Originally published on Forbes.com.
As I write this passage of the Tax Cuts And Jobs Act seems to be looming. The piece of the puzzle that most intrigues me is the treatment of flow-through entities. The Tax Reform Act of 1986 made flow-through entities – entities where owners report income and losses on their own returns rather than having the entity be taxed – much more popular for a variety of reasons that we don’t need to get into. The Tax Cuts and Jobs Act with a radical cut in the corporate rate will require us to take another look at that.
Some flow-through entities may become C corporations. But there is to be special treatment of flow-through income which might stem the rush to convert to C corporations. More significantly, for the little people, there will likely be a rush to convert employment income to flow-through income. And that is what may create a sharp rise in the number of income partners. Only we won’t call them that anymore. I’m going to use my own industry as an example which besides including people who perform important functions like assuring the integrity of financial statements and providing sound management advice has quite a few tax schemers. I’m a CPA – large local and regional for most of my career and focused on tax.
What’s An Income Partner?
The concept of income partner was not something I learned about until I was fairly far along in my career. We didn’t have income partners at Joseph B Cohan and Associates. Just partners, technically shareholders because JBC was a corporation, but we still called them partners. One time I was at a seminar with some of my JBC buds and when we sat down for lunch there were a few guys from Goff Cagan which had their offices on the opposite side of Worcester Common from us. What really struck us was that all the GC guys seemed to be partners, We wondered if there were any employees over there. Sometime after that, I became a partner in JBC, the last one ever as it turned out. And not all that long after that we merged with Goff Cagan and I learned the reason for their superfluity of partners.
You see in some firms, there are equity partners and income partners. I was blessed to be an equity partner – just barely. Income partners internally had the same status as equity partners and could put their lives and fortunes on the line by signing financial statements and tax returns, but economically they were really employees, being paid a fixed amount and possibly a bonus. And they didn’t have to sign on the debt, which was about the only plus of their status. When the light at the end of the tunnel came and we were acquired by a national firm, they didn’t get a piece of that and while the equity partners became partners or managing directors in the national firm, the income partners, who were not let go, became directors.
I have a sneaking suspicion that accounting and law firms that pat themselves on the back about having a lot of woman partners would not look as good if they only counted equity partners, but that’s another issue.
The Tax Deal
Under current law whether somebody is an employee or an income partner is pretty much a wash for income and payroll tax purposes. I ran some numbers, which I hope I didn’t screw up too badly, on Sally CPA. She works for a large local/small regional firm and has about six years of experience. Everybody loves her. About half of newer CPAs are women. About 17% of partners are women. By my reckoning, women do about 80% of the actual work. Sally has a salary of $100,000 per year. The managing partner wants to improve his firm’s reputation in promoting the status of women – without spending any money.
Sally, who is single, has by my reckoning taxable income of $89,600, which should work out to federal income tax of $18,138. Also, she has $7,650 of FICA/Medicare withheld from her pay for a total tab of $25,788. The firm matches the $7,650 in FICA/Medicare.
MP calls her in and tells her what a great job she is doing and that he wants her as a partner. Of course, she has to prove herself as a partner, so for now, she will have a guaranteed payment of $100,000 and she can come to the partner’s meetings – except when they are talking about the firm’s finances, which she doesn’t need to worry about. And besides her other duties of doing all the work she does now and starting to bring in business, she will be the woman empowerment partner, allowing her to rack up non-billable hours making the firm look good.
Under the new regime, Sally will have taxable income of $81,950 for an income tax of $16,226. She will pay $15,300 in self-employment tax for a total tab of $31,526. If Sally has just become an audit partner, she will be so ecstatic about her new status that the extra taxes won’t enter her mind. If Sally has just become a tax partner, unless she focuses on corporate, she will be onto the con. MP will then say. “Of course, of course, we will adjust for the payroll tax difference.”
The New Deal
I don’t know where we will end up with the new rates so purely for analytical purposes I’ll use current rates. The Senate bill, which apparently is what they are going with, treats the little people better on flow-through income. So Sally’s flow-through income, properly structured, will qualify for the new deduction. One of the rumors is that the rate of the deduction will be lower than proposed in the original Senate bill. Just for talking purposes, I will call it 20%. Now when Sally goes from employee to partner she gets an extra $20,000 income tax deduction more or less. That will almost wipe out the after income tax cost of the SE tax over FICA/Medicare. Under the old regime, the conversion was pretty much a wash when you combine Sally and the firm. Now it saves around 5% after tax.
No Guaranteed Payments Here
There was language in the bill to the effect that it would not apply to guaranteed payments. But who needs guaranteed payments? Last year Sally’s firm shared $10 million among the equity and income partners. It ended up being a 50/50 split. $5 million for the thirty income partners and $5 million for the 15 equity partners. The equity partners celebrated by going to a football game. The income partners celebrated by going to the ballet. The $5 million to the income partners was $4.7 million in guaranteed payments and $300,000 in bonuses.
After the Tax Cuts and Jobs Bill passes, there will be a totally new deal No more income partners. There will be Class A and Class B partners – no guaranteed payments for anybody. The first $4.7 million in profits go to the Class B partners – before the Class A partners are allocated a dime. Then there is $300,000 sprinkled among them at the discretion of the managing partner. Profits above $5 million go the Class A partners until you get to, I don’t know, let’s say $15 million. After that 10% go to the Class B partners. Just remember to tell the poor schnook who has to do the firms return that there are no more guaranteed payments to anybody ever.
Even the fourth tier equity partners will be getting a better tax deal. Tempers will be flaring on the executive committee as they once again feel persecuted for how meager their return is for all the sacrifices they have to make.
Maybe It Won’t Work
You have to 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. Still the bill shaping up will result in scheming to convert employment income to flow-through income . And the Tax Court will be littered with decisions on which schemes work and which ones don’t.
This Is Worse
There are three ways that we all tend to get income. One way is by deploying our capital. Another way is by working where we pretty much show up and do what we are told. That can require a great deal of skill, discretion, judgement and training or maybe not so much, but there are many highly trained and capable professionals who are told who they are providing services to and provided with what they need to do that particular job. In that very limited sense a physician in an emergency room, an accountant preparing tax returns and somebody stocking the shelves in Walmart can all be the same. Then there is entrepreneurial activity where you provide capital with a return and employees with work and hope to have something left over for yourself.
Sometimes the distinctions between the three ways of getting income are quite clear. Think of an office building. It might be owned by an insurance company or a REIT. And there are people maintaining it and providing security and other people who did the physical work of building it. There were other people in between assembling all the pieces. Maybe they made a fortune. Maybe they went bankrupt or to prison if they cut too many corners. Other times it is hard to sort out whether somebody is being an investor, an in-effect employee or an entrepreneur.
I tend to think that a more sane income tax system would say that income is income and tax it the same – regardless of whether rates are flat or progressive. In the seventies and early eighties labor income had a more favorable rate than investment income other than capital gains.
Now we will have several flavors of income with different advantages and disadvantages. And a lot of energy will go into gaming the system. It does not make much sense. On the other hand, it gives people work – people like me. So it can’t be all that bad.