By Ben Steverman
September 29, 2017
In the emergency room, there’s a good chance your doctor isn’t an employee of the hospital. She might be an independent contractor and, for tax purposes, the owner of a small business whose sole purpose is to sell her services as a physician. That’s one example of a “pass-through business,” now a hot topic in the U.S. tax reform debate. Everything from a giant real estate business to a corner liquor store can be a pass-through, so called because it doesn’t pay taxes itself but instead passes profits on to the owner, who pays taxes based on his or her own individual rate. Now, everybody else might want to get in on the act, or at least think about it if they’re in a higher tax bracket. The tax reform framework released this week by President Donald Trump and congressional leaders offers a lucrative treat to pass-through business owners. A key provision would cap the federal rate for many pass-through businesses at 25 percent, a huge tax cut if owners are now taxed at the maximum individual rate of 39.6 percent.In fact, of the 26 million businesses in the U.S. in 2014, according to the Brookings Institution, 95 percent paid taxes on a pass-through basis. Unless a company is large or its ownership is complex, a pass-through is usually the simplest and lowest-tax option. Actors, architects, factories, and football teams can all structure themselves as pass-through entities.
Under current law, there’s rarely a huge financial advantage for salaried workers to set up a pass-through structure to capture their income. For that emergency room doctor, for example, a pass-through can make it easier to deduct expenses and can offer some protection from legal liability, depending on the state. The tax savings are relatively small, mainly from skipping some payroll taxes, and might not even cover the cost of hiring a lawyer and accountant to create the more complex business structure. But a drop in the marginal tax rate from 39.6 percent to 25 percent changes the economics, said Anjali Jariwala, a CPA and financial adviser who specializes in doctors at FIT Advisors, of Redondo Beach, Ca. “This is really going to be impactful for high-income earners, especially if they’re dual income,” she said.
Is a custom homebuilder providing a service (his architectural expertise) or a product (a house)? An emergency room doctor might be providing a service, but what about a couple of doctors running an extensive chain of clinics? Their personal labor is a small contribution to their business’s income compared to the millions of dollars they’ve invested in equipment and the hiring and training of employees. No matter how the law is written, wealthy taxpayers will try to pay the lower pass-through rate on as much income as possible. “If they leave a big enough loophole, the accountants are going to be out there taking advantage of it,” said Michael Allmon, a CPA at Michael B. Allmon & Associates LLP in Manhattan Beach, Ca. “If there’s a way to do it, we’ll figure it out.”
