Plan would turn flow-through tax precedent upside down

The Trump administration has proposed tax reform based on vague premises sketched on one page. House Speaker Paul Ryan has also proposed more comprehensive Republican tax reform which mirrors some of those proposals. And President Donald Trump raised even deeper reform concepts before being elected. We don't yet know the seriousness of individual reform provisions in the context of the change desired, but tax reform has a real shot of actually happening - in at least some form. One proposed provision is worth serious reflection: The reduction of tax on flow-through entities to a 15 percent flat rate.

Reducing this tax rate to 15 percent would be a meaningful change. Flow-through entities tax at the owner level and include sole proprietorships, partnerships, LLCs and S corporations. Currently, their marginal tax rates can exceed 50 percent in California, as they're often subject to self-employment, alternative minimum and state taxes. According to some estimates, flow-through entities employ over 50 percent of the private sector work force and account for 37 percent of private sector payroll. Flow-through entities earn over a trillion dollars in income annually. Quirky Internal Revenue Code provisions provide varying advantages to the different structures. For example, an owner of an S corporation can designate income as either profit distribution or wages. A partnership can make distributions tax-free up to the amount of a partner's basis.

Should this tax reform provision pass, it will turn years of tax dogma on its head. Traditionally, under the current rules, taxpayers want to designate the maximum amount of income as compensation, not business profits. Compensation is deductible, while business profits are not. Meanwhile, the tax rates are roughly the same, hovering at around 40 percent at the highest level, with variability based on numerous factors. Compensation can also be used to determine the amount of (tax deductible) contributions to retirement plans, and, obviously, all income in a flow-through entity is taxed only once.

For years, the IRS fought to have reasonable compensation under IRC Section 162(a) and related regulations defined and restricted. Numerous Tax Court and other cases document the relevant standards. Such factors as the employee's qualifications; the nature, scope and extent of their work; size and complexities of the business; comparisons of salaries paid in the industry and entity; general economic conditions; comparisons of salaries versus shareholder distributions; and past year payments to the employee all bear weight. Given that many owners work in at least some capacity in their related flow through entity, determining a reasonable compensation number can be tricky. For example, deciding whether a payout is due to an individual's skills or is the result of a good business model or lucky investment is a complex determination.

So, while numerous Tax Court rulings have for years focused on lowering reasonable compensation to increase the amount allocable to the higher-taxed business profits, the IRS might regret all those victories. Suddenly, precedent would turn more taxpayer favorable. This issue continues to be subject to ever ongoing litigation today.

Using tax favorable structures to maximize deductions and minimize taxes paid has taken numerous forms over past years. Personal Service Corporations enjoyed popularity, especially in the entertainment industry. A highly compensated individual or "talent" could pool their (high) income with that of their employees to likewise determine deductible compensation and retirement account amounts. Sometimes, royalties and profit participation were bundled into "compensation." Originally, the income was taxed at graduated rates. The IRS made great efforts to minimize related tax favored treatment, disallowing excess compensation, whether statutorily or through the courts, for the structure. In 1987 Congress amended tax law to require Personal Service Corporations to pay tax at a flat 35 percent rate, making them less attractive.

Now, the IRS might need to "live by the sword, and die by the sword," with this proposed flow-through entity tax rate reform. If flow-through entities are taxed at 15 percent while our top compensation tax rates hover around 30 percent or higher, compensation income becomes less advantageous than business profits. Under the Trump plan, itemized deductions could also be capped, with most deductions no longer allowed. Thus, more ordinary (compensation) income at higher levels will be subject to tax. Compensation will thus be taxed at a much higher rate with fewer offsetting deductions reducing the percentage that is taxable.

A Department of the Treasury working paper from October 2015 determined that partnerships currently pay an average of 15.9 percent tax (marginally lower in real estate and finance), sole proprietorships pay 13.6 percent, C corporations pay a rate of 31.6 percent, and S corporations pay about 25 percent with a flow-through of 19.5 percent. Factors which lower the rate include capital gains and dividend income (about 45 percent of partnership income); tax exempt and foreign entities' lower rates; and unidentifiable and circular partnerships.

While these numbers might make the shift to a 15 percent tax rate for flow-through entities look less than dramatic, the practical reality is different. Each effective rate is based on careful balancing to achieve such lower rates, driven in large part by convoluted Internal Revenue Code provisions. For many individuals and corporations, the factors which can reduce their rate don't apply so the rate they pay a measurably higher rate.

Other tax-driven decisions will also be viewed through a different lens. If all income, including that derived overseas, will be taxed at 15 percent, some entities might decide to repatriate such funds instead of leaving them in holding structures overseas. Certain credits might also be reconsidered. For example, do we need an R&D tax credit if an entity has more internal research funds available since they pay less in taxes?

If business profits are to be taxed at 15 percent, and only once, then they will be taxed at the lowest rate available. Capital gains and dividends will still be taxed at 20 percent for those in the higher income brackets, as they are today. The business profits number is also net of all allowable deductions, which lower the taxable amount and which don't seem to be on the chopping block as they are for individuals (against ordinary income). Will investments be viewed differently as the tax rates on different forms of related returns are beginning to converge?

Commentary that this change would create a loophole in the tax system which could be exploited for tax avoidance purposes is only somewhat correct. As the Department of Treasury numbers attest, numerous tax loopholes already exist.

What is interesting is the idea that business income would be taxed at the lowest rate, with individuals still paying relatively high tax rates, contrary to what we've come to expect. What has been historically considered investment- or passive-related income would also be taxed at a higher rate. A big shift like this proposed one will lead to material changes in how best to classify income going forward, with the shocking disparities in the tax rates that result. The tax code has historically and increasingly been used to incentivize certain behaviors, and this reform will have that effect.