How Might Congress Limit Lower Passthrough Rate?
May 31, 2017
Both President Trump and the House have proposed a lower tax rate for farm income that comes from a pass-through (S corporation, partnership, etc.). Wage and other income would be subject to a higher rate, while the pass-through income would be capped at a possible lower rate (25% for the house and 15% for President Trump). With these lower rates, taxpayers will have an incentive to convert high-tax income to lower rates.
To prevent this type of “gaming” of the system, there will likely be rules in place to maintain the higher rate. However, how will these rules look like. Here are some possible provisions:
•Reasonable compensation – Currently, there are provisions in place to require reasonable compensation to be paid to owners from S-corporations. However, there is no definition in the income tax code as to what reasonable is. Therefore, most business owners, including farmers, err on the low side when it comes to compensation. The reduction in taxes under current law lowers self-employment taxes and has little effect on income taxes since the income is taxed at the same rate (whether wages or S corporation pass-through income). However, under the new law, there would be an incentive to keep wages low and pass-through income high. This would lower both payroll and income taxes.
•Mechanical Rules – Under this option, Congress could have a hard-and-fast rule that would apply some percentage of pass-through income at the higher rate and part at the lower rate. Former House Ways and Means Chairman Dave Camp had proposed a 70-30 rule in his 2014 tax reform. Under this rule 70% of pass-through income would be subject to regular tax rates and 30% to the lower rate. Self-employment tax would also be owed on 70% (silent on how it might effect pass-through farm rental income).
•Rate of Return Calculations – This option would apply…