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Pass-Through Entities

November 15, 2017
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The landscape of tax reform continues to change, with further mark-ups, compromises, and changes occurring in the near future. But we believe it important to communicate to you where we are now. Below is a detailed comparison of the Senate proposed tax legislation (released on November 13, 2017) as compared to the House proposed tax legislation, which includes mark-ups.

Topic

House Bill (H.R. 1)

Senate Plan

Pass-Through Tax Treatment

After 2017, 25% maximum tax rate on portion of pass-through entity net income distributions treated as business income (remaining portion of distributions treated as wage income subject to individual income tax rates). Owners or shareholders receiving distributions from active business activities would be able to elect to: (1) treat 30% as business income and 70% as wage income, or (2) determine ratio of business income to wage income based on capital investment. Owners or shareholders receiving distributions from passive business activities would be able to treat 100% as business income. Certain personal service businesses (e.g., businesses involving the performance of services in the fields of law, accounting, consulting, engineering, financial services, or performing arts) would not be eligible for the pass-through rate. Transition rules would apply.

Deduction for pass-through entities in lieu of changing rates.

 

After 2017, would generally allow an individual taxpayer to deduct 17.4% of domestic qualified business income from a partnership, S corporation, or sole proprietorship. Qualified business income would not include income from specified service trades or businesses, i.e., those involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, 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, except in the case of a taxpayer whose taxable income does not exceed a threshold amount (subject to phase-out).

Reduced Rate for Owners of Small Pass- Throughs

The bill would provide a 9% tax rate, in lieu of the ordinary 12%, for the first $75,000 ($37,500 for unmarried individuals, $56,250 for heads of household) in net business taxable income of an active owner or shareholder earning less than $150,000 ($75,000 for unmarried individuals, $112,500 for heads of household) in taxable income through a pass-through business. As taxable income exceeds $150,000, the benefit of the 9% rate relative to the 12-percent rate would be reduced, and it would be fully phased out at $225,000. Businesses of all types would be eligible for the preferential 9% rate, and such rate would apply to all business income up to the $75,000 level. The 9% rate would be phased in, such that the rate for 2018 and 2019 would be 11%, the rate for 2020 and 2021 would be 10%.

Qualified business income would not include any reasonable compensation paid by an S corporation, any amount allocated or distributed by a partnership to a partner who is acting other than in his or her capacity as a partner for services, or any amount that is a guaranteed payment for services actually rendered to or on behalf of a partnership..

 

The deduction would be limited to 50% of W-2 wages of a taxpayer who has qualified business income from a partnership or S corporation.

 

While qualified business income or loss would not include certain investment- related income, gain, deductions, or loss, dividends from certain cooperatives or a real estate investment trust (other than any portion that is a capital gain dividend) would be included.

 

If the amount of qualified business income is less than zero for a taxable year, i.e., is a loss, the amount of the loss would be carried over to the next taxable year.

S Corporation Conversion to C Corporation

Effective for S corporations which revoke their S corporation elections during the 2- year period beginning on the enactment date and have the same owners on both the enactment date and the revocation date, distributions from a terminated S corporation would be treated as paid from its accumulated adjustment account and from its earnings and profits. Adjustments under §481(a) would be accounted for over a 6- year period.

Not addressed.

Contributions to Capital

Beginning with date of enactment, contributions to capital of partnership would be included in partnership’s gross income unless exchanged for interest in partnership. Contributions in excess of fair market value of interest received would be included in gross income.

Not addressed.

Substantial Built-in Loss

Not addressed.

A partnership generally does not adjust the basis of partnership property following the transfer of a partnership interest unless either the partnership has made an optional election to make basis adjustments, or the partnership has a substantial built-in loss immediately after the transfer. After 2017, the definition of a substantial built-in loss would be expanded, as it affects transfers of partnership interests. Under the current provision, a substantial built-in loss exists if the partnership’s adjusted basis in its property exceeds by more than $250,000 the fair market value of the partnership property. Under the plan, a substantial built-in loss would also exists if the transferee would be allocated a net loss in excess of $250,000 upon a hypothetical disposition by the partnership of all partnership’s assets in a fully taxable transaction for cash equal to the assets’ fair market value, immediately after the transfer of the partnership interest.

Basis Limitation on Partner Losses

Not addressed.

After 2017, the basis limitation on the deductibility of partner losses would apply to a partner’s distributive share of charitable contributions and foreign taxes, which are exempted from such limitation under the current regulations.

Tax Gain on the Sale of Partnership Interest on Look-through Basis

Not addressed.

Gain or loss from the sale or exchange of a partnership interest would be effectively connected with a U.S. trade or business to the extent that the transferor would have had effectively connected gain or loss had the partnership sold all of its assets at fair market value as of the date of the sale or exchange. Any gain or loss from the hypothetical asset sale by the partnership be allocated to interests in the partnership in the same manner as non-separately stated income and loss. Rev.Rul.91-32 essentially is codified and the Tax Court rejection in Grecian is overturned via legislation. Effective for sales and exchanges after December 31, 2017.