We have much to be thankful for in the U.S., though taxes are not usually thought of as one of our many blessings. Tax reform, if enacted, will provide benefits to many, but there is still significant work ahead when it comes to reconciling the differences between the House version and the proposed Senate version. Much of the current effort is focused on two major areas that may affect many businesses and their owners: the corporate tax rate (and non-deductibility of dividends paid) and the flow-through business tax rate.
Senate Finance Committee Chairman Orrin G. Hatch (R-Utah) has been pushing for a dividends-paid deduction as a way to integrate the corporate and individual income tax systems. This concept, known as corporate integration, would help reduce what Hatch and others object to as the double taxation of corporate profits distributed as dividends. Under current law, corporate profits are taxed at the entity level and then taxed again as dividend income at the shareholder level. Legal avoidance of this double taxation is a main driver for closely held businesses to often choose to be taxed as an “S” corporation or as a partnership rather than a “C” corporation.
A new provision in the current Senate version of the tax reform bill provides for a zero percent deduction for dividends corporations pay to shareholders. Under current law, there is no deduction for dividends paid to shareholders (unlike the deduction for interest paid to bond and debt holders), so why then is there a need for new specific language that provides for a zero percent deduction, unless a negotiation may be taking place that provides for some percentage of dividends paid to be deductible? Whether this may be just a placeholder for future consideration, or that it is an indicator that this item is being seriously negotiated, is not clear. It is possible that lawmakers are using the provision to establish a framework for corporate integration, but will not actually change the zero percent rate in the tax reform package they are hoping to pass before the end of the year. If that is the case, the provision might lay the groundwork for movement toward “corporate integration” in the tax code.
Whether this deduction could be enacted simultaneously with a corporate tax rate reduction from 35% to 20% is not certain. The 20% corporate tax rate is almost like a line drawn in the sand. It has become symbolic, with many business leaders, politicians and analysts buying into the rate, but the effects of a higher corporate rate could be offset by now allowing some level of deduction for dividends paid.
Pass-through relief, meanwhile, may be one of the most revised sections of tax reform over the coming weeks. Many pass-through businesses – which include partnerships, S corporations, single member LLCs and sole proprietorships – have been unhappy with the approach taken by both the House and Senate bills for lowering tax rates on pass-through entities citing a larger tax rate reduction for corporations. Since Republicans hope to pass a tax bill by the end of the year, there’s not a lot of time remaining to redraft provisions related to pass-through taxation and it’s likely changes will need to be incorporated into the two regimes that already exist.
While both plans include provisions that target cuts to pass-through entities, they go about the reduction differently. The Senate measure provides a 17.4 percent deduction for pass-through income with the net taxed at the individual rates. The House tax bill, meanwhile, would allow businesses to subject 30 percent of their income (or calculate an amount based on income from capital assets) to a 25 percent rate. One possible solution might be for the Senate bill to increase the deduction amount from the 17.4 percent currently proposed.
While it’s often said the only two certain things in life are death and taxes, what is not so certain is how those taxes will be assessed. Please stay tuned for updates; we will continue to monitor developments and provide our insights. In the meantime, if you have questions regarding tax reform and business income taxes, contact us.