Some Perspective on the New Tax Rate Structure

One of the most problematic aspects of the Tax Cuts and Jobs Act (P.L. 115-97) is the rate structure that results from combining the newly changed tax rates with other rates that are unchanged from prior law. We’ve never had a rate structure quite like this before, and it’s not just that tax rates are now more likely to vary depending on the type of income. Different rates might well be available for what is fundamentally the same type of income. What’s particularly important is the combination of rates.

For example, we have the same relatively high payroll taxes and self-employment taxes, the additional tax on net investment income, and what’s left of the individual alternative minimum tax. There is also now a giant rate differential between the low flat rate for C corporations and the stated ordinary income rate brackets for higher-income individuals. Meanwhile, the low C corporation rate has moved closer to the individual rates on qualified dividends and net capital gains. It’s the combination of possible rates that increases the likelihood that dramatically different tax rates might apply depending on the type of taxpayer, the source of income, and a variety of different circumstances.

Practitioners will appreciate the tremendous new opportunities for tax planning. From a policy standpoint, however, this rate structure makes the tax system much more complex and difficult to administer, provides greater potential for abuse, and promises to increase the perception of unfairness. Recall that President Trump’s first principle of tax reform¹ was to “make the tax code simple, fair, and easy to understand.” This rate structure does quite the opposite.

This article considers examples of some of the behavioral changes, avoidance issues, and other problems we might expect. While it doesn’t consider state and local tax rates, it’s worth noting that when those are added to the mix, they could further change the results.

I. Similar Income, Different Rates

It’s as if we haven’t learned anything from our experience with favorable capital gains rates and taxpayers who would bend over backwards to exploit them. Perhaps some congressional Republicans seriously believe that low capital gains rates pay for themselves and that it’s just that simple.² Moreover, if lower capital gains rates are a good thing, adding more low rates into the mix for selected other kinds of income, or creating a much lower corporate rate, might also seem like a really good idea.

When I refer to different tax rates, it’s not just to the rates stated in the code. Those were already complex, and providing a flat corporate rate and repealing the AMT for C corporations makes the mechanics less complex, even as it increases the potential for tax avoidance.

The TCJA adds what are conceptually a number of unstated rates using artificial deductions to create a lower effective tax rate.³ The new unstated rates that are most likely to affect individual taxpayers are in section 199A, providing a deduction based on “qualified business income.”⁴ This deduction is really designed to provide a lower tax rate on that kind of income.

The Ways and Means Committee’s version of the bill would generally have imposed a 25 percent maximum rate on a portion of net income distributed by a passthrough entity to an owner or shareholder. This would still have been extremely complicated given the other details that were then proposed, mostly as guardrails to curb potential abuses, particularly by wealthy individuals.

In response to complaints that the 25 percent maximum rate would not have benefited many small businesses that were already paying at a lower rate, the proposal mutated into what is now a 20 percent deduction, subject to many complex limitations and other excruciatingly complex details.⁵ This deduction is not like a business expense that represents an actual outlay by the taxpayer in determining taxable income. Rather, it is designed solely to provide the equivalent of a lower tax rate on qualified business income. So conceptually, it can be viewed as just another part of our already messy rate structure.

For Congress to create a 21 percent flat tax rate for C corporations, which is so much lower than the higher brackets of the ordinary income rates for individuals, presumably it had to do something for the majority of other businesses that are not organized as C corporations.⁶ But rather than using this as an opportunity for developing a broad, comprehensive means of taxing all types of business income (or better yet, for taxing every kind of income), Congress rushed through a giant tax cut that some contributors demanded, thereby creating a complex mess.

That is particularly ironic given that as a candidate, Trump said he would address the treatment of carried interest to make hedge fund operators pay more. There have been earlier tax bills that would have addressed carried interest, so it’s not as if lawmakers were unaware of taxpayers exploiting differences in tax rates. The old law allowed a relatively small group of wealthy taxpayers in limited industries to use carried interest to turn what is effectively compensation for services into favorably taxed long-term capital gain, exploiting that cheap rate. Yet the TCJA does almost nothing to address that situation.⁷

Moreover, the TCJA creates a host of other situations in which taxpayers will try to structure their affairs to take advantage of lower rates. It’s no longer as focused on the distinction between ordinary income and capital gain, which has already created so much of the complexity in our tax system.

Under the TCJA, for example, services performed by an individual will apparently be taxed at completely different rates depending on whether those services are performed as an employee receiving wages or as an owner of a passthrough (which in modern parlance apparently includes a sole proprietorship). For an individual using a passthrough, the rate effects of section 199A may turn on the nature of the services (whether or not it’s a “specified service trade or business”); whether the taxpayer’s taxable income is above or below specified thresholds or within stated ranges (which is also affected by the taxpayer’s filing status); whether the business holds eligible property; whether the business itself pays W-2 wages to employees or has those services performed by independent contractors; as well as many other technical distinctions.⁸ The result may also depend on how much of the taxpayer’s income is treated as reasonable compensation.⁹ This adds a whole new level of complexity to taxing income from services.

Moreover, the cut in the corporate tax rate to a flat 21 percent and the repeal of the corporate AMT create new incentives for individuals to use C corporations to earn their income and to keep it (including some kinds of investment income) off the individual return. Given our relatively high FICA and self-employment tax rates, the combined rate structure provides new incentives to use both C corporations and S corporations to avoid self-employment tax and reduce FICA.

This new rate structure will induce many already-existing businesses and some investors to create various new entities as they pursue lower tax rates. It will also induce some traditional employees to become business owners, perhaps in pursuit of their dreams, or at least in pursuit of lower taxes. This combination of alternatives makes the code much more complicated, offers new opportunities for tax planning and avoidance, and is likely to further the perception that the tax system is unfair.

Many people seem willing to accept that a hedge fund manager, private equity operator, or venture capitalist gets a lower effective tax rate than they do (if they’re not in that line of work), probably because they don’t really understand it. Under the TCJA, however, it seems likely that two people in almost any industry doing the same work with the same total income could pay tax at drastically different rates depending on how they structure their affairs and some other details. It’s hard to call this fair.

Even among individuals doing the same kind of work, there may be different degrees of opportunity for this kind of planning. It should not be surprising that people with higher incomes and more valuable skills will likely have greater negotiating power and opportunity to exploit this aberration.¹⁰

There may also be cases in which employers, seeking to end their employer responsibilities, will try to use the TCJA as an inducement to ordinary employees to relinquish employee rights, benefits, and protections, and join the gig economy. However, even an agreement between the worker and former employer does not turn an employee into an independent contractor. The TCJA does not create anything like an independent contractor safe harbor, and tax classification may not impress the many regulators who are supposed to be looking out for the rights of workers. It’s hard to guess how all of this might work out until we have some further guidance.

II. Lessons From the Past

A. The 1986 Act

By comparison, the Tax Reform Act of 1986 created a broader base with fewer deductions, exclusions, and credits, and a lower, flatter rate structure that would apply to most types of income. The new structure reduced the incentive to shift income to C corporations. In fact, it resulted in a large increase in the use of passthrough entities and a reduction in the use of C corporations.¹¹ It also added much tougher versions of the AMT, making it harder to avoid paying taxes.

An important underlying principle of the TRA 1986 was supposed to be fairness — to stop the tax sheltering and other ways of gaming the tax system that were eroding our voluntary compliance system. Much of the goal of simplification was traded away for increased fairness — witness the passive activity loss rules. The idea that working stiffs got stuck paying taxes while wealthy individuals and even the corporations employing those working stiffs could avoid taxes was perceived as a threat to the very survival of the voluntary compliance system. From the tone in Washington today, it may be that many Republicans no longer care about that survival.

Clearly, the 1986 reforms have eroded over the years, especially as Congress created reduced rates on net capital gain and qualified dividends along with all kinds of new deductions, exclusions, and credits. The TCJA, however, with its 21 percent flat corporate rate and the 20 percent deduction for qualified business income, effectively creates a tax rate structure that is just asking to be exploited. Rather than broadening the base to make everyone pay what might be perceived as their fair share, today’s base broadening seems designed almost entirely to raise revenue to offset massive tax cuts for corporations and other businesses, including the very provisions that will create the new opportunities for gaming the tax system.

A major goal of the TRA 1986 was to stop the focus on chasing tax savings and shift that energy toward more economically productive activity. But the TCJA’s rate structure looks like a major step in the opposite direction.

B. The Flat Tax

By the mid-1990s, Republicans were promoting fundamental tax reform, mostly focused on changing to a consumption tax in the form of the flat tax or a national sales tax. They claimed that this would be fair and simple and would get the IRS out of our lives. Although there are lots of things that most taxpayers would probably find objectionable about the flat tax proposal, there is something to be learned here from the rate structure that was one of the underlying principles of the flat tax.

Robert E. Hall and Alvin Rabushka, the economists who designed the flat tax, reasoned that there should be one flat rate that would apply to all types of income, and that the rate should be the same for an individual and for any business, whether the business is incorporated or not. They intended that taxpayers should not be able to engage in various kinds of rate arbitrage or shifting of income or deductions, taking advantage of lower rates for different kinds of income or through different entities.

A closer look at the flat tax shows that it didn’t meet that objective. Most notably, while the flat tax contained one flat stated rate, there was effectively a second unstated rate of zero that applied to various amounts that we would consider income when received by an individual under present law. Among other items, dividends, interest, and gains from selling investments were not taxed to the investor, effectively creating a zero rate.¹²

Moreover, the wage tax return provided a deduction for personal allowances, the equivalent of exemptions or a standard deduction. Hall and Rabushka acknowledged that business owners, even sole proprietors, would probably pay themselves wages. Those wages could be deducted on the business tax return and included on the individual’s wage tax return to take advantage of the personal allowances, which would have shielded those wages from tax on the wage tax return. Thus, the flat tax relied on some degree of shifting to exploit what was effectively a second rate of zero.

The flat tax also did not address the potential for avoiding payroll taxes, and it arguably created major opportunities and incentives for their avoidance (and of course, the additional Medicare taxes on higher-income individuals did not yet exist).

Nevertheless, a flat rate structure with the same rate applicable to every type of income and all taxpayers would tend to minimize the potential abuse and complexity that arises from having different rates for different kinds of income and for different entities. In creating the TCJA, with lower effective rates on qualified business income compared with most other ordinary income of individuals and the new low corporate rate, Republicans seem to have missed this lesson entirely. This is particularly ironic because so many Republicans over so many years have claimed to be supporters of changing to some variation of the flat tax.

III. Employees Become Business Owners

Some proponents will argue that this new rate structure gives employees an incentive to become entrepreneurs and start their own businesses, which is arguably a good thing. In some circles, there seems to be great respect for “job creators,” and much less regard, or even contempt, for ordinary employees.

We might all agree that government shouldn’t stand in the way of new business creation and perhaps should even support it. However, even if those arguably desirable results occurred with no undesirable side effects, there is still the question of how much of an ongoing subsidy for such activity should be provided through the tax system, effectively paid for by other taxpayers. This isn’t like a one-time incentive to help entrepreneurs get started.

Should it be the role of government to reward one kind of work over another, or to favor some taxpayers over others? If so, should that be based on how taxpayers structure their affairs? Even if it should, could anyone seriously read section 199A and say with a straight face that the differing results are justified? Should government effectively be doling out subsidies based on those criteria?

For example, should a moderate-income physician qualify, but not a high-income physician? If the high-income physician should not qualify, why should an architect or engineer qualify with the same income? Should a hardworking, very successful tradesperson with a high taxable income be required to have employees or hold business property to benefit, while a tradesperson with lower taxable income should not? Should it matter if that higher taxable income has nothing to do with the business but is based on investment income or a spouse’s income? It would be easy to raise hundreds of similar questions. Republicans who claim to be conservative and to favor free markets and less government regulation should have trouble explaining why this convoluted code section or the rest of our poorly designed rate structure should be used to pick winners and losers.

Meanwhile, it’s not hard to imagine the person who leaves work on Friday as a W-2 employee and comes back on Monday to perform those same services as an independent contractor or through a partnership or corporation. Should that person really qualify for one of these tax breaks? How many other clients or customers should they have and what other criteria should apply before we recognize their new “business”?¹³

A grossly underfunded IRS that is struggling to handle its current responsibilities will be required to provide early guidance, create necessary forms and instructions, help write regulations, and enforce this poorly designed new law. We’ve had a long history of serious problems dealing with the employee/independent contractor controversy and, to a lesser extent, the use of corporations to avoid tax. The new law promises to create even more complex problems. Apart from whatever tax treatment the IRS applies to these new business relationships, there are many regulators at the federal, state, and local level who deal with workers’ rights and protections who might take a different view for other purposes.

For workers with large employee business expenses that are not reimbursed under an accountable plan, the TCJA further discourages employee status by temporarily suspending the deduction for miscellaneous itemized deductions subject to the 2 percent floor. However, most of those deductions would generally still be available, without a 2 percent floor, on the Schedule C or other new business return. Operating a business may offer greater opportunity for other deductions as well, with greater opportunity for abuse.

Moreover, this conversion of employees into small business operators encourages shifting from Form W-2 reporting and wage withholding, for which there tends to be a high degree of compliance, to a much more lenient system. In some cases, we’ll turn W-2 employees into operators of cash businesses with no third-party reporting. For example, an auto repair business operating as a sole proprietorship with three employees who were receiving W-2s may turn into four smaller one-person businesses with large amounts of cash flowing through them and few internal controls. We can have a lot fewer employees and a lot more businesses, but we are going to need a lot bigger and better-funded IRS if we are serious about compliance.

IV. Some Predictions

This is almost certain: Proponents of these tax cuts will tell us that any good economic results come from the tax cuts, and any bad economic results come from something else. I call this the fallacy of tax cuts, and I wrote about it nine years ago in these pages.¹⁴ Given today’s politics, where claiming credit and casting blame regardless of any factual basis have become so much more commonplace, and inconvenient facts can simply be dismissed as “fake news,” we should expect to hear a lot more of this.

Another thing is almost as certain: Proponents of tax cuts will be praising them for creating new small businesses and C corporations. They won’t mention that much of that increase is not an indicator of economic growth but merely represents people shifting the form in which they carry on their activities, including the formation of new corporations and other business entities to take advantage of the new rate structure.

Moreover, the giant corporate rate cut won’t cause total C corporation tax revenues to go down commensurately, and they might even increase. Watch for proponents of the tax cuts to cite this as proof that when you cut tax rates, tax revenues don’t go down very much (or go up), or even that tax cuts pay for themselves. They won’t mention how much of that increased tax revenue merely represents a shifting of tax revenue that would otherwise have been attributed to wages, sole proprietorships, passthrough entities, and to investment income that was shifted to corporations. Even if the total tax revenue from all those sources increases, the better question is how much would it have been without the tax cut. Tax cut proponents will almost certainly attribute anything that looks like good results to the tax cuts.

Payroll tax revenues will increase, and proponents of the tax cuts will probably attribute that increased tax revenue to the tax cuts as well. Of course, even with no tax cuts, we would expect a big increase in payroll tax revenues. The unemployment rate has been improving over many years and we are now near full employment, so there is pressure to raise wages, which should bring in more payroll taxes.¹⁵ Moreover, 18 states raised their minimum wage starting January 1, 2018. Nearly every dollar of those extra wages should bring in the full 7.65 percent from both the employee and the employer.

While the new tax law might result in additional payroll tax revenue, it will likely also cause an increased avoidance of payroll taxes by some taxpayers who are offered greater incentives and opportunities to game the system under the TCJA. Of course, proponents of these tax cuts probably won’t be acknowledging any of that increased tax avoidance.