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 so-called 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 pass-through business income to the 39.6 percent individual rate. Trump's initiative would apply the 15 percent rate to pass-throughs and multinational corporations.
But many tax-fairness advocates contest that argument. 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.
A Section on 04/30/2017