The Trump administration’s proposal to slash the tax rate on partnerships and limited liability companies could set off a stampede of individual taxpayers trying to reclassify themselves as so-called pass-through businesses in order to take advantage of the savings, according to tax experts.
Call it the Kansas problem.
In 2012, Kansas exempted pass-throughs from state income taxes, a move that was billed as a chance to spur so much business growth and job creation that it would actually raise money for the state treasury. Instead, an unexpectedly large number of taxpayers began calling themselves pass-throughs, and state tax revenues fell by hundreds of millions of dollars. Kansas lawmakers passed a bill to eliminate the exemption, which was derided as the “LLC loophole,” but Governor Sam Brownback vetoed the measure.
Now, Trump’s administration wants to try a similar move. Pass-through businesses -- which include small businesses like corner stores and free-lancers but also doctors, lawyers, consultants and vastly profitable hedge funds -- get their name from the way they file taxes: The businesses pass their income through to their owners, who then pay tax based on their individual income-tax rate.
The top individual income-tax rate is now 39.6 percent, though Trump’s plan would cut that to 35 percent. But for pass-through businesses, he’d cut it even more: to just 15 percent.
‘Working Feverishly’
Cue the rush among high-earning individuals to recast themselves as LLCs, sole proprietorships or other pass-throughs. “Absolutely!” said J. Richard Harvey, a tax law professor at Villanova University and a former senior official at both the Internal Revenue Service and the Treasury Department. “If a taxpayer has a choice between paying at a 15 percent top rate versus a 35 percent rate, the taxpayer and their tax planners will be working feverishly to take advantage of the 15 percent rate.”
Trump’s plan was applauded by many small-business groups and Republicans, who say it would remedy an inequity in the current tax code, which taxes corporations at a maximum rate of 35 percent, while subjecting much pass-through business income to the 39.6 percent individual rate. Trump’s initiative would apply the same 15 percent rate to pass-throughs and multinational corporations.
“We support efforts to treat America’s small business community just as their corporate counterparts and that requires an equal playing field when it comes to our tax system,” The National Association for the Self-Employed, which advocates on behalf of the 27 million Americans who file their taxes as self-employed, said in a written statement.
Dividends Taxed