We finally have a tax bill to look at (The Tax Cuts And Jobs Acts – H.R. 1). You can look at the new rates and learn about the mortgage deduction and the enhanced standard deduction elsewhere. (I doubt you can do better than Kelly Erb.) I’m going more for the hardcore tax geek stuff. President Trump, with his characteristic truthful hyperbole, wanted to call it the Cut Cut Cut Bill. I was thinking based on the framework that it was not such a bad name. In reality, though, there is quite a bit of tax reform in there, various revenue raisers needed to balance out the dramatic rate cuts. I will be posting on them soon, but what has me immediately intrigued is Section 1004 of the act – Maximum Rate on Business Income of Individuals.
Watch Fargo
If you want to picture who will really benefit from the maximum tax rate on business income of individuals, think of Wade Gustafson in the movie Fargo – the gruff entrepreneur father-in-law of the hapless Jerry Lundgaard. My favorite character in the movie is actually Stan Grossman, Wade’s accountant. There has never been a more accurate screen portrayal of the consigliere role that accountants play for entrepreneurs than what you see in Fargo.
I figure old Wade owns a couple of office buildings, a few strip malls, and of course the dealership where Jerry works – maybe a couple of the McDonalds he doesn’t want his grandson to go to. Wade has been grudgingly making contributions to his congressman for years wondering when he will finally get something out of it. Well, here it is. If President Trump signs the Tax Cuts and Jobs Act, after Stan and I are done shifting things around, Wade will never have another dollar of income on which he will pay more than 25% in federal income tax.
The way the provision works is by subtracting from the tax computed at the 12%, 25%, 35% and 39.6% rates 4.6% of qualified business income to the extent that taxable income is over $1,000,000 (which is where the 39.6% bracket kicks in) and 10% to the extent that taxable income is over $260,000 which is where the 35% bracket kicks in. (In this and all examples I am using the married joint numbers. Thresholds are different for other filing statuses, but principles are the same).
So this great boon to Main Street won’t be doing anything for couples with taxable income less than $260,000. Anyway, what is this Qualified Business Income? (By the way, I can’t help but point out that in my piece about what a stupid idea this is, I predicted it would be called Qualified Small Business Income. Not bad eh?) Well in a brilliant maneuver, that helps not add pages and pages to the Code, QBI is defined in terms of an already extant concept. It is 100% of any net business income from any passive business activity plus (here’s the hard part) the “capital percentage of any net business income derived from any active business activity.” (There are some complications if there are losses which I am going to gloss over for now. Let’s assume Wade has the Midas touch and makes money on whatever he turns his hand to).
A Blast From The Past
For the definition of passive activities, which might well be the most important part of this scheme, we are sent to Code Section 469(c). Code Section 469 was introduced by the Tax Reform Act of 1986 and it was designed to kill tax shelters. It is pretty much all about losses. Losses from passive activities can only be used to the extent of income from passive activities. Otherwise, they are suspended. Most of the regulations, rulings, and case law about 469 have the IRS arguing that this or that activity is passive and the taxpayer arguing that it is not. People with the Midas touch have not been worrying about it so much. That is until the last couple of years. The Net Investment Income Tax applies to passive activities, giving people with consistently profitable activities an incentive to have them considered active rather than passive. Well, now the shoe is on the other foot.
Think about that dealership where Jerry works.
Say its an S Corporation owned by Wade. Back when Jerry was messing up the inventory and there were losses, Wade was there all the time sorting things out – you betcha. After that, it did not matter so much and then the NII came in and Wade and Stan had a talk about making sure Wade breaks 500 hours a year and has some contemporaneous proof of that. Well, you know what? Come January, Wade is going to spend a little more time ice fishing and next summer he is going to be on the golf course more. Gosh darn, when it all adds up he is going to come up short on hours. He’s going to have to pay NII on the $500,000 that flows through from the dealership. And the income from the dealership is QBI which saves him about seventy grand in income tax. You betcha.
The Capital Percentage – A New Concept For Us To Play With
Of course, not everybody can get away with that. Which brings us to the capital percentage. The general rule is that the capital percentage is 30%. So if Wade really needs to be at the dealership a lot and he and Stan don’t want to fib, $150,000 of the $500,000 is QBI, if he uses the default. For service providers, the default capital percentage is 0%. Service providers is defined very broadly, by reference to another section (1202(e)(3)(A), if you must know).
any trade or business involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of 1 or more of its employees,
Most plotters and schemers like myself have probably been thinking that Stan would be fooling around with Wade’s salaries in order to game the system, but on the face of it, this will not be the case. Salaries and directors fees are considered to be income from the activities for purposes of determining qualified business income. For people who clearly can’t qualify as passive, it is the “capital percentage” that we will want to game. Here is how that works, if you are not using the default.
Your capital percentage is the “specified return on capital” divided by the business income from that activity (It can’t be more than 100%). So what is the “specified return on capital” (SRC) ? SRC is the deemed rate of return for the taxable year (DRR) times the asset balance (AB) with respect to that activity. DRR is the federal short term rate for the last month of the years plus 7 percentage points. The federal short term rate has been very low for a long time. For planning purposes, I would call the SRC 8% (It will be a bit more than that under current conditions).
So what is the “asset balance”? AB is the “taxpayer’s adjusted basis of the property used in connection with such activity” without regard to sections 168(k) and 179. So if Wade buys a new bulldozer for the earthmoving company I forgot to tell you about, its cost will be the asset balance even though it has been written off. In the case of S corporations and partnerships, the taxpayer looks through to the entity’s basis. All of this is really easy, except for determining asset balance, which is going to be a real bear. I was talking to a friend of mine who is the main tax geek for a good-sized practice that focuses on a particular industry. He thinks that he and I will get this, but none of his preparers will. He is worried that he will have to do all the returns.
It Should Not Be 0% For Anybody
Let’s put Wade aside for the moment. You may have read that service professionals like doctors, lawyers and accountants won’t be getting any benefit from the special rate. It turns out that that is not accurate . There is no reason for anybody to live with a zero default percentage. Some professionals might have a fairly significant asset bases, particularly if they pay for goodwill. And all of a sudden, it might become a lot more fashionable to buy the building that practices operate out of. When you throw in some purchased goodwill and, of course, that corporate jet, your asset base might be quite high. That would be particularly true of some fields where there is a significant equipment need. Think dentistry and radiology, for example.
And remember, it is assets, not equity. The top insurance agent does not have to pay cash for the jet that he uses to call on his high-end clients. With a $10 million asset base, $800,000 of his income will be subject to the special rate which saves him over a hundred grand. Maybe its not much in the grand scheme of things, but it is better than being poked in the eye with a sharp stick.
Another interesting feature not much remarked on is that now there will be a “labor percentage” to determine income subject to self-employment tax. The labor percentage is one minus the capital percentage. So active partners will see their self-employment tax go down a bit.
I should mention that there will be regulations, assuming that Congress maybe stops cutting the IRS budget and you have t remember Reilly’s Third Law of Tax Planning – Any clever idea that pops into your head probably has a corresponding rule that makes it not work.