Highway advocates are accustomed to guardrails, but tax reformers and small businesses not so much. So it’s not surprising the head-scratching from those affected than over the “guardrail” for the lower passthrough business tax rate. To be clear, the Ways and Means Committee legislation provides an excellent starting point for powerfully pro-growth tax reform, but all acknowledge much work remains to be done. The tax code is complicated and the economy is complicated, so fixing the former to help the latter is no cakewalk.
One of tax reform’s pillars is substantially lowering the tax rates for all businesses. Chairman Kevin Brady’s (R-TX) efforts are right on target in this respect, with rates of 20% for corporations and 25% for pass-throughs. In principle, we appreciate the desire of some small business advocates for exact parity in rates, but since C corporation shareholders pay dividend and capital gains taxes on their returns, full parity could mean an additional layer of tax on the passthrough owners’ returns, and nobody should want that.
However, the “guardrail” issue remains. The guardrail issue is simply that with a disparity in the rates between wage income, which could face statutory rates up to 39.6%, and small business income at 25%, a strong incentive would exist to recharacterize a passthrough owner’s wage income as business income to gain the lower rate. Some device or options must be crafted to prevent such an obvious manoeuver.
Many passthrough owners seem perplexed that such a guardrail would even be needed. Perhaps one way to understand the issue is to consider the rhetorical question: Should C corporation CEOs pay a 20% tax on their salaries and bonuses just because their corporation does? No doubt most such CEOs would answer in the affirmative, at least privately, but the rest of us would be fairly unanimous in our opposition. The CEO should face whatever individual income tax rate applies to his or her labor income, and the corporation should face whatever rate is applicable to corporations. The same basic principle applies to pass-throughs, the complication being that often top management and ownership are one and the same.
The purpose of the guardrail is to try to ensure the lower tax rate applies to income earned as owners while the normal individual income tax rate applies to wages and salaries. That’s the theory.
The Ways and Means legislation provides a couple options passthrough can use as guardrails, one based on a simple rule that 70% of the business’s net income would be treated as wage income and 30% as business income subject to the lower rate. The merit of this proposal is its simplicity, but little more.
The legislation also includes a second method taxpayers can choose if it yields a better tax outcome. This method is based on the amount of depreciable capital the firm is using and so more closely relates to the underlying purpose of the lower passthrough tax rate. Tweaks to these methods and possible additional methods are certainly under discussion, so for those worried about this issue, the best advice is to stay tuned, more to come.