*This article is based on Trump’s proposed tax plan. There’s no guarantee it will actually happen, given that Congress would have to pass a tax reform bill to effectuate it, but if it does, you can expect the changes outlined herein*
Following up on a previous post about Trump’s plan for estate and gift taxes, this article will address another portion of the Trump tax plan – taxes on “flow-through” or “pass-through” income. But first, let’s address what I mean by “flow-through” and “pass-through” income.
The IRS disregards a number of different entities for the purposes of corporate taxes and, instead, attributes the income to the individual owners or shareholders of the company, as opposed to being taxed at both the corporate and individual levels, as is the case with C-Corporations. These flow-through entities include LLCs, Partnerships, and S-Corporations.
Without additional tax planning, the income of the business is just earned income for the individual – no payroll, social security, FICA, etc. taken out. Currently, owners of flow-through entities tend to pay relatively high tax rates because they do not benefit from employer-side payroll taxes, so they pay “self-employment” taxes, meaning they are responsible for all of the payroll taxes from their income.
Traditionally, the Republican platform is focused on individual income tax cuts for certain segments of the population, but also on cuts to the corporate tax rates. Ordinarily people would assume this only applies to big C-Corporations like GE and Ford Motor Company, not the local small business owners.
Under Trump’s tax plan – corporate federal income tax rates (meaning C-Corporations) would be capped at 15%, but, unlike the traditional Republican platform, Trump wants that cap to apply to ALL business, including flow-through entities. You read that right: a 15% cap on flow-through income tax.
The tax change is supposed to help small business, most of which operate as flow-through entities – meaning business owners would be taxed at a lower level, since the business itself is not taxed.
According to the Center on Budget and Policy Priorities, the tax cut would mostly benefit the highest-income 1 percent of tax filers, because they own more than two-thirds of flow-through businesses.
Slashing the top rate on flow-through income to below the top income and payroll tax rate, which applies to salary and wages, also would spur large-scale tax avoidance by expanding the incentive for high-income professionals to classify their income as business income instead of salary and wages. While most small businesses are flow-throughs, “flow-through” is not synonymous with “small business”.
Kansas implement a flow-through income tax exemption and saw the number of flow-through entities grow by the thousands. It’s easy to see why. Why would anyone work as a salaried employee at a 25% tax rate when they could form an LLC and operate as a contractor and pay a 0% tax rate? Or, under Trump’s plan, a 15% tax rate.
It’s likely that the use of Family LLCs and Family Limited Partnerships would skyrocket. Traditionally these planning tools are used to hold investment and real estate assets as a way to 1) pass on fractional interests to younger generations while not using up the unified estate and gift tax exemption, while also giving a tax basis benefit to the younger generations, and 2) protect assets from potential creditors or divorce. Income generating assets owned by the LLC or LP may be allowed to fall under this new 15% cap – although its unclear if this cap will apply to both income and long-term capital gains – effectively further reducing the total tax liability for the most wealthy.
The next few months will be exciting to watch as the new tax strategies of the Trump Administration get sorted out among the Republicans in Congress. A lot of changes may be in store for business, families, and individuals.