The Tax Cuts and Jobs Act of 2017 (the “TCJA”), presently being negotiated in Congress (the Senate and House each have versions), proposes creating a new 25 percent tax rate for “pass-through” businesses — sole proprietorships, partnerships, limited partnerships, limited liability partnerships, LLCs, and S corporations, which currently pay taxes at the individual rate of their owners.

Furthermore, the current version of the TCJA makes a clear distinction between an active owner-member of a limited liability partnership owning an accounting firm (“Active Owner”), for example, whose earnings would still be taxed as ordinary income at the highest applicable marginal tax rate, and a ten percent limited partner in a limited partnership owning real estate investments (“Passive Owner”), whose earnings would be taxed at a flat 25 percent.

According to the New York Times, pass-throughs now make up about 95 percent of businesses in the country and the bulk of corporate tax revenue for the government. Pass-through income can presently be taxed up to the top 39.6 percent rate.

In California, pass-through entities such as the LLC and limited partnership are used for a range of business objectives from small enterprises to real estate investment funds. These pass-through entities and their owners would be significantly impacted by the TCJA if it is enacted, with massive winners and losers depending on the activity of the pass-through business.

Attorneys forming new business entities will want to examine whether individual principals are likely to be treated as Passive Owners or Active Owners. The tax implications inherent in such distinctions may become even more important in the very near future depending on the ultimate fate of the TCJA. Whether or not the current version of the TCJA becomes law, recent versions shed much light on how Congress views owners of pass-through entities, how they should be taxed, and why.

The House version of the TCJA can be viewed at https://www.congress.gov/bill/115th-congress/house-bill/1. PLLC will continue to track and comment on the TCJA and other legislation affecting partnerships and LLCs.

This e-bulletin was prepared by Holden W. Stein, Esq., of Fathom Law PC, in San Francisco.