WASHINGTON DC–Congressional Republicans are close to fulfilling a promise they have made repeatedly for years, comprehensive tax reform.

On the business side, the core elements of tax reform are a reduction in the corporate tax rate, a restructuring of the tax rules for multinationals, and some form of tax relief for pass-through businesses. Commercial real estate is primarily constructed, owned, and managed by businesses and entrepreneurs operating in pass-through form.

We asked Real Estate Roundtable CEO Jeffrey DeBoer and Roundtable Senior Vice President Ryan McCormick to help GlobeSt.com readers understand what type of relief Congress is considering for pass-through businesses, and what it could mean for both the commercial real estate industry and the broader economy.

We have been hearing for years that our corporate tax rate and rules are hurting US competitiveness. Why are pass-through businesses part of the tax reform conversation?

DeBoer: Today, most economic activity in the United States is conducted by pass-through businesses—partnerships, LLCs, S corporations, REITs, and sole proprietorships. In 2013, the most recent year we have data, pass-throughs generated nearly 62 percent of total business income. Well over 90 percent of small businesses (500 or fewer employees) are organized in pass-through form, and remarkably, these businesses created more than 60 percent of the net new jobs over the last 25 years.
Increasingly, the focus of US corporations is on their global operations and activities, which are vast and complex. Pass-through businesses, in contrast, are the principal employer and, in reality, the economic engine of the domestic economy.
Early on, policymakers recognized that in order for tax reform to spur real economic growth, they would need to encourage capital formation, investment, and job creation at all levels of economic activity, including pass-through businesses.

OK, so pass-through businesses have grown and now represent over half of the business activity. Other than the lack of an entity-level tax, what is their great appeal? Why do they deserve special treatment?

DeBoer: The ability to use the pass-through, partnership form to flexibly and effectively raise capital and conduct business is one of the great American innovations of recent decades. At a time when other countries are doing everything they can to catch up with us, our highly developed partnership tax rules have helped us stay the forefront of start-up and entrepreneurial activity. They are a critical part of our “intangible infrastructure”: the legal, regulatory, and tax system that makes the United States the envy of the world when it comes to entrepreneurship, risk-taking, and productive investment.
Take the case of real estate. Partnership tax rules in the United States facilitate new construction, increased investment, and job creation—much more than would occur if every owner was forced into the corporate form with a single class of stock. In partnerships, real estate professionals can join forces with institutional investors or other passive owners and allocate the risks and rewards of the business however they choose, as long as the arrangement has “substantial economic effect.” In reality, virtually every partnership agreement is different. The result is a much more dynamic and robust commercial real estate industry that reacts quickly to the changing needs and demands of America's communities. This same phenomena plays out in other industries—our flexible partnership tax rules promote capital formation and the allocation of risk in ways that accelerate investment and create jobs.
And that's just partnerships. Our tax rules related to real estate investment trusts (REITs) have made it possible for individuals at all income levels to efficiently and responsibly invest in professionally managed real estate. Our REIT rules have been such a success that they are now being rapidly adopted and implemented in countries around the world.

Aren't pass-through businesses already tax advantaged, compared to corporations? Do they really need the relief?

DeBoer: Currently, the tax rate on pass-through businesses can get as high as 43.4% (39.6% plus 3.8% tax on net investment income, which includes rental income). Corporations pay a top rate of 35%, and corporate income may be taxed again (at a top rate of 20%) if it is distributed to shareholders. Of course, corporations don't have to distribute their income, and many don't. For example, Berkshire Hathaway, Warren Buffett's firm, hasn't paid a dividend in over 50 years. Corporations can permanently defer the second level of tax. In contrast, the owners of pass-through business are taxed on the business's net income every year, even if the profits are reinvested in the business and not distributed.
In light of corporations' permanent tax deferral, if the corporate tax rate was reduced to 20%, and the top pass-through rate remained where it is today, the tax burden on partnerships and other pass-through businesses would be roughly double that of large corporations.
Combined, the outsized and important role that partnerships and other pass-through businesses play in the economy, and the relatively high tax rates on pass-through income, it is critical that meaningful tax reform include robust relief for pass-through businesses.

The full House of Representatives has passed its version of tax reform. What are they proposing for pass-through businesses?

McCormick: The House bill would create a new, reduced rate for pass-through business income of 25%. In addition, a lower rate of 9% rate for small businesses would be phased in gradually over five years. Eligibility for the 9% rate would phase out for taxpayers filing a joint return with incomes over $150,000 ($75,000 for singles).
For months, critics have suggested that taxing pass-through income at a lower rate would lead wealthy individuals to shelter their income in LLCs or S corps. The House drafters developed a creative and effective solution to this concern. First, the bill would not allow investment income—capital gains, dividends, interest, and similar portfolio income—to qualify at all for the 25% rate. Second, the bill would prevent taxpayers from converting their wages and other compensation for services into income taxed at the 25% rate.
Under a default rule of “safe harbor.” active business owners, i.e., owners who are actually providing labor and services to the business, would be taxed at the reduced rate on 30% of their pass-through income (0% in the case of personal services businesses). Alternatively, the owner could qualify for a higher percentage if they have significant capital invested in the business.
The passive owners of a pass-through business, i.e., limited partners or outside investors who are not being compensated for providing labor or services to the business, would get the full benefit of the 25% rate.
In so doing, the House bill creates strong “guard rails” against abuse of the pass-through rate, while creating a powerful new incentive that would attract capital and investment to entrepreneurial activities.

What is the Senate proposing? Would it differ from the House approach?

McCormick: The Senate pass-through proposal differs dramatically from the House approach. First, rather than a reduced tax rate, the Senate creates a 17.4% deduction for qualifying pass-through income. The deduction translates into the equivalent of a 6.7% rate reduction (less than half of the 14.6% rate reduction in the House). Second, the Senate proposal is temporary and would expire at the end of 2025.
More importantly, the Senate includes an odd rule that limits the total deduction to no more than 50% of W-2 wages paid by the business. Thus, if the total direct wages of the partnership represent less than one-third of business profits, the taxpayer would not qualify for the full 6.7% rate reduction.
Moreover, the Senate bill lacks effective guard rails against abuse. For example, employees could recast themselves as independent contractors and fully benefit from the pass-through tax benefit. In contrast, under the House proposal, taxpayers who provide labor or services to the business only qualify for the benefit to the extent that they have capital invested, or it is not a personal services business.

OK, that is the general structure of the House and Senate proposals. How do you see these concepts working in the case of commercial real estate?

McCormick: It is important to keep in mind that this debate is about the operating profits of a business. It is unrelated to capital gains and asset appreciation, which is so important to real estate investment. In our case, this is really about how the government taxes the leasing income generated from commercial real estate tenants.
Real estate has a life cycle, and early on, significant capital is spent constructing, improving, and repositioning properties to their most productive use. At the front end, a lot of risk is borne by general partners and investors, and significant operating profits may not emerge for many years. By distinguishing between active and passive investors, and allowing active owners to get the reduced rate to the extent of their investment in the business, the House model is well-designed for capital-intensive businesses, like real estate or energy, that pool capital from many sources. It would help attract investment to the industry, that would be used to put people to work.
By limiting the pass-through deduction to no more than 50% of the entity's W-2 wages, the Senate proposal largely eliminates the potential benefit for commercial real estate. Unless a business spends 35% of its income on W-2 wages, it will not qualify for the full deduction. This penalizes businesses that put lots of people to work indirectly, but don't have large direct payrolls, such as real estate partnerships that put capital at risk for a new project and hire contractors, subcontractors, architects, engineers, brokers, and many others. All of this labor activity is put in motion by the initial deployment of capital, which is disregarded under the Senate proposal.

Are there related provisions that could affect capital formation and investment in pass-through businesses?

McCormick: Another proposal, which first emerged for the first time when the Senate bill was introduced two weeks ago, would prohibit general partners and other active owners of pass-through businesses from currently netting all business losses against their wages and investment income. The proposal appears to be aimed at preventing tax rate arbitrage (active pass-through income is preferred, while losses would be deducted against high-taxed income). However, the same could be said for the deferred tax liabilities of corporations. In the corporate context, deductions were claimed against high-rate income, but the income will now be taxed at a reduced rate.
The effect of the Senate's active loss limitation proposal is to discourage entrepreneurship—for example, if an executive uses her evenings and weekends to go out on her own and start a new business, and the start-up loses money in the early years as it gets off the ground, she would be out the cash but still taxed on her full salary. It is very hard to understand how such a harsh proposal fits in with “pro-growth” tax reform.

Does the Real Estate Roundtable have a strong preference for the House or Senate approach? Why or why not?

DeBoer: Tax reform that spurs growth and jobs in the underlying economy will be good for the commercial real estate industry, provided it does not alter the basic principle that real estate should taxed on an economic basis, avoiding excessive incentives or disincentives that distort business decisions.
We are concerned that eliminating the deductibility of state and local taxes will harm many local communities and disrupt demand for commercial real estate in certain markets. We are also concerned about potential changes in the incentive for homeownership, which has so many benefits from neighborhoods and the overall economy. Lastly, tax reform that leads to large deficits could have adverse economic consequences over the long term.
But unlike early tax reform blueprints, both the House and Senate bills generally preserve rules that tax real estate based on the economics of transactions—e.g., the deductibility of business interest, cost recovery, and like-kind exchanges.
Reducing the tax burden on pass-through businesses is an opportunity to spur entrepreneurship and give a real lift to America's true job creators—the partnerships, family businesses, and others who drive economic activity here at home, including commercial real estate. This effort should not be relegated to the back pages, an afterthought in the race to reduce the corporate tax rate.
The Roundtable favors the House pass-through proposal, which recognizes that not all owners of pass-through businesses are the same—some owners run the business, whereas others are just investors. The House approach promotes capital formation and job growth while avoiding potential abuse by looking to the active owner's investment in the business. It will be a powerful catalyst for entrepreneurship that reduces the cost of capital for businesses that lack easy access to public equity markets.

Is the Roundtable advocating for specific changes?

McCormick: If policymakers opt for the Senate approach, they should remove counterproductive rules that would restrict the ability of capital-intensive businesses to qualify. The final pass-through provision should recognize that not all job creators have large direct payrolls and eliminate the W-2 wage restriction. Property owners and developers deploy capital that leads to immense labor activity, and they should not be penalized under the final bill.
The W-2 wage restriction would lead to tax-motivated restructuring. Firms will seek to “game” the rules by merging labor-intensive and capital-businesses under one roof. Others will look to “in-source” job functions, such as accounting or janitorial services, to boost their W-2 wages. These are functions that are more efficiently conducted in the hands of specialized businesses. That is exactly the type of tax-motivated, uneconomic activity that tax reform should discourage.

Great overview, what are the next steps in the process and what is the timing?

DeBoer: After years of debate and discussion, tax reform is now moving forward at break-neck speed. The House has passed its bill, and the full Senate could pass its version as early as the week after Thanksgiving. While much has been made about their differences, the reality is that the two bills are remarkably similar. The major outstanding issues include the state and local tax deduction, homeownership tax incentives, and relief for pass-through businesses. Assuming Senate Leaders can bring along reluctant Members—an open question right now—we believe tax reform could be on the President's desk before Christmas. That is why it is critical for those in our industry to fully understand what's on the table and what's at stake.

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Real Estate Roundtable Explains Congress' Tax Reform Proposals

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