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Explaining the Pass-Through Income Anti-Abuse Rules in the House Tax Cuts and Jobs Act

  Sanjiv Gupta CPA  Published 
Explaining the Pass-Through Income Anti-Abuse Rules in the House Tax Cuts and Jobs Act

An issue regarding taxes that deserve tax payer’s attention is the provision that lowers the rate for businesses that are classified as “pass-through.” Top marginal income remains at 39.6% and passes through the business income to remain at 25%. It is important to note that business income from C corporations is taxed two times. As for the pass-through businesses, such as sole proprietorships, S corporations, and LLCs, only have one layer when it comes to taxation. This means that once the income has been passed, then it is passed. This single taxation makes the policy.

Because of this new tax cut, taxpayers are concerned and would prefer to recategorize their earnings as “business income” in order for them to get a rate cut that works for them and is also substantial. For a better example that can explain this situation clearly, an engineer can opt to provide his services as a contractor to his firm as opposed to working 8 to 5. This cuts his income tax liability. If this is the case, then he must pay the employer’s Medicare and Social Security. He could also adjust his contracting fees and the “cost” of this would be the amount the employer has to shell out to hire him.

This would benefit the engineer. For federal revenues, this is a bad deal. Tax collections decrease substantially but there is no economic activity that occurs. This results in the engineer having to carry a similar workload for less pay to bring home due to higher taxes.

As for the sole proprietorship scenario, if the entrepreneur receives taxable and ordinary rates on the wages, then she could benefit from the business income that is within the lower rate. It would be more practical to limit the number of wages received. In theory, the portion of the income that the entrepreneur receives is due to the wage income or the labor as well as some portion that is from the ownership and investment stake. The pass-through rate also provides the incentive for the place to generate as much income as possible and put this in the basket.

Lawmakers have also made it transparent that they must provide a cut in the taxes for the businesses. This is targeted mostly to small businesses. Economists can agree to this and also look into the tax-advantages of the C corporations that are taxed twice. The reductions also have to reach a lower minimum rate especially for the businesses that are regarded as “pass-through.” This also encourages the recategorization of the income of a substantial level.

There are three strategies that federal lawmakers can resort to which will solve specific problems that arise to drawbacks when it comes to taxes:

Method # 1:

Choose the formula that will determine the income that can be regarded as wages especially on the business owner’s tax return. This ensures that the income is still subjected to tax rates.

The idea is that the portion of the income is always attributed to the labor and the returns generate the capital for the business profits.

Advantages and Disadvantages

The method deducts the incentives that allow the employees to work as subcontractors, solely for the purposes of a tax return. This limits the degree of entrepreneurs to reclassify their income from the overall wages to the profits of their business.

The disadvantage is that this is the tax preference that is likely to induce the least recategorization due to the fact that the entrepreneurs have to pay 70% of the income in the wages.

Another is that this is a blunt instrument that overcounts the business income and also undercounts it for the others.

Method # 2

Excluding the owners and the businesses from the expected benefits of the pass-through that are at the lower rates.

Advantages and Disadvantages

Attorneys, financial advisors, and accountants, who are also regarded as professional service providers, incurs low returns to the capital and also the high returns of the labor, this can then receive the disproportionate advantage through the low pass rate. It is also absent from sufficient guardrails. Another option to look at is to exclude these service industries from eligibility and to the lower pass-through rate.

It is also important to not note the non-neutral. This favors specific industries above the others but there is a wrong assumption that there is no return to the capital along with the businesses.

Method # 3

There are facts and circumstances that are determined to be holistic. There is also much income that is required to be set as wages.

Advantages and Disadvantages

This method lets the taxpayers show how much percentage of their income is from the business capital and how much of this is from the labor. The disadvantage is that the calculations for these rates are complicated.

For a number of pass-through businesses, there is the rule of 70-30. This means that 70 percent is for the wage and 30 percent is allotted to the business income. This is by default. It also means that they can make the most out of the rate that is lower than 30% of the overall income. This is said to be the derived amount from the returns and to the capital.

As for the businesses that believe there is an accurate assessment of the returns set to the capital, then there is proof that this can show a depreciation and tangible capital of the business. This is also the purchase that is less than the MACRS depreciation. According to Applicable Federal Rates, this amount is multiplied by 8% and then added 7% to it. The income is usually greater than 30% of the income in that year. The businessmen would pay lower than the pass-through of the income tax rate on the specific amount. This is represented in the normal return on the investment.

Another impact is that there are professional business companies such as law and accounting firms that are excluded from the pass-through rate that is in the lower level. This means that the income they generate is preliminarily subjected to the ordinary tax rates of the individual. These taxpayers are also able to prove that their businesses generate an income that is based on the property that is of an amount that is depreciated. This is subjected to the maximum rate that is lower and at its 25 percent.

It may sound a bit complicated, but these anti-abuse rules are actually a representation of an approach that is well-thought-of with the intent to deal with this sensitive issue when it comes to taxes. Imposing weak rules could only open the opportunities for a certain group of taxpayers to recategorize their income.

How the rich goes around the tax bill’s break

The hallmark of the recently signed tax revamp is a breakthrough for small businesses that are regarded as “pass-through deduction.” This benefits the wealthy most of all, specifically President Donald Trump. To top this off, those who are earning high levels of income can easily skip the restrictions that the bill puts on the pass-throughs.

The target of this deduction is the small businesses. This composes the vast majority of the entities that are defined as pass-through. Its intention is to give a helping hand. When looking at the laws of previous years, the profits from hairdressers, landscapers, and corner grocery stores, including small-business entrepreneurs are taxed at the range of its tax rates on a personal income level. This can range as much as 39.6%

Among these small operations is a string of large businesses like the Trump Organization, the Georgia-Pacific wood products company and the Dallas Cowboys Football Club. There are slightly more than two-thirds of the income from a high 1% of American households, as analyzed by the Treasury Department analysis.

Beyond that, it is also possible for the average entrepreneurs to go through the system and then slide through the restrictions that the lawmakers have placed in the tax bill so the system cannot be abused. For example, the Congress that controls the GOP can ban certain types of firms that are pass-through such as financial service providers and medical practices from receiving deductions. Other than that, it also imposes ceilings on what can be deducted. However, there are ways to go around these.

Let’s take a minute to look at the reason why these small companies are called pass-throughs? Well, first of all, the proceeds can just flow straight to the owners of the business. This avoids the double tax that the government requires large companies that earn at the corporate level as well as the compensation of the employees. As the personal rates on the highest group are lowered to 37% then those responsible for making the law let the pass-throughs take in 20% reduction from the earnings. This then translates to a tax rate amounting to 29.6% of the owners.

When the new tax bill was signed, Democrats in the Senate and House unanimously voted against this because they believe that this is a provision that benefits the wealthy. However, there are still others who regard the deduction in the pass-through as a way to encourage the risks of entrepreneurial turns, which leads to growth in the economy. This leads to job creation. Despite the merits that the pass-throughs encourage, it is still the early stage that appears to be beneficial for the taxpayers. This means that it can still go around the barriers that Congress have erected. Here are some examples:

  1. Sidestep limits when it comes to reductions

This prevents the law from being the setting where the big bucks are placed. Congress has capped the pass-through in the income of the filers. This results in their inability to take deductions on half of the wages of the company. For real estate owners like Trump, who has few workers and would not get anything from the headcount method, there is another way. Base on this deduction on 1/4 of the wages, 2.5 percent of the real estate assets run through the millions, and sometimes billions. It is important to note that the Trump Organization has more than 500 entities.

  1. Alter your job classification

The new law that the bars submit through the businesses of lawyers, athletes, doctors and financial service providers such as stockbrokers are known in the legislation as “specific services” – and this takes some kind of deduction.

  1. Riding reputations

Famous people can organize the side business interests into the pass-throughs. Celebrities like Gwyneth Paltrow who have their own companies like Goop can sell products and even get better tax rates for product income. However, it is not possible for her to run on her being a celebrity to advertise her products.

Be a contractor

First, entrepreneurs should convince their bosses that they quit and then hire themselves back as contractors after this has been set as a sole proprietorship. Assuming that this can be done for the tax treatment is way better. It also offers the ex-employer similar services for less than the company has to worry about giving benefits or paying the share for Medicare and Social Security taxes. This specific law requires that the regulations are written and also implemented. However, under the Trump Administration, it is highly doubtful that there will be damage or effect of the GOP vision. It is clear that the administration has some kind of hidden alternative for presenting this bill. It benefits the wealthy more than working-class Americans. Worse, it may even put individuals working in the United States and paying their taxes more in the coming years. The take-home may be bigger now because of the cuts in the taxes, but in the long run, it might be more difficult for them to attain the financial stability that they have in mind and desire to have. Only time will tell how this turns out.