Lawmakers and tax lawyers are raising doubts about a crucial piece of the Senate tax plan that would affect small businesses, partnerships and real-estate developers as the Senate Finance Committee takes up the overhaul this week.
The Senate's plan for taxing pass-through businesses such as partnerships and S corporations departs from the House approach. It features a deduction of 17.4% of income instead of a special 25% rate that only applies to some business income, as in the House bill.
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As concerns emerge, Republican aides to the Senate Finance committee say they are considering changes to the plan. A modified version of the proposal is due out Tuesday.
A pass-through provision that is too generous to businesses risks busting the $1.5 trillion cap on the size of the tax cut under the GOP tax plan. But an overly restrictive rule could turn business groups against the Republican tax agenda.
Republicans want a bill on President Donald Trump's desk by the end of December that the Internal Revenue Service could start to implement in January.
"Nobody has any idea how this works," said Victor Fleischer, a tax law professor at the University of San Diego who was, until recently, a Democratic aide to the Senate Finance Committee. "Nobody knows the answers, and that's what happens when you try to jam something through on short notice."
Regular corporations pay the corporate tax of up to 35%, and their taxable owners pay a second layer of tax on dividends or capital gains.
Pass-throughs pay no corporate-level tax. Instead, profits pass through to owners' individual returns, where they're taxed at rates up to 39.6%.
Republicans want to cut the corporate rate to 20% from 35% and have promised pass-throughs rough parity with a rate cut of their own. Calculating parity is tough because of that second layer of tax on some corporate income. Also difficult: Limiting the new break to business income and preventing top earners from taking too much advantage by getting what would otherwise be wage income to get the new benefit.
The framework released by the Trump administration and congressional Republicans in September called for a 25% top rate for pass-through income. Neither the House nor Senate bills truly provide that rate for most income.
The House shows a 25% rate, but requires many business owners to report 70% of their pass-through profits as ordinary income, subject to ordinary tax rates as high as 39.6%. That would create a blended top rate of about 35%. Professional service businesses, including lawyers and consultants, wouldn't get any of their income taxed at the lower rate.
Under the House bill, both kind of businesses could argue their way into lower rates by proving that they have more invested capital than the default percentages.
The House later added lower rates for the smallest businesses. The House bill is set for a vote this week.
Under the Senate bill, a taxpayer would calculate what income qualifies, multiply by 17.4% and then subtract that from taxable income.
For a business at the Senate's proposed top rate of 38.5%, getting that deduction drops the rate to about 32%. But foreign income doesn't qualify. Service businesses don't qualify -- except for those whose owners have incomes below $150,000 for married couples and $75,000 for individuals, the point at which that benefit starts phasing out.
Businesses that do qualify can only deduct up to half of what they pay in wages, though sole proprietors wouldn't face that limit. The idea is to provide benefits in every tax bracket.
"That's the backbone of the community and they'll have the opportunity to grow and provide more jobs," said Sen. Mike Enzi (R., Wyo.)
But in the days since the Senate plan's release, it has been drawing criticism.
The S Corporation Association told its members that the Senate bill "falls well short" of the promises lawmakers had made.
Sen. Ron Johnson (R., Wis.) said Monday he was frustrated by the process and by a result that would leave pass-throughs paying higher tax rates than corporations.
"We were supposed to leave that competitive balance, that competitive position in place basically untouched when we made American businesses overall globally more competitive," Mr. Johnson said. "I don't know what happened along the way, but we're talking somewhere about 33% to 35% rather than 25%."
And tax lawyers have been looking -- publicly and privately -- for ways to game the new rules, even before legislative text of the Senate plan is released. Some took to Twitter.
"If we can come up with these kinds of examples sitting here on Twitter, imagine what the high-priced lawyers are going to come up with," Mr. Fleischer said.
As the proposal is currently written, hedge funds would be able to qualify for the low rate by adopting a different legal structure, wrote David Miller, a tax lawyer at Proskauer Rose LLP, in a paper published Monday.
Service businesses could take advantage of the low rates by pushing some of their profits into a separate partnership that owns real estate and goodwill, suggested Daniel Shaviro, a New York University law professor.
At Tuesday's Senate Finance Committee hearing, witnesses disagreed on whether the proposal as written would allow that maneuver.
One possibility, said a Democratic Finance Committee aide, is that business owners could buy low-margin firms with lots of employees to maximize the deduction and then use it to offset profits from a high-margin business with few employees.
"It's so complex," Sen. Maria Cantwell (D., Wash.) said Monday. "It's so challenging. I don't know what small businesses are going to benefit from this."
Republican aides on the panel say they've heard some of the criticisms and that the GOP may suggest changes soon.
"This will be something they'll reconcile" between the House and Senate, Treasury Secretary Steven Mnuchin said Monday at The Wall Street Journal's CEO Council. "In both these cases, what is important is that businesses get the benefit of this and that's what's about growth and the economy."
--Siobhan Hughes and Nick Timiraos contributed to this article.
(END) Dow Jones Newswires
November 14, 2017 13:38 ET (18:38 GMT)