Tax Reform Watch: Is a Lower Pass-Through Entity Tax Rate the Solution for Smaller Businesses? – June 23, 2017 by Mike Kolk

In recent years it seems the tail wags the dog when it comes to finding tax savings and even when discussing tax reform. But there may be a bone to throw into the mix that many don’t even know about.
 
First let’s look at one of the more intriguing features of the President's tax proposal released back in April:  the provision to reduce tax rates on pass-through entities to as low as 15%. This rate would align with the proposed 15% tax rate suggested for C Corporations and give a form of parity between taxes assessed on big and small businesses. Previously the House advocated for a 20% corporate rate and a 25% rate on pass throughs and self-employed income. In either case, there would be an incentive for income to be taxed as a pass-through entity versus at the proposed ordinary rate of 33%.
 
The lack of detail in the President’s proposal thus far creates a fertile playground for speculation, but many have observed that such a change would open incentives for taxpayers to route their income through the lowest rate path. This gamesmanship might involve employees attempting to recast themselves as independent contractors or driving up pass-through entity profits by lowering owner salaries. These and other techniques aren't new ideas; they are just old ones with a new purpose.
 

But the concern for this new application is real. Treasury Secretary Steve Mnuchin recently said the President’s legislation would include rules to prevent people from gaming the system, but it seems unlikely that the guidance and regulation needed to adequately provide such safeguards would be achieved anytime soon. And one can easily look to similar incentives on the state level in places such as Kansas and Ohio to determine if the goal of spurring business investment via a low pass-through rate has worked. 
 
While such a change in pass-through rates at the federal level likely would spur creative thinking from savvy tax professionals that would yield enhanced tax savings for business owners, there appears to be a much more straightforward way to achieve the economic goals of the government while fitting more seamlessly into a broader tax structure.
 
Prior to the Tax Reform Act of 1986, many smaller businesses were organized as C Corporations. S Corporations were also popular, and LLCs hadn't made it to the scene yet. A C Corporation was a viable option because the gain on the sale of a business’ assets could be done tax free and there was typically only one tax to the owner when the company was disposed. This came as a result of a doctrine put forth in a 1935 case called General Utilities & Operating Co v. Helvering (General Utilities doctrine). Since 1986 however, when the General Utilities doctrine was repealed, one of the knocks against C Corporations has been that they are subject to a double tax on the sale of the company.
 
If the upcoming tax reform proposals were to drop the alternative pass-through entity rate scheme and simply reinstate the General Utilities doctrine, small businesses easily could take advantage of the proposed lower C Corporation rates if they cared to. Significant case law and existing laws and regulations provide well-defined "bumpers" to allow more certainty in tax planning. Other benefits of becoming a C Corporation also may be realized. For example, the Ohio small business income exclusion is limited to $250,000 of income, whereas there is no state income tax on any income taxed to C Corporations. There would be reduced compliance and administrative costs that can mushroom when a pass-through entity has numerous owners and does business in multiple states. C Corporations also can choose any fiscal year that suits them to report their income, and this can lead to enhanced tax benefits as well as the ability to choose a more convenient time of year for internal accounting staff to deal with year-end responsibilities.
 
All in all, the desired small business incentive can be achieved with significantly more simplicity than current proposals. Adding back in the General Utilities doctrine may even score better with the Congressional Budget Office, as there is less speculation on the economic impact as the feared gamesmanship will be conducted on familiar ground and is less likely to provoke wild schemes from the ill-informed. Unfortunately, simplicity does not seem to fit on the current stage, and it's likely this old dog can't hunt anymore. Stay tuned for the great reveal.
 
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