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Trump wants to create an amazing new tax loophole — here's how to use it for yourself

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President Trump will create an enormous opportunity for tax avoidance if his wishes on tax reform are granted. And if you’re in the 38 percent of Americans earning more than $40,000 per year, you can take advantage of it.

All you have to do is become a one-person company.

Trump’s plan to change the tax code involves abolishing the estate tax, expanding the standard deduction for all taxpayers, and lowering the corporate tax rate from 35 percent to 15 percent. It would also lower the tax rate for owner-operated businesses to 15 percent.

These businesses — which can range from the local barbershop to a private law firm or a Wall Street hedge fund, and include most of Trump’s businesses — can be sole proprietorships, S corporations, and partnerships. Right now they’re taxed at the same rate as individual personal income. The majority of this income, research shows, goes to the top 1 percent of earners, whose income tax rates can reach up to 39.6 percent.

Trump’s plan would lower the tax rate for many wealthy Americans who get their money from their law firms, hedge funds, or private medical practices. But it also creates a tempting loophole for many others to reclassify their personal income as business income. The Tax Policy Center estimates the change could cost the federal government $650 billion in lost revenue over 10 years.

While Treasury Secretary Steve Mnuchin has promised to come up with rules to prevent this kind of tax avoidance, tax policy experts says it would be hard to stop. “You can always pay a high-priced accountant to find a way around it,” says Eric Zwick, a finance professor at the University of Chicago.

So here’s what you’d have to do: If you stop being an employee, and make your employer hire you as an independent contractor, the tax cut could save you thousands … and blow a hole in the federal budget, if enough people try it.

Step 1: find out if it would actually lower your taxes to form a business

To get a tax break from starting your own business under Trump’s plan, you need to make sure you are currently paying more than 15 percent of your income in federal taxes. If you make more than $37,950 a year as an individual, or $75,900 as a married couple (filing taxes jointly), that means you probably qualify.

Most American workers don’t make enough money to pull this off, but about 38 percent could, since they make more than $40,000 a year, according to the latest wage estimates from the Social Security Administration. That’s still a lot of people — about 61.8 million workers in 2015.

Step 2: make sure your job is flexible enough

Workers who have the easiest time creating owner-operated or “pass-through” businesses are those who are self-employed — contract workers. Uber drivers, freelance writers, and anyone who files their taxes with a 1099-MISC form can easily create a business to reclassify their earnings as business income. The IRS doesn’t publish the number of 1099 forms it receives, but a 2016 study by the Freelancers Union and Elance-oDesk determined that about 34 percent of American workers filed one.

It’s a little harder, though not impossible, for full-time salaried workers to do the same. They would have to negotiate with their employers to hire them as contractors instead of salaried workers.

For example, a financial adviser could tell her employer that she no longer wants to be paid as an employee, and would rather work as a contractor. She would then create a sole proprietorship — or another pass-through business — called Jane Doe Wealth Management (or something like that) and work for her employer under a contract. Instead of getting a W-2 at the end of the year, the company would give her a 1099-MISC form.

This arrangement has advantages for employers too. They don’t have to worry about payroll taxes or paying for retirement benefits, vacation time, or other perks of the modern workplace. “Having a flexible relationship with your employer is key,” says Zwick.

Step 3: calculate the cost of lost benefits

Going from an employee to the owner of your own one-person business carries costs, though. You’ll have to pay the full cost of your health insurance premiums, time off work, and retirement savings. You’ll have to calculate whether a lower tax bill is still a good deal if you include the cost of paying for these benefits.

Then there’s the uncertain future of Obamacare, which made it easier — and more affordable — to access health insurance on the individual market. If Congress allows states to roll back protections for people with preexisting conditions, you’ll have to take that into account too.

Aside from that, business owners have to pay at least 15.3 percent in self-employment taxes on income of up to $118,000 to fund Social Security and Medicare. In a traditional job, workers only pay half of that amount through payroll taxes, and employers pay the other half. So that’s an extra 7.65 percent of taxes they weren’t paying before.

To make the shift worthwhile for middle-class salaried workers, they would need to ask their employers to pay them extra as contractors — whatever the company was paying for the employee’s benefits, such as the 401(k) retirement match and the 7.65 percent in payroll taxes.

Still, the more money you make, the bigger the tax break from reclassifying your income as business income. In other words, the top 1 percent of earners (any individual making more than $250,000 in 2015) would make the most money. That’s because they are in the highest income tax bracket, paying up to 39.6 percent of their income to the IRS.

The wealthiest Americans could lower their tax rate to 30.3 percent (the 15 percent business tax rate plus the 15.3 self-employment tax rate). If they can persuade their employers to pay them what they were paying for half of the payroll taxes — 7.65 percent — that would lower their tax rate even more, to 22.7 percent (15 percent business tax rate plus 7.65 in self-employment taxes). It’s important to note that self-employment taxes are only levied on the first $118,000 of a person’s annual income.

Step 4: choose what kind of business you want to form

There are three main types of pass-through businesses: a sole proprietorship, which is an unincorporated business owned by a single individual; a partnership, which is an unincorporated business with multiple owners; and S corporations, which can have up to 100 shareholders and must have more than one employee.

For people who are trying to avoid paying taxes, as opposed to legitimately starting a business with partners and employees, the easiest option is a sole proprietorship. In some states, all you have to do is register a business name, which usually costs less than $100.

Step 5: forming a sole proprietorship

Pick the name of your business and register it with the county clerk, or the department of state, depending on where your business is located. Some states also require a business license, and the cost for that varies. In Washington, DC, it costs about $55 to register a business name and at least $300 for a basic business license.

Step 6: file your taxes

This is pretty easy. Just fill out an extra form (Schedule C) and attach it to your 1040 income tax form. Done!

The case for not starting your own business

This might seem like a good deal for you, as long as you don’t mind the extra paperwork. But it could cost the government billions of dollars in lost revenue and eventually lead to big spending cuts in key government programs.

The state of Kansas’s own tax reform experiment illustrates how easy it could be to take advantage of this kind of loophole — and the chaos that could result.

In 2012, the state lowered its income tax rates and eliminated income taxes for all pass-through businesses. State tax analysts expected about 191,000 taxpayers to get a tax break from the carve-out for pass-throughs, but almost 400,000 people claimed that exemption. The state lost $700 million in personal income tax revenue and now faces a severe budget crisis. Kansas has cut millions of dollars in funding to public schools, and that still hasn’t been enough to offset the lost revenue.

Since the campaign, Trump and his aides have promised to adjust their plans to address concerns about how people might exploit the loophole to lower their taxes. But no one, including Mnuchin, has explained how.

And according to Michael Graetz, a tax law professor at Columbia University, the outlook for blocking the loopholes is bleak. Those kinds of rules are hard to enforce, he said: “I’m not sure they’re even possible to write.”

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