Owners of a trading business are anxious to learn if they will qualify for tax cuts with the House’s 25% pass-through rate or the Senate’s 17.4% pass-through tax deduction. While the two bills have a few things in common, they are vastly different, and both contain nuances for a trading business.
The House bill provides little relief for active owners of a service business, which likely includes a trading business. The Senate bill has a more generous provision for service companies.
Last week, the House passed its bill, the “Tax Cut & Jobs Act” (H.R.-1), and the Senate Finance Committee approved its modified mark. The Senate expects the Joint Committee on Taxation (JCT) to complete drafting its bill this week and release it for floor debate the week after Thanksgiving. Republican Senator Ron Johnson came out in opposition to tax reform proposals, saying they don’t go far enough to help small-business pass-throughs vs. big corporations. He’s right. In current form, the Senate’s modified mark is better than the House bill for active owners of pass-throughs, and I hope GOP leaders choose the Senate’s pass-through proposals, with further improvement, for final legislation.
Here are the steps required for a trading business to achieve tax relief under the House vs. Senate proposals. (Spoiler alert: It’s much easier in the Senate.)
The first requirement is business income
Because the House and Senate bills limit pass-through tax cuts to business income, a big question remains: Does income in a pass-through entity meet the definition of “qualified business income”? A trading business, eligible for trader tax status (TTS), with capital gains income, is likely not included in the definition of business income. But a trading business with Section 475 MTM ordinary income might be included.
Here’s my rationale. The House bill’s summary states, “Certain other investment income that is subject to ordinary rates such as short-term capital gains, dividends, and foreign currency gains and hedges not related to the business needs, would also not be eligible to be recharacterized as business income.”
The House bill goes on to state, “Net business income or loss shall be determined with respect to any business activity by appropriately netting items of income, gain, deduction, and loss with respect to such business activity.” The bill notes “certain investment-related” exceptions, a list that includes short-term and long-term capital gains, dividend income, any interest income other than interest income that is properly allocable to a trade or business, and annuities.
Section 475 ordinary income and rental income are not on the exceptions list. A TTS futures trader has lower Section 1256 contract 60/40 capital gains tax rates (60% is a long-term capital gain), so it’s doubtful he or she could qualify for the more moderate pass-through rates.
The Senate mark (JCX-51-17, Nov. 9) states, “Qualified business income or loss does not include certain investment-related income, gain, deductions, or loss.” This language is similar to the House summary.
A TTS forex trader has foreign currency ordinary income (Section 988) that is business-related. Without TTS, that forex trader’s ordinary income is investment-related. Forex traders may want to consider a capital gains election to be eligible for Section 1256(g) 60/40 tax rates on “major” pairs, but that may disqualify them from pass-through benefits. They can consider which is better for them.
Section 475 ordinary income is also considered business-related for TTS traders. Steven Rosenthal, Senior Fellow, Urban-Brookings Tax Policy Center, weighs in: “Section 475 treats the gain as ordinary income,” he says. “Section 64 provides that gain that is ordinary income shall not be treated as gain from the sale of a capital asset.” Mr. Rosenthal thinks Section 475 income is business income under the House bill and Senate mark. (Section 475(f)(1)(D) excludes Section 475 ordinary income from self-employment income and self-employment tax.)
The next requirements for receiving pass-through tax cuts vary significantly in the House vs. Senate bills.
Does the House bill consider a trading business a service activity?
It’s essential because active owners of service businesses may receive a tiny pass-through tax cut in the House bill. The bill states, “The term ‘specified service activity’ means any activity involving the performance of services described in section 1202(e)(3)(A), including investing, trading, or dealing in securities (as defined in section 475(c)(2)), partnership interests, or commodities (as defined in section 475(e)(2)).” When my partner Darren Neuschwander, CPA, and I read this definition two weeks ago, we thought it expressly included a trading business.
The House summary that accompanies the bill is different from the actual bill, it states, “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.” Notice the summary version dropped the second part, “including investing, trading, or dealing in securities.” Section 1202(e)(3)(A) lists the personal service fields.
The thousand dollar question is: Does the House consider a trading business a specified service activity, or not? Rosenthal believes a hedge fund with Section 475 ordinary income does not meet the House definition of specified service activity. His interpretation is that an investment manager offers trading services to a hedge fund and the fund receives those services. The manager is a service activity; the hedge fund is not. It’s about how Rosenthal interprets the comma placement in the definition, which he knows well because he used to be a legislation counsel at JCT.
I pointed out to Rosenthal that a management company is the general partner of a hedge fund limited partnership, to bring trader tax status to the fund level, which is a requirement for the hedge fund using Section 475. For this blog post, I assume a trading business is a service company based on how I read the House bill’s definition.
The House gives little benefit to active owners of service companies
An active owner of a non-service activity receives a 70% labor percentage and a 30% capital percentage. Calculate the pass-through benefit as “distributed” business income, multiplied by the capital percentage, multiplied by the maximum pass-through rate (25% for the 35% and 39.6% ordinary brackets and 9% for 12% ordinary bracket).
Active owners of a service business get a 100% labor percentage and 0% capital percentage. If they have a significant investment in business equipment and other fixed assets, they may have an “alternative capital percentage,” providing it’s at least 10%. Most TTS trading businesses won’t have an alternative capital percentage and therefore won’t get any relief in the House bill, except for the preferential 9% rate.
The House bill’s summary states, “Under the provision, the first $75,000 of an active owner or shareholder’s net business taxable income would be subject to a 9-percent rate in lieu of the ordinary 12-percent rate. Owners or shareholders in personal service businesses would be eligible for the preferential 9-percent rate.” This provision gives a small tax benefit to a service business.
The House bill favors passive business activities
The bill summary states, “Net income derived from a passive business activity would be treated entirely as business income and fully eligible for the 25-percent maximum rate.”
The original House bill had a sneaky proposal to expand self-employment tax on the labor percentage of active owners and for all limited partner income. After blowback, the House scrapped the self-employment tax provisions, yet it retained the significant tax break on limited partners. Active owners of non-service businesses get 30% of the benefits vs. limited partners. Many active-owners of service companies will get very few benefits.
I think Congress and the IRS will object to active owners restructuring their interests into general partner vs. limited partner ownership stakes to cash in on the House bill provisions favoring limited partners.
Will hedge fund limited partners get the 25% pass-through rate?
The House bill’s summary states, “The determination of whether a taxpayer is active or passive with respect to a particular business activity would rely on current law material participation and activity rules within regulations governing the limitation on passive activity losses under Code section 469. Under these rules, the determination of whether a taxpayer is active generally is based on the number of hours the taxpayer spends each year participating in the activities of the business.”
Some tax advisers suggest limited partners in hedge funds with TTS and Section 475 income can get the 25% House rate. I think there is likely a problem with that position. Under the “trading rule” exception to Section 469, a hedge fund investment is not a passive activity. Hedge fund investors are “non-active” owners, rather than passive-activity owners so that the House bill may treat them as an active owner of a service business with 0% capital percentage.
The Senate proposal is better for TTS Section 475 traders and funds
The Senate mark’s definition of a “specified service activity” does not include a trading company, but it has not yet released the final bill. It’s conceivable that the Senate could render a trading company a service activity. But, service companies fare much better in the Senate modified mark vs. the House bill.
Active owners of non-service businesses get the full benefit of the Senate pass-through proposals. The Senate’s original mark allows a 17.4% pass-through deduction on net business income, limited to 50% of owner wages.
The Senate’s original mark excluded service activities unless the owner had taxable income under $150,000 married and $75,000 for other individuals. (See How The Pass-Through Tax Cut Is Better In The Senate.)
The Senate modified mark significantly improved the provision for all owners of pass-throughs, including non-service and service businesses. It doesn’t mention passive activity owners or limited partners, so I presume they should be able to get the benefits since the Senate waived the wage limitation under the income threshold.
The modified mark states, “Under a special rule, the W-2 wage limit does not apply in the case of a taxpayer with taxable income not exceeding $500,000 for married individuals filing jointly or $250,000 for other individuals. The application of the W-2 wage limit is phased in for individuals with taxable income exceeding this $500,000 (or $250,000) amount over the next $100,000 of taxable income for married individuals filing jointly or $50,000 for other individuals.
“The modification further provides that the exception allowing the 17.4-percent deduction in the case of certain taxpayers with income from a specified service business applies to those whose taxable income does not exceed $500,000 for married individuals filing jointly or $250,000 for other individuals. The benefit of the deduction for service businesses is phased out over the next $100,000 of taxable income for married individuals filing jointly or $50,000 for other individuals.” (See Senate Juices Up Tax Cut For Pass-Throughs.)
The process is moving fast
I look forward to reading the Senate bill after Thanksgiving, and I will update this blog post accordingly. I hope GOP leaders agree to use the Senate bill as the vehicle for passage as they rush to pass tax reform legislation before year-end.
The timing is right for taxpayers and accountants. If Congress finalizes the legislation by mid-December, TTS traders will have time to consider a new tax plan for 2018, which might include a revised entity solution and a Section 475 election.
TTS traders with Section 475 should not count their tax chickens on pass-through tax breaks before they hatch. Stay tuned for updates.
Darren Neuschwander CPA contributed to this blog post.
Robert A. Green, CPA
Author of Green’s 2017 Trader Tax Guide
Managing Member, Green, Neuschwander & Manning, LLC