Pass-through income tax reform proposals

By Cara L. Smith, CPA, CFP


The House and Senate bills both provide tax benefits to owners of pass-through businesses (those taxed as S Corporations or Partnerships), but they use different methods to determine the benefit.  The House bill would impose a 25% maximum tax rate on pass-through business income.  Lower rates would be available for those pass-through business owners earning less than $225,000 ($112,500 for single filers).  Wage income would still be subject to the regular individual income tax rates.  To determine the split between wage and pass-through income from an active business, an election would be available to either (1) treat 30% as business income and 70% as wage income, or (2) determine wage income based on a ratio of capital invested.  Owners receiving income from passive business activities will be able to treat 100% as business income subject to the 25% maximum tax rate.  Businesses involved in the performance of professional services such as law, health, accounting, consulting, engineering, financial services or performing arts would not be eligible for the lower pass-through rate on income.

The Senate bill approaches tax savings for business owners using a deduction rather than maximum tax rate.  Starting in 2018, a deduction of 23% would be available for taxpayers with qualified business income for income from a partnership, S Corporation or sole proprietorship. The 23% deduction will be capped at 50% of wages paid by the business.  This 50% limit would not apply in the case of taxpayers with income of $500,000 or less for married couples filing jointly ($250,000 for other individuals).  Qualified business income would include all domestic business income other than amounts from (1) investment income (interest, dividends, capital gains, etc.), and (2) income from personal services (fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services or any trade or business with the principal asset of which is the reputation or skill of one or more of its employees).  There is, however, good news for taxpayer providing personal services is their taxable income is $500,000 or less, the 23% pass-through income deduction would apply to the income from personal services.

To illustrate tax liabilities under the current proposals, take for example, a business owner of an active pass-through business (not professional services) making $250,000 a year, $500,000 a year or $1,000,000 a year as a total of combined wages and pass-through business income.  Assume married filing a joint return and salary of $130,000 in all three examples.  The chart below reflects an estimate of the tax liability under the different proposals.  Notice the House bill reallocates the amount of income taxed as wages as 70% of the overall business income.

Example of $250,000 of Income
House Bill Senate Bill
Wages $175,000 $130,000
Pass-through Income 75,000 120,000
23% Deduction (27,600)
AGI $250,000 $222,400
Federal Tax 41,080 36,695
Example of $500,000 of Income
House Bill Senate Bill
Wages $350,000 $130,000
Pass-through Income 150,000 370,000
23% Deduction (85,100)
AGI $500,000 $414,900
Federal Tax 122,300 88,294
Example of $1,000,000 of Income
House Bill Senate Bill
Wages $700,000 $130,000
Pass-through Income 300,000 870,000
23% Deduction (200,100)
AGI $1,000,000 $799,990
Federal Tax 272,580 223,044