Why tax reform is a lot harder than it looks

Does the U.S. have the highest corporate tax rate?
Does the U.S. have the highest corporate tax rate?

All that happy talk in Washington about getting tax reform done fast is already proving unrealistic.

Even if Congress chose to do nothing but rewrite the tax code in 2017, it would be a monumental task because there are so many constituent interests and competing demands to balance. With the Trump administration kicking up a daily dust storm, Washington is hardly laser focused on taxes.

And one of the biggest complexities is business tax reform -- an issue marked by intense special interest lobbying.

For years, the focus has been on big business, with everyone calling for lower corporate tax rates and changes to make it easier for U.S. corporations to compete internationally.

Related: How Congress could get Trump's tax returns

But now lawmakers and President Trump want to reform how all businesses are taxed.

It makes sense: The vast majority of businesses in the United States aren't corporations. They're so-called pass-through entities. They run the gamut from mom-and-pop shops on Main Street to law firms and hedge funds.

A pass-through business passes its profits through to shareholders and partners, who then report those profits on their individual tax returns. So they're paying federal income tax rates up to 39.6% on their pass-through income.

House Republicans and Trump have proposed lowering tax rates for both corporations and pass-throughs. The House plan would lower the top pass-through rate to 25%, Trump to 15%. The highest rate on regular wage income, meanwhile, would fall to just 33%.

The disparity between business and wage rates worries policy experts. Why? Shareholders and owners of pass-throughs who also happen to work at those firms will be tempted to recharacterize their paychecks as "business" income to get the lower tax rate.

It's not an idle concern.

A few years ago, Kansas lowered its ordinary income tax rates and eliminated them altogether for pass-through income. Unsurprisingly, the number of filers who claimed the pass-through exemption was more than double what the state estimated. That's been a "major contributing factor" to the state's steep drop in income tax revenue, noted Frank Sammartino, a senior fellow at the Tax Policy Center.

So lawmakers will have to figure out a way to prevent people from gaming the system.

The House plan, for instance, indicates it would simply assume -- perhaps by some kind of formula -- a certain amount of "reasonable compensation" that a pass-through pays its employees who also happen to be the firm's owners or partners.

The affected employees would have to report their portions of that compensation as wage income on their personal returns and pay tax on it up to the 33% individual rate.

That's one way to address the problem, but it may not work well or be perceived as fair in every type of situation.

For example, what if an owner-employee wants to plow some or all of her compensation back into the business, especially at the early stages to help it grow? Should that not be considered "active business income" subject to the lower 25% rate?

Or what if an owner-employee actually pays herself less than what the House plan defines as "reasonable"?

That's why there should be a few options to calculate or justify one's compensation to the IRS, to better suit the circumstances of individual businesses, said Mel Schwarz, a partner in the national tax office of Grant Thornton, at a Bipartisan Policy Center event.

Related: A fight is coming over the border adjustment tax

How to tax compensation, of course, will be just one of the debates about pass-through taxation that could soak up real oxygen. That's why some say it would be easier and faster to address corporate taxes first and put a win on the tax reform board.

But that also would be a fast way to tick off major constituencies among everyone else in the business universe, Janice Mays, a former chief counsel to the Ways and Means Committee, said at the same event.

"This is [lawmakers'] rotary club, their donor club, the people they know back home. ... So to go home and deliver a corporate rate cut of any magnitude and not have delivered something to this group is unacceptable."

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