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
