Most of the discussion around anticipated U.S. tax reform has focused on the possible impact to corporate America.
While most of the large businesses in the United States operate as taxable corporations, there are almost four times as many employee/owner businesses operating through partnerships, limited liability companies, S-Corporations and other "pass-through" entities. As a result, pass-through entities must be included in any business tax reform, and any changes affecting these entities should also consider the proposed personal tax changes before other aspects of reform.
Taxation of pass-throughs
Under current U.S. tax law, income earned by pass-through businesses is taxed as income earned by its owners, at individual rates up to 39.6%, not far off from the top corporate tax rate of 35%. However, corporate income also faces a second tax when it's paid out as dividends to its shareholders, resulting in a tax of 45% on a fully distributed basis.
The House Republican's plan for tax reform, known as the House Blueprint, proposes a 25% tax rate for active business income earned through pass-through entities (compared to 20% for business income earned through corporations). However, if a 25% tax is applied to pass-through income, and the personal income tax is decreased to the proposed 33% top rate, this could create incentives to shift income into pass-through entities and the federal government could lose significant revenue. To address this issue, the House Blueprint proposes requiring employee/owners of pass-through entities be paid a "reasonable compensation".
To illustrate, compare the proposed 25% total tax rate of business income earned through pass-throughs under the Blueprint with no "reasonable compensation" rules (pass-through I in the following example), with the 33.2% effective tax rate applicable to business income earned through a corporation, or the 33% personal tax rate. The 25% tax rate on active business income earned through a pass-through entity provides a significant decrease in the tax cost of operations. Clearly, the requirement that a "reasonable compensation" be paid to employee owners is intended to mitigate part of the decrease in taxes that would otherwise result.
One option the Republicans are considering is incorporating a fixed ratio numerical split that would allocate 70% of pass-through income to wages and 30% to business profits (pass-through II in the example above). While this would certainly be easy for a resource-constrained IRS to implement and audit, it may not be accepted by U.S. voters. And it may be overgenerous to service partnerships that generate all of their income from personal services and for which an argument exists that 100% of income is reasonable compensation. Any deviation from a fixed ratio into a determination based upon facts and circumstances will complicate taxation. Complexity is also bound to arise from the application of the 25% rate to "active" business income.
General business proposals and pass-throughs
In addition to the pass-through specific issues, the United States must also consider how other areas of tax reform may apply to pass-through entities, including full expensing of assets, limitations on interest deductions and NOLs, and border tax adjustments (for more on these rules, see TaxNewsFlash-Canada 2016-56, "U.S. Election Results Spark Tax Reform Talk"). In each case, it must be determined whether the tax applies at the owner or at the pass-through entity level. For example, if interest expense deductions are limited to interest income, the U.S. will have to determine whether it is the owner of the pass-through entity that relevant, and whether an expense disallowed and carried forward at the pass-through entity level can be applied to offset net interest income at the owner level.
Similar questions apply to full expensing of assets, which could create significant losses in some years, with accompanying loss limitation rules. Having a valuable asset with zero tax bases then requires rules for basis adjustments when certain transactions occur. Any tax reform would need to address adjustments to owner's basis when property is contributed, and required basis adjustments when interests in the entity are transferred. As the net operating losses pass through to owners, the U.S. must consider whether the 90% limitation will apply at the owner or pass-through entity level, leading to requirements for tax distributions for the 10% of income not covered.
The application of the controversial border adjustment tax system will be more difficult, particularly for the cross-border structures familiar to Canadian businesses (see Global Tax Adviser, "Border Adjustment Tax - What Canadians Should Watch For"). The border adjustment tax would allow a deduction, or income offset, for any goods or services exported by a U.S. business. Where a U.S. corporation provides goods or services to a non-U.S. partnership, this would be considered an export. Any tax reform would have to address whether that determination would change where the partnership operates a business in the United States, where the partnership is owned in whole or in part by U.S. owners, or where it distributes the goods to a U.S. owner.
Regardless of how Congress ultimately decides to tax pass-through entities, any fundamental changes will lead to additional complexity. Decisions made on the taxation of pass-throughs will clearly affect any overall tax reform.
For more information, contact your KPMG adviser.
Information is current to March 10, 2017. The information contained in this publication is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavour to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act upon such information without appropriate professional advice after a thorough examination of the particular situation. For more information, contact KPMG's National Tax Centre at 416.777.8500