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Active and Passive Businesses and the Proposed Tax Reform Bill

Yes, I’m only a bill. And I got as far as Capitol Hill.” – Schoolhouse Rock

Welcome back, dear reader. I acknowledge that some time has passed since I’ve checked in. When things are too quiet here on the blog, that’s just the quiet before the storm. Oh, how the storm has come to the mental and physical plains inhabited by Brinen & Associates.

Last week, a major event occurred that propelled me back into the blogosphere – one that could “bigly” impact your small business and mine – and that’s release of the proposed “Tax Cuts and Jobs Act” (though, I prefer to call it the “Cut Cut Cut! Act”). I am going through the section-by-section guide to the bill courtesy of LexisNexis and the gestalt of it seems to be that, unless you are a billionaire real estate mogul, there’s not much to like about it.

Before we dive in – today and several times in the near future – let’s identify some basics.

There are two types of businesses for today’s purposes: active and passive. An active business is one where there are employees “actively” working to deliver goods and services. Active would include small and solo businesses like law firms, personal trainers, online media startups, home health nurses and accountants. Passive businesses, like a landlords or real estate holding companies, are ones that do not materially participate in regular trade or business activities. The proposed bill is sweetening the deal for passives. According to the bill:

Under the provision, a portion of net income distributed by a pass-through entity to an owner or shareholder may be treated as “business income” subject to a maximum rate of 25 percent, instead of ordinary individual income tax rates. The remaining portion of net business income would be treated as compensation and continue to be subject to ordinary individual income tax rates.

Passive businesses will all be treated to a 25 percent tax rate and not the historic 39.6 percent rate. Additionally, instead of simplifying the process, the authors of the bill are presenting a formula.

Alternatively, owners or shareholders may elect to apply a formula based on the facts-and-circumstances of their business to determine a capital percentage of greater than 30 percent. That formula would measure the capital percentage based on a rate of return (the Federal short-term rate plus 7 percent) multiplied by the capital investments of the business. Once made, the election of the alternative formula would be binding for a five-year period.

Under the provision, the default capital percentage for certain personal services businesses (e.g., businesses involving the performance of services in the fields of law, accounting, consulting, engineering, financial services, or performing arts) would be zero percent. As a result, a taxpayer that actively participates in such a business generally would not be eligible for the 25-percent rate on business income with respect to such personal service business.

In theory business owners in New York, the epicenter of the financial and business world, are in trouble. They are about to be violated in the most biblical of ways. Filthy.

However, the provision would allow the same election to owners of personal services businesses to use an alternative capital percentage based on the business’s capital investments. This election would be subject to certain limitations. The provision would also apply a maximum 25-percent rate on certain dividends from a real estate investment trust (REIT) and patronage dividends from cooperatives.

Read that last line again. Who do we know who worked in real estate and REITs?

You can try to elect out of it but you’ll be paying business lawyers and tax planners for their services to do so. There is a simple two-part strategy to avoid this, should it become law.

  1. You will need to change your company’s form of entity, which we can help you accomplish.
  2. You will need vote blue in the next election.

I may be biased, but President Reagan’s tax guy thinks this is nuts, too. At the end of the day this act reeks of stupidity and kleptocracy, and thankfully, it’s just a bill for now. As a business owner who handles taxes and business matters, this is great for my company and with the continued work this will throw my way, it will send my three girls to respective schools for NASA engineering, physics and chiropterology. I think you can tell how I really feel about it, though

We will eventually explore how this bill could potentially impact corporations and partnerships. Contact Brinen & Associates to discuss your business and tax strategies.

 

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