Pass-Through Entity Taxation And New Tax Law

Like baseball, young love, and hay-fever, we’ve entered the high season for taxes.

New this year, however, we begin to react to changes in the tax reform law of December 2017. The point of that law was to make the world safe for businesses and their owners, who received healthy tax cuts. If you were not already a business owner, I’m sorry to say the tax reform was really not about you. But, I quipped at the time the bill was passed, you should hurry up and form your LLC or C-Corporation in order to participate in the tax reform largesse. If you are neither a business owner, nor planning to take my advice to form your own business entity, may I make another suggestion? Just go outside and forget reading today’s post about business taxes. Enjoy the day. It’s beautiful out there. I love Spring! Buh-bye.

Ok, great, now that it’s just us business owners, let’s get into the nitty-gritty details.

I’m sure you already know that traditional corporate owners – people with C-Corps – won big in December by getting tax rates on profits dropped from 35 percent to 21 percent. High Five![1] That was awesome.[2]

But the main thing to dig into here is not about traditional C-Corps, but rather the more flexible businesses like limited liability companies (LLC), limited liability partnerships (LLP) or sole proprietorships.

borat_high_fiveA huge range of businesses, including especially small businesses, choose this type of business structure for the greater flexibility, low costs, and ease of administration.

As you no doubt already know, profit from these so-called “pass-through entities” – LLCs, LPs or sole-proprietorships – has for taxation purposes generally been passed through to the owners, just as if they were salaried employees. This means that a high-earning LLC owner potentially pays high tax rates, because personal income tax rates are much higher than corporate rates. Starting in 2018, that highest personal rate is 37 percent – which is now so, so much higher than the corporate tax rate of 21 percent.

Given the massive tax cut for C-Corp owners, and the massive popularity of pass-through entities like LLC, it seems only natural that the tax reform would reward pass-through entity owners somehow. And it did! Pass-through entity owners (remember: LLC owners, LPs owners, sole-proprietors) get to take a 20 percent itemized deduction from income. Which is also awesome! Again, high five everybody. Given that deduction, the main idea is that remaining a salaried employee is really for chumps, compared to being a C-Corp or LLC owner.

So here was my logical thought, upon passage of that law. I need to start charging for finance blog posts,[3] not as an individual, but rather as, for example, “Mike’s Bankers Anonymous LLC.”[4] That should get me the 20 percent deduction off total income, saving a lot in taxes. And like, basically, everybody needs to do the same thing, selling their labor through a pass-through entity, rather than work directly as an employee. What if Mr. Bustlebee sells his librarian services to the local public library through his new business named “Shhh Quiet People are Tring to Read Here LLC?” Bada-boom! 20 percent deduction in taxable income for a librarian.

I recently ran this amazing scheme past my accountant. On your behalf, Mr. Bustlebee.

But my accountant Noah Rifkin, a principle at MBAF in New York City, quickly burst my bubble.[5] The IRS does not want my trick to work for people, or at least for people who make lots of money. It turns out, Rifkin says, my idea totally does not fly as a tax dodge.

pass_through_incomeOne lesson, as always, is don’t take tax advice from a newspaper columnist or finance blogger.

The 20 percent deduction on income from pass-through entities, my accountant explained, can’t be claimed by huge swathes of LLCs engaged in everything from law, health, accounting, performing arts, consulting, athletics, brokerages, actuarial science, and financial services.

Rifkin describes the 20 percent deduction as claimable mostly for businesses that produce “widgets,” that catch-all accounting word used to denote anything manufactured and sold as a product. Not, in other words, a personal service, like I was hoping. The 20 percent deduction isn’t supposed to be claimed for any LLC-type business that depends on, to quote the explanatory paper my accountant sent me, “the skill and reputation of one or more employees or owners.”

Well, I intended to claim that writing a blog does not involve any skill and neither do I have a reputation! Surely you agree? If all readers would continue to vouch for that statement in writing, to both the IRS and my editors, I think this plan could still work.

Slightly more seriously, the law has created some interesting grey areas. The Wall Street Journal gives the example of two restaurants organized as LLCs. One highly profitable restaurant succeeds based on the reputation of a celebrity chef, and therefore can’t take the 20 percent deduction. The other profitable restaurant, succeeding without the celebrity chef’s reputation, might be able to take the deduction. That’s kind of an odd result.

celebrity_chef
Celebrity_chef: May not be able to take pass-through entity deduction of 20% for profitable restaurant

Despite what my accountant says, and all jokes aside, my plan still might work for many people. If you make less than $315,000 as a married couple, or $157,500 as a single filer, you can still claim that 20 percent LLC income deduction, despite being in one of these disqualifying businesses like law or health or accounting or blog-writing that supposedly involve skill and a reputation.

Since 97 percent of people earn less than $157,500, I still say a great number of currently salaried workers could form an LLC, sell their labor though the entity, and potentially save on their taxes. I hope Mr. Bustlebee the librarian is currently scheming with Mrs. Busybody the teacher to form their limited partnership together.[6]

My accountant doesn’t agree with me at all. But, you know, check with yours.

[1] “High Five” is said in the Borat voice, obviously.

[2] By the way, does anybody else here hear and think of the phrase “see corpse” when talking about taxable business entities? Not so much? Nah, me neither. That’s gross.

[3] I know this is illogical, since I don’t actually charge for blog posts, but I’m just trying to suggest whatever activity you do professionally, you should charge though the business entity, not as labor.

[4] Actually I do have a single-member LLC, and when I make consulting income I charge through the LLC, so I’m already taking my own advice. But you should do the same.

[5] Rifkin is a real person, unlike Mr. Bustlebee, who is a figment of my Dickensian-naming imagination.

[6] And you have to admit, that’s hot.

 

A version of this post ran in the San Antonio Express News and Houston Chronicle.

 

 

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Book Review: The Color Of Money

the_color_of_moneyI think of myself as pretty informed about financial history in the United States, but Mehrsa Baradaran’s The Color of Money: Black Banks and the Racial Wealth Gap covers a whole area of history about which I knew very little.

In a narrow sense Baradaran’s book is about the history of black-owned and black-customer-oriented banks. It’s a history without a lot of happy success stories. The story of the Freedman’s Bank, established in 1865 with Lincoln’s signature and a Congressional mandate to help build assets among the newly freed slaves in the South, ends in catastrophe when the (white) managers engage in a combination of speculation and fraud. Decades before the establishment of the FDIC, the bank failure caused direct financial losses to its black customers and a total loss of trust in the traditional banking system.

Of that experience, W.E.B. Dubois would say

“Not even ten additional years of slavery could have done so much to throttle the thrift of the freedmen as the mismanagement and bankruptcy of the series of savings banks chartered by the Nation for their special aid.”

Black Capitalism

In a broader sense, Baradaran’s story is a lesson in the complicated story of “black capitalism” and the 150-year debate within and without the African-American community about separatism versus integration for gaining political and economic power with respect to the majority culture. Beginning just after Emancipation and until the present day, leaders of the black community have urged strength through channeling the “black dollar,” whether through patronizing black-owned businesses or depositing money in black-owned banks. The success or failure of this approach can’t be determined definitely, although Baradaran provides numerous examples of the start-and-stop nature of the efforts. There aren’t a lot of consistent examples where it has worked well.

In fact, a central thesis of Baradaran’s book is that black banks not only cannot thrive outside of the majority culture – collecting black deposits and funneling capital back into the white system – but that they remain inherently weakened by the separation. Serving a depositor community with higher rates of poverty, while lending to a community with depressed housing values, has been a recipe for undercapitalized, unprofitable banks, at least historically. As she documents, the market forces that might outweigh these weaknesses – such as charging higher rates of interest on loans or offering lower rates on deposits haven’t worked either, and they open up the banks to charges of predatory practices.

The black banks might be the victims of (or left weaker by) the larger system, but are often perceived as part of a power structure that’s “disloyal” to the black community. And that’s when they do normal things that banks do.

One of the most interesting sections is Baradaran’s focus on the uses that the Nixon administration – and the federal government before and after Nixon – makes of the idea of “black capitalism.” In Baradaran’s telling, and there’s plenty of evidence in the book of this, Nixon sought to co-opt, blunt, or redirect Black Power through programs that seemed to celebrate and support “Black Capitalism.” But “Black Capitalism” programs historically function as a decoy for the black community and an appeal to the white community, rather than representing something fundamental or substantive.

The “capitalism is the answer” approach of Nixon was then recreated and expanded by Clinton and Obama, and Baradaran remains deeply skeptical of their efficacy as well.

The Southern Strategy

On the even more cynical side of political strategies, Baradaran directs the reader to an (in)famous interview by Republican strategist Lee Atwater, in 1982, about the “Southern Strategy.” I hadn’t heard of the interview before, and happened to locate it on Youtube recently, on the same day as the Senate vote on tax reform. I feel like this is an interview everybody should know about, in which Atwater sort of gives away the whole game, saying:

There’s a part of all contemporary politics wrapped in a nutshell in this recording, so I’m sort of shocked I’d never been directed to this before. But…that’s why we read a history like Baradaran’s about a subject on which we know very little. You should listen to Atwater in the YouTube clip but here’s the gist:

“You start out in 1954 saying Nig–, Nig–, Nig–. By 1968 you can’t say Nig__, that hurts you, backfires. So you say stuff like, uh, forced busing, states’ rights, and all that stuff, and you’re getting so abstract. Now, you’re talking about cutting taxes, and all these things you’re talking about are totally economic things and a byproduct of them is, blacks get hurt more than whites.”

The overlap of listening to Atwater, and the “Tax Reform” rush by the Senate in November 2017 suggested to me that little has changed since 1982.

Capitalism itself

In the broadest sense, The Color of Money spoke to me as a fundamental critique of capitalism itself, via a funny coincidence in my own life. I happened to be reading the book while a teacher friend invited me to lecture to high school senior AP students on a passage from Adam Smith’s The Wealth of Nations. Of course I felt the need to explain to the students the foundational nature of the text – Smith basically kicked off the invention of Classical Economics.

And yet, reading the passage in the light of the history of black capitalism, Smith’s words sound absurd.

In Chapter 10 of The Wealth of Nations, titled “Of Wages and Profit in the Different Employments of Labor and Stock,” Smith writes:

“The whole of the advantages and disadvantages of the different employments of labour and stock must, in the same neighborhood, be either perfectly equal or continually tending to equality….”

Ok, so here we have a classical economics trope on equilibrium between capital and labor, which has certainly not yet come true. BUT! Smith brings in his conditions, in the next paragraph, for how equilibrium and equality will occur:

“This at least would be the case in a society where things were left to follow their natural course, where there was perfect liberty, and where every man was perfectly free both to chuse what occupation he thought proper, and to change it as often as he though proper.”

Ok, so this passage was published in 1776 – a time of an active slave trade and even slave-like working conditions in Smith’s home country of Scotland.

The “perfect liberty” he describes was not true then, and it hasn’t been true yet in the last 150 years. So as I was teaching this passage to the high schoolers, and thinking over Baradaran’s book, the absurdity of classical economics based on this “perfect liberty” just seemed a perfect/imperfect point/counterpoint.

I’m a capitalist, and I’m not willing to give up on the system yet. But Baradaran’s book is just one reminder of the absurdity of some of Adam Smith’s foundational statements about capitalism. There’s nothing inevitable about equality or equilibrium at all. Smith passage just seems absurd. The market actually requires laws and justice and redress, in order to let the market do its thing, effectively.

 

Please see related posts:

Book Review: Nickel and Dimed by Barbara Ehrenreich

Book Review: The Price Of Inequality by Joseph Stiglitz

Book Review: Plutocrats: The Rise Of The New Global Super-Rich by Chrystia Freelander

All Bankers Anonymous Book Reviews in one place!

 

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The Huge Unknowns Of GOP Tax Reform

We know a lot less about the recently proposed federal tax reform than we think we know.

We don’t know what major income tax deductions will stay or go in the final bill. Nobody does, because it’s a highly contested political process right now.

Most importantly, we don’t know what effect, if any, lower taxes rates will have on national economic growth and deficits. We know what tax reform advocates have said, but that’s speculative and unproven. There are even more things we don’t know, but let’s talk about just these two, one at a time.

To start, tax deductions in particular remain a giant mystery. Just as soon as the GOP Congress and Trump White House announced the Unified Framework for Fixing Our Broken Tax Code on September 27th, Democratic opposition leaders zeroed in on deductions for state and local taxes. Eliminating that deduction would theoretically raise an estimated $1.3 trillion in additional tax revenue. But then National Economic Council Director Gary Cohn quickly backtracked on the state and local tax deduction saying “we are willing to work with the tax writers on the other dials that we have in the system.”

That’s just one of the many deductions that might, or might not, end up eliminated in the final bill, as Republican representatives in relatively high-tax states also spoke out in favor of this loophole, err, deduction.

gary_cohn
National Economic Council Director Gary Cohn

FYI “deductions” are things we personally and justifiably benefit from, whereas these are called “loopholes” if somebody else benefits from them. Anyway.

The elimination of tax deductions is absolutely key to this reform, which promised both tax code simplicity and revenue neutrality. The only way you achieve both simplicity and neutrality is by slashing tax deductions down to practically nothing, which the proposed framework did. But then, per Cohn, maybe it didn’t. We don’t know yet.

On the issue of other deductions, the framework proposes a blanket $12,000 deduction for individuals and $24,000 for couples, meant to simplify and substantially eliminate most other deductions. So far, home mortgage interest deductions and charitable contribution deductions are the only ones “safe,” and other presumably popular deductions like for medical expenses, and dependents (aka children) go away. Again, we’ll see.

On the issue of national economic growth, the mantra from reformers focuses on faster economic growth in the economy, which therefore prevents deficits.

Supply-side economist Glenn Hubbard argued in the Wall Street Journal that this tax reform, when combined with lower business regulations, would create 3 percent growth in the economy.

Gary Cohn also stated that the point of tax reform is to achieve 3 percent growth in the economy.

One dividing line on whether one should support this reform, or not, is whether you believe in this 3 percent target, or not.

The summary big idea of supply-side economics is that if you lower taxes, the additional money in households and businesses boosts consumption and investment, and therefore the entire economy. How much it boosts is open to substantial debate.

On an $18 trillion US economy, the difference between, say, 1 and 3 percent growth is astonishing. In fact, it’s everything.

Three percent growth in the economy translates to $540 billion in additional national wealth per year, which happens to be approximately the size of annual federal government deficits lately.

So why does that matter? Here’s my simple fiscal view: If the nation is richer by $540 bucks next year but also borrows $540 bucks (note: I’m leaving off the billion to keep dollars within the human-brain range) we can plausibly say that we’re equally well-off from a “national wealth” standpoint, but at a more pleasant-for-everyone, lower rate of taxation. So that seems enjoyable, as well as responsible.

On the other hand, if the supply side growth thesis is wrong, and we grow less than 3 percent, then we’ve enacted an irresponsible tax cut that worsens our fiscal situation, making us weaker economically as a nation.

So which is it? I would argue we don’t know. The supply side reformers have a theory, which is unproven at best.

The Treasury Department under President George W. Bush studied the supply side effects of the Bush tax cuts of 2001 to 2003, finding that growth could be higher by 0.7 per year, under specific conditions, such as not having to raise taxes later to pay for temporary tax cuts. The next logical step to their theory is that if growth increases, then the tax base is bigger, and tax cuts do not increase government deficits. A lower tax rate on a higher base keeps revenues the same, goes the theory.

On the other hand, supply side theoreticians typically feel much more confident describing the positive effects of lowering taxes when individual rates are above 40%, which they are currently not. So that’s a problem for supply-siders.

President Bush’s own Chairman of the Council of Economic Advisors Gregory Mankiw wrote a response to that Bush-era model, finding that tax cuts only “paid for themselves” by 17 percent for individual taxes and 50 percent for taxes on things like dividends and capital gains. Logically, if tax cuts don’t “pay for themselves” through dramatically higher growth, you either have to raise taxes later or you get a giant increase in government deficits.

Now, Mankiw literally wrote the modern economics textbook that everyone reads these days and he’s no bleeding heart liberal. Yet he found the strongest claims of supply-siders not credible.

The point is not for me to say definitively which one is right or wrong, I’ll let the actual economists fight it out in their position papers. The point is the grand theory of this tax cut is far from certain, despite the confidence with which reformers sell their idea.

In the absence of knowing the answers, we fill in the gaps on this tax proposal according to our own pre-set ideas.

A version of this post ran in the San Antonio Express News and Houston Chronicle.

 

Please see related post:

Adult conversation about Income Taxes

 

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The GOP Tax Reform’s True Target

unified_frameworkTaxes form the backbone of the relationship between government and the governed, revealing most starkly what we value as a society. Spoiler alert: We value business owners and investors.

The most dramatic proposal to emerge from “The Unified Framework For Fixing Our Broken Tax Code”  announced last Wednesday from GOP leadership in Congress and President Trump is the drop in the top corporate tax rate from 35 percent to 20 percent. Other provisions to encourage more investment and business growth include:

  1. A one-time low-tax incentive for on-shoring money held by corporations overseas,
  2. The option for faster expensing of capital investments over the next five years, to incentivize further investment and lower corporate taxes, and
  3. Because 95 percent of businesses are organized as LLCs and LPs subject to “individual pass-through taxation,” paying individual (aka personal) tax rates, the proposed framework would lower top tax rates for such businesses to 25 percent, well below the proposed 35 percent top personal tax rate.

The net effect of this sweeping tax reform would dramatically lower the burden of taxes on businesses. Initial estimates of lower tax revenues as a result of the proposal cite $5 trillion less in revenue, and possibly $1.5 trillion in increased federal debt, over the next 10 years.

Do not get overly distracted by proposals regarding household or individual taxation, because the framework’s central bet is the following: If businesses are the job creators and businesses make most investments in this country, then businesses will be the engine of economic growth and national economic strength. Treat businesses well, and plentiful jobs, higher salaries, increased investment, and national prosperity will follow. That’s the guiding theory of this tax reform. If that theory turns out to be true, this reform will be hailed by future generations as a smashing success.

On the individual and household side, the proposal would reduce the need for most itemization on a tax return by doubling standard household deductions, and it proposes three individual and household tax brackets, with an option for a fourth bracket, targeted at higher earners.

Also on the individual side, the proposal would eliminate the Alternative Minimum Tax, and the estate tax, which only affects 0.2 percent of deceased’s estates. These two proposals would only benefit high earners (subject to the AMT) and the very wealthy (subject to the estate tax), respectively.

So what to think about this proposal?

First, let’s talk about simplification, a stated goal of reformers. Simplicity in a new tax code doesn’t derive from a smaller number of tax brackets, but rather from eliminating itemized deductions, loopholes, and abolishing the AMT.

paul_ryan_white_people
#PaulRyanSoWhite

Perhaps cleverly, but ominously, the framework does not specify whether and how certain deductions popular with businesses and households will survive or not. We know many targeted tax breaks (aka loopholes) must be eliminated, however, to make up revenue lost by lower corporate and household tax rates overall.

That is left, as of now, to the future sausage-making congressional committee process. The basic problem is that everybody likes to keep their own loopholes (which are job-creating and fair, naturally) while eliminating everybody else’s loopholes (which are unfair and benefit special-interests, naturally). There’s a fight to be had there.

The more sweeping the loophole-elimination, the closer we get to the Shangri-La of tax reform: tax filing on one single page, prepared in less than an hour, without hiring a tax specialist. But it’s politically challenging to eliminate loopholes to which specific powerful constituencies have become attached. Getting to simplicity, therefore, won’t be simple.

Next, let’s talk politics.

The political stakes of tax reform could not be higher for the Trump Presidency. This is his legacy moment, as well as the legacy moment for House and Senate GOP leadership.

For many, President Ronald Reagan’s signature triumph was the Tax Reform Act of 1986, forged in compromise with a Democratic House led by House Speaker Tip O’Neill. Top tax rates came down, the code was simplified, the bull market in stocks roared. We remember Reagan’s presidency as a time of increasing national prosperity. Could Trump make this his legacy too?

The political body-language between the President and the Republican leadership of Mitch McConnell in the Senate and Paul Ryan in the House has always been one of mutual wariness and uncomfortable tolerance, at best. The calculation for the fiscally-oriented wing of the Republican party, led by Ryan, is that all of it will have been worth it if they can accomplish comprehensive tax reform in 2017. If they can pull it off, the historic legacies of Paul Ryan, Mitch McConnell, and Donald Trump are dramatically bolstered.

Finally, how to react personally, to upcoming tax reform?

If you are already a business owner, this is a thrilling tax reform proposal. Like seriously, chills and fist-bumps all around. By now you’ve probably already posted on Instagram with LOLOLOL OMG <3 <3 <3 Paul Ryan 4-Eva written in red lipstick font over a selfie of you in a bro-hug with your investors.

paul_ryan_workoutBut if you are currently a salaried employee, what’s in this reform for you? Consider this: If you are a wage earner, rather than a business owner, the framework suggests you are basically doing it wrong. The current proposal to change so-called pass-through taxation of small businesses like LLCs and LPs from top rates like 35 percent to a top rate of 25 percent means that everybody (and their mother!) should earn money only through a business like an LLC or an LP, not through a salary paid by someone else.

I, for example, need to stop charging money personally for my writing, and rather quickly open up “The Smart Money Business Columnist Thing LLC,” a financial opinions consultancy business, and sell my columns to the newspaper as a business service. My income tax rate could be a lot lower that way, under the latest proposal. You need to do the same.

The framework says vaguely that it “contemplates that the committees will adopt measures to prevent the recharacterization of personal income into business income,” but, well, we’ll see. In the meantime, wage earners, open up your LLC and become a business owner.

 

Please see related posts:

Adult Conversation about Income Tax Policy

Death Tax is my Favorite Tax

 

 

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