U.S. Tax Reform Update: Partnership Tax

Among several ambitious proposals relating to U.S. tax reform, the U.S. Congress and President aim to reduce U.S. federal corporate income tax rates from the current 35% to around 20-25%.

Lawmakers propose to apply the same reduction to partnership tax. Whether a business is incorporated or held through a partnership or LLC, the notion is to tax business profits at the same low rate of 20-25%.

This idea has an appealing simplicity. But applying it to partnerships is complicated.

For example, suppose that the business income tax rate is lowered across the board to 20%, and the highest individual income tax rate is lowered from the current 39.6% to 33%. In the case of a typical professional services business formed as a partnership, income derived by the owners would be subject to the 20% tax rate. Employees, on the other hand, would be subject to tax at individual rates of up to 33%.

Even in this simple example, the result does not seem quite correct. As a remedy, one proposal is to tax 70% of the partnership’s income as wages and only 30% of a partnership’s income as business income. In the example, the owners of the business would pay tax at rates of up to 33% on most of their income—the 70% treated as wages. Only 30% would be taxable as business profits at the 20% rate.

If the 70/30 proposal works reasonably well for professional services firms, it might not work as well for other businesses. For example, consider the sole proprietor of a corner grocery store. The above changes would appear to provide no benefit to the sole proprietor, who would continue to be taxed at rates of up to 33% on her entire business profits.

One potential outcome of this proposed change would be the temptation would be for every taxpayer, whether large or small, to own any kind of “business” through a partnership.

If, however, the sole proprietor were to form a partnership, then the favorable rate of 20% would apply to at least some of her business profits. As a result, the temptation would be for every taxpayer, whether large or small, to own any kind of “business” through a partnership. Would a partnership arise if a business owner were to entice an investor into holding a mere 0.1% interest?

One solution would be to classify an individual human being as a business entity solely with respect to her business activities. U.S. lawmakers apparently have considered this approach in the past. But despite its theoretical appeal, treating an individual as an entity—in whole or in part—seems fraught with practical difficulty.

The partnership tax proposals could generate other unusual consequences. For example, holders of carried interests might enjoy a bit of relief. The “carried interest” is a chief source of profit for general partners of private equity funds. Carried interest currently is taxed at roughly 20%. Even if Congress changes the law, so that carried interest is subject to high individual income tax rates in the future, the above proposals might still permit at least some carried interest (i.e., 30% of partnership income) to continue to be taxed at low business income rates.

Legislation giving effect to these proposals has yet to be introduced. But it seems fairly likely that corporate tax rates will fall below 35%. If this occurs, it also seems relatively likely that lowered rates would also apply to partnership income.

At least some partnership income clearly should remain taxable as wages. But any mechanism to achieve this result, such as a modified version of the 70/30 split, seems likely to generate new opportunities for U.S. tax avoidance. Despite the risk, history indicates that Congress will not shy away from introducing further complexity into the area of partnership taxation.