WASHINGTON ― Tax accountants worried that the Republican promise of a new, simpler tax code will put them out of business can take heart in at least part of the proposal: a drastic tax cut for “small” businesses.
While eliminating a number of deductions and credits may indeed simplify an arcane set of rules, the creation of a new, lower tax rate for so-called S corporations, partnerships and sole proprietorships could require a forest of new regulations to prevent high-wage earners from trying to game the system.
Tax policy experts have long wrestled with how to keep both the rich and the not-so-rich from abusing the small business designation to dodge taxes, said Gregg Polsky, a University of Georgia tax law professor.
“Nobody’s come up with a great solution and they don’t even make a halfhearted attempt at it” in the GOP plan, he said.
Republicans acknowledge that their creation of a special, lower rate for these businesses will make that designation even more advantageous. Treasury Secretary Steven Mnuchin said on Sunday that congressional leaders and the administration would create “guardrails” to prevent wealthy filers from unfairly availing themselves of the new, lower business rate.
The innocuous-sounding “guardrails,” though, would likely translate into pages of new regulations and judgment calls by IRS auditors.
Unlike plain old wage income, which can often be handled with the single-page tax return form, even relatively simple corporations like those created under subchapter S of the tax code require far more paperwork. The reason millions do it anyway: the ability to avoid paying thousands of dollars in taxes simply by calling some or most of the money profit instead of salary.
Normal income is subject both to a 12.4 percent Social Security tax up to a $127,000 cap, as well as 2.9 percent levy for Medicare. For incomes above $200,000, there’s an additional 0.9 percent Medicare tax. But these small business owners have the option to call part of that income profits rather than salary, thereby exempting that portion from Social Security and Medicare taxes.
How much of the income has to be characterized as salary is already a contentious issue for small businesses and the IRS. Enacting an enormous financial incentive for the creation of thousands or even millions of more S corporations is certain to further complicate rules, experts believe.
The committee that will oversee new tax legislation in the House will figure it out, spokeswoman Emily Schillinger said, though she didn’t provide any details.
“The Ways and Means Committee is working on strong measures that will deliver accountability,” she said in a statement.
The Republican plan would apply a reduced 25 percent tax rate to profits that “pass through” a business to its owner and are currently taxed as that person’s regular income. Because the top tax rate for wage income would be 35 percent under the plan, high earners ― particularly those who provide services, such as executives at law or financial firms ― would have a strong incentive to set themselves up as small businesses and immediately realize enormous tax savings.
“Members are working to ensure that the pass-through rate applies as intended to income from business operations ― and also that income that is compensation for services continues to be subject to the individual tax rules,” Schillinger said.
The tax code already gives an incentive for high-end service providers like lawyers and doctors to claim income as pass-through profits since doing so allows them to avoid payroll taxes. Tax reformers have held up former Democratic presidential candidate John Edwards as the classic example of a pass-through abuser. Edwards’ law practice filed its taxes as an S corporation, which allowed him to avoid payroll taxes by paying himself huge sums as business profits rather than salary.
People claiming pass-through income already account for more of the so-called ”tax gap″ than any other group of tax filers. That gap is the difference between what people are supposed to pay and what the IRS receives. According to the most recent IRS estimate for 2008-2010, tax filers underreported enough pass-through income to result in $125 billion worth of lost revenue each year.
One way to reduce the tax gap would be to increase the number of IRS agents enforcing the code, though doing so would be contrary to recent Republican efforts to slash agency budgets. The Government Accountability Office has suggested the IRS spend more resources auditing higher-income filers. Republicans in Congress, though, have preferred that the agency focus even more than it already does on low-income filers claiming the Earned Income Tax Credit.
The GOP framework calls for consolidating seven individual tax brackets into three with rates of 12, 25 and 35 percent. Since the middle bracket rate would be the same as the pass-through rate, only pass-through filers wealthy enough to fit in the highest bracket would benefit from the change. (Republicans have not yet specified the income levels where the brackets will fall.)
“This loophole that they’re creating for business income would be uniquely exploitable by high-income taxpayers because only they would get a benefit,” Polsky said. “The distributional impact would be huge.”
He said it seemed as though the plan’s architects proposed the lower rate for pass-through businesses simply for parity, since President Donald Trump has insisted on a 20 percent rate for businesses paying corporate taxes.
The Tax Policy Center, which reported earlier this year that households with incomes above $200,000 receive nearly 80 percent of pass-through business income, estimated that cutting the pass-through rate to 25 percent would cost the U.S. Treasury $769 billion in lost revenue over 10 years.
A similar thing happened in Kansas after state lawmakers eliminated state taxes on pass-through business income. The conservative Tax Foundation reported a spike in the creation of pass-through entities and a sharp decline in state revenue.
“If they passed a provision like this in Washington, D.C., where I live and work, I would benefit from going to my employer the next day and ask them to start paying me as an independent contractor,” the foundation’s Scott Drenkard said in January testimony to the Kansas legislature. “I would still be doing the same job and contributing the same value to the economy, I just wouldn’t be paying any [D.C.] income taxes.”