As businesses rush to exploit GOP tax cuts, government revenue may shrink more than expected

As soon as the last major tax overhaul was enacted in the fall of 1986, accountant Edward Mendlowitz remembers working around the clock to convert corporations into partnerships and other so-called pass-through businesses to take advantage of the new tax code.

Now with congressional Republicans drawing closer to passing a package of $1.5 trillion in net tax cuts, mostly for corporations, Mendlowitz reckons he may soon be doing the reverse. The corporate tax rate is expected to fall from 35% to about 20%, its lowest in more than 75 years and considerably less than what pass-through taxpayers are likely to face.

“We’re not taking the pencil and paper out yet, but at some point we’re probably going to switch a lot of them,” said Mendlowitz, a partner with WithumSmith+Brown in New Brunswick, N.J.

The specter of mass conversions — and the potentially huge tax revenue losses resulting from them — is but one vexing problem for GOP leaders as they try to stay within debt limits and resolve differences in the way the Senate and House bills would treat pass-through entities, which account for about 95% of all businesses.

That will give pass-through taxpayers a strong incentive to switch to C corporations. And Mendlowitz, the New Jersey accountant, says that would not be hard to do — it essentially involves filing a three-page form with the Internal Revenue Service and meeting certain conditions.

That many pass-throughs could convert to corporations has not been lost on the GOP leadership, which can ill-afford to lose any party member vote. Sen. Ron Johnson (R-Wis.) has been championing greater pass-through benefits for a wider array of smaller businesses, but now worries that the package may open a floodgate of conversions that could result in far lower tax revenues than estimates show.

“That’s why I’m trying to convince my colleagues, ‘Let’s fix this,’” Johnson said this week, offering scenarios in which a wave of conversions could add hundreds of billions of dollars of losses to government coffers.

Yet congressional Republicans have practically no room to add to deficits beyond the $1.5 trillion allowed under congressional budget rules. Already they are under criticism from many economists and even some conservative circles because their tax plan is projected to boost the nation’s public debt by $1 trillion over the next decade, after accounting for the economic growth they are expected to spur.

Don Susswein, a principal at the accounting firm RSM, argues that the House version is the better of the two because it would do more for the economy by stimulating investments and entrepreneurial activity. Under the House bill, so-called passive pass-through owners — or investors — would get the lower 25% rate, but active owners involved in managing pass-through entities would see a smaller benefit depending on how much capital was invested.

In creating separate tax calculations for active and passive pass-through owners, the House bill is even more complicated than the Senate’s, undercutting a key aim of tax reform, to simplify an extremely complex tax code.

What’s more, the House tax provision for pass-throughs is seen as skewed more to wealthier individuals than the Senate one — and no less vulnerable to be gamed. As it stands now, the bill excludes certain investment-income items from getting the lower pass-through rate, such as capital gains and annuities — but not others.

“I think investors will try to channel more of their investment income, their rents, their royalties, through pass-throughs,” said Steven Rosenthal, a senior fellow at the nonpartisan Tax Policy Center. “That’s how the system will be gamed the most.”

Even as the Treasury and the IRS will surely write guard rails and anti-abuse rules, he said, past experience suggests that it will take many months if not years to catch up to taxpayers and all of the abuses and glitches that people will be exploiting.

“Meanwhile,” he added, “the Treasury loses a lot of money.”

Times staff writer Lisa Mascaro in Washington contributed to this report.


Twitter: @dleelatimes

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