How the ‘Small-Business Tax Cut’ Would Also Be a Tax Cut for the Wealthy

The following article by Alicia Parlapiano was posted on the New York Times website December 20, 2017:

Republican lawmakers say that one of the largest tax cuts in their tax bill, a 20 percent deduction for pass-through income, is for small businesses and job creators. But there are also millions of other tax filers — many at the highest income levels — who would benefit significantly.

Pass-through income is business income that is taxed once at the individual rates of the business owner, instead of through the corporate tax structure. Nearly 40 million taxpayers claimed pass-through income on their individual tax returns for 2014.

Some Republicans pushed to include the cuts in the bill so that pass-throughs, which make up more than 95 percent of business tax filings, will get similar tax relief as corporations, which are receiving a large rate cut. Here are some examples of taxpayers who might claim pass-through income:

While “pass-throughs” is a term often used to refer to small businesses, a Treasury Department analysis found that many are not actually businesses at all. And 69 percent of pass-through income goes to the top one percent of households.

Less than half of all people who claim pass-through business income on their tax returns conduct traditional business activity, according to the Treasury analysis.

Some “non-business” pass-throughs claim a small amount of income or losses, indicating that they may be claiming earnings from hobbies or vacation home rentals, for example. Others deduct a small amount of expenses and are most likely to be independent contractors who solely provide labor services, like an IT specialist who operates as a sole proprietor and contracts with another company.

Because pass-through rates will be lower than rates for individual income taxes, the bill would provide an incentive for people to find ways to classify their earnings as business income to take advantage of the lower rates.

For example, a journalist could cease to be a direct employee of a company and then contract as a sole proprietor with that same company to benefit from the pass-through tax deduction (though, they would have to pay for their benefits and more of their own payroll taxes).

The bill includes some limits on who can take the deduction, but they would begin to kick in at $157,500 in taxable income for singles and $315,000 for couples. Most “non-business” pass-through filers make less than that and would qualify for the full 20 percent deduction.

The vast majority of pass-through businesses are small, defined as having total income and total deductions of less than $10 million each. But there are a handful of very large pass-throughs, including law firms, hedge funds and multibillion-dollar businesses like Georgia-Pacific (a Koch Industries subsidiary) and Fidelity Investments, that claim an outsized share of pass-through income.

The bill sets limits for how much people with high incomes can deduct. People in professional service industries, like partners in law firms, are the most restricted; the deduction would begin to phase out for those people who earn more than $315,000 for couples and $157,500 for singles.

For high-earners in other industries, the bill would use a calculation to cap their deduction. The limit would be set at whichever was higher — 50 percent of total wages paid or 25 percent of wages plus 2.5 percent of cost of tangible depreciable property.

This means that a pass-through that pays a large amount of employee wages would be able to take more of a deduction than one that pays a small amount. Pass-throughs in capital intensive industries like real estate, including the companies that make up the Trump Organization, would also be able to deduct more, and would benefit significantly from the bill.

Of the pass-through businesses that are considered small, most are self-employed individuals with no employees. More than three quarters were categorized as non-employers in the Treasury analysis because they claimed less than $10,000 in deductions for labor.

Examples of these businesses include a small-town accountant or a house painter who does not employ anyone else but meets the analysis’ definition of a business owner because he deducts a large amount of expenses for things like office space and supplies.

Ultimately, 10 percent of all individuals claiming pass-through income were considered small-business employers in the Treasury analysis. Examples include a local dry cleaner who employs a few family members or a pizza shop owner with a dozen employees.

More than 70 percent of small-business employers had adjusted gross income below $200,000, so many of them would be eligible for the full 20 percent deduction for pass-through income.

Some Republican lawmakers argued that the tax bill should reduce rates for pass-through entities as it reduces corporate tax rates. But many economists say that pass-throughs already have a preferential tax structure.

While the top income tax rate for corporations would fall to 21 percent under the bill, it’s not directly comparable to the top pass-through rate, which would effectively fall to 29.6 percent with the deduction. Corporations are taxed twice, first on income and then on returns to investors, resulting in a higher tax burden overall. And if pass-through businesses determined that their tax burden would be lower under the bill if they organized as a corporation, they could choose to do so.

Additional sources: Tax Foundation; Tax Policy Center

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