Due process requires that laws be clear and direct, so that people can understand and heed them. Congress did not follow this precept in devising the provision concerning limited liability companies, S corporations, partnerships, limited partnerships, and sole proprietorships (“pass-through entities”) in the Tax Cut and Jobs Act (“TCJA”) just signed into law.
The TCJA cut the corporate rate to 21 percent. The idea was to stoke American businesses, and make them more competitive with their foreign counterparts.
The TCJA provides less dramatic relief to individuals, cutting their top tax rate to 37 percent. Pass-through entities are not directly taxed, their income instead passing thru and being taxed proportionately to their owners. Where a pass-through entity owned by individuals operates a business, income of the business is taxed at individual income tax rates, which are much higher than the corporate tax rate.
To bring the effective tax rate of pass-through entities into line with those of C corporations, the TCJA allows a taxpayer other than a C corporation a deduction for the taxpayer’s proportionate share of “qualified business income” from a pass-through entity. Qualified business income is the net, taxable income earned by a pass-through entity in a qualified trade or business. Qualified business income excludes reasonable compensation, i.e., salary, paid by a pass-through entity to its owner(s). Qualified business income also excludes investment income realized by a pass-through entity, such as (1) any item of short-term capital gain, short-term capital loss, long-term capital gain, or long-term capital loss; (2) any dividend, income equivalent to a dividend, or payment in lieu of a dividend; or (3) any interest income other than interest income which is properly allocable to a trade or business.
Why didn’t Congress simply lower individual income tax rates to levels comparable to that of C corporations? Are Federal income tax rates as high as 37 percent for individuals moral? Is it moral to tax individuals at significantly higher rates than C corporations? Is the dichotomy of income tax rates between individuals and C corporations workable? Will not individuals begin to conduct their personal financial affairs in C corporations, feigning a trade or business? How many revenue agents will the IRS need to hire and train to police against such abuse under the new law?
The TCJA provides that a qualified trade or business is any business other than a specified service trade or business. A specified service trade or business is any trade or business involving the performance of services in the fields of health, law, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners, or which involves the performance of services that consist of investment and investment management trading, or dealing in securities, partnership interests or commodities.
A taxpayer’s qualified business income deduction with respect to a given qualified trade or business for a given tax year is the lesser of—
- 20 percent of the taxpayer’s qualified business income with respect to that qualified trade or business for that tax year, or
- the greater of—
- 50 percent of the W-2 wages paid by that qualified trade or business for that tax year, or
- the sum of 25 percent of the W-2 wages paid by that qualified trade or business for that tax year, plus 2.5 percent of the unadjusted basis immediately after acquisition of all qualified property of that qualified trade or business.
If the taxpayer’s taxable income does not exceed $157,500 ($315,000 on a joint income tax return) (the “threshold amount”), then the taxpayer can deduct the full amount of his or her qualified business income deduction. But if the taxpayer’s taxable income exceeds the threshold amount, and
- 20 percent of the taxpayer’s qualified business income with respect to that qualified trade or business for that tax year, exceeds
- the greater of—
- 50 percent of the W-2 wages paid by that qualified trade or business for that tax year, or
- the sum of 25 percent of the W-2 wages paid by that qualified trade or business for that tax year, plus 2.5 percent of the unadjusted basis immediately after acquisition of all qualified property of that qualified trade or business,
then the taxpayer’s qualified business income deduction for the tax year phases out for qualified business income above the threshold amount plus $50,000 ($100,000 in the case of a joint income tax return).
“Qualified property” means, with respect to a given qualified trade or business for a given taxable year, tangible property of a character subject to the allowance for depreciation under Internal Revenue Code (“IRC”) § 167—
(A) which is held by, and available for use in, the qualified trade or business at the close of the taxable year,
(B) which is used at any point during the taxable year in the production of qualified business income, and
(C) the depreciable period for which has not ended before the close of the taxable year.
“Depreciable period” means, with respect to qualified property of a taxpayer, the period beginning on the date the property was first placed in service by the taxpayer and ending on the later of—
- the date that is 10 years after such date, or
- the last day of the last full year in the applicable recovery period that would apply to the property under IRC § 168 (determined without regard to subsection (g) thereof).
There is no excuse for so incomprehensible and misguided a tax law. Congress must, without delay, amend the TCJA to correct its flawed treatment of pass-through entities. We cannot wait for the Internal Revenue Service to go through the slow, methodical process of drafting and promulgating regulations to correct the TCJA’s treatment of pass-through entities, if such regulations would even be lawful.
Stephen J. Dunn is a tax attorney in Troy, Michigan. He is the author of the treatise Foreign Accounts Compliance (Thomson Reuters 2017) and Foreign Accounts Compliance Blog.