The tax plan outlined by the Trump administration revived not only many of the Trump campaign’s major tax proposals, it also revived the controversy about how policymakers would subsequently go about preventing widespread gaming of the tax system for passthrough entities if the plan were to be implemented.
The White House proposed a 15 percent business tax rate that would be available to small and medium-size passthrough businesses, without setting parameters. It likewise proposed three individual income tax brackets with rates set at 10, 25, and 35 percent, but did not designate income thresholds for the brackets. That plan mostly aligns with what the Trump campaign proposed in September.
Administration officials have made clear that they are aware of the incentive for tax avoidance. In announcing the Trump tax plan outline April 24, Treasury Secretary Steven Mnuchin emphasized that the 15 percent business rate would be available to both small business passthroughs and corporations. But he added, “We will make sure that there are rules in place so that wealthy people can’t create passthroughs and use that as a mechanism to avoid paying the tax rate they should be paying on the personal side.”
At an October 2016 tax policy forum hosted by the Urban-Brookings Tax Policy Center, then-Trump economic adviser and now Commerce Secretary Wilbur Ross dismissed concerns about the difficulty of designing rules to prevent tax avoidance stemming from the 15 percent rate. “If all the people in Washington, if all the lawyers, if all the tax experts can’t figure out how to draft a simple thing like that successfully, they ought to quit,” Ross said.
Many lawyers and tax experts don’t think it will be quite that easy.
Back to Kansas
Any discussion of the 15 percent business tax rate inevitably draws comparisons to Kansas, which exempted passthrough entities from the state income tax in January 2013.
Martin A. Sullivan, chief economist for Tax Analysts, at a May 1 tax reform panel pointed out that the top individual income tax rate in Kansas is less than 5 percent, but already there has been a “massive incorporation of self-employed individuals” in response to the 2013 change. With the 20 percentage point differential between business and personal tax rates proposed by the White House, “the pressure will be enormous” to exploit that difference, Sullivan said.
One prominent example of Kansas tax avoidance concerns the state’s highest paid employee, University of Kansas men’s basketball coach Bill Self. At the May 1 panel, Leonard Burman of the Urban-Brookings Tax Policy Center recalled that, following the 2013 Kansas tax reforms, Self renegotiated his contract so that most of his compensation would go into the LLC — effectively zeroing-out the tax rate on that income. “He actually pays a lower effective tax rate than a philosophy professor,” Burman quipped.
Tax Policy Center Director Mark Mazur, who previously served as Treasury assistant secretary for tax policy during the Obama administration, said he was skeptical that rules could be designed to effectively police tax avoidance under the new plan. He told Tax Analysts that it’s “fairly easy on its face to recharacterize your activity as a business relationship rather than an employee-employer relationship,” and that’s what happened in Kansas. The technology and process for making that transition is already becoming more well-known, so “the concern becomes, how do you turn that off? Once people know how to do this, what keeps every accounting company or the tax preparation software people from having a $10 app called: ‘Create Your Own LLC’?” he asked.
When there is an enormous incentive with “thousands, tens of thousands, hundreds of thousands of dollars at stake — and the technology is pretty cheap to move you from one side to the other of that line — it’s really hard to write rules to prevent that,” Mazur said. “The private sector is always one or two steps ahead of the Treasury and IRS rule-writers,” he added.
“I think it could be a ‘Kansas problem,’” agreed Lisa Zarlenga of Steptoe & Johnson LLP. But she said that given time and the right circumstances, she is optimistic that the IRS and Treasury could design effective rules.
However, Zarlenga warned that in that intervening period, as Treasury proposes regulations, gives notice, holds comment periods, and tries to get the rules right, taxpayers will try to claim the 15 percent rate “for years before the IRS can come in and audit it and disallow it and litigate it.”
Rulemaking by Law or by Treasury
There are two basic approaches Congress could take in establishing anti-tax-avoidance rules: include substantive rules that largely set the parameters on how the tax would be implemented, or grant Treasury and IRS broad rulemaking authority within the statute to design the rules.
The best-case scenario for designing rules would be one in which Congress passes a law with the rules largely established in the statute, as former Republican House Ways and Means Committee Chair Dave Camp tried to do in his 2014 tax reform discussion draft, according to Zarlenga.
She noted that Camp’s draft proposed a mechanical rule that would have deemed 70 percent of passthrough income for personal service companies to be taxed as individual wages, and 30 percent would be treated as business income. Though somewhat harsh, Zarlenga said that the 70-30 ratio was based on historical labor and capital trends.
But if Congress does punt on establishing the rules itself and leaves that to Treasury and the IRS, it could take “considerable time” before those rules are finalized, particularly on an “amorphous” topic like reasonable compensation. She cited Treasury’s attempts to settle on a definition for what constitutes a plan for reorganization under section 355 and when acquisitions and spinoffs are part of the same plan. “It took IRS and Treasury like four tries to get it right,” Zarlenga said.
Another reason leaving it up to Treasury to design the rules could be a challenge is that Congress could decide it doesn’t like the rules Treasury comes up with — something that has already happened with passthrough taxation, Zarlenga pointed out. In the 1990s, Treasury and the IRS tried to propose regulations to define what constitutes a limited partner for the purposes of the self-employment tax, but then reproposed them a few years later, she said, because they didn’t get it right the first time. But Zarlenga said that lawmakers stepped in because they thought that the regulations were setting policy that should be decided by Congress, and the IRS and Treasury have not sought to propose new rules on the issue since.
“This is a gap that’s existed for 20 years, and they haven’t been able to do anything because they’re afraid Congress is going to step in and overrule them and say this is the way we’re gonna do things,” Zarlenga said.
That same effect would apply to designing any new anti-gaming passthrough tax rules, according to Zarlenga. “I think IRS and Treasury can do it,” Zarlenga said, adding that “they’ve done facts and circumstances-based regs in the past and after a few tries they generally get them pretty good.” But, she said there would inevitably be that “fear in the back of their minds” that Congress will overrule whatever they come up with, leading them to take a more conservative and less effective approach to antiavoidance rulemaking.
Mazur likewise noted that it could take many years before final, effective rules are put in place. As an example, he cited the section 385 debt-equity rules (T.D. 9790) finalized by Treasury in October 2016. Treasury has had broad authority to promulgate rules on what is debt and what is equity for decades, Mazur said, but “we did nothing since the 1950s until last year's" debt-equity rules.
Regardless of whether the rules are included in statute, set by Treasury, or some combination of both, there are a multitude of challenging trade-offs in trying to make them broadly acceptable both to taxpayers and tax administrators.
Implementing the new business tax regime could prove particularly challenging to the IRS when it comes to partnerships and S corporations, according to Monte A. Jackel of Akin Gump Strauss Hauer & Feld LLP, who previously served in the IRS as associate chief counsel (domestic-technical) and as special counsel in the passthroughs and special industries division of the Office of Chief Counsel.
The challenge would be preventing individuals who receive either a fixed amount in the form of a guaranteed payment or wage income from a partnership, or a fixed salary from an S corporation, seeking to be paid less in the fixed amount — which would be taxed at a top 35 percent rate under the Trump plan — and more in the form of distributive shares, which would be taxed at the much lower 15 percent business rate, according to Jackel.
Passthrough tax gaming exists under current law and is “very common for S corporations where the game is to minimize self-employment tax by paying less salary and having more distributive share,” Jackel noted. He cited proposals by groups like the New York State Bar Association tax section which suggest that partnerships or S corps should be subject to the self-employment tax if they are service businesses, but said if there is significant capital involved, then there would have to be apportionment to capital.
“The same issue would arise under the Trump proposal in that if the business has capital in addition to services, the capital income may not be treated as business income and would need to be separated out,” Jackel said. But determining what constitutes reasonable compensation is “too hard to audit,” and simply treating all partnership or S corporation income as business income is “too broad.”
Nevertheless, Jackel said that taxpayers and the IRS would need objective rules to clarify what constitutes reasonable compensation, and whether compensation — which presumably would be taxed at the higher individual rate — is too low, and distributive shares — taxed at the far lower business rate — are too high. However, reasonable compensation issues have “long been litigated,” Jackel noted. The IRS might establish safe harbors in the form of ratios of what constitutes reasonable returns on capital and what are reasonable compensation ranges for particular types of businesses, but “I don’t think it will be easy,” Jackel said.
Mazur agreed that setting reasonable compensation ranges would be an effort fraught with controversy. “If you’re an S corporation and you’re supposed to pay your owners reasonable compensation, if you’re a top-notch lawyer, is reasonable compensation $200,000 a year or $2 million a year? If you’re a taxpayer, you always choose the lower figure . . . and then it just becomes a fight, every one of those is a potential dispute.”
One option the Trump administration could pursue in setting up rules to prevent tax avoidance would be to exclude some types of businesses from claiming the 15 percent tax rate. Jackel suggested that this could be done as part of an effort to limit the rate to the perceived “backbone of America” businesses. Such a move wouldn’t be without precedent, according to Jackel, who noted, for example, that reg. section 1.448-1T(e)(4) lists, defines, and provides examples of eight different types of personal service businesses exempted from temporary rules limiting the use of cash receipt and disbursement accounting methods — such as those that primarily perform services related to health, law, accounting, or consulting.
However, Zarlenga said that such a broad exclusion based on businesses that are typically higher-income would inevitably encompass truly small passthrough businesses, like a small-town dentist opening a clinic, and prevent them from claiming the rate.
Both Zarlenga and Jackel suggested another potential approach, in which rules establish a definition of small business based on the size of its net assets or net income. Zarlenga noted that while there is currently no universally agreed-upon definition of a small business in the tax code, the code does already restrict some tax provisions to small businesses as defined by income thresholds, such as eligibility for the cash accounting method in section 448.
But Jackel warned that “such an approach could cause a business entity to fall in or out of the lower business tax rate as its assets or income fluctuate from one year to the next.” The result could be a potentially massive and disruptive change in tax rates as it flipped from the 15 percent business rate to the top 35 percent individual rate from year to year.
Mazur suggested that business income could be limited to capital invested in a business, multiplied by “some reasonable rate of return.” But he said both that option and the Camp draft's mechanical 70-30 ratio are “pretty harsh, bright-line rules” that would have to be written into statute, not proposed by Treasury or the IRS.
Jackel pointed out several other thorny questions that would need to be resolved if the new business tax regime is implemented, such as whether lease or license income would be considered business or investment income. Current rules for section 469 distinguish between active income, portfolio income, and passive income. “Are these rules to be the same?” he asked.
The IRS may also need to rethink allowing partners to be treated as employees, contrary to the position it staked out in Rev. Rul. 69-184, 1969-1 C.B. 256, and to “address the current inequality between the taxation of self-employment income of partners as compared to employee wage income,” Jackel said. “Not doing so would disadvantage those operating in partnership form as compared to performing services as an individual employee.”
Additional questions would arise from the increased scrutiny over distinguishing wage and distributive share income, Jackel said. With capital gains taxed at a proposed 20 percent tax rate — after factoring in elimination of the 3.8 percent net investment income tax called for by the Trump tax outline — it “would seem that it would be necessary under the Trump proposal to exclude carried interests for services from the capital gains rate in order to prevent partner distributive shares from receiving a lower rate than ordinary services wage-type income,” Jackel said.