How the wealthy can game tax bill's break for small business

One of the hallmarks of the just-passed tax revamp is a special break for small business, known as the "pass-through deduction," which actually benefits the well-off the most, particularly real estate operators like President Donald Trump. But that's not all: High-income folks can easily skirt restrictions the bill places on pass-throughs.

The deduction is targeted at small businesses, which make up the vast majority of pass-through entities, with the intention of giving them a helping hand. Under previous law, profits from corner grocery stories, hair dressers, landscapers and the whole panoply of entrepreneurs were taxed at personal income tax rates, which ranged as high as 39.6 percent. 

But among these mom-and-pop operations are a number of very large businesses, such as the Trump Organization, the Dallas Cowboys Football Club and the Georgia-Pacific wood products company. Slightly more than two-thirds of all pass-through income goes to the top 1 percent of US households by income, a 2015 Treasury Department analysis found. 

Beyond that, it's possible for canny folks of means to game the system and slide past restrictions that lawmakers inserted in the recently passed tax bill to prevent abuse of the system. For instance, the GOP-controlled Congress banned certain kinds of pass-through firms, like medical practices and financial services providers, from taking the deduction. And it imposed ceilings on what some others could deduct. But there are ways around these obstacles.

Why are these businesses called pass-throughs? The proceeds flow directly to the businesses' owners -- avoiding the double bite the government takes of larger companies, of earnings at the corporate level, then of employees' compensation. As the top personal rate under the new law was lowered to 37 percent, lawmakers also allowed pass-throughs to take a 20 percent deduction on their earnings, which translates to an average tax rate of  29.6 percent on owners. 

Democrats, who this week voted unanimously in the House and Senate against the tax bill, label the pass-through provision a give-away to the rich. "The president will try to tell the American people that his great political victory is a win for working people," said Senator Jack Reed, D-Rhode Island, "but they see all the benefits going to his type of businesses: real estate pass-throughs."

Yet others see the pass-through deduction as a means of encouraging entrepreneurial risk, which in turn will translate into economic growth. "This favors job creation," argued Don Susswein, a principal at the RSM consulting firm, who specializes in pass-through taxation. He contrasts two chefs -- one working in a school cafeteria and one owning a restaurant, which employs four people. The chefs make about the same money. The restaurant chef is generating jobs but taking risk that he may go broke. So Congress has given him a leg up.

Regardless of the merits of encouraging pass-throughs, at this early stage there appear to be several ways that people, often people of means, can get around barriers that Congress erected. Here are a few:

Sidestep limits on deductions

To prevent the law from being a playground for the big-bucks set, Congress capped pass-through filers' incomes: They can't take deductions on more than half a company's wages. But for real estate owners like Mr. Trump, who employ relatively few workers and wouldn't be helped by this headcount method, there's another alternative: Base the deduction on a quarter of the wages and 2.5 percent of real estate assets, which can run into the millions, if not billions. The Trump Organization owns more than 500 pass-through entities

Alter your job classification 

The new law bars pass-through businesses for doctors, lawyers, athletes and financial service providers like stockbrokers -- known in the parlance of the legislation as "specified services" --  from taking the deduction. An end run works like this: A law partner, sick of the barricade to a kinder tax rate other pass-through people enjoy, moves over to be in-house counsel at an engineering firm, which is not on the ban list. "Now she's no longer in a specified service," wrote Ari Glogower, a law professor at Ohio State University, on Vox.com. "Voila, she may qualify for the pass-through deduction."

Ride your reputation 

Professor Glogower said that famous people might organize their side business interests into pass-throughs, if they haven't done so already. Actress Gwyneth Paltrow, for instance, has a company called Goop that peddles face lotion and wellness products. She could set up an entity to get a better tax rate for the products income. Consultant Susswein noted, however, that she couldn't run her show-business pay through the face-cream company.

Be a contractor 

First, you convince your boss to let you quit and hire you back as a contractor after you've set yourself up as a sole proprietorship. Assuming you can do that and your tax treatment is better, you can offer your ex-employer the same services for less -- the company does not have to worry about giving you benefits or paying its share of your Social Security and Medicare taxes. That latter part is the iffy one for you, and the numbers would have to work out. "Do you really want to go without health care and a 401(k)?" asked online financial adviser group Betterment's tax expert, Eric Bronnenkant.

To be sure, this law will require regulations to be written implementing it. And things could change. But under the Trump Administration, it's doubtful that the regs will do much damage to the GOP vision.

  • Larry Light

    Larry Light is a veteran financial editor and reporter who has worked for the Wall Street Journal, Forbes, Business Week, Money, AdviceIQ and Newsday.