Tax Reform Takes a Turn in the Senate

By Doug Fisher • November 30, 2017 • 0 Comments
In the hunt for 50 votes, Senate Republican leaders are floating the idea of increasing the deduction for qualified business income of pass-through businesses from 17.4% to 20% — and that could have consequences for retirement plans sponsored by S Corporation shareholders.

The tax reform measure passed by House of Representatives also includes a tax rate reduction for pass-through businesses, but it is not as large as the Senate’s. We understand that congressional negotiators are leaning toward adopting the Senate’s pass-through proposal.

More than 90% of the businesses in the country operate a pass-through entity — partnerships, S Corporations and sole proprietorships. Reducing the tax rates on small businesses is a core promise made by House and Senate Republicans heading into tax reform negotiations. The Senate’s business income deduction proposal does indeed have the effect of lowering the tax rate paid by owners of these entities by excluding as much as 20% of the business income from taxation. This in turn has the effect of creating two different tax rates for business owners: one rate for wage income and a second, lower rate described above for active business income. Though the American Retirement Association supports reducing taxes on pass-through businesses, an unintended consequence of the pass-through proposals is that the tax incentives S Corporation owners to sponsor a retirement plan become much less attractive in a lower tax rate environment.

This happens under the S Corporation tax rules because retirement plan contributions are generally deducted against the S Corporation’s business income, which under the Senate’s tax reform proposal could be as low as 25%. Now compare this to the ordinary income tax rate S Corporation owners must pay on retirement savings and earnings when they retire, which could be as high as 38.5% under the Senate proposal. We modeled scenarios like this that show S Corporation shareholders may be better off financially if they forego a retirement plan contribution and instead pay tax on their savings and invest the proceeds outside the plan. The attractiveness of a retirement plan is further diminished when a business owner factors in the cost of contributions to meet plan testing rules, plan administration costs and the ERISA fiduciary risks associated with operating and administering a qualified plan.

The same concerns do not come into play for partnerships and sole proprietorships because under current tax rules, a partner’s or proprietor’s share of all retirement contributions flow through to their individual tax return at their prevailing ordinary income tax rates, not at the new pass-through rate. Partners still have an incentive to defer wages into a retirement plan because it offsets their income at the highest tax rates.

While the retirement leaders in the Senate, as well as Senate Finance Committee staff, agree this is an issue and an unintended consequence of the pass-through tax proposal, they have expressed limited bandwidth to address this at a time when they are negotiating core structural issues of their tax reform plan, like individual and corporate tax rates and multibillion-dollar revenue issues. We continue to engage Members and staff to address this issue on the Senate floor or in the Conference Committee, where we expect a final deal to be reached between the House and Senate in December.

Stay tuned.

Doug Fisher is the Director of Retirement Policy at the American Retirement Association.