US Republicans are starting to notice another big problem with their tax plan

  • Another potential problem with the Republican plan for tax reform is starting to get attention in Congress.
  • The issue comes in defining what is — and what is not — a business, for the purposes of a major new business tax break.
  • There’s little consensus on potential “guardrails” for such a provision.

I’ve written before about problems with the provision of the Republican tax framework that President Donald Trump touts as good for small businesses.

This tax break would ensure that people who own so-called pass through businesses would be taxed at no more than 25% on income from those businesses, unlike wages, which may currently be taxed at rates up to 39.6%.

A major problem with this proposal is most small businesses wouldn’t benefit at all. More than 80% of tax filers with small business income are already taxed at rates of 25% or less, so only the wealthiest business owners, who currently face high tax brackets, would get a tax cut.

And many of the businesses getting the tax advantage wouldn’t be small. The president, who would surely contest the idea that his own businesses are small, would get a big tax break from this provision.

But there’s another problem with the proposal that’s starting to get attention in Congress now — one that will make this provision a huge mess even if you like the idea of a big tax cut for business owners.

If you’re going to give a tax break for business income, you have to clearly define what’s a business and what’s just work. That’s surprisingly hard. And while tax reform is supposed to make taxes simpler, this tax break is sure to make a lot of people’s taxes very complicated.

Josh Barro LLC

If this proposal became law, I could form Josh Barro LLC. Instead of drawing a salary, I would charge Business Insider fees for writing services. I would do the same with KCRW and any other employers. And then I would tell the IRS all my income was business income, subject to a maximum rate of 25%.

Unfortunately for me, but fortunately for the government’s finances, the drafters of the Republican tax legislation would like to avoid that.

They intend the tax break to go only to bona-fide businesses involving capital investment and job creation, not to independent professionals like lawyers or doctors (or me, in this scenario). So they need to write a rule that puts “guardrails” between real business income and labour income that a taxpayer might claim was business income.

As Scott Greenberg of the conservative Tax Foundation describes in a useful Twitter thread, there are three main ideas out there about how you might build those guardrails.

Unfortunately, none of the ideas are very good.

A simple, economy-wide rule doesn’t work well

Sen. Ron Johnson, a Republican from Wisconsin with a background as an accountant, has come out strongly against the simplest possible limiting rule for the business tax break — what’s known as a “70/30 rule.”

This rule would say that, if an owner is involved in the management of a business, he or she must treat 70% of the income from that business as though it were salary income for work. Only 30% of the income would be treated as investment income and enjoy the preferential tax rate.

This rule is based on the idea that, in the whole economy, about 70% of income comes from work and 30% from capital investment. But Johnson points out, reasonably, that it isn’t fair to apply the economy-wide ratio to all businesses.

At capital-intensive manufacturing firms, much less than 70% of the income accruing to the owner-manager is likely to be truly compensation for his or her management work. On the other hand, at Josh Barro LLC, 100% of the income is labour income; the 70/30 rule would give me a tax break that Johnson and the writers of the tax bill don’t intend, while giving less than they meant to give to a guy who owns a factory.

Industry-based rules are problematic

Another fairly simple approach would be to offer the tax break only to businesses in certain industries. This could stop me from getting the tax break, but it would create new unfairnesses and economic distortions.

Businesses in some sectors would get a big tax break, while those in other sectors wouldn’t, even if some businesses in those sectors really did require a lot of investment and create a lot of capital income.

Plus, have you noticed the recent tendency that every startup business claims to be a technology company?

I have recently gotten pitch emails about a “digitally native winery” (that is, a wine club that sells through a website) and “a London-based VC-funded tech startup selling original art” (an art gallery that sells through a website.) These sorts of “what industry are you really in?” arguments would start playing out with high-dollar consequences in front of the IRS in addition to the technology press.

A complex rule would be a real mess

The third guardrail option, as Greenberg describes, is to impose “a holistic, ‘facts and circumstances’ test to determine how much income needs to be categorized as wages.”

When tax lawyers and accountants hear the phrase “facts and circumstances,” what they hear is themselves getting rich.

The idea under this approach is we’d let professionals at the IRS work things out with taxpayers’ lawyers and accountants on a case-by-case basis by balancing the results of a variety of qualitative and quantitative tests.

There are a number of tests like this in the tax code already. For example, “Are you an employee or are you an independent contractor?” is a question with important tax implications that is answered by a 20-prong test involving qualitative and qualitative factors.

In many cases the answer is obvious, but life is messy and sometimes the prongs point in different directions.

This ambiguity about employment status leads to a lot of litigation, as we’ve seen in recent years with Uber. The ambiguity also gives companies a lot of latitude to make creative arguments with their lawyers, so they can classify workers as independent contractors when lawmakers probably intended to make them employees.

A facts-and-circumstances test for business income would require a large number of high-stakes, subjective decisions in IRS audits and in the tax court. And in the end, it probably wouldn’t work very well, since taxpayers would work hard with their lawyers to make creative arguments about why they’re entitled to the 25% rate.

Republicans have correctly made simplification a major goal of their tax reform. Some provisions of the reform, like raising the standard deduction and eliminating many itemized deductions, would actually make many taxpayers’ taxes simpler. But anything involving a new facts-and-circumstances test is going to make a lot of business owners’ taxes way more complicated.

This tax break is not needed at all

There’s no really good way to put “guardrails” around the preferential tax rate for pass-through businesses. Fortunately, there is a simple solution: don’t enact the tax preference in the first place.

Officially, the rationale for this tax break is it’s “needed” to go along with the proposed reduction in corporate income taxes. If we cut taxes for large corporations that pay their own taxes, and not for small (and large) pass-through businesses whose owners pay their taxes, then the pass-throughs could end up at a tax disadvantage.

But the existing tax code already has provisions to deal with this situation.

There is a “check-the-box” rule that allows a limited-liability company to elect to be taxed as though it were a big C-corporation, paying tax separately from its owner. If the corporate tax cut means corporate tax is a better deal than individual tax, company owners can start checking the box.

Another kind of pass-through business structure, the S-corporation, is itself merely a tax election. Over the last 30 years, some businesses have started taking this tax election because it became favourable relative to C-corporation taxation. If tax reform switches the advantage back, these businesses can change their tax elections again.

The idea that pass-through businesses should be entitled to the same tax terms as corporations is fair enough. But the 25% limit goes too far, offering many pass-throughs a much lower total tax burden than C-corporations. It will be essentially impossible to offer the tax break to the intended businesses without opening it up to abuse by high-income workers. And it will cost a great deal of revenue.

The best “guardrail” to put around this tax break is not offering it at all.

Correction: An earlier version of this article said a more limited version of the 70/30 rule is already applied to S-corporations. Such a rule was proposed in a Republican tax reform package in 2014, but was not enacted.

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