Friday, November 3, 2017

What is All This Noise About Pass-Through?

Is the new tax plan a simplification or just a give-away to certain groups?


The new GOP tax bill is turning into a nightmare.  The idea was to simplify the tax code, which in the abstract is a good idea.  However, there are so many special interests who have a hand in the pie here, each is carving out exceptions to this simplification.   So the new tax bill is just the same old tax code with some tweaking and further complications - doing the opposite of simplification, really.

One issue is tax rates for "pass-through" entities.   A "pass-through" entity is basically a subchapter-S corporation, sole proprietorship, or partnership, where profits are not taxed at the entity level, but instead passed to the individuals, who report them as ordinary income.

I wrote about this before, and how my brother-in-law sort of got into trouble over this.   His accountant argued that he should be able to declare the profits from his subchapter-S home appraisal business as 100% "dividends" or capital gains, and thus avoid paying the 18% self-employment tax.

You see, when you work for a company, you pay Social Security and Medicare taxes on top of your income taxes and your employer matches the Social Security and Medicare taxes.   Back in the day, this was about 9%, so the total came to 18%, half of which you didn't have to pay - directly.   For those of us who are self-employed, well, we have to pay the whole deal.

Table 1. Single Taxable Income Tax Brackets and Rates, 2017
Rate Taxable Income Bracket Tax Owed
10%
$0 to $9,325 10% of Taxable Income
15%
$9,325 to $37,950 $932.50 plus 15% of the excess over $9325
25%
$37,950 to $91,900 $5,226.25 plus 25% of the excess over $37,950
28%
$91,900 to $191,650 $18,713.75 plus 28% of the excess over $91,900
33%
$191,650 to $416,700 $46,643.75 plus 33% of the excess over $191,650
35%
$416,700 to $418,400 $120,910.25 plus 35% of the excess over $416,700
39.60%
$418,400+ $121,505.25 plus 39.6% of the excess over $418,400


Now if you throw in your income tax rates plus your State income tax rates, well, you could be paying 50% or more in taxes - that is, unless you find ways around it.  For me, it was investment real estate and the depreciation deduction, which lowered my taxes and also provided me with a nice investment.   I also had the home mortgage deduction as well as State and local property tax deductions, charitable deductions and all the other "gimmies" for the middle-class that not only give us breaks on our taxes, but direct our behavior.

As you can see from the table above, the self-employed guy making $200,000 a year or so at a high-paying job and living in an apartment - he gets screwed on his taxes - paying close to 50% of his income to the government.   And now you know why houses in the bay area are so expensive - all those Google and Apple employees with six-figure incomes need deductions to offset their taxes.

Getting back to my brother-in-law, his tax advisor ended up going to jail.   You see, while the tax code is all in black-and-white, there are grey areas when interpreting any text - even the Bible.   So different accountants have different theories and different ideas.   And the IRS doesn't have the time or money to audit everyone.  So as long as your theory looks reasonable, chances are, it will fly.  Well, at least for a while, anyway.

My brother-in-law didn't go to jail, but he discovered later on in life that the lies told to him by Republicans since 1960 were just that - lies.   "Social Security won't be around when you're ready to retire!  We might as well abolish it!"   They still try to sell this story today.   Well into his 50's, he figured out that Social Security will be around and since he was not paying Social Security taxes, he would not get any of it.   So late in life, he struggled to report 40 quarters of income and now he gets at least the minimum amount.

For most wealthier people, this aspect of pass-through is not really very relevant.  You only pay social security and medicare taxes on the first $110,000 or so of income (a regressive tax) and when you are in the $500,000 level of income, well, maybe that is less of a concern.   Still, it does save you quite a few bucks, even though it means you don't get Social Security later on when you retire.   But maybe that is part and parcel of this plan - to "starve" Social Security of cash to "prove" it is broken.   Sort of like pulling the legs out from under Obamacare to "prove" it won't work.  But I digress again.

So what is this obsession with "Pass-through" accounting?   Kansas passed a law basically exempting state income tax for people with pass-through entities.  The result was, of course, that everyone created a subchapter-S corporation and no one paid any state income taxes, which has bankrupted the State.  The only people who paid state income taxes there were the poor middle-class bastards who had salary jobs and could not posit themselves as "contractors".   Yes, the very rich got a huge tax break, and the middle-class got screwed.   Expect more of this in the current tax bill.

In a recent article in Bloomberg, is this interesting quote:

House Republican leaders cite the example of a lawn care business owned by a married couple that brings in $500,000 in profits a year. The pass-through provision, along with the elimination of the alternative minimum tax, should allow this couple to cut its current tax bill of $128,000 by about $25,000, according to a statement issued by the House Ways and Means Committee.

Now, if my lawn care guy is pulling in $500,000 a year, then I am paying way too much for lawn service (He charges $45 to mow the lawn when we are away, I do it myself the rest of the time!).  I suspect their hypothetical is someone who runs a huge company that hires dozens of illegal Mexicans to run those leaf-blowers.  If so, well, they will need this tax break when all of their employees are deported, as they will be.  But I digress. 

The problem is twofold.   First, there is no logical reason why someone who has a business and is self-employed should get a huge tax break just for being self-employed.   This whole thing plays into the false narrative that the GOP uses that employers will hire more people if their personal income taxes are cut.   This flies in the face of logic.  You hire people to make money, and their salaries are business expenses which you don't pay taxes on.   If you can make money by hiring someone, you do it, regardless of your personal income tax burden.

The GOP argument would be akin to saying that people would work less if their taxes go up, and they will work more if their taxes are lowered.   Actually,  the opposite may be true.  If you need more money to pay your taxes, you might think about taking that second job.

But the second part of the problem is that this pass-through is selectively applied based on what kind of job you do and thus creates a whole new layer of bureaucracy, where people will have to sit down and come up with lists of activities that qualify for pass-through and how much pass-through they get.  And that's why a lot of Republicans and business people don't think this tax plan is a good idea, or indeed any form of simplification or reform, but rather just a "gimmie" to very wealthy folks.  From the same Bloomberg article cited above:

That’s why the National Federation of Independent Business, a small-business lobbying group, says it opposes the House bill. “We think the benefits [of the new pass-through rate] should extend to all small businesses,” said spokesman Jack Mozloom. In addition to offering lower preferential rates for smaller businesses, Mozloom said, the bill shouldn’t make distinctions between professional service providers and other pass-through businesses.
“We think that’s bad policy, picking winners and losers based on what they do,” he said. “We certainly want manufacturers to get a tax break, but we want their accountants to try to get a tax break too.”

Picking Winners - a phrase the GOP has used to damn Obama and the Democrats in the past, as exemplified by the Sara Palin quote above.  Actually, if you Google the phrase "government picking winners" you get a plethora of quotes from various GOP notables and wanna-bes who barf-up this line - and then go out and pick winners, usually from the coal and oil businesses - or whoever else donated to their campaigns.   Act shocked - but don't think the Democrats do things any differently.

True tax reform or simplification would provide the same tax schedule for everybody and eliminate as many behavior-directing deductions as possible.   Your tax rates shouldn't be determined by how clever an accountant you can hire, whether you have a subchapter-S corp, or whether you can afford to litigate with the IRS.   And your taxes shouldn't be offset by inducing you to perform certain behaviors, like buying rental properties or even your own house or saving for the future - things the middle-class gets juicy deductions for, but the poor can't take advantage of.

That would be the Libertarian view, anyway - a value-neutral, simplified tax code that applies equally to everyone.   And it is a fantasy, because the folks with the money are the ones who sway elections (that and the Russians).   And that is who is going to write this new tax code - if it has any hope of passing at all.   Given how many disparate factions are demanding their own little set-asides, though, perhaps it will go as far as abolishing Obamacare, the Wall, and the Muslim ban.

Dramatic changes based on pet economic theories are hard to get through Congress.  And maybe that is a good thing.

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