WASHINGTON, Nov. 3, 2017 - The House GOP tax bill’s new rules for partnerships and other “pass-through” small businesses, together with new requirements for paying self-employment taxes, could significantly offset some of the legislation’s benefit to farms, experts say.
The pass-through rules, or “guardrails,” are aimed at preventing wealthy people from using pass-throughs to avoid paying the top individual tax rates by taking advantage of a new maximum rate, of 25 percent, for pass-throughs.
Most farmers are organized as pass-throughs, which include sole proprietorships and S corporations as well as partnerships. Their income is taxed at the individual rates, which currently range up to 39.6 percent.
The new rules in the bill attempt to limit the 25-percent rate to income that represents a true return on a capital investment, rather than wages.
The potential concern for farmers, experts say, is that while farms typically don’t have enough net income to benefit from the lower top tax rate, and they could be hit by having to pay 15.3 percent self-employment tax on income that is considered wages, rather than return on investment. Another concern is that rental income would become subject to the self-employment tax, experts say. S corporations and limited partners in a partnership also would have to start paying self-employment tax. General partners already have to.
Many farms have structured their operations to lower their self-employment tax while also maximizing federal commodity payments.
“The maximum 25 percent tax rate would help some farmers, but almost all farmers historically have never paid higher than this rate,” said Paul Neiffer, an agricultural accountant with CliftonLarsonAllen in Yakima, Wash.
“The major negative is that self-employment tax will now apply to almost all income earned by a farmer other than certain active business income. Much of our planning for farmers over the last 30 years has tried to reduce self-employment tax and this act may eliminate much of our tax savings.”
Kristine Tidgren, assistant director of Iowa State University's Center for Agricultural Law and Taxation, said that the pass-through rules could create new complexity for farmers. “Planning reduced by eliminating the estate tax might shift to address the proposals related to pass-through income,” she said.
The pass-through rules would offer two ways of classifying income. Under a default method, 30 percent of earnings would be considered a return on investment and the other 70 percent would be wages. An alternative formula would allow businesses to make a case that their return on investment is higher than 30 percent.
The bill’s impact on an individual farms will vary, but Nieffer offered this example of the impact the legislation could have on a grower:
Farmer Jones, who rents land from an LLC and that he and his wife own, nets $200,000 from that rented land and has $50,000 in income on his Schedule F, the IRS form used to show farm income and expenses. He would currently pay about $57,238 in total taxes, including $7,650 in self-employment tax on the Schedule F income.
Under the bill’s 70-30 rule, and the new requirements for self-employment tax, the tax bill would rise to $65,127. (Although the farmer’s income tax would fall under the GOP legislation to $42,353, he would now owe $22,774 in self-employment tax.) Using the alternative formula, the tax bill would be slightly lower than it would be under the 70-30 rule.
"Farmers who have arranged their investments to have the land in a separate entity, to lease to their farming operations, would see an increased SE tax," said Chris Hesse, a Minneapolis-based accountant with CliftonLarsonAllen. "And if they have been keeping income in the 25 percent or less tax bracket, they won’t have the income tax benefits from the maximum business rate. They will see a tax increase."
Roger McEowen, the Kansas Farm Bureau Professor of Agricultural Law and Taxation at Washburn University's law school in Topeka, Kan., said the typical farmer that owns land and farms it either as a sole proprietor or as a general partner in a general partnership will actually see a tax decrease, especially for farmers in top tax brackets. The 70-30 rule will actually lower their SE tax bills.
"However, a farmer that owns the land and rents it to a separate farming entity will incur more SE tax than under present law," McEowen wrote in a blog post. "If that farmer would be in a tax bracket higher than 25 percent, the benefit of the maximum business rate may fully offset the additional SE. tax."
House Agriculture Chairman Mike Conaway, R-Texas, said the 25-percent top rate on business profits should be largely irrelevant to farmers given their typical income. He said that the new requirements for self-employment tax would ensure “parity with working men and women.”
Conaway said farmers should benefit overall from the tax bill, which in addition to eventually ending the estate tax would also expand expensing and depreciation allowances. The bill also preserves key farm benefits, including like-kind exchanges for land and the ability to use the cash method of accounting.
“The ultimate criteria will be what do I look like under the current code and what I’ll look like under the new code,” he said. “All in all, am I better off and where I am I not better off?”
But House Republicans are already getting pushback on the pass-through rules from other small-business interests, and there were additional discussions among lawmakers on the issue Friday. “At this point there needs to some work on the small business, pass-through model,” said Rep. Mark Meadows, a North Carolina Republican who chairs the House Freedom Caucus.
The S Corporation Association, an advocacy group for small businesses, said the guardrails would severely limit the benefit of the 25-percent tax rate “to just a fraction of all active pass-through business profits.” The alternative formula for calculating return on capital wouldn’t “provide a reasonable estimate of true business profits,” the group said.
The House Ways and Means Committee is scheduled to begin debating and amending the bill on Monday.
(Updated with McEowen analysis on Nov. 6.)
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