How Might Congress Limit Lower Passthrough Rate?

Published on: 16:24PM 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 some type of rate of return rules to each industry.  This rate of return would be applied to the capital base of the business and this income would be subject to the lower pass-through rate.  Amounts above this calculation would be subject to the higher tax rate.  For example, assume a farm business has $1 million of capital and the rate of return allowed is 8%.  The farm generates $300,000 of net income.  $80,000 ($1 million times 8%) would be taxed at the lower rate and $220,000 would be taxed at the higher rate.  A possible problem is whether this is based on FMV of farm assets or tax basis.  If based on tax basis, it is likely that a greater percentage of farm income would be subject to a higher rate.

As you can see, this can quickly get very complicated.  It is suggested that the last option may be the most "fair".  The first option has been very messy for both taxpayers and the IRS to determine "reasonableness" and mechanical rules are usually too arbitrary.

I will keep you posted as to the final outcome (if there ever is one).