Originally published on Forbes.com.
Since both the Senate and the House have passed a version of the Tax Cuts and Jobs Act, the differences between the two are of significant interest. I think the most important differences are in the area of flow-through taxation. Those differences are profound. I was going to lay off the tax cut frenzy until something finally passed both houses, but I have not seen much comment on the flow-through differences and even less by people who actually understand them. Tony Nitti is an exception, but his post covers a lot of other ground. The Senate and House bills try to do a stupid thing in two differently stupid ways. On net, I would say the House way of doing it is stupider, but maybe I am prejudiced because the Senate version might help me.
The Concept
The idea is that someone who gets flow-through income from businesses should pay less in income tax on a given amount of income than someone who gets wages. I first learned about this concept at a leadership conference of the not-quite Big 4 firm that came to regret acquiring the large regional firm that had me as a partner. The firm was like too cool for school in its mimicry of the Big 4. That included having a PAC, which as a managing director (of too advanced an age to be a partner) I was allowed to contribute. I asked the person promoting the thing why I would conceivably want to donate to it when it gave more money to Republicans than Democrats and not a single penny to the Green Party.
She explained to me that it was not so much that we cared about who got in as it was to get our ideas heard. When I asked what sort of ideas, she told me about having flow-through income taxed at a lower tax rate. I bet having CPAs excluded from the benefit was not part of their scheme. So I’m thinking they want to rub salt in the wound of me not being a partner by lobbying so they pay less in income tax than I do.
I was tempted to quote the late Bruce Carlin, the managing partner who at every other partner’s meeting or so could be sure to say in response to something I said “That’s the stupidest ___________ idea I ever heard” It was truly amazing how I was able to raise the level of stupidity each time. Not once did he say “That idea is almost as _________ stupid as the one you came up with last month”
Instead, I wimped out with something like “I don’t see why that is such a good idea”.
Think about it. Why is this a good idea? Supposedly it is because flow-through entities will now be paying a much higher rate than C corporations. So let them be C corporations if they want to perpetually reinvest earnings. If they want to draw it out and spend it, they can pay taxes like regular people do.
As it happens the House and the Senate bills implement the concept in very different ways. They both add complexity to the Code, but the House bill is probably worse. Here is how they each work.
The House Bill – A Special Rate For The New Gentry
The relief that the House bill gives to flow-through income is a special maximum rate of 25 %. Since the 35% rate kicks in at a taxable income of $260,000 for joint returns and the marginal rate for those with lower taxable income is 25% or less, the House bill does almost nothing at all for the little people (There is a slight break for incomes under $75,000 that is phased out. It is worth a bit over $2,000). Only it gets worse. The special 25% rate is allowed on all the flow-through income of passive recipients. There is a certain economy in complexity in the provision in that the definition of passive is that used under Code Section 469, the passive loss rules enacted by TRA 1986 to squash tax shelters. There are already complicated regulations worked out for 469 and decades of case law clarifying it. There is a problem, though. Almost all the case law in that area is taxpayers arguing they are active and the IRS arguing they are passive. This provision will flip that and in many cases it will not be hard to argue for passivity.
Those who are active still get a break, which I will explain a little differently than you may have seen elsewhere. The people active in the business get the special treatment on the amount of income that is attributable to capital. That is determined based on applying a variable rate (currently about 8%) to the unadjusted basis (cost before depreciation) of assets used in the business. So roughly speaking a business making a million a year that had twelve million in capital assets would provide the special rate even to the owners who were not passive. That treatment is elective. Absent the election 30% of the income is considered to be attributable to capital and 70% to labor, except for certain service businesses like law, accounting, and medicine. The presumption there is zero and they have to get to 10% to get any benefit.
The affected service businesses might as well always make the election since many of them do have significant assets used in the business. Other businesses will have to consider it carefully since the election locks you in for five years.
The capital percentage is an entirely new concept and it will be gamed vigorously by people like me to figure out how to get the best treatment for their clients. There will be complicated regulations and many court decisions. And the IRS will have to rethink its attitude to 469, now that the treatment is a plus for the deep-pocket crowd. Also, any sense that this might be good for family businesses is way off. The family members who don’t work in the business get better tax treatment than the ones who do . That would seem to tilt things towards selling out.
The Senate Bill – It Really Is A Jobs Bill
Instead of a special rate, the Senate bill gives a deduction of 23% of “qualified business income”. And there is a real jobs incentive in the Senate bill. There is a ceiling on the deduction of 50% of the entity’s W-2 wages. This is a huge difference for real estate. Think of a family that owns a lot of triple net lease buildings. Their payroll is likely somewhere between zero and negligible. The House bill favors the very capital intensive. The Senate bill not so much. If you are not employing people in the business you get nothing. Also, the deduction does not apply to the same sort of service businesses
And the Senate bill does more for the little people. The W-2 rule and the exclusion of service business income do not apply to singles with taxable income below $250,000 ($500,000 on joint returns).
And here we get to the really important part. That is whether the bill would help me. I mean, really, what else is there to care about. The Senate bill does not invoke 469, it uses the concept of “reasonable compensation”. “Reasonable compensation” is another much-litigated concept with the IRS and the taxpayers switching sides depending on whether it is using an S corporation to dodge self-employment tax or a C corporation trying to avoid double taxation. The reasonable compensation exclusion from the amount used to figure the deductions has me really intrigued. Sorry to be geeky, but here is some of the actual statutory language:
Qualified Business income shall not include _ (A) – reasonable compensation paid to the taxpayer …….. (B) any guaranteed payment described in section 707(c) paid to a partner for services ……. and (C) ……. payment described in section 707(a) to a partner for services rendered
It does not seem that a sole proprietorship is at all addressed there so the big bucks I am making from my writing career will get the favorable treatment. And the boutique partnership I am partner in doesn’t have no stinking guaranteed payments. We just divide the spoils in a pirate-like fashion. So I’m really liking the Senate bill, although I fear that I am missing something or the regulations will somehow foil my evil plan. 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.
I have not seen anybody remark on how much worse the Senate bill is for commercial real estate when compared to the House bill thanks to the rule about needing to pay W-2 wages.
Gaming The System
It appears that the Senate bill provides both fuel for and a brake on the conversion to a gig economy. Businesses have a strong incentive to have substantial W-2 wages, while independent contractors get a pretty good benefit in comparison to W-2 employees. The House bill with its new concept of a capital percentage will spawn a mini-industry in tax consulting similar to what goes on with cost segregation studies. And as Tony Nitti has observed, either bill might provide a renaissance for C corporations.
Repeal of the estate tax and the expansion of the credit kills a lot of consulting work in that area. I always thought the main function of the estate tax was a kind of white-collar jobs program that facilitated transfer payments from the uber-wealthy to the slightly less intelligent members of the upper-middle class. The ones who could handle law and accounting, but not medicine and engineering. And since the upper-middle-class spends most of their money there was probably a stimulative effect that helped the people who do actual useful work like building cars and repairing them and building houses and cleaning them.
The gaming that will go on with either the House or the Senate bill will probably provide more revenue for accountants rather than lawyers, so that is something to be pleased about. I was 34 when the Tax Reform Act of 1986 passed and it made my career, such as it was. The Tax Cuts and Jobs Act, regardless of its final version, might provide one last burst of lucrative scheming that will ease my golden years. As a citizen, I am still hoping that the whole foolish enterprise falls apart even though the Senate version looks like it will be good for me and either version will be good for my business.
Wasn’t The Code Supposed To Get Shorter
One of the themes of the various Republican campaigns was about how awful it was to have a 70,000-page tax code. Never mind that that was inflated by a factor of more than ten. Making the Code shorter was a priority. It is true that the bill might make returns easier for most of the little people because a lot fewer people will itemize. The taxation of business income is, however, much more complex under either version. And with the Senate leaving the AMT in effect, I think we will see the page count increase significantly.
As I sometimes mention, as a political prognosticator I make a good return preparer, but I will make a prediction of sorts. The only way that President Trump gets a bill to sign by Christmas is if the House passes the Senate bill unchanged. If it goes back to the Senate with any sort of changes and faces Senators who have had time to read the bill and hear from their constituents, it might be game over.