Blocking abuse of lower small business rate slows U.S. tax overhaul

By David Morgan

WASHINGTON (Reuters) - A plan by President Donald Trump and congressional Republicans to slash taxes on so-called pass-through businesses is testing lawmakers' ability to design rules to prevent wealthy people from dodging taxes by paying a lower rate meant to help small businesses grow.

Businesses ranging in size from the corner Mom-and-Pop shop to accounting firms and industrial conglomerates are called pass-throughs because their profits flow to owners and are taxed as individual income, often at the top 39.6 percent rate.

By contrast, publicly held corporations have their own top corporate income tax rate of 35 percent, at least on paper. Corporate profits are further taxed when they flow through to shareholders as dividends.

Republicans including House of Representatives Speaker Paul Ryan have vowed to get tax legislation to Trump's desk before the end of 2017, but pass-throughs are one of the thorniest issues in their effort to enact the first comprehensive tax overhaul since 1986.

The Republican timeline is in doubt because of complexities posed by pass-throughs and other difficult issues that could roll the debate into 2018 and beyond, analysts and lobbyists said.

Trump and Republicans, who control the House and Senate, want to give pass-throughs their own tax rate of 15-25 percent, saying such a low rate would help unleash economic growth by leaving owners with more money to hire and invest.

The danger with this proposal is that high-income people who pay the top individual tax rate could reap enormous windfalls simply by reclassifying their wages and salaries as pass-through business income to qualify for the new low rate.

Tax avoidance schemes along these lines could erase up to $584 billion from government coffers over the next decade, the nonpartisan Tax Policy Center estimated.

The nonpartisan Tax Foundation estimates that over 28 million businesses are organized as pass-throughs. Income from them has been taxed at the same rates as wages and salaries since the individual income tax was enacted in 1913.

"These are tough, tough questions. And politics aside, they're what has held up tax reform for so long," said one corporate lobbyist, who asked not be identified. "This is an area where there's still a lot of discussion and no solution."

To address this, policymakers are looking at limiting how much of a business owner's income should get pass-through treatment. But that's hard to define because pass-throughs range from sole proprietorships and partnerships to S-corporations.

Rebecca Boenigk, chairman and chief executive of the pass-through manufacturer Neutral Posture, worries that Congress could choose solutions that inadvertently add complexity for small businesses and deny business owners the capital they need.

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"There's always a rule that's put into place to take care of the 1 percent of people who are bad, and that rule ends up affecting the 99 percent of people who are good," said Boenigk, who began making ergonomic furniture with her mother 28 years ago in their family garage.

One proposal under consideration would apply the pass-through rate to only 30 percent of a business owner's income, while giving taxpayers the option of qualifying for more favorable treatment from the Internal Revenue Service, congressional sources and lobbyists said. The remaining 70 percent of income would be taxed at the higher individual rate.

The National Federation of Independent Business, a small business lobbying group in Washington, wants Congress and the Trump administration to apply the lower tax rate to 50 percent of a business owner's income.

Some lobbyists warn against the idea of allowing business owners to qualify for a higher percentage of income for the pass-through rate with the IRS, saying an additional layer of complicated procedures could backfire and encourage fraud.

Keith Hall, president of the National Association for the Self-Employed, would rather see business owners pay individual tax on a portion of their income set by living standards data for the geographical areas in which they live.

But if lawmakers adopted the 70-30 approach, Hall said, higher earners should see the larger portions of their income qualify for the pass-through rate to maximize the amount of capital they can invest in their businesses.

Other proposals would limit the pass-through rate according to the business owner's capital or stock value; exclude income from partnerships engaged in "personal services" such as law, accounting, medicine and engineering; or exclude passive income from royalties, rents, dividends and income.