One of the more anticipated features of the House tax bill was a proposal to apply a special reduced tax rate to business income derived by individuals through sole proprietorships, partnerships and other pass-through entities and arrangements. We have previously written about the proposal from a private equity perspective as well as from an overall tax policy perspective.
The bill follows through on the proposal and introduces a special 25% maximum rate on “qualified business income” derived by individuals, but imposes several limitations on eligibility designed to prevent the conversion of wages and other personal services income into business income. The bill also proposes several corresponding changes to the self-employment tax rules that could increase self-employment taxes for certain small business owners.
Eligibility. The proposed bill divides pass-through business activities into three general categories:
- Passive business activities. An individual would be eligible for the 25% rate on all income derived from “passive business activities.”
- A business activity would be treated as a “passive business activity” of an individual if the individual is not actively engaged in the relevant business (i.e., the business is a “passive activity” of the individual under the passive activity loss rules of Section 469 of the Internal Revenue Code).
- For example, a private equity fund investment in an “operating partnership” (i.e., an entity that is treated as a partnership for tax purposes and is engaged in a business) would generally constitute a “passive business activity” for the individual investors in the fund.
- Active business activities (other than specified service activities). Except as described below with respect to “specified service activities,” an individual would generally be eligible for the 25% rate on 30% of the income he or she derives from an “active business activity.” For an individual subject to tax at the highest marginal rate, this would produce a blended marginal rate of 35% on active business activity income.
- A business activity would be treated as an “active business activity” of an individual if the individual is actively engaged in the relevant business (e.g., if the business is not a “passive business activity”).
- The 30% limitation is a “rough justice” attempt to impose the full ordinary income tax rate on income attributable to an individual’s labor. The explanation accompanying the bill states that the 70% presumption is based on data showing that labor has accounted for approximately 70% of national income over the last several decades.
- If an active business activity is capital-intensive, an individual participating in that activity could elect to use the “Applicable Percentage,” instead of 30%. The “Applicable Percentage” is the percentage of the income derived by the individual from the active business activity that is deemed to be a return on the capital of the business, determined by applying an interest rate to the individual’s share of the adjusted tax basis of the assets that are used in the business.
- The percentage of an individual’s income from an active business activity that would be eligible for the 25% rate is capped in all cases at the percentage of such income that does not constitute wages, payments made by a partnership other than as distributions of the individual’s share of the partnership’s profits (e.g, guaranteed payments or payments to the individual other than in his or her capacity as a partner) or directors fees (the “Percentage Cap”). Thus, if 80% of the income derived by an individual from an active business activity constitutes wages, only 20% of the income the individual derives from such activity would be eligible for the 25% rate.
- Specified service activities. Except in the case of an individual who elected the Applicable Percentage, an individual would generally not be eligible for the 25% rate on the income he or she derived from any interest in an “specified service activity.”
- A “specified service activity” is an active business activity in which the principal asset is the reputation or skill of individuals (e.g, a professional services business). This category would include firms providing services in the fields of health, law, engineering, architecture, accounting, consulting, financial services and brokerage services. In addition, investing, trading or dealing in securities, partnership interests or commodities would be treated as specified service activities.
- Subject to the Percentage Cap discussed above, if an individual’s Applicable Percentage with respect to a specified service activity is at least 10%, the individual may elect to apply the 25% tax rate to the Applicable Percentage of the income he or she derives from the specified service activity.
Determination of “net business income.” In general, the income from a business activity that may be eligible for the 25% rate is the net income derived by an individual from such business activity (“Qualified Business Income”). Qualified Business Income includes not only the individual’s share of business income of the pass-through enterprise, but also wages, payments made by a partnership that constitute either guaranteed payments or payments to the individual other than in his or her partner capacity, and director’s fees. However, capital gains and losses (whether long-term or short-term), dividends, dividend-equivalents, interest, gains and losses from foreign currency transactions and other commodities transactions (subject to certain exceptions), income, gains losses and deductions from notional principal contracts and certain other generally passive types of income, gains, losses and deductions are not taken into account for purposes of determining Qualified Business Income. Net income of this latter type is thus not eligible for the 25% rate (although long-term capital gain and qualified dividend income would be taxed at lower rates). For purposes of determining Qualified Business Income, net business loss for any taxable year is carried forward to reduce net business income for subsequent years.
Because the House bill would repeal the deduction for state and local income taxes for non-corporate taxpayers, the special 25% rate would apply to an individual’s share of a pass-through entity’s net income without reduction for state and local taxes imposed by states in which the pass-through conducts business.
Coordination with self-employment tax rules. The bill would also significantly change the manner in which the self-employment tax applies to an individual’s share of the net income of a pass-through entity.
- Under current law, self-employment taxes are generally calculated based on the individual’s income or loss from a trade or business carried on by the individual, including through a pass-through entity. However, an individual’s share of income received in its capacity as a limited partner (other than as guaranteed payments) is not subject to self-employment tax. The limited partner exception has been the subject of much controversy and litigation in recent years, particularly in its application in the context of limited liability companies and limited liability partnerships.
- The House bill would repeal the limited partner exception. It would also provide that individuals are subject to self-employment tax on their “labor percentage” of trade or business income, including from pass-through entities, which is generally 70% but could be less for certain capital-intensive businesses. Specifically, if an individual elects an Applicable Percentage that is greater than 30% for purposes of determining the percentage of the income from an active business activity that is eligible for the 25% rate, as described above, the individual’s “labor percentage” for that activity would be the excess of 100% over the Applicable Percentage. These changes could increase self-employment taxes for owners of small businesses who have previously relied on the limited partner exception.