Though It Would Benefit Me Greatly, the Proposed Pass-Through Entity Tax Cut Is A Bad Idea

In the most recent version of a tax "reform" proposal in Congress, there was a provision for a reduced personal income tax rate on income from pass-through entities.  A pass-through entity is usually an S-corporation or an LLC, where the entity fills out a corporate tax form but pays no income taxes -- instead the income passes through to the individuals who own the entity, and taxes are paid on the individual return.  This was a great innovation because it provides an alternative to the double taxation of income that still exists with traditional C-corporations  (ie tax is paid by the corporation on income and again on the same income when it is passed through as capital gains or dividends to the owners).

I own an S-corp and would benefit greatly from a reduced tax rate on S-corp pass through income.  But I oppose it.  The basis of this tax proposal is a familiar one -- there is some type of economic behavior that Congress thinks is either meritorious or counter-productive, and there is a great urge to tweak the tax code to promote or hinder these behaviors.  We get sold on the idea that owning a home is better than renting and thus we have the mortgage interest deduction.  There are thousands of such tweaks in the tax code, and most have little to do with economic reality and more to do with some special interest rent-seeking with Congress.

Someone in Congress thinks it's good that business people own small businesses and they should get a lower tax rate.  That's me, so thanks. But we end up with craziness, exactly as we do every time Congress tries to pick winners and losers.  Here would be effective tax rates (corporate + individual) for income earned in different ways under the new plan:

  • The lowest rate would be for income to a passive investor in a pass-through
  • The next lowest rate would be for income to an active investor in a pass-through -- yes, from a tax point of view it is less meritorious to actually work at the pass-through entity than just collect checks.  The logic is that part of one's pass-through income is for "labor" and thus needs to be taxed at the higher regular income tax rate.  How anyone can separate how much of my profits are from my labor and how much is from -- what?  unicorns? -- I have no idea
  • The next higher rate would be paid on passive income from a C-corporation like ExxonMobil, which would be taxed at the corporate rate and then taxed at the dividend rate (currently 15%) on the individual return but the combination would likely be less than the maximum personal rate.  For people without a lot of other income, this might be the highest taxed activity.
  • The highest rate would be for people simply working and earning income, assuming they are in the upper tax brackets.

All of this makes zero sense, or to the extent it makes sense to anyone is based on economic theories that likely don't hold a lot of water.  It reminds me of the old efforts to distinguish between the deserving and undeserving poor when giving out relief.  Every person in Congress seems to have a personal vision of deserved and undeserved income.  Just because the current folks have me in the deserving category doesn't mean that the next batch won't put me in the opposite category.

I think the entire corporate tax system needs to be junked.  The amount of effort that goes into compliance, and perhaps more importantly, the number of distortions is creates, make finding an alternative well worth the effort.  My tax plan has always been:

  1. Eliminate all deductions in the individual income tax code except for a single personal deduction
  2. Eliminate the corporate income tax.
  3. Tax capital gains and dividends as regular income.
  4. Eliminate the death tax as well as the write-up of asset values at death

Corporate income all eventually passes through to individuals as capital gains or dividends, so eventually they do get taxed.  The same is true of inherited assets -- because they would not get written up in value at death, they would still trigger large capital gains once tapped by those who inherit the assets.  As far as rates are concerned, I actually don't see a strong need for a flat tax -- I can live with the progressive rates we have now.

I have heard people of late saying that we can't eliminate the corporate income tax because foreign investors would never get taxed.  First, they would get taxed, just in their home country.  And second, who cares?  There have got to be a lot of things worse than a rush of foreign capital into the US.

  • davidcobb

    I agree 100% with your tax plan. However, should we refuse to eat hamburger because we wanted steak? Getting anything past K-street is a win at this point.

  • ErikTheRed

    No, it's really not. Every business has piles of distorted activity that they engage in due to tax regulations. The only thing more stupid, wasteful, and obnoxious than having these due to the obscene Gordian Knot of a tax code is making us rearrange all of our distorted activity every time the vacuous Congress (of chimpanzees) decides to suck up to a slightly different set of ballot leeches. Incremental change is often worse than no change at all - it eliminates your ability to engage in long-term planning (another concept entirely foreign to Washington).

    Keep in mind that we can't always ust take the language of the new rules at face value - we have to wait for cases to go through courts to see how they'll be interpreted, new precedents set, etc. This often takes years. So we're stuck in limbo at every major change trying to figure out where we need to be to be in compliance without getting fleeced. It's often a risky process that adds even more unwanted uncertainty to the business environment.

  • davidcobb

    I agree with you, but reality is a harsh mistress. Until Americans are marching down K-street with tar, feathers and ropes, they are going to have their grubby fingers in the pie.

  • ErikTheRed

    I like the idea, but I would posit that your ire is focused a few blocks too far to the north / northwest. The denizens of K Street are only buying what other people are selling.

    In any case, I'm reasonably certain that the biggest beneficiaries of this and every other major tax code change are the tax attorneys. Heck, even mine would prefer a cleaner system even though it would cost him a ton of income.

  • The_Big_W

    You know, I'd be ok with the tax cuts on S-corps benefiting you greatly. Because I believe that you would take those savings and look to expand your business, provide a better experience to customers, increase employee wages, add employees, manage more parks, etc.

    I think businessmen like you with S-corps were abused by the Obama administration, and deserve a chance to catch a break and work to grow your business for a change instead of following onerous regulations and paying onerous taxes...

  • davidcobb

    My ire is actually focused on the fact that the people K-street buys, have a lot more to sell than they should have.

  • WesternRover

    To eliminate double taxation of corporate profits, wouldn't it be better to tax them the first time and not the second, i.e. when the profits are earned and not when they are distributed? Under your plan I predict a lot of business owners living in corporate-owned houses, driving corporate-owned cars and boats, wearing corporate-owned clothes, so they can avoid taking much money out of the corporation.

  • davidcobb

    That's how trust funds work now. You just have to 3mil. in cash to take advantage of it.

    While it sounds like a good idea. the whole purpose of a corporation is so you don't loose your house, cars, and clothing if business goes south.

  • STW
  • Ellen McKaskle

    There are problems with taxing capital gains and the "write up" of asset values.

    As to capital gains a full income tax ignores inflation. This can be remedied by limiting the tax to gains that exceed the intervening inflation. (Another, lesser, problem is that capital losses are severely limited unless they are set off against contemporary capital gains.)

    As to write up of asset values, heirs may have an extremely difficult time determining the amount of gain on many types of property--houses being one of many examples. For a house held for a long time (we've lived in ours for over 45 years) even the purchase price might be difficult to ascertain let alone the value of improvements made during the long ownership, especially if the decedents kept poor records. If the default is the initial value it may result in excessive taxation simply because of insufficient records (something the decedents may not have considered necessary because the law has long "re-set" the value at the time of their deaths). Inflation is also a problem in write ups of assets. One solution would be no write-ups if the estate is less than a certain value (e.g., $5,000,000) plus an inflation allowance.

  • Magua1952

    About the mortgage interest deduction: it was present in the original income tax legislation of 1894. The income tax was found unconstitutional until an amendment allowed the tax in 1913 and the new income tax retained the original mortgage interest deduction.

    In the late nineteenth century there were almost no mortgages on homes. There were mortgages on farms and other businesses. The interest on a mortgage was a business expense. No one anticipated that many people would take out mortgages for a simple residence. The deduction was baked into the cake from the beginning. Any sudden--or even gradual--repeal will have far reaching consequences for builders, homeowners and banks.

    Houses are probably overpriced because of the interest deduction. Estimates are in the range of 15%.

  • LoneSnark

    Corporate expenses are exempt from taxation. As such, everything a corporation buys or pays for is exempt from corporate taxation. Now, you can pay an employee in kind, and they will need to pay taxes on that.

  • Brandon Claborn

    As an S-Corp, do you compete with C-Corps? If so, why should you be taxed at a higher rate than your competitor? I would also prefer your proposed tax plan but as the current proposal sits I can't support this portion. Full disclosure - I receive income from an S-Corp.

  • Joe - the tax practiioner

    Your bring up one of the most important (and neglected) points regarding taxing capital gains. The taxable portion of the capital gain should be based on the true economic gain (as adjusted for inflation). The lower 15/20% rate was a quasi work around the problem of adjusting the gain for inflation - not the best way to solve the problem, but a reasonable work around.

    Back in the 70's & 80's it was common to have an economic loss on a asset due to inflation , but still have taxable income on the sale of the asset.

  • Joe - tax

    Several broader points regarding tax policy should be addressed before tinkering with any specific items

    1) The driving factor in our high tax rates and complexity of the tax code is the need to generate revenue for our spending. Reduce spending and the complexity and constant tinkering with the tax code is reduced
    2) Our overall tax rates are too high, see comment 1 above
    3) The poor should pay income tax, albeit a small/ low rate, if for no other reason as to have skin in the game and to have a responsible attitude toward fiscal spending
    4) Even as a conservative, I agree with progressive tax rates. The high earners and the rich should pay a greater portion of their income in taxes than the lower earners. Not because they have more money. The reason is that the high earners receive much greater benefit from a stable economic system which enables the rich to earn even higher returns. (think about how much more the rich can earn in the US selling their products vs selling in Cuba)
    5) Our tax rates on labor is exceedingly high and should be drastically lowered. The social security tax is 15.3% on the first $120k. Combining both the social security tax and the income tax resulting in a very high overall rate. The effect is a self employed individual making $100k can easily pay a flat 30%- 35% tax rate (not marginal rate) and a married dual self employed couple both making 100k each will pay nearly an effective 40+% flat tax rate.

  • morganovich

    your tax plan looks ripe for abuse.

    my first act would be to form a conglomerate. it would run my business and retain most of the profits tax free.

    it would also be an investment corp to hold my portfolio. it would also be a leasing corp that owned homes and cars.

    are you starting to see how this works?

    the corp buys my house and leases it to me for some pittance. ditto my car.

    it funds all my travel and entertainment as these can all be business expenses, especially if i have a travel and food blog division.

    i can pay myself almost no salary because all my costs are handled.

    the idea that you can leave an arb between business tax rates and personal ones and not drive a huge surge of absurd incorporation and nonsensical business activity looks pretty fraught.

    it took me 5 seconds to see all this. imagine what a serious tax lawyer could work out in a year.

  • Mike Powers

    "The highest rate would be for people simply working and earning income, assuming they are in the upper tax brackets."

    uh, that's a pretty important "assuming" that you're just sliding right by, there, in your rush to tell us all about how this doesn't make sense.

    I mean, you're ignoring the part THAT MAKES IT MAKE SENSE. The thinking is that the portion of a business's revenues that go to employee salaries ought to be distributed evenly among all the employees, so that no one actor in the business is profiting unduly off the labor of the others. So if you're making a lot of money in salary, it means some other poor bastard is getting screwed out of what he *should* be getting. The tax code disadvantages high salaries because you're supposed to get your money some other way.

    It advantages investors, because investors are (presumably) fronting the capital for other people to create and operate businesses. This is enabling activity, which the government wants to promote; it's also risky, because if the business fails you lose the capital, and the government recognizes that and tries to relieve the costs of investing to compensate for the (presumed) losses.

    Now, you can say "but I don't agree with this or that part of the reasons", but that's not to say that there *aren't* reasons.

  • me

    I'll throw in my 2 cents - I also am the proponent of a drastically simplified tax plan, but it goes in a different direction than yours.

    I believe that the taxation of income is ripe for abuse by definition, as income can be gamed.

    Repeal all income taxes and tax monetary transactions instead: whenever money changes hands, tax it at a rate of about 1%.

    This is an option that would not have been available until recently, but it's effectively what credit cards already do.

    It has obvious loopholes that I believe aren't dealbreakers: exchange of goods and cash transactions. For the former, taxation will happen eventually, when an asset is actually sold. For the latter, inflation will reduce cash value over time, and they are beginning to be on the way out (due to increased scrutiny due to money laundering laws and pure convenience) and of course taking cash out of or paying cash into your account would be a taxable event.

    It's not a progressive tax, which to my mind is not necessarily a desirable goal for a taxation system, but people who really care about this could add on by introducing a tax for net assets on top (not my first choice).

  • tfowler

    Re:"Tax capital gains and dividends as regular income.
    Eliminate the death tax as well as the write-up of asset values at death"

    Then what about an asset that's held in the family for 100 years with no real gain. It cost about $100k initially, now it sells for about $2mil. No real gains, but there is a tax on $1.9mil. The tax would be nearly three quarters of a million dollars at the current regular income rates. Almost 4 tenths of the total value would be taken even no there wasn't any real gain.

  • John O.

    The Tax Code already has provisions to avoid this kind of nonreporting of income, and creating a said corporation to handle your lifestyle expenses will result in an IRS case against you.

  • bannedforselfcensorship

    It's easy to tax foreigners. Have a 20% withholding tax on any income paid to them from corporations. Taiwan does this to me every year without any issues.

  • MSO

    Simplify the tax code? Do you really think all the accountants and lawyers will put up with that?

  • KBK

    Your ignoring inflation of capital "gains" indicates you have no competence to propose tax policy. This is elementary!