Pass-Through Deduction (199A) Will Fuel Wealth Inequality

Christmas came early for tax pros this year.  As a kind of stocking stuffer, the IRS gave us a draft of Publication 535 that explains the qualified business income deduction. And then there was the big present from the Joint Committee on Taxation – General Explanation of Public Law 115-97 (download), known as the Bluebook.  It was a great present  for us, as Andrea Carr, who is now practicing public accounting solo still waiting for her career as a twitter comic to take off remarks

Remember that the TCJA Blue Book is now out, in case you weren’t sure what to do at Holiday parties.

The point of the Bluebook is to explain to us what they really meant when they passed the Tax Cuts and Jobs Act. Frankly, I didn’t find that much in there.  There was one very big thing, though.  I think the Bluebook tells us that Republican tax policy is really an effort to revive aristocracy. It comes in their explanation of Code Section 199A – the 20% pass-through deduction.

U.S. President Donald Trump, center, speaks during an event to mark the sixth-month anniversary of the Tax Cuts and Jobs Act passage in the East Room of the White House in Washington, D.C., U.S., on Friday, June 29, 2018. Trump said his tax cuts “unleashed an economic miracle” and his tariffs are bringing “billions of dollars” to the U.S. Photographer: Andrew Harrer/Bloomberg© 2018 Bloomberg Finance LP

The Pass-Through Deduction

The change that has most excited the tax professionals of my acquaintance is Section 199A, which provides a 20% deduction for qualified business income – Schedule C proprietorships, S corporation and partnership flow-through and Schedule E rental activities (that rise to the level of trade or business) also REIT dividends and something to do with agricultural cooperatives.  It is a really great section with exceptions and requirements that phase out and definitions that require research and various ways to scheme like suggesting to your $300,000 per year law partner client that she finally marry her adjunct professor uber driver, which would get her a $60,000 deduction on the joint return.

What Were They Up To?

And 199A is one of the few provisions, where the Bluebook explains what it is that they were up to.  And it is very disturbing.  Something at least a couple of the Founders might have a hard time with.  Here you go (emphasis added):

The provision reflects Congress’s belief that a reduction in the corporate income tax rate does not completely address the Federal income tax burden on businesses. While the corporate tax is a tax on capital income, the tax on income from noncorporate businesses may fall on both labor income and capital income. Treating corporate and noncorporate business income more similarly to each other under the Federal income tax requires distinguishing labor income from capital income in a noncorporate business.

Back in ancient times, when bluebook meant I was taking an exam, Congress distinguished labor income from capital income.  And why did they do that in the Tax Reform Act of 1969?

While it is not feasible to reduce the tax rates in excess of 50 percent to 50 percent for all types of income at the present time because of the revenue cost, a reduction in the tax rates applicable to earned income to a maximum of 50 percent should substantially reduce the pressure to use and develop tax loopholes. Since the disincentive effect of high tax rates on effort is greatest in the case of earnings, it is most efficient to focus the 50 percent limit on earned income

As you see, the reason for distinguishing labor income from other income in 1969 was so that the labor income could be taxed at a lower rate.  Our current Congress wants to tax labor income at a higher rate than capital income.

Watching how TCJA got made emphasizes how the main push behind it was to favor capital income over labor income.  In the original House bill, the benefit was implemented as a special rate of 25% , meaning that there was no benefit at all for joint filers with taxable income less than $260,000 (at the House proposed rate table).  (There was a phased out bone thrown to the little people making less than $75,000 that was worth about $2,000.)  And the benefit went mainly to people who were defined as passive under Code Section 469.  People who worked in the business would only get the benefit on 30% of their income (more if they could show the business was capital intensive).

The Senate bill maintains the same principle that people who get W-2 wages should be taxed more, but created more incentive to go out and hire people as the benefit would only go to businesses that paid W-2 wages.  It also extended the benefit to all income classes by making it a deduction rather than a special rate and exempting the little people from any sort of requirement to pay wages or refrain from businesses like medicine or accounting.

The final bill went in the Senate direction, but there was a last-minute concession, referred to as the Corker kickback, that extends the benefit to businesses with lots of capital assets and no or negligible W-2 wages – think real estate.

And the Bluebook contains a  tidbit that make the emphasis on favoring capital income clearer.

Reputation Or Skill Of The Owner

Along with the fields of medicine, law, accounting etc., there was a kind of catch-all disfavoured field of endeavor – “any trade or business where the principal asset of such trade or business is the reputation or skill of 1 or more of its employees or owners”.  The regulations ended up defining this pretty narrowly – receiving fees for just showing up, endorsing products or having your name pasted on something.  The Bluebook, however, calls for a broader definition:

For example, a trade or business in which the taxpayer works as an independent contractor for various unrelated businesses, where the business generally holds minimal tangible and intangible property, is a specified service trade or business if the principal asset of such trade or business is the reputation or skill of its owner.

I have not thought up an example of someone who would fall into this category, but the message is clear that denial of the deduction is targeted to people who can actually do something rather than own something.

What A Couple Of The Founders Might Say

The essence of 199A, which has been diluted a bit by the Senate, is that the owners of capital are more important and more entitled to tax relief than people who earn substantial money by their own efforts .  Of course, some people with substantial incomes from their own efforts will accumulate wealth that can then be invested but to be benefiting from the ownership of a substantial enterprise for most of your life, you really need to have inherited it or had it gifted.

Let’s consider two forty-year-olds who are both doing pretty well.  One is a surgeon named Terry who is making $500,000 per year.  Terry is a first-generation college graduate, who has been making this kind of money for a few years and has finally paid down massive student debt.  Besides a spouse and a couple of kids, there is a parent to support.  If Terry can resist the temptation to live up to that income, she will probably accumulate a net worth of a few million dollars and have a very nice retirement and Terry’s kid will not rack up a mountain of student debt as they prepare for professional life. As of now, Terry’s net worth is negligible. Terry’s economic circumstances are certainly enviable, but let’s look at Robin.

Robin does a little bit of this and a little bit of that having started out as an art history major but moved onto literature.  Robin also has an income of around $500,000 per year mostly from an ESOP that owns the widget company that his father founded.  There are also real estate holdings in a family limited partnership.  Clearly, Robin does not have a parent to support.  As a matter of fact, college for Robin’s kids is paid for by Grandma (that’s the transfer tax efficient way).  Robin has a net worth of about $20 million.  Even if Robin spends every dime of his income, the net worth will probably grow from unrealized appreciation that will probably never be subject to income tax.

So who needs a tax break?  Robin of course who will get a free $100,000 deduction thanks to 199A.  Robin is one of those makers.  Terry, the surgeon, not so much.

This really smacks quite a bit of the situation in France that led up to their Revolution that came not long after ours was completed with quite a bit of help from France. In pre-Revolution France the aristocrats, the inheritors. were exempt from taxation.  And what did the Founders of our country have to say about that?  Well, maybe most of them who were busy with the Constitution didn’t have a lot to say about it, but two of them did.  Thomas Jefferson and Lafayette had a hand in writing the Declaration of the Rights of Man and of the Citizen which includes.

Article XIII – For the maintenance of the public force and for the expenditures of administration, a common contribution is indispensable; it must be equally distributed to all the citizens, according to their ability to pay.

Well, there you have it.  Both the author of the Declaration of Independence and one of the greatest heroes of our Revolution agree.  Having taxes based on ability to pay is a basic human right .  And the new 199A is a tax break oriented to those most able to pay.

It’s The Times

In 1969, when the concern was to not discourage working by cutting the maximum tax on earned income, income and wealth inequality were at a very low level.  Now they are skyrocketing and 199A has probably given them another boost.  It is true that the Senate mitigated it a bit, by allowing the deduction to gigsters and slacker CPAs like myself.  It also created the W-2 test, although that was changed at the last minute to let businesses that had a lot of stuff also qualify.  You really don’t hear a lot of politicians speaking in favor of increasing wealth inequality, but actions speak louder than words.

Lafayette As A Founder

Thanks to Lafayette’s crucial contribution to American victory in the Revolution and his ongoing support for the cause of self-government, he really does qualify as one of our founders.  He was immensely popular in the United States.  In a few years, we will be celebrating the bicentennial of his visit to the United States in 1824-1825. We are already warming up as you can see in this video, which I had a hand in making.

Article XIII now has a place of honor along with my other favorite tax quote –

Over and over again courts have said that there is nothing sinister in so arranging one’s affairs as to keep taxes as low as possible. Everybody does so, rich or poor; and all do right, for nobody owes any public duty to pay more than the law demands: taxes are enforced exactions, not voluntary contributions. To demand more in the name of morals is mere cant.

So 199A is something that I both love and hate .  I’m going to be computing my fourth quarter estimate soon, so I’m sure I will go back to loving it.

 

source: forbes.com