Congress Should Pass on Changing the Pass-Through Income Tax Rate
The November election was a shock to many people. Few anticipated the outcome, which created a political environment that is the most conducive to a comprehensive reform of the tax code since it last happened 30 years ago. Given this reality, a close examination of the Tax Reform Blueprint issued in July 2016 by the Republican leadership in the House of Representatives is critical since it will be driving the tax reform process in 2017, at least initially.
The Blueprint is comprehensive and ambitious in scope but light on details in key areas. However, we have to assume it will be the starting point in the process. You have probably heard by now the changes the Blueprint makes to the individual ordinary income and investment income rates — which is sure to affect a small business owner’s financial calculus when considering whether to adopt or maintain a qualified retirement plan — irrespective of any possible cuts to the contribution limits.
Putting that aside, we have identified a further concern that would destroy a small business owner’s financial incentive to adopt and maintain a qualified retirement plan. More than 90% of businesses are organized in some form of pass-through entity (partnerships, S Corporations, REITs, RICs, and small business limited liability corporations). The Blueprint caps the tax rate on those entities at 25% (in addition to providing the 50% exclusion to the reinvestment of that income). However, the Blueprint applies the ordinary income tax rate on retirement plan distributions — which for many successful small business owners under the Blueprint is 33%.
Thus, the owners of these pass-through entities — 90% of American businesses — would have no incentive to defer their current income in the form of retirement plan contributions. In fact, if the Blueprint is enacted in its current form, these owners will be financially worse off.
To illustrate, assume a 50-year-old business owner earns $50,000 per year from her business for the next 16 years and 4% on her investments. Applying the Blueprint’s tax rates on pass-through income (25% tax on pass-through income and 16.5% tax on subsequent earnings) leaves a total accumulation of $839,921. If instead the business owner contributes the same $50,000 to a qualified retirement plan and pays tax on the distributions at retirement at the 33% rate provided in the Blueprint, the total accumulation is $793,867. Clearly, the small business owner who invests in a retirement plan will be at a $46,054 disadvantage.
Comparing this result to current law, a business owner who saves $50,000 annually in a retirement plan and pays an assumed tax rate of 35% on retirement distributions would accumulate $770,169. The same business owner who forgoes the retirement plan and pays tax on $50,000 of income at current tax rates (35% on the 50,000 of annual income and 20% on capital gains on the earnings) would accumulate $719,330 for a $50,839 benefit
from investing in a retirement plan.
Fortunately, there is a solution to this vexing problem — one that we have already been advocating for on Capitol Hill. This problem can be corrected by applying the Blueprint’s 25% tax rate on pass-through income on retirement plan distributions associated with retirement plan contributions that would otherwise be pass-through income if not contributed. Going back to the first example above, if the maximum pass-through rate is instead applied to the retirement plan distribution, the small business owner will gain $48,735
by contributing to the retirement plan. This solution effectively approximates the incentive the small business owner gets under current law and would continue to encourage the small business owner to maintain a plan for themselves and — importantly — for their employees.
Furthermore, we believe it is relatively easy to create compliance systems to track and report retirement plan distributions subject to the proposed 25% rate to the small business owners and to the government. It is common practice today by record keepers to track and report different sources of contributions. For example, this is done today to separately track Roth and pre-tax contributions in most 401(k) plans.
With this simple fix, the Blueprint can continue appropriate tax policy for pass-through entities while maintaining the necessary incentive for these entities and their owners to establish and maintain a retirement plan that is so critical for the retirement security of American workers.
Brian H. Graff, Esq., APM, is the CEO of the American Retirement Association.