by Patriotic Millionaires | Updated on 5.17.18
What is a “pass-through” business? A majority of businesses - about 95% according the Brookings Institution - are not classified as “C-corporations” but rather are classified as “pass-throughs.” Rather than paying the corporate tax rate as C-corporations do, pass-through businesses allow their income to “pass through” to their owners to be taxed at the - lower - individual income tax rate.
Pass-throughs include S corporations, partnerships, limited liability companies (LLCs), and sole proprietors.
What did the GOP tax bill do for pass-through tax rates? Because the GOP bill lowered the corporate tax rate to just 21% while keeping the top individual income tax rate at 37%, the bill’s authors felt it necessary to include a provision further helping pass-through owners. Under the new law, pass-through owners are now able to deduct 20% of their business income from their taxes, meaning most will pay a dramatically lower rate than before.
Who benefits from this cut to the pass-through rate? Both the Trump administration and House Republicans have repeatedly referred to this as a tax cut for small businesses. But in reality, this tax cut created a new loophole for some of America’s wealthiest business owners, including President Donald Trump.
While Trump and House Republicans described their proposal as a tax cut for small businesses, the biggest beneficiaries are anything but small businesses. Some of the most profitable and largest companies in the United States are organized as pass-throughs, including hedge funds and other financial firms, lobbying firms, and law firms. In fact, many people would be surprised to learn that large companies such as Bechtel and the Trump Organization are also pass-through businesses. The largest accounting firms, such as PricewaterhouseCoopers, Ernst & Young, and Deloitte, as well as the largest global law firms, are as well.
It is mainly the owners of these really big pass-throughs, which make the majority of all pass-through business income, that will benefit from the cut in the top pass-through business income tax rate. There is technically a cap for the full use of the 20% deduction at $315,000 a year of income for service businesses, but the bill also includes a “capital element” in the formula for determining eligibility beyond $315,000, meaning many will be able to take advantage of this tax break well beyond the cap.
Do small business benefit from a cut in the pass-through tax rate? Cutting the top tax rate for pass-through businesses through the 20% business income deduction may help some small businesses, but the vast majority of people who will be able to take advantage of this are not small-business employers at all.
According to an analysis by the Department of Treasury, less than half of all people who claim traditional pass-through business income actually conduct traditional business activity. Of those who do, the vast majority are self-employed, with no employees. In fact, only 10% of all individuals claiming pass-through income were small-business employers.
Does lowering the pass-through tax rate affect their competitiveness? Some policymakers argued that cutting the top pass-through rate was necessary to provide “parity” with C corporations. In fact, pass-through businesses today are taxed more favorably than C corporations.
Historically, S corporations and partnerships were created for smaller, simpler forms of business. But cuts to the individual tax rates in the Tax Reform Act of 1986 combined with more lenient legal rules for pass-throughs across the 50 states led an increasing number of businesses to shift to LLC and S corporation form. These companies can now enjoy limited liability for their owners, just as traditional, or C, corporations do, and have up to 100 unrelated shareholders or an unlimited number of partners, while not paying corporate income tax. Overall, the average effective tax rate for passthrough businesses—the percentage of their income that they actually pay in taxes, taking into account both business-level and owner-level taxes—has been consistently lower than for C corporations.
What is at stake now that the pass-through tax rate is lowered? The 20% deduction for pass-through businesses is going to add hundreds of billions of dollars to the national debt, debt that Trump and the House Republicans plan to pay for with cuts to programs that help ensure an economy that works for all, including small-business owners. For example, the Trump budget released in May would cut domestic programs (so-called nondefense discretionary programs) even further than they were cut under the automatic, across-the-board “sequestration” cuts. These funds go to investments in education, job training, basic research, and infrastructure—which provide a foundation for economic growth and support domestic businesses.
Written by Patriotic Millionaires
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