The tangled web of pass-throughs

No doubt like many a tax-nerd, I spent part of the weekend trying to understand the senate and house tax bills and their impact on clients.  Obviously, it is a waste of time as there is no guarantee that either will become law as the tax acts are going to conference but, it is educational none-the-less.

I wrote the other day about how it works for individuals but now, what about someone who owns rental properties or other pass-through business?

Nothing I have read so far indicates that they are doing much in the way of changing the Passive Activity Loss (PAL) rules, so your investment in a rental property while probably still follow current law which means that you will likely not be able to take rental losses if you make more than $125K.  On the other hand, if your rental is a Passive Income Generator (PIG), you could see some tax savings… maybe.

What you should realize is that the very generous immediate write-off for business purchases does not include buildings.  You will still need to capitalize the purchase of rental property.  And it appears that the tax life will likely remain as it is today – 27.5 for residential and 39 for commercial.

If your rental is a PIG and throws off $10,000 of income, your tax liability would be no more $2,500 under the House’s version as this one taxes pass-through income at 25% maximum.  Obviously, if your total income puts you in a lower tax bracket, you would be taxed at that rate.  The senate version, on the other hand, provides a deduction of 23% of taxable income.  But as will all things tax-related, it isn’t quite that simple.  It limits the deduction to 50% of wages paid.

Since this is a rental property, you will likely not have employees.  Therefore 50% of zero is, of course, zero.  Since this is zero, you would pay tax at your regular tax rate.  Again, if you are in a lower tax bracket, it doesn’t really matter but, if you make more than $200,000, then you are in the 32% bracket and there really isn’t any savings.

The senate version is aimed at S Corporations and attempts to exert pressure on shareholder/employees to take “reasonable compensation”.  But take the following fact patterns.  Z Company has $1.0 Million of profits before taking into consideration officer wages.  Z Company employs 50 employees and has $2.0 Million in payroll.

50% of $2.0Million is $1.0 Million.  23% of $1.0 Million is $230,000.  Without the owner/officer taking payroll, they will get the full 23% deduction.  It doesn’t matter that the owner did not take wages.  For what it is worth, W2 wages could be as low as $560,000 in this example, with or without officer compensation, before the shareholder starts to lose the deduction.

Another problem is that both versions limit the types of businesses that can qualify.  Professional services businesses will not get to take advantage of the lower rates since it is assumed that professionals do not employ others.  So, take a doctors office: the doctor has a front desk person, an office manager, four nurses and the doctor.  Six employees.  Compared to a small contractor with a bookkeeper, a foreman and 4 laborers.  Also six employees.  If they both make the $1.0Million of profit and pay $600,000 in wages, the contractor gets the deduction of $230,000 and the doctor doesn’t.  This is true even if the contractor works more hours than the doctor.

It will be interesting to see how the pass-through entity issue plays out in conference.

Have a great day.

 

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