessarily blunt instrument, overcounting business income for some and undercounting it for others.

Method #2

Exclude some businesses and owners from the benefits of a lower pass-through rate.

Advantages

Professional service providers, like attorneys, accountants, and financial advisers, have low returns to capital and high returns to labor, and could thus receive a disproportionate advantage under a lower pass-through rate absent sufficient guardrails. One option would be to altogether exclude select service industries from eligibility for the lower pass-through rate.

Drawbacks

This approach is nonneutral, favoring some industries more than others, and wrongly assumes no return to capital from such businesses.


Method #3

Set out a holistic “facts and circumstances” test to determine how much income needs to be categorized as wages.

Advantages

This method allows taxpayers to show exactly how much of their income is derived return on business capital, and how much of it is from their labor.

Drawbacks

These calculations can quickly become extraordinarily complex.


The House Ways and Means Tax Plan has a novel solution that ends up utilizing components of all three of these approaches.

For most pass-through businesses, a 70/30 wage-to-business income rule will apply as default, allowing them to take advantage of a lower rate for 30 percent of their income, which is assumed to be derived from returns to capital.

For businesses that feel that this is not an accurate assessment of their returns to capital, they can “prove out” if they can show that the depreciated tangible capital of the business (that is, the purchase price less MACRS depreciation) multiplied by about 8 percent (specifically, Applicable Federal Rates plus 7 percent) is greater than 30 percent of their income that year. They would then pay the lower pass-through income tax rate on that amount, which is intended to represent a normal return on investment.

Next, certain professional business services like accounting and law firms will be excluded from the lower pass-through rate by default, with all income preliminarily subject to ordinary tax rates. However, these taxpayers will still be able to prove out their business income based on depreciable property, on which they would be subject to the lower maximum rate of 25 percent.

Though admittedly a bit complex, these anti-abuse rules represent a well-thought-out approach to dealing with this issue. Imposing weaker rules would open the door for arbitrage opportunities for certain taxpayers to recategorize income. By beginning with a default rule that will be sufficient for most taxpayers, the rules limit excessive complexity while providing a “facts and circumstances” alternative for businesses with higher returns to capital.


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