Pass-Through Plan: The Republican Tax Plan’s Magic Asterisk

The premise of having lower rates for businesses than individuals is to encourage investment and hiring, and achieve higher economic growth. The problem arises because there is often a fuzzy line between what constitutes “business income” and “labor income.”

If an accountant or lawyer operates a partnership, for example, that may be business income, yet it’s fundamentally a reward for the hours of labor each accountant or lawyer puts in. By taxing pass-throughs at the lower rate, the new plan creates tremendous incentive for any upper-income person to find a way to structure that income as pass-through-business income rather than wages.

Under the current tax code, income up to $153,100 for a married couple is taxed at 25 percent or below, meaning a couple with earnings below that threshold has nothing to gain from the lower pass-through rate.

But people above that level — and especially those at $470,700 and above paying the top 39.6 percent rate — could reduce their tax bill precipitously by, for example, forming a limited liability company and signing a consulting contract with their employer rather than working as an employee.


Waiting in line to mail tax returns before the April 15 deadline at the James A. Farley post office in Manhattan.

Spencer Platt/Getty Images

There are ways to close, or at least limit, that loophole. But each has its own problems.

One approach would be to allow only some fixed proportion of pass-through income to be taxed at the special low rate, with the rest taxed as regular income. So, for example, if a person earned $1 million from a real estate partnership, perhaps $300,000 of that would be taxed at only 25 percent, with the other $700,000 taxed at the full income tax rate.

That’s a blunt tool, though. It doesn’t differentiate between the many types of pass-through corporations — some of which are built on large capital investments, and others that are mainly vehicles to collect income for labor.

Another approach would be to impose more stringent requirements for pass-through corporations to differentiate labor income from income derived from capital investment. That seemed to be what Treasury Secretary Steven Mnuchin was advocating at a conference this month.

“If you’re an accountant firm and that’s clearly income, you’ll be taxed an income rate, you won’t be taxed a pass-through rate,” Mr. Mnuchin said at the Delivering Alpha conference. “If you’re a business that’s creating manufacturing jobs, you’re going to get the benefit of that rate because that’s going to be passed through to help create jobs and better wages.”

The problem is that trying to differentiate between the two could require a lot of detailed work by companies to justify their breakdown of labor versus capital income — and intrusive efforts by the I.R.S. to ensure they follow the rules.

In other words, for all of the Republicans’ talk of simplifying the tax code, they could create onerous complexity in trying to sort labor income from capital income at each of the 5.1 million pass-through businesses in the United States that currently pay a rate higher than 25 percent.

The tax blueprint essentially tells the tax-writing committees in the House and Senate to just go figure it out. But it’s not as if the problem is a new one, or that some perfect solution is sitting on the shelf ready to go.

“They’ve been working hard on this for a long time, but it has been one of the most vexing parts of trying to draft tax reform,” said John Gimigliano, head of federal tax legislative services at KPMG. “You run into challenges no matter what you attempt to do.”

It’s a three-way tension for the tax-writers. They can devise a law that makes tax avoidance by the wealthy easy. They can come up with one that unfairly penalizes certain industries over others. Or they can create one that involves complexity for taxpayers and a big enforcement responsibility for the government.

Put like that, it’s clear why the blueprint released Wednesday retreated to a magic asterisk instead.

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