The tax plan that President Trump signed into law last week creates one of the largest new loopholes in decades: a 20% deduction for “pass-through income.”
Pass-through income is business income that is immediately “passed through” to the owner’s personal tax return, thereby avoiding the corporate income tax. Proponents of the Republican tax plan claim the cut benefits small businesses, but that’s a red herring. In reality, the new deduction disproportionately benefits the wealthy, penalizes workers and, in part because it is so complex, will ultimately reward those who can afford the best tax advice.
The new deduction could have profound effects on the American workplace over time. It essentially requires employees — most workers — to choose between benefits such as employer-based healthcare and the deduction. By creating a strong incentive for employees to give up these benefits and become independent contractors, it could further erode job, health and retirement security.
Let’s start with how it works. The new deduction allows people with pass-through income — profits from a partnership or sole proprietorship, for instance — to write off 20% of that income before calculating their taxes.
The clearest winners are therefore owners of existing large pass-through businesses with many employees or lots of physical assets. The wealthy, in other words. President Trump, for one, stands to gain significantly. He reportedly owns more than 500 large, pass-through real estate firms — just the type of business that would qualify most easily.
Far more than most other types of income, pass-through business income is concentrated among the country’s highest earners. The top 1% currently earns less than 12% of labor income, but more than 50% of all pass-through business income. By slashing taxes for pass-through businesses, the deduction will exacerbate our widening income gaps.
Because it is such a big loophole, you might reasonably wonder: Am I a chump if I don’t try to claim it?
The short answer is “maybe,” but proceed with extreme caution. The law is so poorly drafted, and its objectives so unclear, that you probably won’t know for a while whether or how you can qualify. What’s more, the law creates traps for the unsuspecting that could make you worse off in the long term.
Let’s say a hypothetical worker wants to claim this 20% deduction. The first hurdle is that the new law says that you cannot claim the deduction if you are an employee. This means the worker would probably need to give up all or most of her employee benefits — health insurance, retirement plan, vacation pay — in order to be considered an independent contractor, since benefits are one way the tax system determines who is an employee. She will also have to pay her employer’s share of the payroll tax.
She could potentially convince her employer to pay her more in exchange for giving up her benefits, but many workers don’t have that kind of negotiating leverage. And even if she can, she may not fare better for it in the long run. Benefits such as health insurance typically cost much more when purchased independently rather than through an employer.
She could forgo such benefits altogether, but that’s risky and inadvisable in the long term. Alternatively, she could band together with her fellow employees to purchase benefits, but that requires organization and resources.
The new law also says you can’t claim the deduction for “reasonable compensation” for services. So our hypothetical worker may get the deduction only to the extent that she argues she is getting paid too much.
She might be able to avoid this requirement by carefully choosing the type of pass-through entity she creates or by striking out as an independent contractor. But the law is unclear, and it could take the IRS and Treasury Department a while to clarify the issue. In the meantime, if she proceeds, she risks incurring penalties.
Whatever route she chooses, this worker is going to need more tax advice. If she is in the middle class, the additional fees might exceed her relatively modest savings.
If she is single and earns more than $157,500 in taxable income, or married and earns more than $315,000, she might need to jump through further hoops. In that case, it’s really going to matter what line of work she’s in. If she’s a real estate developer, she should be golden. But if she’s a doctor, not so much — because doctors and host of other professionals are specifically forbidden from claiming the deduction if they are above the income thresholds.
It could take the IRS and Treasury Department many years to clarify exactly how the pass-through loophole works. By then, the new deduction will be on the verge of expiring, creating further uncertainty and risks for regular employees.
But that’s exactly the point. The new deduction could provide a small tax cut for some middle-class employees — but only if they give up their benefits, spend scarce resources on tax advice, and pretend not to be employees in the first place. In the meantime, some of the richest Americans will get richer.