Trump’s Proposed Tax Cut Could Open a Path to Widespread Avoidance

2017-05-09 20:43:03

 

Trump’s Proposed Tax Cut Could Open a Path to Widespread Avoidance

President Trump’s proposal to cut taxes is short on details. But some people can already see opportunities for widespread tax avoidance.

The problem: an across-the-board business tax of 15 percent intended not only for large multinational companies, but also for partnerships and sole proprietorships that are also known as pass-through businesses. Trump administration officials have said the proposed tax is a critical way to encourage hiring and investing in the United States by companies large and small.

But individuals would have an incentive to characterize themselves as independent contractors who run small corporations in order to use the 15 percent pass-through tax when they should simply be paying the personal income tax rate — which could reach as high as 35 percent under Mr. Trump’s proposal.

“If this proposal were to pass in substantially the same form, it’s going to be hugely expensive in terms of revenue loss,” said Edward D. Kleinbard, a former chief of staff for the congressional Joint Committee on Taxation and a professor of law and business at the University of Southern California. “It’s going to be hugely advantageous to wealthy taxpayers.”

He added, “It’s going to be very difficult for the I.R.S. to administer.”

Treasury officials are aware of the problem. So are members of Congress who will write the tax legislation. But so far there is little agreement over what to do about it.

“We need to have a tax rate that’s available for small and medium-sized businesses,” Treasury Secretary Steven Mnuchin said at the Milken Institute Global Conference in Beverly Hills, Calif., where he spoke to hundreds of corporate executives on May 1. “At the same time, this is not going to be an opportunity for somebody who should be paying 35 percent personal taxes in the top bracket that can use a 15 percent pass-through to arbitrage the system.”

Under the current system, pass-through businesses avoid paying corporate taxes, which include taxes on dividends and capital gains. Instead, the income that their owners earn is taxed at individual income tax rates that are currently as high as 39.6 percent. More than 90 percent of businesses in the United States are taxed this way, according to the Tax Foundation. Mr. Trump’s proposal brings both the corporate rate and the pass-through rate to 15 percent. An analysis conducted by the nonpartisan Committee for a Responsible Budget found that lowering the pass-through business tax rate to 15 percent would add $1.5 trillion to the federal debt over a decade.

In the two weeks since the administration’s one-page outline of the proposed tax overhaul was revealed on April 26, Treasury officials have considered an array of ways to prevent taxpayers from using the theoretical 15 percent rate improperly, according to people who have been briefed on their conversations.

One potential fix under consideration: a tax increase for individuals who file as pass-throughs so they pay tax on par with personal-income tax rates. Another fix would impose a second layer of taxes on individuals who do so. Under that scenario, the taxpayer would preserve the 15 percent business-tax rate, but then be subjected to an additional rate, probably 20 percent, on the remaining income. The total tax bill would be the same as the proposed top personal income tax rate.

The issue could present problems for Speaker Paul D. Ryan as he makes the case for a tax overhaul at a factory in Ohio on Wednesday. The House Ways and Means Committee will not hold hearings until later this month to turn Mr. Trump’s tax-reform wish list into an actual bill, but Republicans have promised it will be made law by the end of the year.

The administration is still tinkering with how best to translate its sparse initial wording into legislative language. When the proposal was first presented, government officials were not yet ready to articulate, for instance, how a small business would be defined under the new tax plan.

The lack of answers on such fundamental issues leads only to more questions. Officials were also still debating the future of the so-called carried interest tax loophole, under which executives of private equity companies currently pay taxes on their compensation at a relatively low rate of about 24 percent.

The pass-through issue is another area of disagreement between the White House and House Republicans, who proposed a higher top pass-through tax rate of 25 percent in “A Better Way,” the legislative blueprint they issued last summer. Proponents of the higher rate argue that it could prove critical for helping Republicans pass tax legislation that does not cause deficits to balloon and that it would reduce incentives for individuals to try to game the system by incorporating themselves.

Stephen Moore, a Heritage Foundation economist who advised Mr. Trump during his campaign and talks frequently with administration officials, said Mr. Trump’s economic team knew it was problematic to have employers paying lower tax rates than their workers because of low pass-through rates. He said the White House was inclined to tax income that is reinvested in businesses at a lower rate than money that is pulled out and used for personal reasons.

“We don’t want the owners to just take the money out of the company and use it for personal consumption, even though they have every right to do that,” Mr. Moore said. “The goal is to get more businesses reinvesting in their companies.”

Robert Willens, an independent accounting consultant, suggested that having “parity” between the corporate tax rate and the pass-through rate might not be such a bad thing after all. For individual taxpayers, incorporating oneself is harder to do in practice than it is in theory, he said, and bigger businesses might be less inclined to turn themselves into partnerships to chase lower rates if all businesses were subject to the same relatively low tax level.

“Leaving a disparity will lead people to be spending all their time trying to become business entities,” Mr. Willens said.

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