Biden-Harris’s High Hopes for Mitigating Tax Rate Disparities

The Democratic presidential ticket will be former Vice President Joe Biden and California Sen. Kamala Harris, and their battle is certain to include progressive tax proposals, which are based on one’s ability to pay. Yes, of course that means the wealthy will pay more than those in lower-income brackets. Many massive benefits given to the wealthy will likely be repealed. Harris’s proposals¹ largely align with Biden’s,² but she brings more ideas to the table, including those designed to improve American infrastructure and clean energy.³

Notably, Harris was more aggressive on raising taxes, such as proposing to restore the corporate tax rate to what it was before the Tax Cuts and Jobs Act. This article shows how some tweaks that align with both Biden’s and Harris’s historic positions can help them achieve their goals of eliminating disparities. Of course, a comprehensive overview of the Democratic proposals shows that their plan doesn’t favor the wealthy in many ways the TCJA did, a topic we’ll continue to explore in another article.

Biden and Harris want to increase tax on the wealthy and increase tax revenue. They want to repeal the TCJA’s individual income tax cuts for taxpayers with incomes exceeding $400,000 and tax capital gains and dividends at the same rate as ordinary income — instead of 15 percent to 20 percent — for taxpayers with more than $1 million in income. Biden and Harris want a return to a top individual income tax rate of 39.6 percent, and they want to raise capital gains tax rates to match ordinary income tax rates for high-income earners. Making his goals clear, Biden said during his August 20, 2020, speech at the Democratic National Convention: “Working families will struggle to get by, and yet, the wealthiest one percent will get tens of billions of dollars in new tax breaks.” One of the new tax breaks is a key focus of this article.

Coupling those changes with an increased corporate tax rate of at least 28 percent alone leaves us with many unanswered questions regarding choice of entity and one of the TCJA’s largest gifts to many of the wealthiest business owners in America, section 199A. If section 199A remains unchanged, the disparities it created could increase if their proposed rate changes go into effect, which is why we expect it will be eliminated, scaled back, or altered to minimize the disparities discussed below. In fact, without eliminating or changing section 199A a rate disparity of roughly 25 percent could be created in favor of certain passthrough entities. We will also begin to explore how best to deal with the health and economic crisis — which the Coronavirus Aid, Relief, and Economic Security (CARES) Act (P.L. 116-136) began by freeing up losses now arising for hurting businesses.⁴ That is more than enough for an initial analysis of some big potential changes in the tax law.

Section 199A

The implementation of section 199A as part of the TCJA was hastily done, incoherently drafted, unjustifiably discriminatory against some professions, and most egregiously, unnecessary. While its purpose is as clear as mud, given its random beneficiaries and the extent to which they benefit, the original congressional goal for what came to be the section 199A deduction was “to treat corporate and noncorporate business income more similarly under the income tax.”⁵

Section 199A encourages active high-income passthrough owners to misclassify labor income as business profit, thereby reducing both income and employment taxes.⁶ Income earned by passthrough entities like partnerships and S corporations is generally taxed only once, at the owner level, bypassing the entity-level tax on earnings that C corporations are subject to. All C corporations benefit from the TCJA’s rate reduction from 35 percent to 21 percent. While some passthrough businesses benefit from section 199A’s 20 percent deduction, including many in real estate such as construction, architecture, and engineering, many don’t, including many in healthcare. Section 199A provides a 20 percent deduction for qualified business income (QBI), reducing the top individual rate from 37 percent to 29.6 percent for eligible passthrough owners.⁷ However, this does more than bring parity regarding the new corporate tax rate of 21 percent.

The section 199A deduction is available only for qualified trades or businesses, which is inherently discriminatory, with exclusions for specified businesses. Qualified trade and business is defined via exclusion to indicate that everything except some services such as being an employee and “specified service” trades or businesses, is considered a qualified trade or business.⁸ Specified service trade or business — typically businesses involving the performance of services in law, accounting, financial services, and several other enumerated fields — aren’t considered qualified trades or business.

In today’s current economic and health crisis environment, one must question policies underlying the exclusion of health businesses, and thus those on the front lines of the COVID-19 pandemic, while maintaining the inclusion of real estate, architecture, and engineering businesses among those that qualify for the 20 percent section 199A qualified business deduction. The discrimination against some service providers doesn’t align with the questionable purposes of parity with corporate business. But there, the numbers themselves don’t support that purpose.

The point here is to consider the need for section 199A in the first place, as well as following a potential increase in the corporate tax rate to 28 percent. Along with a corporate tax rate cut, there was an effort to argue for a passthrough deduction to level the playing field for corporate and passthrough businesses. The irony is that the QBI deduction doesn’t do that, and it never has.

Table 1 illustrates the pre-TCJA rates that were generally applicable before January 1, 2018. Table 2 illustrates the relevant TCJA rates, including the maximum corporate tax rate reduction from 35 percent to 21 percent and the maximum individual rate reduction from 39.6 percent to 37 percent.

Table 1. Pre-TCJA Rates = No Parity

	Corporation (35%)	Passthrough (39.6%)
Revenue	$1,000,000	$1,000,000
Expense	$(900,000)	$(900,000)
Net income	$100,000	$100,000
Tax rate	35%	39.6%
Tax	$(35,000)	$(39,600)
Net profit after tax	$65,000	$60,400
Dividend	$65,000	$0
Capital gains tax rate	20%	20%
Capital gains tax	$(13,000)	$0
Net Income to individual	$52,000	$60,400
Effective tax rate	48%	39.6%

Table 2. TCJA Rates = Parity

	Corporation (21%)	Passthrough (37%)
Revenue	$1,000,000	$1,000,000
Expense	$(900,000)	$(900,000)
Net income	$100,000	$100,000
Tax Rate	21%	37%
Tax	$(21,000)	$(39,600)
Net profit after tax	$79,000	$60,400
Dividend	$79,000	$0
Capital gains tax rate	20%	20%
Capital gains tax	$(15,800)	$0
Net income to individual	$83,200	$60,400
Effective tax rate	36.8%	37%

While the stated intention of altering the tax rates under the TCJA was to create parity among various types of business entities, lowering the individual tax rate to 37 percent and reducing the corporate tax rate to 21 percent — alone — creates parity between types of entities. The TCJA’s tax rate changes give owners of both C corporations, subject to double taxation, and passthrough entities an effective tax rate of roughly 37 percent. This eliminates the at least 8 percent historic rate bias that favored the wealthiest owners of passthrough entities.⁹ This move immediately places corporations and passthrough entities on equal footing when it comes to taxes, and no further steps are necessary “to treat corporate and noncorporate business income more similarly under the income tax.”¹⁰

TJCA’s Discriminatory Passthrough Preference

Table 3. TJCA With Section 199A Deduction = No Parity: Passthrough Preference

	Corporation (21%)	Passthrough (37%)
Revenue	$1,000,000	$1,000,000
Expense	$(900,000)	$(900,000)
Net income	$100,000	$100,000
Section 199A deduction percentage		20%
QBI deduction amount		$(20,000)
Modified adjusted net income		$80,000
Tax rate	21%	37%
Tax	$(21,000)	$(29,600)
Net profit after tax	$79,000	$70,400
Dividend	$79,000	$0
Capital gains tax rate	20%	20%
Capital gains tax	$(15,800)	$0
Net income to individual	$63,200	$70,400
Effective tax rate	37%	30%

Table 3 illustrates a rate preference of more than 7 percent in favor of select passthrough entities. These extremely generous benefits led to the proliferation of “crack and pack” strategies, which taxpayers have successfully used to separate ineligible trades or businesses from eligible ones or combine businesses to maximize eligibility for the deduction.¹¹ While the complex and poorly designed section 199A deduction allows for manipulation, its discrimination in service business that are afforded the 20 percent deduction seems random at best. Also, it fails to eliminate the discrimination between passthrough entities and C corporations consistent with Congress’s stated goal to treat these entities similarly for tax purposes. Biden and Harris also want to minimize tax disparities.

Biden-Harris Rates: Section 199A Increases Discrimination

Table 4. Biden-Harris Rates With Section 199A Deduction = No Parity

	Corporation (28%)	Passthrough (39.6%)
Revenue	$1,000,000	$1,000,000
Expense	$(900,000)	$(900,000)
Net Income	$100,000	$100,000
Section 199A deduction percentage		20%
QBI deduction amount		$(20,000)
Modified adjusted net income		$80,000
Tax rate	28%	40%
Tax	$(28,000)	$(31,680)
Net profit after tax	$72,000	$68,320
Dividend	$72,000	$0
Capital gains tax rate	20%	20%
Capital gains tax	$(14,400)	$0
Net income to individual	$57,600	$68,320
Effective tax rate	42.4%	31.7%

Maintaining the section 199A deduction with the expected Biden-Harris proposals for increased tax rates continues and expands the disparity between passthrough entities and corporate entities from a tax perspective. However, even with increased rates as proposed, there is still an argument that the elimination of section 199A generates more equality between passthrough and corporate entities than was available before the TCJA.

Biden-Harris Rates Can Help Achieve Parity

Table 5. Biden-Harris Rates – Without Section 199A Deduction = Near Parity

	Corporation (28%)	Passthrough (39.6%)
Revenue	$1,000,000	$1,000,000
Expense	$(900,000)	$(900,000)
Net income	$100,000	$100,000
Tax rate	28%	39.6%
Tax	$(28,000)	$(39,600)
Net profit after tax	$72,000	$60,400
Dividend	$72,000	$0
Capital gains tax rate	20%	20%
Capital gains tax	$(14,400)	$0
Net income to individual	$57,600	$60,400
Effective tax rate	42.4%	39.6%

Before the passage of the TCJA, passthrough entities had a better effective tax rate than their corporate brethren; the TCJA wasn’t intended to flip that analysis, but simply put passthrough entities on par with corporations.¹² It must be surmised that the 21 percent corporate rate is meant to create parity between corporate and passthrough entities from an effective tax rate perspective.

The numbers above demonstrate the futility of section 199A. The creation of section 199A destroys that parity in qualified businesses and provides an incentive to use passthrough entities over C corporations, which is a decision the treasury should be neutral about at best.¹³ Parity in rates creates less gamesmanship regarding choice of entity between the complex structures designed to get the benefits of C corporation status, which is largely deferral of income and thus a higher return on investment on assets held long term, and passthrough entities that allow for immediate deductions and special allocations often designed to reduce current tax obligations.

Repealing section 199A would restore parity among corporate and noncorporate taxpayers on an end-to-end basis, from the generation of revenue to the receipt of cash by business owners. It would also eliminate behavioral distortion involving taxpayer use of corporate versus noncorporate entities by eliminating a subsidy for passthrough entities and sole proprietors. While not now a part of the Biden tax plan, the rationale for repeal is stronger than for retention, and therefore it would make sense for Biden and Harris to pursue.

Capital Gains on Millionaires

For 2020 the long-term capital gains 0 percent rate applies to taxable income of up to $40,000 on individual returns and $80,000 for married joint filers, the 15 percent rate for income above $40,000 and below $441,451 for single filers, and $496,601 for married joint filers, at which point the 20 percent rate kicks in. So the 20 percent rate only applies to high-income earners. Those income thresholds are adjusted for inflation, and the rates also apply to qualified dividends.

The Biden-Harris 39.6 percent rate would apply to people with incomes that exceed $1 million. We will assume rate parity for the 3.8 percent net investment income tax¹⁴ that affects most capital gains and the 3.8 percent Medicare taxes that affect most high-wage earners.¹⁵ Thus, these capital gains would generally be taxed at the same level as wages, which would provide several advantages.¹⁶ It would create a more progressive tax system.

It would nearly eliminate the need for section 1061, which attacks carried interest by merely extending the holding period to three years. Private equity fund managers earning millions would be taxed for their services at the same rates other service providers are taxed, and this loophole would actually be eliminated. The benefits afforded for some executive compensation for wealthy CEOs would be trimmed back, and section 83(b) elections wouldn’t allow for the conversion of ordinary income into capital gains in the same way.

In 1988, 1989, and 2000, the top tax rate on capital gains was the same as the top tax rate on ordinary income.¹⁷ Critics are correct that low tax rates on capital gains and dividends accrue disproportionately to the wealthy. The benefit capital gains have received has been historically viewed as favoring the rich and hurting the working man. Also, about three-quarters of stock in U.S.-based corporations is held by people or entities that are indifferent to capital gains tax rates,¹⁸ which includes section 401(k) plans, endowments, and foreign investors. More than 75 percent of the benefit¹⁹ of today’s lower rates on capital gains and dividends goes to households with incomes exceeding $1 million, according to the Urban-Brookings Tax Policy Center.²⁰

Abraham Lincoln said in his State of the Union address on December 3, 1861: “Capital is only the fruit of labor, and could never have existed if labor had not first existed. Labor is the superior of capital, and deserves much the higher consideration.” Many others also believe the sweat of one’s brow is deserving of more value compared with old money and its gains, which perpetuate shifts in socioeconomic impact to the wealthy, a view with origins in the Bible.²¹ The following illustration shows how this affects choice of entity determinations for those earning more than $1 million a year.

Biden-Harris’ Progressive Rates

Table 6. Biden-Harris Millionaire Rates With Section 199A Deduction = Extreme Disparity

	Corporation (28%)	Passthrough (39.6%)
Revenue	$1,000,000	$1,000,000
Expense	$(900,000)	$(900,000)
Net income	$100,000	$100,000
Section 199A deduction percentage		20%
Modified adjusted net income		$80,000
Tax rate	28%	39.6%
Tax	$(28,000)	$(39,600)
Net profit after tax	$72,000	$68,320
Dividend	$72,000	$0
Capital gains tax rate (39.6%)	39.6%	39.6%
Capital gains tax	$(28,512)	$0
Net income to individual	$43,488	$68,320
Effective tax rate	56.5%	31.7%

Increasing capital gains rates would persuade millionaires to restructure their businesses as passthroughs, given that these owners of corporations would move from a 42 percent to a 56.5 percent effective tax rate.  Eliminating the section 199A deduction would mitigate that result however, as owners of passthroughs would be taxed at 32 percent with the deduction for QBI and 39.6 percent without it. In short, not eliminating or modifying section 199A after increasing the capital gain and individual rates under proposals made by Biden and Harris would increase the rate disparities between extremely high-earning entity owners by nearly 25 percent, the spread between the 56.5 percent rate for corporate owners and 31.7 percent rate for many passthrough owners (taxed at 39.6 percent with a 20 percent section 199A deduction unless changed).

This move could stimulate revenue collection because the ultra-rich won’t be able to use corporations to defer income, which is in line with the accumulated earnings tax and personal company holding taxes that became a greater concern once the 35 percent rate dropped below 30 percent. In other words, these potential Biden-Harris changes could greatly aid in preventing tax avoidance through the deferral of income and provide some of the benefits associated with corporate integration proposals. In short, with the elimination of section 199A and the proposed Biden-Harris rates, many business owners will have near parity in rates among entities while the wealthiest owners of C corporations will bear a relatively higher tax rate.

Table 7. Biden-Harris Millionaire Rates Without Section 199A Deduction = No Parity

	Corporation (28%)	Passthrough (39.6%)
Revenue	$1,000,000	$1,000,000
Expense	$(900,000)	$(900,000)
Net income	$100,000	$100,000
Tax rate	28%	39.6%
Tax	$(28,000)	$(39,600)
Net profit after tax	$72,000	$60,400
Dividend	$72,000	$0
Capital gain rate (39.6%)	39.6%	39.6%
Capital gains tax	$(28,512)	$0
Net income to individual	$43,488	$60,400
Effective tax rate	56.5%	39.6%

While millionaire corporate owners will pay more taxes, the 42.4 percent tax rates non-millionaire corporate owners will ultimately pay compared to the 39.6 percent passthrough owners will immediately pay makes sense given the benefit of deferral that C corporations often provide their owners. We warn you, however, that too much weight given for the benefits of corporate deferral on reinvested profits can be dangerous as evidenced by the recent economic downturn. Thus, we have not analyzed this potential benefit that varies greatly and is as difficult to predict as an owners need for cash and the profits or losses a corporation will incur.

Net Operating Loss Revision

The TCJA further implemented a limitation on net operating losses that was intended to generate funds likely required to satisfy budget constraints of the reconciliation process. This limit no longer permits a current loss-making entity from reaching back into taxes already paid (and therefore funds already in the hands of the fisc) for a refund. Rather, the revision under the TCJA requires that such losses be carried forward only, with an annual limitation on use capped at 80 percent of taxable income, meaning that an NOL can no longer reduce a business’s taxable income to zero.

For tax years beginning after December 31, 2017, a corporation’s NOL carryover utilization has been limited so that NOLs can offset only 80 percent of taxable income. In exchange for limited utilization and the elimination of carrybacks, after the imposition of the TCJA, NOLs can now be carried forward indefinitely instead of limited to 20 years.

While this revenue-raising limitation may have funded the section 199A deduction on profits, for example, it restricts a taxpayer’s opportunity to monetize losses via tax refund and recovery, and significantly detracts from the economics of business operation, which would in essence permit unlimited carryforward and carryback of tax losses to ensure economic impacts are realized in real time and don’t depend on the fictional construct of “tax years.” At the very least, this is because the taxpayer must wait — at a minimum — until the next tax year, and if losses are greater than 80 percent of the next year’s taxable income, the taxpayer must wait at least two years to recover. Within two years of enactment, this policy has been upended by the enactment of the CARES Act. Taxpayers need consistency to properly plan for tax costs, and these periods often shift for large-scale downturns; but small downturns for industries and businesses happen all the time.

The CARES Act amended the treatment of NOLs established less than two years earlier. The CARES Act provides a five-year carryback period and temporarily repeals the 80 percent limitation for NOLs arising in 2018, 2019 and 2020. This means the CARES Act restored taxpayers’ opportunities to carry back losses, specifically losses arising in tax years 2018, 2019, and 2020.²²

The reinstated rule requires that any carryback must be carried back five years, or to the earliest possible year in which the taxpayer made a net positive tax payment.²³ This carryback permits the use of current-year losses by taxpayers to generate refunds for taxes previously paid, equalizing the net impact to taxpayers and, in effect, disregarding timing distortions that may arise in the calculation and payment of taxes and the generation of revenue. As revised, the NOL carryback utilization requires a five-year carryback. This is a concern for many taxpayers because an NOL carryback could open previously closed years for IRS audit.²⁴

The five-year carryback provided within the CARES Act is structurally similar to the NOL provision enacted as part of the American Recovery and Reinvestment Act of 2009 (ARRA). While the treatment of NOLs within the TCJA is structurally different from what has existed in the IRC historically, it represents a policy shift away from protecting struggling businesses. The tax legislation passed during the past two recessions demonstrates the economic necessity to permit taxpayers to bypass the tax year fiction to recover tax funds; the appropriate economic treatment is to enable the taxpayer to carry back losses to more effectively match current economic losses with prior tax outlays. We expect the Biden-Harris proposals will aim for what is best for the people, including those who face economic hardship.