U.S. Sen. Steve Daines got to yes on GOP tax reform Wednesday after party leaders agreed to sweeten tax cuts for pass-through businesses.
Montana’s Republican senator had held out for a new, 23 percent deduction on income for pass-through businesses, which are businesses that do not pay corporate income tax. Instead, the owner reports her business income as personal income on her 1040 tax form.
Pass-through businesses include sole proprietorships, Limited Liability Companies, partnerships and small corporations taxed as partnerships. The broad pass-through category includes start-up small businesses, which Daines highlighted when announcing earlier in the week that he wouldn’t support the Senate tax cuts until more was done for “Main Street businesses.” In Montana, it also includes some mining, oil, lumber and construction companies, among others.
Montana leads the nation in business startups per capita, according to a 2015 report by the Kaufmann Foundation. Those businesses more often than not start as pass-through businesses, and politicians frequently refer to those startups as Main Street businesses.
Daines put that tax savings stemming from the 23 percent deduction at $60 billion for pass-through businesses. Small Montana businesses account for 68 percent of the state’s jobs.
Montana’s Department of Revenue officials said it was unlikely Montana’s startup businesses would be the ones benefiting from the new deduction, namely because startups tend to operate at a loss for several years and have little — if any — profit to deduct in the first place.
In Montana, 43.2 percent of pass-through partnerships reported zero or negative income in 2014, the most recent year for which data is available. Among Montana's Subchapter S corporations, which are pass through businesses with 100 or fewer shareholders, 30 percent reported negative to zero income, while 15.3 percent reported income ranging from a dollar to $10,000.
The main beneficiaries will likely be larger pass-through businesses, not the Main Street variety associated with retail trade.
DOR’s Ed Caplis explained the reason so many business startups use pass-throughs. Say someone wants to start a small brewery. They want to limit their liability, and they also want to avoid paying corporate income tax. The way to accomplish both is to form a sole proprietorship, or LLC and just declare, on your form 1040 personal income tax return, whatever income might result from your small-time beer sales.
A would-be brewer could form a corporation, but then the corporation has to pay taxes, and so does the owner as an individual being compensated by the corporation. Using the pass-through option, the sole proprietor basically avoids being taxed twice, Caplis explained.
These startup businesses deduct their expenses and have little income to report afterward.
The entities earning the majority of pass-through income tend not to be Main Street startups. Hedge funds, law firms, accounting firms and real estate brokerages are just some of the not-so-Main-Street groups that also operate as large pass-through businesses.
The Senate tax bill excludes Hedge funds from the pass-through deduction. It also puts deduction caps on partnerships in which a partner's skill is the stock in trade, such as law and architectural firms.
In Montana, there are oil pipeline companies operating as pass-through businesses. When Plum Creek Timber was a wood products industry giant in Montana, it operated as a pass-through business. Plum Creek, which sold to Weyerhaeuser for $8.4 billion in 2015, was not a Main street business in the mom-and-pop shop sense.
Businesses like KFC of Montana could use that 20 percent pass-through deduction, said company president Brett Harris. The company has plans for six more locations in the coming years. And why shouldn't a pass-through business successful enough to pay taxes not receive a break? Harris asked rhetorically.
In Montana pass-through income is no small matter. Department of Revenue records for 2014, the most recent year available, show that most pass-through income — $64 billion — comes from financial activity partnerships, like hedge funds. The next-largest business sector contributed a little more than $1 billion, professional and business services, for example.
The trade, transportation and utility sector, which includes pass-through retail businesses, reported a negative $266 million in net income.
“The conception of what pass-throughs are is different from what they really are,” said Dan Dodds, DOR senior economist. “Having looked at this, a lot of pass-through entities are strictly investment vehicles that a couple will set up and have that pass-through own all of their investments.”
There are real tax benefits for pass-through businesses of all sizes in the Senate tax plan, according the Daines’s staff. Business owners typically pay taxes at the highest marginal rate, currently 39.6 percent. The senate cuts that rate to 38.4 percent and then offers the pass-through deduction of 20 percent requested by Daines and fellow Republican Sen. Ron Johnson of Wisconsin. After the 23 percent deduction on pass-through income, the highest marginal rate drops to 31.8 percent.
That cut to the highest marginal rate, as well as the 20 percent deduction, target actual income, according to Daines’ staff, not capital gains. The Senate bill recognizes no difference between passive and active investors.