Tax Analysts Blog

Wage Credit Is a Simple Solution for Tax Reform of Passthrough Businesses, But Greed Gets in the Way

Posted on Oct 16, 2017

For years—especially since the Republican Congress and President Obama agreed to extend the Bush tax cuts to all but those in the highest brackets -- passthrough businesses have been bemoaning their potentially unfair treatment under the next tax reform.

You see, for international competitiveness reasons, tax reform must lower corporate rates, and the traditional way to pay for a corporate rate cut is to rid the code of business tax breaks. But if business tax credits and deductions are repealed, they’ll be stripped from passthroughs as well. Passthrough taxes will be raised to pay for tax relief for multinationals. God forbid, Congress raise taxes on “small business.” Even though logic and many estimates indicate this would not be unfair because passthroughs are subject to only one layer of tax unlike double–taxed corporations, it would be political suicide for Congress.  We put “small business” in quotes because many passthrough businesses are big law firms, accounting firms, and manufacturing businesses (like Koch Industries).

The solution sought by the all-powerful passthrough lobby is a special (and unprecedented) low rate on passthrough profits. Currently, the all-consuming goal of the Republican Congress and the Trump administration is to chop the top 35 percent rate most passthrough income would pay without special relief to 25 percent.

But there is a seemingly intractable, practical problem that is preventing this dream from coming true.  All sides agree that unless there are enforceable rules to prevent it, there will be a bum’s rush for closely held businesses (many with just one owner-employee) to convert wages taxable at 39.6 percent to preferentially taxed profits at 25 percent. But even after years of searching for a solution and a chairman’s markup (the first real completely drafted and scored tax reform proposal) promised in just a few weeks, there is no workable solution in sight.

The three general approaches being bandied about are:

(1) Require passthroughs to hire accounting and compensation consulting firms to determine reasonable compensation (with the remaining passthrough income being low-tax profit). This would create endless controversy because (like international transfer pricing) it requires a detailed facts and circumstances analysis of each.  And unlike a few thousand multinational corporations, here we would be talking about millions of passthroughs. This means big fees for tax planning consultants. And as for the quaint notion of simplifying tax for small business, you can toss that out the window.

(2) Estimate profit by assigning some rate of return to capital contributed (with the remainder being subject to high-tax wage rates). But what rate should be assigned as a return on equity? And how do you put a monetary value on the “sweat equity” that is so much a part of the investment owners make in small and start-up businesses?

(3) As in the 2014 proposal from then-Ways and Means Chair Dave Camp, Congress could simply deem 70 percent wages (taxed at the new proposed 35 percent rate) and 30 percent profits (taxed at 25 percent). This just means all passthrough profits earned by high-income owners are taxed a weighted average 32 percent rate. Passthroughs hate that idea. Perhaps the net resulting rate is too high. Perhaps they know that (as with transfer pricing) with good consulting, they can likely get a better deal. A more complicated variation on this would have different rates and/or percentages for different industries.

OK, before we end up with some new rules that are the antithesis of fair, simple, and efficient tax reform, let’s take a step back and think outside the box. Why are we doing all this anyway? Are we trying to enrich already wealthy passthrough owners or, as we are repeatedly reminded, are we trying to create jobs? (Passthrough owners are still steaming over the 2012 deal that screwed them and saved Wall Street from the potential calamity of the federal government surpassing its debt ceiling.) So instead of relying on the trickle-down effect where owners get more after-tax profits, and then presumably invest more, which presumably increases productivity and the demand for labor, why not take the direct route and simply give passthrough owners tax credits for hiring workers? The first X percent of the Y dollars of each worker’s income would be creditable against income tax. 

This simple rule has two enormous advantages -- providing a direct and more effective incentive to increase employment and being easy to administer. The parameters could be set so the employer wage credit would be equal to the money Congress would have spent on their unwieldy passthrough rate cut and all the regulations that go with it.  A simple wage credit would redistribute the tax relief for passthrough businesses from businesses that add little value except for accepting risk and investing passively to those that hire people who make things and provide services.

But the passthrough lobby -- no matter the complexity and potential for abuse -- is dead set on tying its share of tax reform goodies to its profits and not to its employees’ wages. This is the opposite of tax reform.

For more tax talk, follow me on Twitter @M_SullivanTax

Read Comments (6)

Travis RechOct 17, 2017

Whats so wrong about passthrough income being taxed as ordinary income again? Does the business activity of pass through entities provide some powerful social benefit whereby our commonwealth gains a notable benefit from these entities and we ought to grant them a lower tax rate in exchange? I think not. This is nothing more than a cash grab for millionaires. If people really cared about simplifying the tax system they would be pushing for more items to be taxed as ordinary income rather than fewer.

Edmund DantesOct 17, 2017

Travis, as much as we often disagree, I am in complete agreement with you today.

One of the strengths of the 1986 tax reform, to me, was that capital and labor income was taxed the same, so no difference between long and short term capital gains. I believe that the best tax reform would be simply to re-enact the original 1986 tax code.

David RobertsOct 17, 2017

I agree that the large amount of US business income earned through passthroughs complicates tax reform, but trying to provide a lower rate for some pass through income is the wrong approach.

My view is that all income tax is ultimately paid by individuals, so I would make the corporate tax rate equal to the top individual marginal rate, but then make dividends paid by a corporation to a US resident individual deductible by the corporation up to the corporation's taxable income (apparently, Senator Hatch's integration proposal). With the corporate rate the same as the top individual rate, there would be no incentive to use a "C" corporation rather than a pass through, but the deductible dividends would eliminate the double taxation of corporate income, so no incentive to use a pass through. The high statutory US corporate tax rate (relative to the rest of the world) would apply only to income retained in the corporation, so would be effectively voluntary. Dividends paid by the corporation would be subject to a withholding tax if paid to a non-US person at whatever ultimate rate was thought appropriate. I will assume 25%. Dividends paid by the corporation to tax-exempt foundations would be deductible by the corporation, but subject to the same withholding tax, keeping tax-exempt foundations in about the same position on business income since they likely bear some corporate tax now through their investments in taxable corporations. Dividends paid by the corporation to pension plans would be deductible by the corporation and may be subject to the same withholding tax as dividends paid to tax-exempt foundation on the same reasoning, or the withholding tax could be tracked by the pension plan and ultimately creditable by the individual pension recipient once pension payments are made. I could also be persuaded to require withholding on corporate dividends to US individuals (so that corporate payers have 25% withholding on all dividends) with that credited against the US individual shareholder's actual tax due.

Edmund DantesOct 18, 2017

Makes sense to me—probably too much sense for today's Congress.

Mike55Oct 18, 2017

Great article. Like you, Travis, David and Edmund, I strongly dislike the special "business income" tax rate proposal. In a perfect world I would want all income earned by individuals to be taxed at the same rate. I can appreciate why that's not realistic for investment income (thereby justifying that special regime), but have never seen a compelling argument pass-through earnings paid to the non-wealthy somehow require their own tax category.

I will say though, your "solution" is pretty much the exact opposite of what Republicans are trying to accomplish. They want to give the owners of small pass through entities a tax advantage over wage earners. In contrast, you are proposing a special credit... on wage earning! If forced to choose between the two I actually prefer your idea, but that doesn't make it an answer to any of the myriad problems Republicans have.

I do of course appreciate that your solution ties very nicely to the Administration's tax rhetoric: Trump claims tax reform is all about labor participation rates and small businesses, and your wage credit delivers on both fronts. But to me that just demonstrates that we need more forthcoming/honest tax policy explanations from the Administration, not that we need new/special tax rules to try and make previously misleading claims less misleading.

N.HaydenNov 2, 2017

I keep hearing the reduced 25% tax-rate for pass-through income is to help job creation, but that doesn’t make much sense. After having spoken to multiple owners of various pass-through entities, they all essentially tell me the same thing: they hire one additional worker when they expect the additional revenue gained to exceed the cost of that worker. Their income tax rate has zero impact. That is, they would hire the additional worker whether their income tax rate sits at 25% or 50%.

There’s also an inherent unfairness by discriminating between business owners and wage earners. Compare a pediatrician earning $300,000 working for a hospital with another pediatrician with her own office (also earning $300,000 through her pass-through entity). One gets taxed at reduced 25% rate while the other faces highest marginal rate of 39.6%? Does this make sense?

We all know there are many pass-through entities that earn millions (and even billions) so the owners of these entities would get a huge windfall. Think of hedge fund managers, owners of restaurant franchises, real-estate developers, etc. This 25% rate for pass-through income sounds less than dubious to me.

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