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One of the biggest changes in the Republican rewrite of the tax code involves a tax rate known as the "pass-through rate." Experts are watching to see how businesses, employers and individuals adjust, and what kind of loopholes it offers. Lisa Desjardins learns more from Adam Looney of the Tax Policy Center about how various professionals will be affected.
Now additional details of the new tax laws.
The rewrite of the tax code, signed by the president last week, takes effect on Monday. One of its central features and biggest changes involves a tax rate known as the pass-through rate. Many experts are watching to see how businesses, employers and individuals adjust, and what kind of loopholes it may offer.
Correspondent Lisa Desjardins reports on what that pass-through rate is and who might be affected.
In the tax code, not all business is created equal.
Corporations, defined by the fact that they pay direct corporate taxes, saw the biggest tax cut in the Republican law. That led Republicans to create another tax break for smaller companies.
President Donald Trump:
Historic small business tax cuts and pass-throughs now are made really, really good for the business owner. The small business tax cut and the pass-throughs are now really incentivizing people.
So, what is a pass-through? First, it's not necessarily small. Put that out of your mind. Instead, pass-throughs are any of several business, partnerships, limited liability or sole proprietorships, where the business is not taxed on its own, no corporate tax.
Instead, profits pass-through to individual owners, and they are taxed for those profits as their own individual income.
These can be smaller businesses, like local hardware stores and doggy care, or pass-throughs can be much larger high-dollar businesses, like Sunoco LP. That's why the GOP tax bill is so dramatic. It gives millions of pass-through owners a new 20 percent deduction.
Now, there are some limits, as Congress tried to guard against a surge in pass-throughs. One, for some professions, like doctors and attorneys, the deduction phases out after $157,500 in income for individuals or $315,000 for a married couple.
And, two, for larger businesses, the deduction cannot be more than a certain percentage of all the wages they pay.
Also blocked, tax experts and accountants, who lose a deduction, but seem certain to gain a lot more business this complex part of the law alone.
For more on the pass-through rate and changes in the tax law, Adam Looney watches this closely for the Tax Policy Center, run by the Brookings Institution and Urban Institute.
Thank you so much for joining us.
And I want to ask you right off the bat, Adam, how big of a change is this really in tax law?
So we have never had a system where business income was taxed at a lower rate than wage income. And we have never had a system where the self-employed paid lower taxes than ordinary employees.
So, for those taxpayers, it is a really big deal.
So businesses have really never been cut up like this. It's either been a corporate rate or an individual rate.
And, moreover, it's always been a better deal to be a wage earner than to be a corporation, at least for the last 40-plus years.
As we reported, Congress is trying to put some guardrails in here, worried that perhaps everyone, including you and me, might rush to try and establish their own pass-through business.
But how clear are those? Do we know that those are really going to be effective limits at this point?
Well, there's two issues.
So, one is, in order to get the pass-through deduction, you have to be pass-through or you have to be self-employed. And so there are some hurdles to jump over to get to be self-employed.
A lot of those are practical issues, not so much legal ones. In fact, the difference between being self-employed and an employee is a legal gray area that the IRS really doesn't have authority to issue regulations about.
So that will continue to be a gray area. The second issue is that, once you are — if you are a self-employed person or a small business owner, then your income has to qualify in order to receive the deduction. If you make less than $315,000 and you're married, then you get the deduction. Above that level, it depends on whether you're a doctor or a lawyer or in a different trade.
Or I think professional sports stars. There's all kinds of high-income exceptions in here.
That's right. That's right.
Right. Again, we see a lot of specific carve-outs in this law.
Can you give us an example, though, of someone who would benefit, you think, from this kind of deduction next year?
Well, a lot of people who are small business owners, pass-through business owners, or self-employed will benefit. So, for instance, if you're a plumber that makes $60,000 a year and you're self-employed, you get a pretty big break.
So, for instance, if you had instead been paid wages of $60,000, the wage earner is going to pay something like 45 percent more in income taxes, several thousand dollars a year on the same income for doing the same job.
So, in that case, the pass-through deduction really benefits that person a lot.
So, for a plumber just who makes $60,000 a year, for them, this pass-through is going to mean how many thousand of dollars, do you think?
It's a couple thousand of dollars a year every year that it's in effect. So, it's a big bonus for the self-employed person.
On the other hand, are there concerns about what this will do for revenue for the federal government, especially if we see many more people deciding to be self-employed?
So, if people simply switch their classification, if they're doing the same job, but changing from being a wage earner, an employee, to being a pass-through business owner, then revenues are going to fall without contributing much to economic growth, because that person is going to be doing the same job.
And so we actually had an experiment much like this in Kansas, where Kansas reduced its tax rate on pass-through businesses. Tax revenues fell below projections. There was little economic growth. They had a budget crisis, and ultimately reversed those changes.
It's always risky when you make these big changes in the tax code.
And, briefly, the IRS, do we know if they're ready to sort of put out the rules for something like this?
Well, this bill was passed very quickly. It goes in effect in basically a week.
And so I think that they are going to be scrambling for quite some time to get the rules and regulations in place and to issue guidance to taxpayers, so that they can get ready and take advantage of these new provisions.
Adam Looney, thank you so much for trying to clear up a very complicated area of this tax bill.
Sure. Thank you.
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