By Laura Saunders
A special 25% tax rate on "pass-through" businesses is emerging as one of the most controversial elements of the Republican tax plan for many reasons, including who won't benefit from it and whether it's ripe for abuse.
House Republicans want to spur economic growth by lowering taxes on a portion of income earned by many pass-through businesses, dropping the top rate from 39.6% to 25%. So-called pass-through businesses include millions of partnerships, limited-liability companies, S corporations and sole proprietorships that don't pay corporate taxes or dividends. Instead, their net income goes directly to the owner's personal return and is only taxed once, at the owner's individual rate.
Businesses organized as pass-throughs include large private companies, as well as fast-food franchises, manufacturers, and mom-and-pop businesses.
The tax cut would be a boon to many pass-through firms because they won't benefit from a proposed drop in the top corporate tax rate to 20% from 30%. Pass-through entities have surged in popularity in recent decades and account for more than 40% of all business income, according to the Joint Committee on Taxation.
But many others would be left out of the new break because the change only lowers taxes for owners whose rate is above 25%. That means couples earning less than $260,000 and singles earning less than $200,000 wouldn't be able to take advantage of it.
"At least 10 million small-business owners wouldn't see a dime from this tax cut, because they don't earn enough," says Caroline Bruckner, a managing director at the Kogod Tax Policy Center at American University, which studies small-business tax issues.
The National Federation of Independent Businesses, which advocates for small firms, said it won't support the bill in its current form.
Other critics note that the rule benefits the highest earners most. According to research by the Tax Policy Center, just over half of pass-through income flows to the top 1% of taxpayers, and they would reap nearly three-quarters of the benefit of the 25% rate.
"This is not a tax cut targeted to the middle class," says Michael Graetz, a former Treasury Department official under George H.W. Bush who is now at Columbia University's law school.
Others object because they wouldn't get the tax cut at all. Most doctors, lawyers, accountants, architects and professionals who provide services wouldn't be eligible for the 25% rate, unless they can prove they have a capital-intensive business.
A spokesman for the American Institute of Architects said the bill "would unfairly damage the majority of U.S. architecture firms," and that the AIA won't support it as drafted.
Tax professionals are also concerned about how the pass-through change could be abused. They argue the special 25% rate will aggravate an issue that is already a major source of tension with clients: a murky distinction between compensation and business income.
The tax cut requires business owners to divide their earnings into two portions. The part that is their compensation would be taxed at the owner's higher rate of up to 39.6%, plus payroll taxes, while their "business income" would get the 25% rate.
Current law for S corporations requires owners to make this distinction in order to determine which earnings are subject to employment and Medicare taxes. S-corp. owners often push to understate compensation in order to lower these taxes -- a maneuver made famous by former Democratic Sen. John Edwards and former Republican House Speaker Newt Gingrich. The 25% rate would raise the stakes on this issue.
"They are so asking for trouble if this passes. Determining how business owner contributes to his firm is a known minefield," says David Lifson, a CPA in New York with many high-income clients. In 2014, the Joint Committee on Taxation estimated that tightening the rules under existing law would raise more than $1 billion year.
To prevent abuses, the law has "guardrails" that assume the income of active business owners is 70% compensation and 30% "business income" that qualifies for the 25% rate. There would rare exceptions for capital-intensive businesses.
Many pass-through owners will soon owe more payroll taxes if lawmakers adopt the 70/30 standard, because currently they are paying themselves far less. According to Martin Sullivan, an economist with the non-profit publisher Tax Analysts, compensation of all S-corporation officers totalled just 57% of net income in 2013. For S corporations that were manufacturers, compensation was 30% of net income.
Meanwhile, tax-policy specialists worry that the large difference between the 39.6% rate on some earnings and 25% rate on others will encourage schemers to look for loopholes. These critics include senior analyst Scott Greenberg of the Tax Foundation, a group many consider pro-business.
"Any time there's a large differential in rates, people try to exploit it," says Mr. Greenberg.
Write to Laura Saunders at email@example.com
Corrections & Amplifications
This item was corrected at 2:42 p.m. ET to show that lawmakers propose to drop the top corporate rate to 20% from 35%. The original incorrectly stated to 25% from 30%.