The Senate’s tax reform mark provides for favorable tax treatment of so-called “pass-through” business income derived by individuals by permitting an individual taxpayer generally to deduct 17.4% of “domestic qualified business income” from a partnership, S corporation, or sole proprietorship. The House tax bill, by contrast, provides a special 25% maximum rate on certain types of business income derived by individuals through partnerships, S corporations or sole proprietorships.
The Senate proposal also introduces a new rule, that is not in the House bill, that would require a non-U.S. shareholder to treat all or a portion of the gain from the sale of an interest in a U.S. “operating partnership” as “effectively connected income,” effectively overturning a recent Tax Court decision and codifying a prior IRS revenue ruling.
Deduction for domestic qualified business income. Under the Senate proposal, an individual is eligible for a 17.4% deduction from net income derived from qualified domestic businesses. Similar to the House bill, most services trade or businesses (including financial services) would not qualify. However, the Senate plan would allow the 17.4% deduction for taxpayers with income from services trade or businesses of $75,000 or less ($150,000 for joint filers), which is phased out over the next $25,000 of income ($50,000 for joint filers). Qualified business income would not include any amount paid by an S corporation that is treated as reasonable compensation of the taxpayer or any amount paid by a partnership to a partner as a guaranteed payment or for services provided to the partnership in a capacity other than as a partner. Similar to the House bill, the JCT summary states that qualified business income or loss also does not include certain investment-related items of income, gain, deductions, or loss (other than dividends from REITs), but the summary does not specify what types of these items are ineligible. The determination of qualified items takes into account items only to the extent they are included or allowed in the determination of taxable income for the year. Net losses from qualified items may be carried forward to offset qualified income in subsequent taxable years.
Because the Senate tax bill repeals the deduction for state and local income taxes for non-corporate taxpayers, the deduction would apply to an individual’s share of a pass-through entity’s net income without reduction for state and local income taxes imposed by states in which the pass-through conducts business.
Wage income limitation. In the case of a taxpayer who receives qualified business income from a partnership or S-corporation, the amount of the deduction is limited to 50% of W-2 wages paid by the entity. The JCT summary does not provide additional detail on this limitation. One plausible interpretation of the language is as a pro-jobs incentive that would limit the amount of partnership or S corporation income eligible for the deduction to 50% of the W-2 wages paid by the partnership or S corporation (to the employees of the entity and possibly a share of the partner’s or shareholder’s income treated as labor income). In any event, the description of this limitation in the JCT summary is unclear and more cannot be known until actual legislative text is released.
Sale of an operating partnership interest by a non-U.S. partner. The Senate proposal would also provide that gain or loss from the sale or exchange of an interest in an operating partnership generally would be treated as effectively connected with a U.S. trade or business. This proposal would effectively codify Revenue Ruling 91-32, which had been rejected by the U.S. Tax Court earlier this year in Grecian Magnesite Mining v. Comm’r, 149 T.C. No. 3 (July 13, 2017) (which we discussed in a July memorandum). The Senate tax bill would also require the transferee of a partnership interest to withhold 10% of the amount realized on the sale or exchange unless the transferor certifies it is a U.S. person. If the transferee fails to withhold the correct amount, the partnership would be required to deduct and withhold the shortfall from distributions to the transferee.