Tax Analysts Blog

Opportunities for Tax Planning in the Pending Legislation

Posted on Dec 11, 2017

Whether you love or hate the tax bill soon to receive President Trump’s signature, knowing about its hidden problems and opportunities could play a major role in determining everything from your own personal finances to the outcome of the 2018 elections. Figuring out this technical tax stuff is impossible for regular folks. Even experienced accountants and lawyers will privately tell you they are dazed and baffled by so much complexity thrown at them in such a short period of time. But, in what must be considered a valuable service to the American public, 13 tax experts (mostly law professors) have combed through the statutory language of both the House and Senate bills and found some fascinating details that could rock your world. Their 35 page paper, “The Games They Will Play: Tax Games, Roadblocks, and Glitches Under the New Legislation,” is a summary of what they have discovered so far.

If you or your employer wants to pay less tax, the loopholes highlighted by this study can get you started on what to ask your tax adviser. If you’re a policy wonk who cares about fairness or deficits or complexity, this paper is required reading. If you are a member of Congress, you may want to consider some of the glitches in this bill that are now mostly unknown but will become very well known before the next election. And maybe, if time permits, you may even want to fix these problems before voting on the bill. Many or most of its provisions (depending on whether the Senate or House version prevails) will go into effect in less than three weeks.

The 13 authors of what is being known in tax circles as the “tax games” paper are Reuven Avi-Yonah (University of Michigan), Lily Batchelder(NYU ), J. Clifton Fleming (Brigham Young University), David Gamage (Indiana University), Ari Glogower (Ohio State University), Daniel Hemel (University of Chicago), David Kamin (NYU), Mitchell Kane (NYU), Rebecca Kysar (Brooklyn Law School), David Miller (Proskauer Rose LLP), Darien Shanske (UC-Davis), Daniel Shaviro (NYU), and Manoj Viswanathan (UC-Hastings).

Even though this all-star team of tax experts has boiled down what easily could be a 300-page law review article into a one-sitting read, nobody can be under the illusion that any more than the most tax-curious folks will give it a look. (There have been “only” 13,000 downloads in the four days since it was posted.) So to help spread the word, I (not a lawyer), with all humility, have taken the liberty of summarizing their summary. Still, everybody who deals with taxes –that is, most of us who are no longer teenagers--should read the original paper. In the meantime, below is a partial list of some of the main technical shortcomings of the proposed legislation described by the 13 authors.

Using Corporations as Tax Shelters

In the House bill, the top individual rate remains at 39.6 percent. In the Senate bill, the top individual income tax rate declines modestly to 38.5 percent. In both bills, the corporate rate drops a full 15 percentage points from 35 percent to 20 percent (but not until 2019 in the Senate bill). This starkly sharper drop in the corporate rate (combined with the ability to defer or even entirely escape individual income tax) gives corporations a new, irresistible gravitational pull that attracts income from all sources.

Convert interest income to low-tax corporate profits. In the absence of effective antiabuse measures, individuals may incorporate and use taxable corporations as tax shelters so that interest income otherwise taxed at individual rates of up to 43.4 percent--39.6 percent income tax plus 3.8 percent net investment tax under the House bill; 42.3 percent under the Senate bill, where the top individual income tax rate drops to 38.5 percent--can be taxed at the 20 percent corporate rate. Individual tax would be due only on distribution, so individuals can enjoy significant deferral benefits, and if held until death, individual tax can be completely eliminated. In the most abusive cases, current antiabuse rules might be effective but, the authors note, “existing rules are notoriously porous and easy to evade” and any antiabuse rules are costly for the resource-constrained IRS to enforce.

Convert dividend income to low-tax corporate profits. Without effective antiabuse measures, individuals may use a taxable corporation as a shelter so that tax on dividend income otherwise taxed at individual rates up to 23.8 percent will be subject to 10 percent corporate tax under the proposed law because under the bills, corporations get a 50 percent deduction for dividends received. Again, individual tax is deferred until distribution or eliminated at death.

Convert wages to low-tax corporate profits. Employees (presumably wealthy, who do not need immediate income) may become taxable corporations. Then, instead of receiving salaries taxed at regular rates (in many cases higher than 40 percent), they can receive fees charged by their corporation from their former employer and pay 20 percent tax. And under both the House and the Senate bill, taxable corporations can deduct state and local taxes while state and local tax deductions for individuals are limited.

Cut the salary you pay to yourself. Active business owners of taxable corporations can minimize taxes by paying themselves low salaries. (Remember: Wages and salaries pay full freight, while ownership income gets a reduced rate.) Determining “reasonable compensation” is a judgment call fraught with controversy. The underfunded IRS could be easily overwhelmed.

Put your corporation in a Roth IRA. To turbocharge tax benefits, individuals can put their taxable corporation shares into their Roth IRAs and, if payouts are delayed until retirement, they only pay 20 percent corporate tax on profits as they are generated with no individual taxes upon distribution.

Games for Passthrough Businesses

A passthrough business is a sole proprietorship, a partnership, a limited liability company, or a subchapter S corporation in which income tax is only paid at the individual level on income passed through to owners. It is an absolute political necessity that passthrough (often, but not always, small) businesses get a significant tax break in this bill. But at the same time, Congress wants to save money and focus benefits on certain business segments.

Convert wages to small business income. Although there are some restrictions in the bills, many employees at firms may be able to form their own passthrough businesses. Then they can receive a 23 percent deduction (in the Senate bill) or pay tax at a maximum rate of 25 percent (in the House bill) on their fees for service instead of paying regular rates on wages. In the House bill, this game is limited because the deductible amount available to employees-turned-businesses is tied to the amount of tangible capital in the business. In the Senate bill, to claim the full deduction individuals must have incomes below $250,000 if filing separately and below $500,000 if filing jointly. In both bills they may not receive deductions for income in excess of “reasonable compensation”—a standard that is hard to police and depends on the facts and circumstances in each case. 

Splitting off nonprofessional income from professional income. Legislators don’t like the optics of giving tax breaks to rich doctors, lawyers, and other white-collar professionals. In both bills, deductions could be denied to professionals in “health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, [or] any 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 investing, trading, or dealing in securities, partnership interests, or commodities.” Looks like Larry’s lawn-mowing service is spared. But for others, these limits on benefits to professionals might be circumvented by splitting businesses into an unqualified (high-tax) professional business and a qualified (low-tax) business. The low-tax business then can charge (likely excessive) fees to the high-tax professional business (for example, rent for office space owned by low-tax businesses, royalties for the use of an established company name transferred to a low-tax business, and interest for loans provided by the low-tax business).  All the profit-shifting shenanigans that multinationals engage in will now be relevant for domestic businesses.

Reaction of State and Local Governments

Both the House and Senate bills would limit deductions for state and local taxes to $10,000 of property taxes for each taxpayer. The reaction of state and local governments to this unprecedented challenge is hard to predict, but with a little legal finesse Congress’s intent could be largely undone.

Convert nondeductible tax into functionally similar deductible payments. State and local governments could respond creatively to the restriction on deductions for their taxes. For example, they could impose payroll tax on employers for wages paid in lieu of income taxes on wages. Also, a state government could provide a 100 percent credit against state tax for a deductible contribution to charities that duplicate state government functions. For example, in lieu of paying nondeductible income taxes, an individual could make a deductible charitable contribution to a fund (certified by the state) to fund primary education. Then the state could put in place automatic reductions in budgeted amounts for primary education equal to contributions received by the fund.

International Intrigue

Congress wants to move to a territorial tax system. The general idea here is that foreign income is exempt from U.S. tax. But as with the passthrough tax benefits, Congress also wants to prevent abuse and to keep costs low without compromising competitiveness. The multiplicity of goals yields a tangled array of rules with several unintended and unwelcome consequences.

Incentive to send capital abroad. Under the Senate bill (whose international provisions are more likely to be adopted), the location of hard assets in the United States reduces the proposed benefit for profits related to exports and the location of hard assets abroad reduces proposed U.S. tax on foreign profits. Therefore, international provisions provide incentives to shift production abroad.

Phony exports. The special deduction in the Senate bill (a related provision in the House bill is a non-starter) for export income can be gamed by round-tripping products back into the United States or selling unfinished U.S. products to a foreign manufacturer for resale into the country.

Illegal export subsidies. The Senate bill contains a provision that is strikingly similar to an old export subsidy (known in the biz as DISC-FISC) that sparked a trade controversy that lasted more than three decades (1971-2004). This deduction for export income runs afoul of WTO rules and could invite retaliation (whether or not sanctioned by the WTO). 

Illegal tarifflike taxes.  A new minimum tax on U.S. income applies to related-party imports--in other words, a tariff—and could also be a violation of WTO rules. 

Other Glitches

The Republican majority has pushed these highly complex tax bills through the legislative process at a pace that most experts thought was near-impossible. The bill was formally introduced on November 2 and is likely to be signed into law before Christmas—a total of seven weeks. The time span from formal introduction to presidential signing for the Tax Reform Act of 1986 was 13 months. As might be expected, the rapid pace has resulted in unusually numerous errors that need correction and consequences that have not been fully anticipated.

A huge (but temporary) tax shelter is born. Immediate 100 percent bonus depreciation in combination with a delay in the cut of the corporate tax rate until 2019 in the Senate bill would create huge tax sheltering opportunities and incentive for leasing in 2018. This sets up the U.S. economy for an unhealthy boom-bust cycle in capital spending. Corporations will buy equipment like crazy in 2018 to deduct the entire cost at the 35 percent rate or, once tax is zeroed out, will lease from corporations with high tax (still being paid at 35 percent rate).  Afterward in 2019, the demand for equipment would drop precipitously. 

Corporate AMT aftershock. As is now well-understood by the business community, last-minute retention of the current-law 20 percent corporate alternative minimum tax in the Senate floor amendment in a bill with a 20 percent regular corporate tax rate effectively eliminates the research credit and the proposed tax benefit for exports in the Senate bill. This clearly is an unintended effect. It’s predicted that this will be corrected in the final version of the bill (the “conference report”). But what is unknown is what those modifications will be and, given the haste and lack of scrutiny with which these provisions will be put together, we may be jumping out of the frying pan and into the fire.

Now please remember that these are the loopholes and glitches found by professors who have nothing to gain monetarily from their efforts. We should expect more as now-hazy details become clearer and the tax community’s understanding of this behemoth legislation expands. We should also expect more as attorneys and accountants anxious to generate fees set to work on discovering more ways to cut their clients’ taxes. The odyssey that is the Tax Cuts and Jobs Act only begins when the bill arrives on the president’s desk. 


Read Comments (2)

Iain CampbellDec 11, 2017

The UK tried this in 2002 and it went very badly wrong. A worrying precedent for US reforms?

"In April 2000, a tax credit for R&D was introduced (see Appendix for details). At the same time, a 10% lower rate was introduced for companies with less than £10,000 of taxable profits, and this lower rate was cut to zero in April 2002. This last tax cut came as a surprise, with potentially large costs if self-employed individuals registered as companies to reduce their tax liabilities. Having apparently failed to anticipate the scale of this effect, the government swiftly reversed the reform. In April 2004, the zero rate was abolished for distributed profits, removing much of the tax advantage but at a cost of greater complexity; and so in December 2005, the zero rate was abolished for retained profits as well."

Mike55Dec 12, 2017

Nice article on an interesting work product. A couple thoughts:

First, most of these "games" exist under current law, so media characterizations of the paper as somehow proving there are more/worse "games" under the proposed law is false. To their credit the authors candidly acknowledged as much within the paper, explaining that what has really changed is the incentive to utilize certain "games" vs. others.

Second, the temporary full expensing matter is not a "glitch." It is arguably bad policy, but "glitch" implies something unintentional: many Republicans view the anticipated capital spending boom as the very best feature! For better or worse, lots of voters deem a boom-bust cycle desirable so long as the "boom" will occur first.

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