Passthrough income under the New Tax Reform

Passthrough income: Under a new Sec. 4, a portion of business income distributed by a passthrough entity, such as a partnership, S corporation, or limited liability company, would be taxed at a maximum rate of 25%, instead of at ordinary individual income tax rates, effective for tax years after 2017. The rest of the business’s passthrough income would be treated as compensation and would be subject to ordinary individual tax rates.

Income from passive activities would be taxed entirely at the 25% rate.

Business owners receiving income from active business activities (including wages) would determine the amount of their business income eligible for the 25% rate by reference to the “capital percentage” of their net income from the activity. As a safe harbor, owners would be able to elect to apply a capital percentage of 30% to their business income—meaning 30% would be eligible for the 25% rate, and the other 70% would be taxed at ordinary income rates.

However, owners will also be allowed to make a facts-and-circumstances determination of their capital percentage if that will result in a capital percentage greater than 30%. The formula would be based on the federal short-term rate plus 7 percentage points multiplied by the owner’s capital investment in the business. An owner who chooses to use this formula would be required to use it for a five-year period.

Income subject to preferential rates, such as net capital gains and qualified dividend income, would be excluded from the determination of the owner’s capital percentage and would not be recharacterized as business income. Certain other investment income subject to ordinary income tax rates, such as short-term capital gains, would also be ineligible for recharacterization as business income.

To prevent owners from recharacterizing wages as business income, the capital percentage would be limited if actual wages or guaranteed payments exceed the owner’s otherwise applicable capital percentage.

For specified service activities, the applicable percentage of business income that would be eligible for the 25% rate would be zero. These activities are those defined in Sec. 1202(e)(3)(A) (any trade or business involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees), including investing, trading, or dealing in securities, partnership interests, or commodities.

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