Tax cut implications

Stampede of individual taxpayers likely to reclassify as LLCs

NEW YORK — The Trump administration’s proposal to cut the tax rate on partnerships and limited liability companies (LLCs) could set off a stampede of individual taxpayers trying to reclassify themselves as so-called pass-through businesses to take advantage of the savings, according to tax experts.

Call it the Kansas problem. In 2012, Kansas 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 actually raise money for the state treasury. Instead, an unexpectedly large number of taxpayers began calling themselves pass-throughs, and state tax revenues 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, Trump’s administration wants to try a similar move. Passthrough businesses — which include small businesses like corner stores and free-lancers but also doctors, lawyers, consultants and vastly profitable hedge funds — get their name from the way they file taxes: The businesses pass their income through to their owners, who then pay tax 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.

Cue the rush among highearning individuals to recast themselves as LLCs, sole proprietorships or other pass-throughs. “Absolutely!” said J. Richard Harvey, a tax law professor at Villanova University and a former senior official at both the IRS and the Treasury Department. “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.”

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 pass-through business income to the 39.6 percent individual rate. Trump’s initiative would apply the same 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 are also 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,” Marr, a former economic adviser to Senate Democrats and the Clinton White House, said. “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 worry that the steep cut would cause massive increases to the federal deficit — as much as $1.5 trillion over the next decade, according to the conservative Tax Foundation.