Senate Republicans are expected to vote on their version of the tax bill this week — and it includes several massive tax cuts. Vox’s Dylan Matthews has an excellent explainer on the bill, but one of the changes is a cut that would directly benefit Donald Trump and other very wealthy business owners.
This cut is a change in how “pass-through” businesses are taxed. These are businesses that can bypass corporate taxes and instead pay taxes like individuals. It was designed to benefits small business owners.
This is becoming more important now because Republicans have a slim margin in the senate and one member, Sen. Ron Johnson (R-WI), is saying that he won’t vote for the bill as it stands because it’s not generous enough to pass-through businesses — and President Trump apparently agrees.
But here’s the issue: The Trump Organization is a pass-through business — but it is not a small business. It owns hotels, resorts, golf courses, and much more; in fact, it’s the 48th-largest private company in the US, and brought in $9.5 billion in revenue last year. Yet the way the Trump Organization is structured makes its taxes very different than a typical corporation.
And the Trump Organization isn’t the only large company taking advantage of this policy; huge corporations have increasingly made money as pass-through businesses.
Trump has lobbied for lower tax rates for pass-through businesses, but now we have an actual bill that shows what Senate Republicans want to do. In short, it’s a huge benefit to the wealthy.
This cartoon explains how the pass-through system works now, how Trump and Senate Republicans want to change it, and why it would benefit the wealthy.
Let's say you earn money as a sandwich maker.
Since you're an employee, when you get paid by your employer...
...you only have to pay individual taxes.
But you’re the sandwich shop owner, the money you earn has to go through two layers.
First, you pay corporate taxes.
Then, since you're receiving the money, you pay your individual taxes. The Treasury Department estimates that owners of these corporations pay about 32 percent of their income in federal taxes.
(If you're getting dividends, you may qualify for a lower rate. But we’ll ignore that for now.)
But there might be something you can do to pay less in taxes: become a pass-through business
Under the current tax code, you can set up your sandwich shop as a "pass-through" entity. These are LLCs, S corporations, partnerships, or sole proprietorships.
They're special because they distribute their profits to the owners, who only have to pay the individual tax rates — even though it's business income. (Pay attention to that orange limo. It’s a business, but it’s going through the individual lane!)
And according to Treasury, owners of these pass-through corporations pay on average 19 percent in federal taxes.
This is a contentious issue because it's not just small sandwich shops that use the "pass-through" designation in their favor.
Huge companies — like President Trump's businesses — are also structured as pass-through entities.
And for them, the numbers work out.
If you're the owner of a traditional corporation, you would have to go through two layers of federal taxes:
- Up to 35 percent for corporate taxes
- And also the individual tax rate (or the capital gains tax) on the dividends paid out by the company
But as a pass-through entity, you only have to pay the individual rate.
Now, this makes sense if you’re a small sandwich-shop owner. But those aren’t the people benefiting most from pass-through businesses.
Increasingly, it’s the very wealthy people who are increasingly taking advantage of pass-through income.
And in the past four decades, they’ve taken more and more advantage of pass-throughs. In fact, right now pass-throughs earn more income than traditional corporations:
What Senate Republicans want to do: help pass-throughs even more
The Senate Republican bill allows people who earn pass-through income to deduct 17.4 percent of it from taxes.
This means that the top rate they’d pay is about 31.8 percent.
Now here’s the problem: Pass-throughs used to go through the individual lane — and the Senate Republicans bill lowers the top tax rate on that lane to 35 percent. But that’s still higher than the top rate for this pass-through lane.
So this change creates a weird situation for individuals making a lot of money and paying the top income tax rate of 39.6 percent. They might be thinking, “Wait! I’m an individual and I’d rather go through the pass-through lane and pay 31.8 percent, rather than the individual lane. It’s a better deal.”
The Senate bill includes a provision to curtail this a bit, though not entirely. Matthews writes:
To limit the deduction, wealthy people with “service industry” income (think accountants or lawyers) would see the deduction phased out. But people earning under $200,000 (for married couples) would still benefit from the deduction if they work in those companies.
What happens when you lower rates on pass-through businesses?
The main argument Republicans use for further lowering rates for pass-through entities is that it would spur economic growth.
That was the logic Kansas Gov. Sam Brownback and his advisers used in 2012 when they carved out a part of the state tax code that didn't tax pass-through entities:
One of the architects of that Kansas plan, Stephen Moore, who was an economic adviser to Trump's presidential campaign, said the tax change would create “near immediate” growth in Kansas.
But that instant growth didn't materialize, contributing to a $350 million budget shortfall. This example has been used by economists to show that allowing pass-through entities to pay lower tax rates doesn’t actually spur economic growth.
Pass-through entities are becoming more common, helping the wealthy, and driving up inequality
If you work in the private sector, chances are you work for one of these pass-through businesses.
But that doesn't mean it's a small business.
And it doesn't mean the average person is earning more money from these companies. Rather, it's the wealthy who benefit most from these tax provisions:
This wasn't always the case. Since 1980, the top 1 percent of earners have increasingly gotten involved in pass-through entities and used this loophole to accrue more and more wealth.
But despite all these trends, the Senate Republican bill wants to further help these pass-through entities. Right now, rich people who benefit from pass-through businesses are at least paying the top individual rates.
The new reforms — proposed in the name of economic growth — would give these businesses a special lane that allows them to pay an even lower tax rate than an individual.