President Donald Trump’s newly unveiled tax reform plan has one major component: Businesses need to receive significant tax cuts.
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The proposal would reduce the corporate tax rate from 35 percent to 20 percent. It also would limit the tax rate on so-called pass-through businesses to 25 percent.
Today the owners of those smaller businesses are taxed according to their individual tax brackets, which range as high as 39.6 percent.
Should you consider declaring yourself a pass-through if tax reform passes? Would that help beef up your savings?
What ‘pass-through’ means
Pass-throughs include S corporations, partnerships and sole proprietorships. They amounted to 95 percent of American businesses in 2014, according to the Brookings Institution.
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They’re called pass-throughs because their income is passed through to their owners, who pay personal income tax on the money.
Pass-throughs are not necessarily “small businesses,” though most are, in fact, relatively small. Brookings says 85 percent were taxed at 25 percent or less in 2014, because they didn’t earn enough to bump them into a higher tax bracket.
People as pass-throughs
How could you become a pass-through?
“For the majority of individual who are employees, it would be really difficult to incorporate as an independent contractor and then convince your employer to hire you,” says Tim Steffen, director of advanced planning for Baird’s Private Wealth Management Group.
But it’s different if you are or want to become self-employed.
You could set yourself up as an S corporation. You’d pay personal income tax on your business profits, and you’d have to pay yourself a reasonable salary, what people in your field with your education level and experience generally earn.
Pass-throughs and tax avoidance
On that salary, you’d pay employment taxes, for programs like Social Security and Medicare. But you would not pay those taxes on your remaining income from the business.
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Former vice presidential nominee John Edwards, House speaker Newt Gingrich and other high-earning individuals have been accused of using pass-throughs to avoid tens of thousands dollars in payroll taxes.
Some observers say that under the Trump tax plan, high earners also could rely on pass-throughs to save tons in income taxes, by reclassifying what they make.
“There would certainly be further incentive to try to diminish you what you pay,” says tax attorney Timothy Jessell with the Greenberg Traurig law firm.
A tantalizing tax difference
The Trump tax plan calls for three individual income tax brackets: 12 percent, 25 percent and 35 percent.
It’s the 10-percentage point gap between the 35 percent top income tax rate and the 25 percent top rate for S corporations that could make pass-throughs very attractive.
The Trump administration and Republican leaders say in their tax plan outline that they hope congressional tax writers “will adopt measures to prevent the recharacterization of personal income into business income to prevent wealthy individuals from avoiding the top tax rate.”
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Skeptics at the nonpartisan Tax Policy Center estimate that the Treasury will lose $108.9 in 2027 under the pass-through provision, versus $38.2 billion in 2018.
So, should you incorporate?
Forming a corporation can cost hundreds of dollars in fees, and you’d likely need the help of a corporate attorney. You’d probably want to have a good tax attorney, too.
If you’re not currently self-employed, you’d need to figure out where your health insurance would come from, and you’d want to make a plan for saving for retirement, too.
It’s a big step to take toward saving some money on your taxes. And note that you’d have to earn enough to put you in the highest tax bracket, which is $418,400 for a single filer in 2017.
Maybe you’d better not become “You Inc.” until you dream up your billion dollar idea.