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House Ways & Means Committee Chairman Kevin Brady’s recently-introduced tax plan promises to cap the income tax rate for income generated by pass-through businesses at 25 percent. However, the real story is much more complicated than that. The provision is likely to become a windfall for high-income investors, while many genuine business owners, including some small business owners, will end up paying a top rate as high as 35.22 percent. Overall, it would add great complexity to the tax code—giving small business owners additional headaches. And despite Brady’s attempts to prevent taxpayers from abusing the new system, the proposal would provide plenty of opportunity for clever investors and business owners, with help from their tax lawyers, to game the system.
Pass-through businesses are sole proprietorships, partnerships, limited liability companies, and S corporations. Unlike traditional C corporations, their income is not subject to a business-level income tax and, instead, income tax on these earnings is paid by the owners at their ordinary income tax rate—up to 39.6 percent both under current law and Chairman Brady’s plan. Many people equate pass-through businesses with small businesses, but that characterization is misleading. Pass-through businesses can be large multistate pipelines, timber product companies, real estate developers, private equity firms, hedge funds, and other types of large businesses.
In addition, millions of owners of businesses, both big and small, would not benefit from the new low rate because they don’t earn enough income. Nearly 90 percent of pass-through owners already pay a tax rate of 25 percent or less (under current law). Thus, the 25 percent income tax rate cap on pass-through income would not benefit them at all. By contrast, the ones who could benefit most from the 25 percent tax rate cap are those in the 39.6 percent bracket, who currently receive half of all pass-through income.
The Brady proposal divides pass-through businesses into those with passive owners and those with active owners. And the passive owners get a better deal, because there is less risk passive owners will treat wages as business profits. The proposal would cap the income tax on the pass-through businesses with passive owners at 25 percent, which would benefit taxpayers who make more than $260,000 and otherwise would pay rates of 35 percent and higher, under his proposed brackets. Brady’s plan would cap the income tax rate on income from pass-through businesses with active owners at 35.22 percent, with a lower cap for businesses that are capital intensive. (This 35.22 percent rate reflects the proposed legislation’s default rule that 30 percent of their active income is deemed to be eligible for the 25 percent rate and the remaining 70 percent is characterized as ordinary compensation taxed at a maximum rate of 39.6 percent.)
Pass-through businesses may be eligible for the new 25 percent rate only if the owners are “passive,” that is, do not materially participate in the business. The current law test is based on the number of hours a taxpayer devotes to the business. Today, taxpayers try to document those hours because there are certain tax advantages for those considered to be active owners. However, under the Brady bill, many taxpayers will prefer to be passive to benefit from the 25 percent maximum income tax rate. Thus, they may either reduce the hours they devote to their businesses or conceal the extent of their involvement from the IRS, which would be hard-pressed to challenge them.
And the bill would create other new tax planning opportunities. For example, owners of businesses that produce rental or interest income would be eligible for the favorable 25 percent rate; instead of being taxed at a top rate of 39.6 percent (as under current law). Rental activity is inherently passive, and rent can easily be earned through a pass-through business (and, currently, often is).
But interest income also is passive—and can be earned from a pass-through entity that trades bonds or lends money (many hedge funds and private equity funds already engage in these activities—which can be a business). So taxpayers might invest more often in these funds, where the tax rate on “business income” would be capped at 25 percent, instead of buying bonds whose interest income is taxed at rates up to 39.6 percent. Finally, they could invest in REITs, which can pass through both rent and mortgage interest income and are explicitly eligible for the 25 percent cap under the proposal.
Another possibility: Investors might borrow to invest in these funds (or in REITs). That way, the investors could deduct interest at 39.6 percent and pay a 25 percent tax on the “business income” received. Or, perhaps, investors might borrow from a pass-through business and invest back in the same business, if it is managed by unrelated persons.
Moreover, business owners also may borrow and make contributions to their businesses rather than have their businesses borrow. That way, the owners could deduct interest at 39.6 percent, rather than having their businesses take the deduction at 25 percent. The statute also encourages the separation of ownership from the performance of services, and so, instead of directly investing in their own businesses in which they perform significant services, investors might also maximize their income eligible for the 25 percent rate by cross-investments in other businesses. They might even purchase “preferred equity” in the other businesses which can be structured, economically, to function just like debt (and would be less risky).
Finally, many actual small businesses would miss out on the 25 percent rate. Owners of a family business, say a corner hardware store, are “active,” they’d be subject to a top rate of 35.22 percent rather than 25 percent. The bill permits a lower cap for businesses that are capital-intensive, which would be determined by the basis of depreciable assets that are used in the business. Typically, however, the total basis of depreciable assets that are used in a business is relatively small—so the cap could remain at 35.22 percent.
Inevitably, lower tax rates for activities conducted through pass-through businesses and arbitrary distinctions invite abuse—and add complexity. And for what? Under present law, any pass-through that is attracted to the proposed 20 percent corporate rate could always convert to a C corporation--without creating new pass-through rate caps that add inefficiency and complexity to our tax code.
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