Republican taxwriters say they are confident that they can legislate around a loophole that Democrats say they have identified in President Trump’s tax plan, namely that it would cut taxes for Trump’s own company and lead rich professionals to game the tax code by claiming to be small businesses.
Under scrutiny is the Trump proposal for a special tax rate of 15 percent for businesses that file taxes through the individual side of the tax code, commonly referred to as pass-throughs. While the idea could pose one of the major substantive policy obstacles to Republican tax reform, congressional leaders projected confidence they could surmount it.
The proposal is a big deal. Pass-throughs, such as partnerships, sole proprietorships and S-Corporations, account for the majority of employment in the U.S., and the special rate would cut taxes by about $1.5 trillion over a decade, according to one outside analysis of Trump’s similar campaign plan.
While it would benefit many small businesses, Democrats were quick to point out that it also would represent a tax cut for many big businesses, including Trump’s, and would encourage large-scale gaming of the tax code by lawyers, athletes or other professionals in a position to declare their earnings business income rather than salaries.
“Wealthy businessmen, like President Trump, will be able to use pass-through entities to pay 15 percent in taxes while everyone else pays in the 20 percents and 30 percents,” said Senate Democratic Leader Charles Schumer while speaking Thursday on the Senate floor.
Trump administration officials did not include enough detail in their plan to defend it from the charges, but GOP legislators, who have been drafting tax reform legislation for years, did so.
“Frankly, that could mean more jobs, more opportunities, more investment,” said Sen. Orrin Hatch, the Republican chairman of the Senate Finance Committee. “It depends on how it’s all put together.”
Speaking to reporters at the Capitol Thursday, Hatch said he thought that the Treasury, led by Secretary Steven Mnuchin, would be able to create rules for businesses that get the pass-through rate to ensure that it was not abused. Yet he acknowledged that “there’s nothing easy here.”
Peter Roskam, the chairman of the House Ways and Means Committee’s tax subcommittee, said Friday that he was confident that rules could be written to prevent abuse of the special pass-through rate. But writing those rules shouldn’t be left up to the Treasury and IRS, he said.
The committee is “making sure that the system isn’t gamed and people mischaracterize their own income as business income to get an advantage,” Roskam said. “We’re aware of it, we’re working through it, and we’re determined to make the rules in the statute, and not defer to the IRS.”
House Republicans have been trying to work out those rules since including a similar special tax rate for pass-throughs in their “Better Way” tax plan introduced last summer by the committee and Speaker Paul Ryan.
But Trump’s plan would create even greater incentives for abuse. Under the Trump outline, the top individual tax rate would be 35 percent, while the pass-through rate would be 15 percent — a difference of 20 percentage points that an enterprising high-earner could exploit. In comparison, the top individual rate would be 33 percent in the House GOP plan, versus a special pass-through rate of 25 percent — only an 8 percentage point gap.
Furthermore, the Ryan-authored plan would have assured that companies with owner-operators would have to pay the owners a reasonable amount of income that could be taxed at individual income rates. For instance, a high-earning lawyer who said his earnings were small business income to try to take advantage of the 25 percent rate would be taxed as if he were earning a salary.
On the campaign trail, Trump’s advisers brushed off the problem. Wilbur Ross, now commerce secretary, said that if government lawyers couldn’t figure out how to write rules to stop such abuse, they should just quit.
Nevertheless, writing and enforcing those rules would not be easy.
A recent tax reform effort in Kansas illustrated the seriousness of the problem. In 2012, the state eliminated taxes on pass-throughs. In response, the number of pass-through entities in the state doubled, according to the Tax Foundation, a Washington think tank, as individuals rushed to avoid taxes. Consequently, the tax bill reduced revenue much more than thought. The University of Kansas’ football and basketball coaches both created LLCs and classified themselves as independent contractors, according to local media, avoiding hundreds of thousands of dollars in taxes.
If Republicans want to put together a tax reform that won’t blow out the deficit on paper, said Alliantgroup national managing director Dean Zerbe, they will have to find a way to put credible anti-abuse rules in the statute.
Otherwise, the congressional agencies responsible for estimating the budgetary costs of legislation will “clobber them like a baby seal on their scoring,” said Zerbe, a former tax counsel to the Senate Finance Committee.
The lower the preferential rate, the stronger those rules have to be. At the same time, a low rate will be necessary to get buy-in for tax reform from small businesses, which mostly are pass-throughs.
Cutting the corporate tax rate without lowering tax rates for small businesses would put them at a competitive disadvantage and elicit pushback from groups that represent small businesses such as restaurants, construction companies, mom and pop stores, and much more. That dynamic helped kill an Obama administration push for business tax reform in 2015.
While under the current tax code pass-throughs face a higher top income tax rate of 39.6 percent, compared to the corporate rate of 35 percent, in reality owners of the two kinds of businesses pay similar taxes on profits, after all breaks and deductions are included, largely because corporate owners also must pay dividends taxes on earnings that are paid out to them. According to the Congressional Budget Office, C-corporations pay an effective rate of 31 percent on average, versus 27 percent for pass-throughs.
In other words, from the perspective of ensuring that LLCs and partnerships remain competitive with corporations and go along with tax reform, ensuring that their rates will be lowered is important, Zerbe said. The Obama administration, in contrast, was cool to the concerns of those non-corporate businesses. Treasury Secretary Jack Lew reportedly told them that if they wanted to get the benefits of a lower corporate tax rate they should just incorporate.
Democrats, however, are also right that many of the benefits of the special rates would flow to Trump, who has structured the Trump Organization as hundreds of individual companies, many pass-throughs.
And much of the total income earned by pass-throughs is earned by big businesses, rather than sympathetic mom-and-pops. Further, about half of pass-through income flows to the top 1 percent of households, according to the Center for Budget and Policy Priorities.
