Joe had a nice little plumbing business in a pleasant small town. After paying his business expenses, he pulled in a tidy $100,000 a year. For protection against lawsuits, he was incorporated. But he didn’t pay corporate tax. His accountant, Mrs. Ledger, said Joe’s business was a subchapter S corporation, and that meant all his business income passed through to his 1040. So he paid tax on his plumbing income at his personal income tax rate. It was all simple enough.
Then along came the Tax Cuts and Jobs Act of 2017.
Mrs. Ledger told Joe that under the new law, he could save on his taxes, but only after deducting “reasonable compensation” on what he would pay himself if he were an employee. Joe thought that seemed weird, but if it’s what the IRS wanted, he could deal with it if it meant lower taxes.
So the question was, what’s a reasonable salary for a plumber? There is no one right answer to that, said Mrs. Ledger. It can be complicated, and you can never be sure what the IRS will accept. It depends on each owner’s “facts and circumstances.” It was out of the question for Joe to hire some sort of expert on compensation, but he remembered that his brother-in-law in a nearby city made $40,000 working for a big plumbing company, so that seemed reasonable. That’ll have to do, said Mrs. Ledger. So with some trepidation and lots of uncertainty —“playing the audit lottery,” as Mrs. Ledger put it -- Joe paid regular tax on $40,000 of what he now called salary and got to deduct 20 percent of the $60,000 he now called profit.
Joe was well liked and had a reputation for doing quality work at affordable prices. So it was no surprise to anyone that soon his business was booming, especially when a housing development and strip mall were built close by. After paying his expenses, he netted what seemed like an astronomical sum of $300,000 the following year.
Mrs. Ledger told him the bad news was that now that his taxable income was so high, he would no longer qualify for the 20 percent deduction for his taxable profit . . . unless he made the case that he wasn’t in a “specified activity.”
What’s that all about? Mrs. Ledger explained that some -- mostly white-collar -- professionals could not get the benefit if their income was too high. Joe was not a lawyer or an optometrist or an athlete — a few of those specified professionals that would get the shaft under the new law. But Mrs. Ledger said that he might be a “trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners.”
What does that mean? queried Joe. Good question, said Mrs. Ledger. There are no regulations yet, so we’ll just have to feel this one out.
Joe and Mrs. Ledger pondered. On the one hand, Joe was the man and everybody in town knew it. He was a whiz at the art of plumbing. He was organized. He hired an outside firm to do his clerical work. And he was even a bit of an amateur mechanic who could repair and maintain the company truck. Joe was a modest fellow, but to him it seemed that without Joe there was no Joe’s Plumbing, so he guessed he would no longer qualify for the deduction. Mrs. Ledger agreed that that was solid reasoning but noted that this was totally new law, nobody really knew how it worked, and anyway everybody’s situation was different.
Mrs. Ledger said there might be another way of looking at it, especially from an accountant’s point of view. On the asset side of the company’s balance sheet there was a truck, the inventory of spare parts, the latest in high-tech plumbing tools, and the garage-warehouse and adjacent land in the company’s name. She didn’t see any line item for “Joe’s skill.” There was no asset called “Joe’s reputation.” So she considered the company’s principal assets to be tangible capital. It was plenty uncertain, but they decided to roll the dice and see if it would work. Besides, Mrs. Ledger had heard the regional IRS office was laying off agents because of budget cuts, so there was little chance Uncle Sam would notice.
But there was still another issue. What now? wondered Joe. I thought this tax reform was going to make things simpler for small business. Mrs. Ledger explained that there was a limit on his deduction based on 50 percent of wages paid. In his case that would be half of what paid himself — that is, $20,000. His business income, let’s say just for rounding sake, was about $250,000. So his deduction before the limit was $50,000. But with the “W-2 limit,” as Mrs. Ledger called it, his deduction went from $50,000 to $20,000. Ouch.
There was still another rule for Joe to learn. Under the new law, there’s an alternative limit he can use if it is more beneficial— something called the “Corker kickback,” named, perhaps unfairly, for Tennessee Republican Sen. Bob Corker, who besides being a senator is a wealthy real estate investor. He allegedly changed his vote from no to yes at the last minute when this provision was added to the tax bill. This alternative limit is equal to 25 percent of wages—$10,000 in Joe’s case—plus 2.5 percent of the purchase price of his hard assets. The truck and tools and inventory and real estate--especially the real estate he inherited from his parents--totaled $1 million in value. That meant he could add $25,000 to $10,000 and his new limit would be $35,000.
That wasn’t as good as the $50,000 deduction Joe was hoping for, but it was more than the $20,000 he would get without the Corker kickback. Mrs. Ledger told him that his circumstances put him in a special class of passthrough business owners like President Trump. These weren’t easy calculations to make, and it sure seemed convoluted but Joe guessed he was glad for the tax cut.
Mrs. Ledger said she had some more ideas on how he could split his business into parts and shift profits from one business to the other and save even more. Joe was tired of the math and the nonsensical rules. This is the kind of thing you have to do if you want lower taxes, Mrs. Ledger told him. You don’t think the government is just going to give it to you, do you? Of course, her fees would go up but she assured Joe it would all be worth his while.