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Tax Reform: Some Thoughts on Simplification and Passthrough Income

Posted on Sep. 29, 2017

This past week saw the release of the outline of the next big push for tax reform. Titled a “Unified Framework For Fixing Our Broken Tax Code” the Trump Administration and the majority in the Senate Finance and House Ways and Means Committees discuss in 9 pages basic principles and  major changes, including corporate and individual rate reductions, a new top rate for some passthrough entities lower than the top individual rate, an expansion of the standard deduction, elimination of many personal deductions, and a shift to a territorial system of taxation.

We try to stay in our lane of tax procedure and tax administration on this blog. I will state the obvious and note that tax reform is a heavy lift, and there is likely to be some serious legislative give and take over the next few months.

Just this past week the National Taxpayer Advocate blogged on her vision of tax reform, in Tax Reform: Hope Springs Eternal This Fall. The NTA, while noting many policy goals around tax reform, picks one issue for emphasis: the need for simplification. Stating that if she had to sum up everything she has learned in her tenure as NTA, it is that the “root of all evil in the tax system is the complexity of the Internal Revenue Code.”  To that end, the NTA discusses sources and effects of complexity and offers a number of suggestions that she has discussed in past reports as a way to meaningfully simplify the Code. Those include streamlining the Code’s myriad savings and education incentives and consolidating civil penalties and family status provisions. As someone who has thought about tax reform for a long time, the NTA makes sensible substantive suggestions that I hope Congress considers as it moves forward.

There have been many articles discussing complexity in the tax system: they often define differing levels of complexity; some suggest that simplification in a meaningful sense is often diametrically opposed to other goals we also care deeply about, like equity (itself a loaded term) and the need for certainty. (For a good example see a 2013 article in the Wyoming Law Review by Jeffrey Partlow). It is easy to see how other goals soon run smack into and conflict with the shared stated goal of simplifying the tax code.

Consider one of the Framework’s proposals: a lowering of the top rate on small and family owned business income from passthroughs to 25%, a rate lower than the top individual rate. Now it does not take a law professor to consider the possibility for mischief from such a proposal: people with labor income will be incentivized to funnel their work into a small business passthrough format to try to game the rate differential. We already see that to an extent in existing law (for much less at stake), as individuals use S Corp structures to try to avoid paying employment taxes on what might otherwise be compensation income.

The proposal addresses that mischief by noting that the framework “contemplates that the committees will adopt measures to prevent the recharacterization of personal income into business income to prevent wealthy individuals from avoiding the top personal tax rate.”

I have not deeply thought through the ways that legislation could achieve that anti-abuse goal, but I suspect that any measure will require greater IRS attention to this structure (already we have discussed in PT the heavy resource lift of IRS  trying to determine on audit whether S Corps are paying shareholders a reasonable compensation). The Center on Budget and Policy Priorities in a report that predates the current proposal discusses some of these challenges, including discussing how some estimate that over 30% of the cost of this change would come from high earners trying to shift income into this structure to game the system and the challenges IRS would likely face in trying to stem the abuse[Ed: note that the CBPP discussion looks at an earlier proposal with an even lower passthrough rate].


It is far too early in the tax reform season to know where things will land. I note that the Trump Administration’s “first principle” of tax reform is to “make the tax code simple, fair and easy to understand.” The passthrough proposal suggests the potential for significant administrative complexity. As IRS struggles with resources (like we learned this week as IRS has confirmed that it has suspended its ASFR program, at least temporarily), Congress should explicitly consider whether it will give the IRS the resources it needs to police a program that at first blush is one that is susceptible to abuse.

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