Tax Reform

Small Businesses Say GOP Pass-Through Tax Reform Excludes Many of Them

Guidelines to prevent abuse of lower tax rates criticized as blocking benefits to wide range of small businesses

House Way and Means Chairman Kevin Brady (R-Texas), joined by members of the House Republican leadership, introduce tax reform legislation Nov. 2 in Washington. (Win McNamee/Getty Images)
  • GOP bill would lower pass-through tax rate to 25 percent, from the current top rate of 39.6 percent.

  • 70 percent of pass-through business income would be counted as wages subject to normal individual income tax rates.

The House Republican tax legislation released Thursday received a lukewarm reaction from small business groups, which said the measure’s rules to prevent the abuse of lower tax rates would keep a wide range of small businesses from reaping the benefits of tax reform.

Under the bill, H.R. 1, the top tax rate for pass-through businesses such as LLCs and sole proprietorships, whose income is taxed at individual rates, would be 25 percent, from the current top rate of 39.6 percent. That new rate is higher than the proposed top corporate tax rate of 20 percent, and lower than the 35 percent and 39.5 percent individual rates for high-income earners.

To discourage individuals from establishing as small businesses to take advantage of the lower pass-through rate or big businesses from using the special rate, the legislation contains what Republicans are calling “safeguards.”

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This bill leaves too many small businesses behind.

Under one provision, business owners would be able to assume that 70 percent of their income can be counted as wages subject to normal individual income tax rates. Thirty percent of income would then qualify as business income for the 25 percent pass-through rate.

House Ways and Means Committee Chairman Kevin Brady said at a news conference on Thursday that he thinks many small businesses will opt to report using the 70/30 approach because they will want to avoid a “hassle” with other options.

A separate safeguard Brady outlined would take into account the capital investment of business owners who are behaving as owner-operators and so are earning less in wages. More income could be classified as business income under this rule compared to the 70/30 approach, the Texas Republican said.

”This ensures that there won’t be gaming the system, and people switching to pass-throughs even though their services are exactly the same,” Brady said of the second option.

Under the second option, according to Brady, personal service providers like doctors who make investments in assets like equipment will be able to use the capital safeguard.

Other personal service providers, however, would not be eligible for the 25 percent rate, according to a section-by-section description of the legislation released by Ways and Means Republicans. Lawyers, accountants and consultants are among the professionals that could face a default capital percentage of zero, the summary states.

“As a result, a taxpayer that actively participates in such a business generally would not be eligible for the 25-percent rate on business income with respect to such personal service business,” the Ways and Means summary stated. “However, the provision would allow the same election to owners of personal services businesses to use an alternative capital percentage based on the business’s capital investments,” subject to some limitations.

The new pass-through provisions were met with a negative reaction from the groups that represent small businesses in Washington. Juanita Duggan, chief executive of the National Federation of Independent Business, said in a statement Thursday that the bill requires “necessary corrections so that the benefits of tax reform extend to all small businesses.”

“This bill leaves too many small businesses behind,” Duggan said. “We are concerned that the pass-through provision does not help most small businesses.”

Jack Mozloom, an NFIB spokesman, said by phone that NFIB is still hoping the legislation will cut the top pass-through rate to lower than the 25 percent outlined in Thursday’s draft.

Additionally, Mozloom said, 85 to 90 percent of the members in NFIB, which represents 325,000 small and independent business owners, would be ineligible for the pass-through rate cut under the House GOP bill. He noted that the group generally supports the goal of the rules — to prevent large businesses from abusing the pass-through rate — but that the current proposal would negatively impact too many small businesses.

“There appear to be certain kinds of exclusions in the bill that would make certain kinds of services ineligible,” Mozloom said. “Our members are not hedge fund managers.”

Other groups indicating skepticism about the pass-through rules include the Job Creators Network, a conservative-leaning organization focused on small business issues. JCN’s president, Alfredo Ortiz, said in a statement that Congress should “adjust the final legislation so that it allows all small businesses, including professional services which create millions of jobs, to access the new 25 percent top tax rate.”

Democrats have long been skeptical of Republicans’ plans for pass-throughs as well, and liberal economists said Thursday that the anti-abuse rules could easily be bypassed.

“It is, by design, intended to the top 1 percent,” said Gene Sperling, a former Democratic director of the National Economic Council, on a Thursday conference call with reporters.

Avoiding the abuse of pass-through rates has been a simmering policy debate in Washington throughout the drafting of the tax reform legislation. At a state level, pass-through business rates were famously controversial in Kansas, which implemented a zero rate intended for small businesses and saw revenues to state coffers plummet after it became a widespread tax avoidance strategy.

Kansas GOP Gov. Sam Brownback, who enacted the revamp of Kansas’ tax code, was on Capitol Hill on Thursday as Republicans rolled out their bill.

When asked by a reporter to react to the pass-through rules in the House GOP plan, Brownback declined to comment.

“No, you’re going to get me in trouble,” Brownback said.

— Cameron Easley contributed reporting