Tax reform: Advisers spy loopholes in proposed pass-through tax rules

Financial advisory firms might feel snubbed by the House’s tax-reform package that specifically excludes such service-sector businesses from a lower tax rate, but that doesn’t mean advisers and tax planners won’t be busy helping their business-owner clients navigate the proposed rules.

“I think there will be some repositioning within family businesses,” said Leon LaBreque, managing partner and chief executive at LJPR Financial Advisors.

“My mind is already whirling as I’m thinking about what we can do with this new tax plan,” he added. “It certainly presents some cool and provocative questions.”

The House Republicans’ tax plan cuts the tax rate on a portion of the income of so-called pass-through businesses to a top rate of 25% from a current top rate of 39.6%.

Pass-through businesses are typically structured as sole proprietorships, partnerships and S-corporations.

Unique from corporations, in which income is taxed at both the corporate level and as that income is paid out, income from pass-through entities is taxed once.

Financial advisory firms, along with other service-sector business like law firms and accounting firms structured as pass-through entities are generally excluded from the lower tax rate because the rule was written to primarily support capital-intensive manufacturing businesses.

Tax professionals described the exclusion of service-sector businesses as a unique and unprecedented proposal.

But even for firms that qualify for the lower tax rate, the rule would only allow 30% of the business income to be taxed at 25%. The remaining 70% would be taxed at the business owner’s individual tax rate, which includes paying additional individual taxes such as Social Security and Medicare.

The 30% limit was introduced as part of the proposal to prevent business owners from claiming a smaller percentage of the business income as salary and receiving a larger percentage through the lower-taxed business.

“If I’m a pass-through I’m probably optimizing compensation to take the least amount of salary as possible,” said Armand D’Alo, a tax specialist and co-founder of Oak Tree Advisory Services.

“They wrote that part smart, by locking in the owner’s income at 70% of the business income,” Mr. LaBreque said.

But even as Mr. LaBrecque gives the authors credit for tightening the loophole on optimizing business income for tax purposes, he believes the new rules will still create opportunities for strategic tax management.

“The way I read it, the 70-30 rule is a presumption, which means you could rebut it,” he said. “Maybe you could lobby for more than 30% of a business’ income being taxed at the 25% rate.”

Anjali Jariwala, a financial planner at FIT Advisors, is also pondering ways that her clients might benefit, even though most of her clients are physicians that would likely qualify as service-sector businesses and thus not be able to take advantage of the provision.

“The default seems to be 70-30, and there’s an exception for service providers unless you make an election, and then you have to prove you are eligible to classify some of the income under the 25% rate,” she said. “It seems to be geared toward businesses that are capital intensive, and there is a multi-step process to determine what that is. So, I’m wondering if doctors that purchase a lot of equipment would qualify.”

Indeed, just days after the initial proposal was unveiled by the House Ways and Means Committee, and with much political wrangling ahead, there are lots of unanswered questions.

There is also the distinction between active and passive income with pass-through entities.

Jeff Erickson, a principal at E&Y, explained that passive income, such as income from an investment in a master limited partnership, would be 100% eligible for the 25% tax rate, but it is not yet clear how the income on real estate investment trusts would be treated.

“In terms of passive-versus-active income, it is a nuanced definition,” he said. “At a very high level, it is the difference between just putting money into the business and hoping for a return, or actually doing stuff related to the generation of income.”

This is one of the areas where Mr. LaBrecque sees a potential opportunity.

“If grandpa is retired, but still owns part of a manufacturing business, that should make him a passive investor,” he said. “Or, what if grandpa owns the building and rents it to junior to run a manufacturing business? These are the kinds of questions we need answered about this pass-through rule.”

Mr. LaBrecque added that even his advisory firm could potentially carve out a non-service portion to qualify for the 25% rate.

“I’ve written six e-books,” he said. “What happens if I put the copyrights to those e-books in a separate pass-through entity?”

On the active-income side, including owners and partners actively operating a business, Mr. Erickson said he has never seen a specific category of businesses, such as the service sector, excluded from the pass-through tax rate.

“I think the distinction really relates to trying to provide an incentive to more capital-intensive businesses, versus service-intensive businesses, where you don’t need a lot of capital to generate income,” he said.

From Mr. Erickson’s perspective, even some manufacturing businesses might not automatically meet the 30% threshold for the lower tax rate.

“A business that is more labor intensive, even as a manufacturer, might not be able to get 30% of income eligible because wages count as income,” he said. “If wages equal more than 70% of business income, that 30% would be cut back.”

Considering all the new wrinkles, Ms. Jariwala said some pass-through businesses will now be considering whether it makes more sense to convert to a traditional corporation, on which the proposal cuts the tax rate to 20%, while the earnings passed on are still taxed a second time.

“It seems like they are trying to balance the appeal of pass-throughs and C-corps, but even with two levels of taxes, the C-corp could still be a better rate for some people,” she said. “I’m not looking forward to January if this bill goes through as is. It’s clear, but it’s not, because there is need for a lot of interpretation.”