THE SPECIAL TAX RATE FOR FLOW-THROUGH ENTITIES REALLY IS A BAD IDEA

I agree with fellow tax pro and tax blogger Peter J.  Reilly, who posts at FORBES.COM “Special Rate For Flow-through Entities Is A Really Bad Idea”.

 

Peter begins by comparing the scribblings on a cocktail napkin that is the current tax “plan” with the initial presentation of tax reform proposals that eventually became the Tax Reform Act of 1986 -

 

“. . . but the elderly curmudgeon in me can't resist reflecting on how comprehensive tax reform was handled in 1986. In 1984, the Treasury issued the two volume, Tax Reform For Fairness, Simplicity, And Economic Growth (Vol. 1. Vol. 2) .  All in it was over 700 pages.  The Unified Framework is nine pages.  Only it kind of looks like the nine pages you would get if a kid were assigned a ten page paper, figured he could get away with turning in nine, but realized he didn't have even nine pages of material and thought of every possible way to stretch it.”

 

He then goes on to address one of the cocktail napkin scribblings, described in the 10-page paper as -

 

“The framework limits the maximum tax rate applied to the business income of small and family-owned businesses conducted as sole proprietorships, partnerships and S corporations to 25%. The framework contemplates that the committees will adopt measures to prevent the recharacterization of personal income into business income to prevent wealthy individuals from avoiding the top personal tax rate.”

 

Pete “first heard about the concept of a special rate for pass through entities about six years ago”.  His response –

 

“I thought then it was one of the stupidest ideas I had ever heard, and continue to think that.”

 

As I said above I also oppose this scribbling from the Trump “framework”.  Small business earnings should not be taxed on the Form 1040 differently from salaries and other “ordinary income”.

 

I do not oppose lowering the corporate income tax rate, although I have suggested a better idea in “Something to Think About”.

 

Regular “C” corporation income is taxed twice – first at the corporate level and second when dividends are distributed to shareholders.  Lower income taxpayers pay 0% tax on “qualified” dividends, so there is some relief from double-taxation, but those with higher incomes pay 15% or 20%.  This is less than the corresponding tax rates on ordinary income, but it is still double-taxation.  Pass-through income from sub-S corporations, as well as self-employment income from partnerships and sole proprietorships, are taxed one time on the Form 1040 as ordinary income.

 

If you work for someone else, including your own C corporation, you receive a W-2 and your wages are taxed as ordinary income.  If you are self-employed, either reporting income expenses on a Schedule C or a partnership return, you do not receive a W-2 and your net income is taxed as ordinary income, and losses reduce ordinary income.

 

If you are a shareholder in a sub-S corporation you receive a W-2 for your salary, or at least should if you are actively involved, which is taxed as ordinary income, and the balance of the corporation’s net income is taxed on your Form 1040, also as ordinary income.  This is true whether or not you actually receive a distribution, the equivalent of C-corporation dividends, from the sub-S activity. 

 

The purpose of the sub-S corporation appears to be primarily to avoid the double-taxation of corporate income for small corporations (to be a sub-S corporation you cannot have more than 100 shareholders).  Before the creation of the LLC it was also a way to get some of the limited liability protection available to corporations for the self-employed, who would otherwise operate as a sole proprietor or partnership with full liability, while maintaining the tax benefits of a Schedule C or partnership.

 

Currently most sub-S corporations are “professional corporations” – those owned by licensed professionals such as attorneys, architects, engineers, accountants, physicians, etc.  Professional “C” corporations pay federal income tax on net income at a flat rate of 35%.  Pass-through income is taxed on the Form 1040 at between 10% and 39.6%, depending on the shareholder’s level of income.  Under existing tax law, the pass-through income from a sub-S professional corporation is often actually taxed at a lower rate than the C corporation flat 35% tax rate.

 

As a kind of funny aside, the IRS takes opposing positions on the “appropriateness” of the salary paid to the owner(s) of a one or few person corporation depending on whether the corporation is a “C” or an “S”.  In the case of a “C” corporation the IRS tries to say that the salary paid is too high, to create dividends that are doubly-taxed.  With a “S” corporation the IRS tries to say that salary paid is too low, to reduce the amount of net profit that is “passed-through” and avoids payroll taxes.

 

For the self-employed sole-proprietor or partner no salaries are paid to owners.  A Schedule C filer and partners pay tax at ordinary income rates on the entire net profit from the business activity – much of which is really the equivalent of W-2 earned income.  But these individuals also get a full tax deduction (although limited in certain situations due to basis and “at-risk”) for a net loss, reducing other income taxed at ordinary rates.  C corporations get to carry back or forward any net losses to reduce net income taxed at C corporation rates.

 

Taxing Schedule C and partnership and sub-S K-1 income at a lower rate could make those who work for someone else pay more tax on their earned income than those who are self-employed.  And the tax differential would most certainly disproportionately benefit higher income taxpayers – those who would be taxed on W-2 income at the new 35% rate.  It is obvious that this would result in higher income taxpayers creating pass-through entities for income that otherwise would be reported as W-2 income to avoid taxes big-time.  

 

Under my corporate tax reform proposal, which calls for a dividends-paid deduction, I would think there would be less need for sub-S corporation status.  There would be no double-taxation to be avoided, and LLC status would provide limited liability protection.

 

As a separate issue, self-employed sole-proprietors and partners are currently treated unfairly in the area of self-employment tax (the equivalent of FICA tax for employees. 

 

If you have a corporation for your self-employment activity you pay yourself a salary, on which you pay FICA tax.  You claim a corporate tax deduction for employer paid health insurance and pension contributions.  If your salary is $100,000 and your health insurance and pension deductions total $25,000 you are only paying FICA tax on $100,000.

 

If you are a sole-proprietor or partner you still get a deduction for your health insurance premiums and pension contributions, but as an “adjustment to income” reducing Form 1040 net taxable income and not as a deduction against self-employment income.  You begin calculating the self-employment tax on $125,000 of income.  So the sole-proprietor and partner will pay more FICA-equivalent self-employment tax than the corporate employee pays FICA tax on the same net income. 

 

Is all this too confusing?  Any questions?  What do you think? 

 

TTFN