High-income professionals could exploit a tax loophole designed for farmers

Highly paid professionals including investment managers, doctors and lawyers are eyeing a loophole in what's supposed to be a mom-and-pop benefit of the new tax law as a way to supersize their savings. The loophole lies in the law's 20% deduction for owners of small businesses run as partnerships, limited liability companies and the like. These so-called pass-through entities underpin the U.S. economy, ranging from small-town builders to law practices, but also private equity and hedge fund firms. The law features a guardrail intended to keep service professionals such as hedge fund managers or cardiologists from using the break once their income hits a certain level. But top earners can exploit a gap that lets the benefit go to anyone who runs profits through an obscure entity known as a cooperative. You can make gobs of money and still get the deduction," said Erin Fraser, a tax and wealth-planning lawyer at Hanson Bridgett in San Francisco, who has gotten calls in recent weeks from lawyers, consultants and a wealth management firm about the advantages of the cooperative model. Signed by President Donald J. Trump in December, the law marked the biggest change to the tax code in a generation. Yet the rush by congressional Republicans to finish the bill may have inadvertently created a way for highly paid professionals to exploit a special break that the GOP has advertised as benefiting mom-and-pop operations. The cooperatives benefit applies to a business model more often associated with farmers, groups that distribute electricity to rural residents and progressive collectives than with elite doctors' offices. A cooperative is a worker-owned, worker-run enterprise whose members earn salaries and share profits paid out as so-called patronage dividends. Members then pay ordinary rates on them. The dividends are deductible to the cooperative, which pays the corporate rate on anything retained for reinvestment in the business. Employees who aren't members typically receive regular wages. "It's a weird little corner" of the tax code, Ms. Fraser said.

Bigger Savings

For cooperatives, the 20% deduction applies to a much larger bucket of income than it does for pass-through entities — resulting in bigger savings that can potentially wipe out a tax bill. The pass-through deduction, which expires after 2025, is part of the broader package signed by Mr. Trump that cuts individual tax rates, nearly doubles the standard deduction and lowers the corporate rate to 21%. The break costs more than $414 billion over a decade — almost a third of the $1.5 trillion law. Pass-throughs — which include S corporations and sole proprietorships — don't pay taxes themselves. Instead, they pass profits to their owners, who then pay taxes at individual rates. The new law lowers the top individual rate to 37% from 39.6%. With the new 20% deduction, pass-through owners taxed at the top rate can now get their rates as low as 29.6%. Critics say this creates an incentive for top earners to recast themselves as independent contractors and funnel wages taxed at ordinary rates through a pass-through entity.

Gross Income

Now, tax advisers are exploring another move: to recast a pass-through as a cooperative, because the new law lets cooperatives apply the deduction to their gross income. By contrast, pass-throughs can only apply the break to net taxable income, which is gross income minus expenses and the like. The new law sets income limits on the deduction for high earners in health, law and service professions such as financial services, consulting and performing arts. But those limits apply only to pass-throughs — not cooperatives. The law starts phasing out the pass-through deduction once the net income of an owner in one of those professional fields hits $157,500, or $315,000 for joint filers. Once their income hits $207,500 — $415,000 for joint filers — the deduction disappears altogether. Pass-through owners who aren't in those fields but who earn above those initial limits — think of a booming contractor in Greenwich, Conn. — can continue to use the deduction if they pay certain levels of wages or invest in real estate. Engineering and architectural firms were hit by the phase-out in early bill drafts but later exempted. Here's an example of how it could work. A group of plastic surgeons making millions of dollars a year could set themselves up as a cooperative and pay themselves via dividends on their gross income, saving far more than if they continued to operate as an S corporation.

'Lucrative Avenue'

"Unless Congress takes action to fix it, the new deduction for cooperative dividends could become a lucrative avenue of tax avoidance for people across the country," said economist Scott Greenberg, a senior analyst at the conservative Tax Foundation. The strategy could also be used by hedge funds. "There's got to be a way for an investment professional to do it," said Gregory Wilson, a tax lawyer in solo practice and an authority on cooperatives. One possibility is to form a cooperative consisting of several companies, and keep the investment capital in one of those companies but the profits in the cooperative, he said. "You could probably do this with most businesses," Mr. Wilson said. "I'm talking to a very profitable law firm interested in doing this." Adopting cooperative status could be as simple as changing your bylaws to reflect the three pillars of being a cooperative: control of capital by the owners, who are also called members; giving each owner one vote; and distributing profits to owners.

'Crazy Easy to Do'

While the maneuver sounds complicated, "it's crazy easy to do," Ms. Fraser said, especially for groups of high-earning doctors, accountants, consultants and lawyers. Lawmakers have vowed to fix one related quirk in the legislation. That one, known as the "grain glitch," lets farmers who sell their crops to cooperatives deduct 20% of their gross sales. It encourages farmers to bypass corporate buyers like Archer-Daniels-Midland Co. and can erase a farmer's tax bill. Farmers who sell to a corporate buyer can deduct only 20% of their net income and still wind up with a tax bill. But lawmakers have been silent about the benefit for cooperatives in industries outside farming. And it's unclear whether the loophole for well-paid professionals could be fixed through a technical correction or instead would require new legislation. Tax planners caution they're keeping an eye on what Congress does while also looking for ways to use the cooperative to their clients' benefit. "Even if this is only around for a year or two, if you roll the dice, you may save a lot of money," Mr. Wilson said.