Pass-Through Loopholes Provide a Windfall to Wealthy Tax Avoiders, not Main Street

Through backroom deals and a vote in the dark of the night, Senate Republicans passed their version of the Tax Cuts and Jobs Act (TJCA) last week.  They only provided Democrats with the revised bill, which contained significant changes from the previous draft, hours before the vote, complete with handwritten edits that ran off the pages.  One of the eleventh-hour changes was a reduction in the pass-through rate.

Most businesses are pass-through businesses. They do not pay corporate incomes taxes, but instead, business profits are “passed through” to the owners of a business, and taxed at the individual income tax rate.  This is known as the pass-through rate.   In theSenate version of the TJCA, pass-through entities are given a 23 percent deduction on net business income. TheHouse bill similarly decreases the pass-through rate, cutting the top rate from 39.6 percent to 25 percent. A lower rate of 9 percent is also available for some lesser-earning businesses in the House plan. 

Republicans have been touting these provisions as benefiting small businesses, but in reality, gutting the pass-through rate creates a new loophole that would entice the very wealthy to re-characterize personal income into business income to avoid the top personal income tax rate.  The loophole will provide a windfall for wealthy tax avoiders such as hedge fund managers, investment bankers, Wall Street lawyers and real estate investors like Trump,while the vast majority of Main Street small businesses won’t benefit.  Eighty-six percent of pass-through businesses are in the 25 percent bracket or lower, and therefore won’t benefit from cutting the top tax rate

Cutting the top rate to 25 percent would cost $770 billion over the next decade, with 88 percent of the net benefit going to top 1 percent.  For example, decreasing the pass-through rate will increase Trump’s own personal earnings on over500 of his businesses.  According to conservative estimates, the House bill could save him an estimated$23 million dollars annually.  

Senator Ron Johnson (R-WI), who under the guise of benefitting small business, crusaded for a greater reduction in the pass-through rate, serves to personally benefit the loophole as well.  Johnson opposed the Senate plan until he was granted a higher deduction for pass-through businesses, raising the proposed deduction from 17.3 percent to 23 percent.  His efforts only serve to help wealthy business owners like himself and Donald Trump.  Based on estimations from public disclosures, in 2016, Johnson had an estimated $1.1 million of pass-through business income.  

Another last-minute amendment to the Senate bill put forth by Senator John Coryn (R-TX), enables oil and gas company managers and investors to receive receive the 23 percent pass-through deduction.  It’s no coincident that Texas is home to the largest number of oil and gas companies in the U.S.  Large oil and gas companies executives are not small business owners, and they shouldn’t profit from a rate that was originally intended to help small business owners.    

Creating a loophole in the pass-through rate is nothing more than a boon for wealthy investors.  While the bills appear to have guardrails that Republicans claim will keep the wealthy from gaming the system, the limits are weak and corporate tax accountants can easily skirt the limits.  Though certain service professions could face exclusions, it’s notable that those in real estate, the chosen field of Donald Trump, do not.  

Moreover, the tax plans further complicates the tax code, costing small business owners time and money. The new rules create enormous complexity for small businesses because only certain types of pass-through businesses and certain categories of business income are eligible for the loopholes, and owners have to figure out how much of their business income fits into the loophole.  Many Main Street businesses are already operating on thin margins, and by adding complexity to the tax code, small business owners annual tax preparation costs increase as well, which would no longer be deductible.

The House also bill creates different tax rates for “active” and “passive” business owners. Purely passive owners, that is wealthy, static investors in a business, get the full benefits of the pass-through loophole.  That means 100 percent of income from passive investments is eligible for the lower rates regardless of type of income or business classification.  People who actually work in and run the business, like Main Street small business owners (i.e. active business owners), are largely denied the loophole, or at least will have to navigate extremely complicated rules. 

The reductions in the pass-through rate are governed by complicated and morass rules, which create different rates on different types of income, and are designed to only benefit very wealthy tax avoiders, not Main Street small business owners.