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Editorial 7 MIN READ

The House 'Better Way' blueprint, read from a pass-through

A 25% top rate on active business income, full expensing, and a border-adjustment fight the Senate is not sure it wants

The Editors
Staff, Incorporator.org
7 min read Updated
Contents 5 sections
  1. What the blueprint actually says
  2. The border-adjustment argument
  3. How the scoring lands
  4. What to do in the meantime
  5. Sources

he number a pass-through owner is watching in January 2017 is 25. That is the top rate the House Republican tax blueprint would apply to active business income earned through an S-corp, partnership, or sole proprietorship — down from the 39.6% top individual rate that governs most of that income today. The blueprint is seven months old, the election has changed what it means, and the Senate has not yet agreed to any of it.

This is the state of the pass-through tax conversation as of the end of January: a House framework with specific numbers, a Senate posture that is visibly cooler, and a White House whose own one-page outline overlaps with the House plan on rates but not on the financing mechanism. Anyone budgeting a 2017 conversion, reasonable-compensation study, or equipment purchase needs to know what is in the blueprint and what is still argued about.

What the blueprint actually says

"A Better Way: Our Vision for a Confident America — Tax," released by Speaker Paul Ryan and Ways and Means Chairman Kevin Brady on June 24, 2016, is 35 pages and contains specific numeric provisions. On the individual side, the current seven brackets collapse to three — 12%, 25%, and 33% — with a standard deduction of roughly $12,000 for singles and $24,000 for joint filers, and a 50% exclusion for long-term capital gains, dividends, and interest income (producing effective top rates of 6%, 12.5%, and 16.5% on that income). The blueprint repeals the alternative minimum tax and the federal estate and gift taxes.

On the business side, the C-corporation rate drops from 35% to 20%, and "active business income" earned by individuals through pass-through entities is capped at a 25% rate. That second number is the one that matters for most readers of this publication. It is the first time a major House framework has proposed separating labor income from business income inside a pass-through, and it is also the place where the plan is most under-specified: the blueprint acknowledges that an owner-operator's wage-equivalent compensation will need to be taxed at ordinary rates, but it does not say how that line will be drawn. The existing "reasonable compensation" doctrine under the S-corp rules (long litigated — see, e.g., Watson v. Commissioner, 668 F.3d 1008 (8th Cir. 2012)) is the obvious template, but extending that doctrine to partnerships and sole proprietorships that have never operated under it is a non-trivial drafting problem.

The other two business-side moves are structural, and they travel together. First, the blueprint allows full and immediate expensing of capital investment — land is excluded, but buildings, equipment, software, and inventory all get 100% first-year deduction. Second, it eliminates the deduction for net interest expense on future borrowing. The trade is deliberate: you get to write off the asset today, but you no longer get to write off the cost of the debt you used to buy it. For a pass-through that finances growth with bank debt, that rearrangement is not neutral; it rewards equity-financed expansion and cash-financed equipment purchases and punishes leverage.

The border-adjustment argument

The financing leg of the plan is a destination-based cash-flow tax, the academic framework Alan Auerbach has promoted since the late 1990s and which the blueprint adopts as its corporate-tax structure. The border-adjustment piece is the specific feature drawing fire: under the DBCFT, revenue from exports is excluded from the tax base, and the cost of imports is not deductible. In plain terms, a U.S. retailer that imports sneakers would no longer subtract the cost of those sneakers from taxable revenue, which raises its effective U.S. tax bill even at the lower 20% rate.

The Tax Foundation estimates the border adjustment alone would raise roughly $1.1 trillion over ten years, offsetting a large share of the rate cuts. That is the plan's revenue spine. Without it, the arithmetic does not work at the rates quoted.

The early-2017 political problem is that the Senate is openly skeptical. Senate Majority Whip John Cornyn and Finance Chairman Orrin Hatch have each signaled reservations in recent weeks, and Hatch has floated that his committee may draft its own bill rather than wait for the House. Retailers (Walmart, Target, Best Buy), oil refiners, and the automakers have lobbied against the adjustment; exporters (Boeing, GE, Dow) support it. The retailers' argument is straightforward: even if Auerbach is right that the dollar will appreciate roughly 25% to offset the tax, the adjustment is not guaranteed to happen cleanly, and margins on imported goods are thinner than the transition.

For a pass-through, the border-adjustment debate matters less directly than it does for a C-corp importer, but it matters indirectly through the scoring. If the Senate strips the border adjustment, the 20%/25% rate structure loses its pay-for, and either the rates rise, the cuts shrink, or the deficit widens — any of which changes the planning calculus.

How the scoring lands

The two serious analyses out on the blueprint point in similar directions on magnitude, different directions on growth.

The Tax Policy Center's September 16, 2016 analysis found the plan would reduce federal revenue by $3.1 trillion over ten years before accounting for added interest costs and macroeconomic effects; debt would rise by at least $3.0 trillion in the first decade and $6.6 trillion in the second. Distributionally, TPC found roughly three-quarters of the net tax cut going to the top 1% of households, who would receive an average cut of about $213,000, or 13.4% of after-tax income. Households in the middle quintile would see an average cut of about $260, or 0.5% of after-tax income.

The Tax Foundation's 2016 analysis reaches a smaller static number — a $2.4 trillion ten-year revenue loss — and a much smaller dynamic number, a $191 billion loss, on the assumption that the plan would lift long-run GDP by about 9.1%, wages by 7.7%, and employment by 1.7 million full-time equivalents. Those are large estimates; they assume Auerbach's border-adjustment mechanics work as advertised and that full expensing produces a zero effective marginal tax rate on new investment. The Joint Committee on Taxation has not formally scored the blueprint.

The Congressional Research Service's forthcoming review (Gravelle, CRS R44823) reaches a similar $2.3 trillion ten-year loss figure excluding the ACA-tax repeals and finds that "the plan increases the after-tax income of higher-income individuals compared with lower-income individuals," with the top quintile gaining 5.5% versus 1.2% for lower quintiles.

What to do in the meantime

The blueprint is a framework, not a bill. It has not been introduced as legislation; the Senate has not signed on to its financing; and the new administration's one-page campaign tax outline differs on the corporate rate (15%), the pass-through rate (same 15%, without the wage/business income split), and is silent on the border adjustment. The odds that a 2017 bill emerges with the blueprint's exact numbers are low. The odds that some pass-through rate cut, some form of expanded expensing, and some version of lower corporate rates passes this year are materially higher.

For a pass-through owner looking at 2017, three observations are worth holding. First, do not restructure yet. Converting an S-corp to a C-corp to catch a 20% corporate rate that may be 25% by the time it passes — or may not pass — is the kind of tax-motivated move that looks expensive in retrospect. Second, if you are weighing a large equipment purchase, the current § 179 and bonus-depreciation rules already give most small businesses near-full expensing; you do not need the blueprint to pull that trigger. Third, the reasonable-compensation question is the one to watch. Whatever the final bill does with the pass-through rate, the line between wage income and business income inside a closely held entity is about to become the most litigated part of the tax code. S-corp owners who have been aggressive on low salaries should expect that position to get harder, not easier, regardless of which version of the plan survives.

The blueprint's authors want a bill on the President's desk by August. The people who have actually written tax bills do not think that is realistic. Plan for a framework in motion, not a rate you can rely on.

Sources

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