Experts see LLC rush in tax plan

15 percent ‘pass-through’ rate could spur reclassifications, they say

NEW YORK — The proposal from President Donald Trump’s administration to cut the tax rate on partnerships and limited liability companies could set off a stampede of individual taxpayers trying to reclassify themselves as socalled pass-through businesses to take advantage of the savings, tax experts say.

A similar scenario played out in Kansas. In 2012, the state exempted pass-throughs from state income taxes, a move that was billed as a chance to spur so much business growth and job creation that it would raise money for the state treasury.

Instead, an unexpectedly large number of taxpayers began calling themselves pass-throughs, and state tax revenue fell by hundreds of millions of dollars. Kansas lawmakers passed a bill to eliminate the exemption, which was derided as the “LLC loophole,” but Gov. Sam Brownback vetoed the measure.

Now, the Trump administration wants to try a similar move. Pass-through businesses — which include small businesses such as corner stores and freelancers but also doctors, lawyers, consultants and vastly profitable hedge funds — get the name from the way they file taxes: The businesses pass their income through to their owners, who then pay taxes based on their individual income-tax rate.

The top individual income-tax rate is now 39.6 percent, though Trump’s plan would cut that to 35 percent. But for pass-through businesses, he’d cut it even more: to just 15 percent.

“If a taxpayer has a choice between paying at a 15 percent top rate versus a 35 percent rate, the taxpayer and their tax planners will be working feverishly to take advantage of the 15 percent rate,” said J. Richard Harvey, a tax-law professor at Villanova University and a former senior official at both the Internal Revenue Service and the Treasury Department.

Trump’s plan was applauded by many small-business groups and Republicans, who say it would remedy an inequity in the current tax code, which taxes corporations at a maximum rate of 35 percent, while subjecting much passthrough business income to the 39.6 percent individual rate. Trump’s initiative would apply the 15 percent rate to pass-throughs and multinational corporations.

“We support efforts to treat America’s small business community just as their corporate counterparts, and that requires an equal playing field when it comes to our tax system,” the National Association for the Self-Employed, which advocates on behalf of the 27 million Americans who file their taxes as self-employed, said in a written statement.

But many tax-fairness advocates say that comparison is mathematically unsound. In addition to the current 35 percent tax on corporate profits, any dividends paid by corporations also are taxed as investment income received by the shareholders who collect them, at rates up to 23.8 percent. But pass-through income is taxed only once, said Chuck Marr, director of federal tax policy at the Center on Budget and Policy Priorities.

“The notion that this plan would achieve parity is a false comparison,” said Marr, a former economic adviser to Senate Democrats and President Bill Clinton’s administration. “Most of the savings of this change would go to the wealthiest businesses and the top 1 percent. But politicians love to stand up and say they are defending small businesses, so I fear it’s an argument that isn’t going away.”

Meanwhile, budget hawks have said they fear the steep cut would cause big increases to the federal deficit — as much as $1.5 trillion over the next decade, according to the conservative Tax Foundation. Gauging the precise costs and benefits of Trump’s tax plan is difficult because the administration has released few details about how it would be implemented.

Given that about 70 percent of pass-through income comes from banks, hedge funds and holding companies, the cut would be a boon for the financial-services industry and many of the wealthiest taxpayers. Because Trump’s business interests derive millions in earnings from real estate, critics have accused the president of proposing a tax windfall for himself.

“Trump is seeking to dramatically reduce his own tax bill,” said Frank Clemente, executive director of Americans for Tax Fairness, a left-leaning advocacy group.

White House spokesman Sean Spicer brushed aside that concern Thursday, saying average taxpayers are far more interested in how Trump’s plan would affect their own pocketbooks.

“I would guess that most Americans would applaud what the president is doing to spur economic growth and job creation in this country,” Spicer said.

Trump’s plan faces many hurdles in Congress and within the Treasury Department. But if enacted, it would present a challenge to the IRS, which would have to determine whether any influx of new pass-through businesses was legitimate. Over the past decade, the agency has seen steep funding and manpower cuts that drastically reduced the number of classification audits it performs, said Garrett Gregory, a former senior attorney at the IRS until 2014 who worked in the agency’s large and midsize business and international unit.

Gregory said classification audits are notoriously time-intensive — involving a 20-part test — so the prospect of retraining auditors would strain an already overburdened workforce.

“The IRS manpower is so low that it’s not like you have a lot of people sitting around twiddling their thumbs,” he said. “So it’s not a good time to have to retool them and redeploy them overnight. But there would be no choice. Otherwise, everyone and their dog will be filing as an LLC.”