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 But if business tax credits and deductions are repealed, they’ll be stripped from passthroughs as well.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.
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