In GOP Tax Bill, How You Get Rich Matters

The House Republican tax bill intensified a debate about whether the GOP is setting up a big giveaway to the rich, but there is a broader policy shift embedded in the proposal: What matters isn't just how rich you are, but how you are rich.

The plan, which was unveiled this past week and will be further dissected when lawmakers return to Washington on Monday, aims to eliminate estate taxes by 2024. It cuts to 20% the tax rate on corporate income. It also cuts to 25% the rate on some income that owners of so-called pass-through businesses such as partnerships and S corporations earn from their operations.

At the same time, the House plan leaves a top tax rate of 39.6% for those earning big salaries from their employers and doesn't touch the top tax rate of 23.8% for capital gains and dividends.

In total, the party's proposed vision of the tax code shows its focus in rewarding taxpayers who lawmakers think boost the economy the most.

"If you earn your income as a doctor, a lawyer, an architect, you're not getting anything," said Rep. Chris Collins (R., N.Y.). "But you're not supposed to get anything -- that's how you earn your income. It wasn't intended to lower the tax rate for a doctor, a lawyer or an architect. It was intended to lower the rate for manufacturing companies making widgets and employing other people."

The GOP says its plan, if enacted, would encourage investment, hiring and growth by allowing owners and investors to keep more of what they put into their businesses. "The kind of growth you're looking for is not quick stimulus," said Republican economist Douglas Holtz-Eakin. It is "to raise the return to saving and investment, improve productivity."

Yet because of these changes, the tax code could become even more complex for America's wealthiest households and open new avenues for tax avoidance.

The changes also could lead to inconsistencies that some construe as unfair. Some billionaire professional sports team owners, for example, would get sizable tax cuts while their millionaire employees on the field see little change.

Take a simplified example of $2 million, received at the relevant top rates, by five different people: a salaried executive; the owner-operator of a manufacturer; an investor receiving dividends; a passive business owner, such as one who has a stake in a real-estate property; and an heir from a large estate.

Under the GOP plan, the executive would pay $868,000 in taxes, according to a rough calculation by Tony Nitti, of WithumSmith + Brown, an accounting firm. The manufacturer pays $704,400, but might be able to argue her way into a lower bill. The passive business owner pays $576,000. The dividend-earning investor pays $476,000. The heir to the estate pays nothing. The manufacturer, the estate and the passive owner all get big tax cuts from the GOP plan. The investor and the wage earner generally don't.

On top of that, upper-middle-class taxpayers who make far less than $2 million could see tax increases, especially if they live in high-tax states and would no longer be able to deduct state and local income taxes.

"It creates a lot of complexity for taxpayers and a lot of opportunities to game the tax code, which tend to benefit people who are richer and able to afford the best tax advice," said Lily Batchelder, a New York University tax-law professor and former aide to President Barack Obama.

Early estimates show that about $1 trillion worth of the tax cuts in the plan go to businesses, including pass-through ones, while about $228 billion goes to individuals and $172 billion goes to estates. The plan is likely to change repeatedly, both in the House and the Senate.

Democrats seized on some of the plan's provisions, including its proposal to repeal many deductions and end the estate tax, as a sign that the benefits were tilted to the highest-earning households. The Tax Foundation, a conservative-leaning think tank, estimated Friday that the top 1% of households would see their after-tax incomes rise by 7.5% in 2018, compared with a 2.2% boost for the middle 20% of the population.

The Republican effort to overhaul and update business taxes causes these twists and turns. Republicans say cutting the corporate rate would make U.S. business more competitive with firms taxed at lower rates overseas. Because the U.S. business and individual tax codes are intertwined, Republicans are considering changes to both.

Under current law, the corporate tax rate is 35%. But much business income is taxed through the individual tax system, such as partnerships, S corporations and sole proprietorships. For them, business income appears on the owner's individual tax returns and gets taxed at individual rates of up to 39.6%, not far from the current corporate tax rate on profits.

More than half of U.S. business income goes to pass-throughs, and more than half of pass-through income goes to the top 1% of households, according to the Tax Policy Center, a group run by a former Treasury Department official under President Barack Obama.

Pass-through businesses are a powerful force in the GOP political coalition. Republicans promised a 20% rate for incorporated businesses and a 25% rate for pass-through business income. But the changes get complicated from there.

Under the GOP plan, passive investors in pass-through businesses get the 25% rate. Active owners instead fall into two groups. Those in professional services businesses, such as lawyers and, ironically, accountants, don't get it. They are treated just like the CEO taxed at a 39.6% high-end rate.

Others, such as a retail-store owner or a manufacturer, are treated as part CEO and part investor; 70% of their income under the House bill is taxed at individual rates up to 39.6%, and 30% of their income is taxed at the lower 25% rate for business owners. Further complicating matters, business owners could argue to the Internal Revenue Service that they should get a different ratio based on how much they invest in their business, say on equipment and property.

Not surprisingly, lawyers and architects are unhappy.

"The issue is fairness," said Andrew Goldberg, a spokesman for the American Institute of Architects. "If Congress is going to provide a new rate for pass-through entities, it shouldn't knock out some arbitrarily."

Some business owners could have an incentive to leave pass-through status and turn their businesses into corporations. They would pay a 20% tax on profits and keep their money inside the corporation. They could also get the benefit of deducting state taxes from their profit calculations. They could then invest the retained earnings and defer the tax on dividends. They might also pass appreciated stock to their heirs without estate or capital-gains taxes.

"There's all different ways to structure," said Gregg Polsky, a tax-law professor at the University of Georgia. "They're going to pick whichever's the lowest."

Republicans say their approach marks the best way to level a skewed tax system while charging up the incentives for economic growth. Getting there in practice and diagnosing the effects, however, aren't so simple.

"From the standpoint of abstract theoretical economic models, the idea of having different rates in these different categories is not problematic," said Alan Viard, a tax economist at the center-right American Enterprise Institute. "There's never going to be a foolproof way to try to distinguish the two."

--Laura Saunders and Siobhan Hughes contributed to this article.

Write to Richard Rubin at richard.rubin@wsj.com

WASHINGTON -- The House Republican tax bill intensified a debate about whether the GOP is setting up a big giveaway to the rich, but there is a broader policy shift embedded in the proposal: What matters isn't just how rich you are, but how you are rich.