There has been an a lot of discussion about how, under the Republican tax plan, highly paid professionals will want to turn themselves into LLCs in order to take advantage of special cuts for business owners. This week, the Tax Policy Center produced the clearest analysis I’ve seen yet demonstrating why, sadly, that will almost certainly be a good idea.
The Tax Policy Center analyzed the recently passed Senate bill, because it’s the most recent piece of tax legislation that Republicans have actually finalized. Under it, Americans who make most of their money from wages and salaries would have seen their after-tax income rise by 1.5 percent on average. Pass-through business owners, however, would get a boost about three-times as large.
Pass-throughs are businesses like partnerships and S-Corps whose owners pay taxes on their profits as personal income, and which range in size from small construction contractors all the way up to giants like the mutual fund manager Fidelity. The Senate bill would have allowed pass-through owners to deduct up to 23 percent of their profits from their taxable income. So, if your local Ford dealer pocketed $1 million selling pickups, he wouldn’t have to pay any taxes on as much as $230,000 of those profits. This measure is supposedly meant to help pass-throughs stay competitive with large corporations, which are about to score a major tax cut of their own. But it also sets the stage for an enormous amount of tax chicanery, since someone who successfully sets themselves up as a “business owner” on paper will pay less in taxes than someone who doesn’t, even if they’re doing the exact same job for the exact same pay.
The discrepancy between business owners (or “business owners”) and people just drawing a salary is especially big among the richest Americans. Among the top 0.1 percent, business owners would receive a 5.1 percent increase in their after-tax income on average under the Senate plan, worth more than $327,000. Those living on salaries and bonuses (think super-successful bond traders), would actually see a small tax hike, likely because they’d lose a number of deductions. Their after-tax income would shrink by 1.3 percent, or almost $70,000.
Because TPC’s numbers are based on the Senate bill, they’re unfortunately a tiny bit outdated. A GOP conference committee is currently finalizing a plan that will be voted on by both houses of Congress, and as of now it appears the compromise bill might create a somewhat smaller gap between salaried employees and business owners. As of now, the new legislation would reportedly lower the pass-through deduction to 20 percent, instead of the 23 percent under the Senate bill. And it would drop the top income tax rate to 37 percent, instead of the 38.5 percent that the Senate originally planned.
Still, that shouldn’t change the basic fact that the legislation is more generous to business owners than to employees. As a result, we should expect well-paid professionals to play whatever tax games are necessary in order to qualify for the lower rate, whether it simply means making a personal LLC or trying a more complicated maneuver, like splitting a law firm into multiple pieces so that associates can be the “owners” of a separate partnership. (It’s less important for middle class Americans, since they pay lower tax rates to begin with, making the deductions less valuable.) Republicans have come up with a number of “guard rails” intended to stop these sorts of shenanigans, but it’s unclear how well they’ll hold up. If they don’t, and a wide swath of wealthy Americans start slashing their IRS bills by posing as business owners, this legislation could end up an even more expensive drain on the treasury than any of the official scores have predicted.