President Donald Trump's plan to cut the tax rate to 15% for so-called pass-through businesses could create many opportunities -- and leave plenty of room for abuse.
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Advocates say lowering the tax rate for the business income of partnerships, S Corporations and limited-liability companies would spur U.S. business growth and job creation.
"This is an incentive for business owners like my wife and me to reinvest in our own firms rather than pay the government," said James Jungbauer, president of Hollstadt Consulting, a firm in Mendota Heights, Minn., with 200 employees that specializes in business analysis.
Critics said the measure creates an incentive to minimize compensation as a way of avoiding higher income and payroll taxes, among other issues.
Lawrence Gibbs, a former IRS commissioner under Ronald Reagan who is now with Miller & Chevalier in Washington, said if this measure becomes law, "you will have scams coming out of the woodwork."
"Large tax-rate differentials encourage abusive tax planning," he added.
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As he unveiled the measure on Wednesday, Treasury Secretary Steven Mnuchin said the administration would work on protections to ensure that a tax cut for pass-through businesses wouldn't be abused.
The rate-cut proposal still lacks important details, but it would apply to business income from many small firms as well as large global law firms, hedge funds and Mr. Trump's own real-estate and branding businesses.
All of these firms are partnerships, S corporations and limited liability companies that "pass through" to their owners a proportional share of income, losses, and other tax items. Currently the top rate on such income is 39.6%, but Mr. Trump's proposal would cut it to 15%.
More than half of all business income is now earned by pass-through entities, which have surged in popularity in recent decades.
Of all pass-through income, more than half is earned by top-bracket taxpayers, according to estimates by the Tax Policy Center in Washington. The top brackets begin at $470,700 for married couples filing jointly and $418,400 for singles.
Under current law, pass-through owners have little income-tax incentive to distinguish between business income and compensation, although some have tried to minimize compensation in order to lower Medicare and Social Security taxes.
If this proposal becomes law, owners will likely try to reduce their compensation in order to save income taxes as well, says Troy Lewis, a certified public accountant in Draper, Utah, who advises wealthy clients. "People try to structure their affairs to achieve lower rates."
For example, say a pass-through owner has $200,000 of net income currently taxed at the top 39.6% marginal rate. Under the proposal, the part that is compensation would be taxed at a 35% rate, and the portion that is business income would be taxed at a 15% rate.
So taking wages of $50,000 instead of $150,000 could save $20,000 in income taxes, plus any additional payroll-tax savings. While there are laws defining "reasonable" compensation, they are cumbersome for the IRS to enforce because each case is different.
It is still unclear whether the proposal would apply to self-employed workers and how much wealthy owners of hedge funds and private-equity firms would benefit, if at all.
Gregg Polsky, a tax-law professor at the University of Georgia, said the proposal wouldn't immediately affect private-equity partners because much of their income is taxed already at lower capital-gains rates. On the other hand, he said, they could restructure arrangements to benefit from the lower 15% rate.
One adviser to hedge funds, Michael Laveman of accounting firm EisnerAmper LLP, said the proposal would act as a tax cut for hedge-fund owners who share management fee income. Management fees, he said, are typically taxed at the current top 39.6% rate.
Mr. Laveman's own firm, also a partnership, would be among the beneficiaries. "I'm trying not to tell my wife about the huge tax break we are about to get," he said.
--Rob Copeland and Mark Maremont contributed to this article.
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(END) Dow Jones Newswires
April 26, 2017 19:41 ET (23:41 GMT)