Originally published on Forbes.com.
The Unified Framework For Fixing Our Broken Tax Code has the tax blogosphere in its grip. I was thinking of passing on it, but the elderly curmudgeon in me can’t resist reflecting on how comprehensive tax reform was handled in 1986. In 1984, the Treasury issued the two volume, Tax Reform For Fairness, Simplicity, And Economic Growth (Vol. 1. Vol. 2) . All in it was over 700 pages. The Unified Framework is nine pages. Only it kind of looks like the nine pages you would get if a kid were assigned a ten page paper, figured he could get away with turning in nine, but realized he didn’t have even nine pages of material and thought of every possible way to stretch it. The Unified Framework fits quite comfortably on four and half pages, as I show here.
TRA 1986 Complications Stayed Simplification Went
The devil is in the details and the Unified Framework does not provide enough of the devilish details to really evaluate it. One thing is quite clear though. If a plan consistent with the framework is passed, the taxation of business income will become much more complicated than it is now.
A Major New Proposed Complication
One great simplification of the Tax Reform Act of 1986 was the elimination of a special rate for capital gains. The great complification was the passive activity loss rules. It did not take long for the simplification to be eliminated. The complification got more complicated as a special exception was carved out for real estate professionals. The regulations on how to define an activity and define passivity and who did or did not qualify as a real estate professional are voluminous and there are a large number of court decision which are the tip of the iceberg of many audits. And of course classifying income as capital gain rather than ordinary remains a staple of tax planning and area of controversy.
Now a new category of income will be defined that will have a favorable tax rate for those in the upper income reaches. We don’t know how the new tables are going to look, but based on the current tables a 25% rate would be favorable at single income of $91,901 and married joint of $153,101, but it really doesn’t get exciting until $191,651 single and $233,351 married. Having your income defined as let’s say “qualified small business income” (QSBI) will mean a rate swing of at least 10%, perhaps more if a higher maximum rate is put in, which is a possibility that has been left open.
Here is what has been worked out so far:
The framework limits the maximum tax rate applied to the business income of small and family-owned businesses conducted as sole proprietorships, partnerships and S corporations to 25%. The framework contemplates that the committees will adopt measures to prevent the recharacterization of personal income into business income to prevent wealthy individuals from avoiding the top personal tax rate.
Those measures that are adopted will likely add quite a few pages to the Code and the required regulations will likely run into hundreds of pages. Of course, after the bill has passed Congress can claim that it has simplified taxes so much that there can be even deeper than usual IRS budget cuts. With enforcement totally gutted, the special 25% rate will become in effect the top rate among the people who still bother to pay anything.
Stupidest Idea I Ever Heard
I first heard about the concept of a special rate for pass through entities about six years ago. I was a Managing Director with a not quite Big 4 national accounting firm (more nimble, you know) that the firm of my youth had sold to. I couldn’t be a partner, because I was already too old, but being an MD was almost as good. We got to go to the firm leadership conference just like the partners. Another great privilege was that we were allowed to contribute to the PAC. This gave me another opportunity to exhibit my bad attitude. I told the lady promoting the thing that I didn’t like it so much because it was giving more money to Republicans than Democrats and nothing at all to the Green Party. She told me that was not the point. The PAC made it so that we were listened to in the halls of power.
So I asked what it was we were trying to move along and she explained the idea of a special tax rate for pass-through entities. I thought then it was one of the stupidest ideas I had ever heard and continue to think that. And I think I would have thought the same thing even if I had been a partner getting a K-1 rather than a managing director getting a W-2.
On the other hand, if I was 35, like I was when TRA 1986 was being phased in, I would love the idea, because it will be so darn complicated and I would learn the rules better than maybe 95% or so of the other CPAs. And there would be a couple of years where knowing the rules really well and how to apply them to a variety of situations and maybe even identifying the situations where you don’t worry about them because there are other fish to fry would be at a premium. It would still not be as valuable as playing golf, sipping single malt scotch and knowing rich people is, but it would make those CPAs, who run things, have to throw me a few more crumbs.
Maybe Nothing Will Pass
Reflecting on the current situation in comparison to 1986, I think it likely that nothing is going to pass. President Trump will often tweet complaints about the Senate needing 60 votes to pass anything, but apparently, by some legislative magic, this will not be the case with what I will call the Tax Reform Act of 2017. The other important factors I note from this Reuters piece are that the Republicans have 52 senators and that the budget resolution has $1.5 trillion in reduced revenue over ten years contemplated. Tax Policy Center’s preliminary analysis of what is detailed in the Unified Framework has it costing $2.4 trillion over the next ten years.
Just for talking purposes let’s buy the TPC number for now. That means in the actual bill there will have to be provision that raise an additional $900 billion. The place to go looking for that is this report on Tax Expenditures. There is a table starting on page 21 that scores 169 different tax expenditures. Given the lower rates contemplated, the various benefits would have to be re-scored downward. The Unified Framework has already taken or foreclosed a few of them such as Number 80, the deduction for US production activities (already spoken for) and Number 76, accelerated depreciation of machinery and equipment (foreclosed by the new expensing option in the framework).
So pick and choose among the remaining tax expenditures to get up to maybe $1.2 trillion or so. Number 69, capital gains, will get you most of the way. Good luck with that. Or you could go to Number 126, exclusion of employer contributions for medical insurance premiums and medical care. At $2.7 trillion that is way more than you need, so maybe you could do what they did with meals and entertainment and social security and just tax a portion (Say half to make the math easy). Or you could add up a lot of little ones like Number 39, tax incentives for historic structure, which is worth $5 billion and Number 18, tax credit for clean burning fuel vehicles worth $4.8 billion.
Here is what you will find. Every single tax expenditure has a fierce constituency. They may like the idea of tax reform in general, but when it comes to their particular break, keeping it is much more important. When public comment starts rolling in on the tax reform project, it will pretty much take the following form:
Comprehensive tax reform and simplification is a fantastic idea. We here at the ABC Coalition for DEF just love the idea that you are working on it and totally support you. Of course we are sure that you know the DEF is critical to the American way of life and the health, safety and well-being of the world. We would just like to remind you that the GHI deduction and the JKL credit play a critical role in supporting DEF. So when you are doing your simplifying don’t even think about messing with the GHI deduction and the JKL credit. As a matter of fact, you probably should beef them up a bit and get busy on the MNO exemption that we have been asking for. Other than that, chop away at those special tax breaks and give us a simpler Code.
If we assume that there will not be any Democrats voting for the bill, all that the ABC Coalition for DEF needs is three Republican senators to take a stand that for them, messing with the GHI deductions is a deal-breaker.
You can read about the process in this piece by Alan Rappeport and Thomas Kaplan in the New York Times.
“We have always said that tax reform — a worthy endeavor — should first do no harm to homeowners,” said William E. Brown, president of the National Association of Realtors.
Damn The Deficits Full Speed Ahead?
Of course, the other possibility is that the revenue loss will be covered with exuberant expectations about growth, which is what passed the Economic Recovery Tax Act of 1981. ERTA created what looked like big deficits then. So what? We can kick the can down the road. After all, what has posterity ever done for us?