Although it comes as no surprise, President Trump and Republican leaders have proposed lowering tax rates for small-business income from pass-through entities like partnerships and sole proprietorships to 25 percent, significantly less than the highest proposed tax rate on wage income of 35 percent. Having a different tax rate for a special source of income is the opposite of two stated goals for tax reform, simplicity and fairness, and is contrary to the principles of Ronald Reagan's Tax Reform Act of 1986, none of which suggested that wage earners should subsidize small-business owners.
Sen. Ron Wyden, D-Ore., the ranking Democrat on the Senate Finance Committee, recently expressed alarm about efforts to lower tax rates for pass-through business income: “The day the pass-through loophole becomes law would be Christmas morning for tax cheats. It would make a mockery of the Trump pledge that, quote, ‘The rich will not be gaining at all with this plan.’”
On the surface, lower rates for pass-through business income may appear reasonable, but there are serious downsides. In Reagan's 1986 tax act, all items of income, including wages, pass-through business income, dividends, and capital gains were taxed at the same rates. Reagan and a bipartisan Congress wanted simplicity and fairness to accompany tax reform.
One suggestion by Republican leaders toward providing simplicity is to shrink the individual tax brackets from seven to three. Certainly fewer tax brackets do provide a minor amount of simplification. However, a great deal of complexity is provided by having different tax rates for different sources of income such as a separate tax rate for pass-through business income.
For example, recently I helped an accounting student manually fill out a Form 1040 for a person who had a modest amount of income that included a small amount of long-term capital gains. Have you ever tried manually to make the tax calculation when long-term capital gains are included in taxable income? The process is onerous and laborious, including completing special tax forms and IRS worksheets -- an enormous amount of complexity that certainly is not offset by having three tax brackets versus seven. The same complexity will occur if pass-through business income is taxed at separate rates.
In the General Explanation of the Tax Reform Act of 1986, the authors expressed a rationale for eliminating reduced taxes for long-term capital gains. That same rationale for simplicity should apply today and be one of several reasons to reject reduced taxes for pass-through business income: “This will result in a tremendous amount of simplification for many taxpayers, since their tax will no longer depend upon the characterization of income as ordinary or capital gain.”
If lower tax rates are provided for business income of partnerships and other pass-through entities, tax avoidance schemes undoubtedly will be used in an attempt to characterize profits of the business as strictly business income versus higher-taxed compensation. Litigation will pit taxpayers against the IRS in arguments over how much of business profits constitutes “reasonable compensation” versus lower-taxed business income.
In addition to simplification, providing the same tax rates for all types of income increases the important element of fairness. The Senate Finance Committee observed in its final report on the Tax Reform Act of 1986:
”First, the committee desires a simpler tax system for individuals.”
"Second, the committee desires a fairer tax system. It is difficult for the committee to find fairness in a tax system that allows some high-income individuals to pay far lower rates of tax than other, less affluent individuals."
"A primary goal of the committee is to provide a tax system that ensures that individuals with similar incomes pay similar amounts of tax.”
Many of the pass-through “small businesses” operate as large and profitable S corporations, partnerships or sole proprietorships. As pass-through entities, they already receive preferential tax treatment compared to regular corporations since there is no “double taxation,” as any profits are taxed only at the individual level, similar to wages.
Now is the time to reclaim Reagan's great compromise with Congress in 1986 that allowed ordinary wage earners to pay taxes at no higher rates than those individuals who received capital gains and pass-through business income. That guiding principle should not be lost today under the guise of 21st century economic needs being substantially different than 31 years ago. It was not fair in 1986 for wage earners to subsidize small-business owners, and it is not fair today.