Thursday, November 02, 2017

All hail the NPIP!

NPIP stands for "New Plutocratic Industrial Policy."  It's the label that occurs to me with regard to the 25% maximum tax rate for business income that the House Republican drafters have decided they like.

While they have been claiming it's for "small business," there is absolutely nothing that so limits it. Indeed, it's been very carefully drafted to make sure that people in the 39.6 percent get the full rate reduction. Under the bill, these are people with taxable income of at least $1 million. So we can be reasonably confident that its $4448 billion 10-year revenue estimate is mainly about big non-corporate businesses and their very rich owners. (Since I first posted this, it's been pointed out to me that reportedly 86% of small business pays at a rate of 25% or less anyway, meaning they'd get nothing from giving them a 25% maximum rate.)

So what must you do, or whom must you be, to get the 25% rate? First, you get it for 100% of your net business income from passive activities, which generally are business activities in which you personally do not materially participate. (They take this definition directly from the passive loss rules, which I helped to draft back in 1986.) This typically applies to people who invest money in all kinds of partnerships, S corporation activities, etcetera  that engage in pretty much any type of business - subject to the carve-out that I'll mention below. But they are passive investors, giving $$ but not sufficiently working in the business to meet the passive loss rules' material participation standards.

Second, you get the low business rate for 30% (in the simplest case) of net business income from all such activities in which you DO materially participate. This percentage can change under complicated, and at least partly elective (by the taxpayer) tests that seem aimed at raising it for more capital-intensive activities.

Suppose, then, that I have a business activity on which I work full time, earning $1 million and having no expenses. So far as I can tell at an initial read - subject to the limitation that I discuss next - 30% of the $1 million gets the 25% rate. But this income does count to pushing me into higher tax brackets for the rest of my taxable income.

Okay, so what exactly limits this? Under the passive activity rules cross-reference, a business activity is any activity which involves the conduct of a trade or business. I note that being an employee is a trade or business activity. So the one big thing limiting it is an exclusion from the special rate for "specified service activities," defined in a preexisting Internal Revenue Code section that the provision cross-reference as follows:

"ANY TRADE OR BUSINESS INVOLVING THE PERFORMANCE OF SERVICES IN THE FIELDS OF HEALTH, LAW, ENGINEERING, ARCHITECTURE, ACCOUNTING, ACTUARIAL SCIENCE, PERFORMING ARTS, CONSULTING, ATHLETICS, FINANCIAL SERVICES, BROKERAGE SERVICES, OR ANY TRADE OR BUSINESS WHERE THE PRINCIPAL ASSET OF SUCH TRADE OR BUSINESS IS THE REPUTATION OR SKILL OF 1 OR MORE OF ITS EMPLOYEES."

There are also a couple of items added for particular functions in the financial services industry.

What does this mean? If you're in the professional service industries, the arts, sports, financial services, consulting, etc., you lose. If you're in the trade or business of being an employee, you lose. But if you're a business owner (including via passive investment) in, say, the real estate, oil and gas, manufacturing, or retail sectors, it sure looks like you win. Although you win more (from 100% vs. 30%) if you aren't actually doing the work.

This is industrial policy - picking favored industries that should win while the rest lose.  Businesses using capital and not just selling services are good, services businesses are bad. Perhaps the regulations will pick winners and losers in an even more fine-grained manner, especially if you can lobby the White House, not just the Treasury and IRS.

And it's a weapon to enhance plutocracy - offering the biggest rate cut to millionaires, allowing plutocrats who work to get the low rate for 30% of their income, and those who are in effect rentiers to get the low rate for 100%.

And here's a tax planning trick that occurs to me right off. I'm a plutocrat and so are you. If we just got the $$ from our own businesses, in which we're working actively, we'd only get the low rate for 30% of our net business income. But if we invest in each other's business, 100% since we're passive as to the other person's business.

So why don't I invest in your business and you invest in mine? And I get some of the returns from your business, while you get some of the returns from mine? But since we don't really want to invest in each other's businesses, rather than our own, what can we do to ensure indirectly that, at the end, of the day, our takes from each other will be somehow adjusted so that we are really getting ultimate net payouts based on our own stuff, not each other's?

Let the drafting, of contracts followed by tax opinions, begin.

But that's not the worst of it, purely as a matter of tax administration. Consider also this. Under the passive activity rules, people most commonly want to AVOID being classified as passive, and to show that they are materially participating. This often depends on things such as how many hours they spent working on the activity. They are as a practical matter encouraged, although not required, to keep records establishing their hours spent. There has actually been Tax Court litigation about what sorts of hours count.

But now it's reversed. To get the 25% rate for ALL of your business income, not just 30% of it, you have to AVOID materially participating. So it's up to the IRS to prove how you actually spent your time (!!). How exactly are they supposed to do that, for business people with ownership interests who go around doing this & that?

So you have a horrendously bad statute administratively, devoted solely, it seems, to enforcing an incoherent industrial policy and enhancing plutocracy. If there's ever been a worse federal income tax enactment, I'd like to know what it could possibly be.

15 comments:

DM Hasen said...

Let us not forget estate tax repeal with full retention of 1014 basis step-up, because (per W&M explanation) "[t]he estate and generation-skipping taxes impose additional levels on tax on income and assets that have generally already been subject tax" and "family businesses that would pass from one generation to the next would no longer be subject to double or even triple taxation."

Daniel Shaviro said...

Retaining full 1014 basis step-up while repealing the estate tax is amazingly crass.

DM Hasen said...

It really is something, especially remembering (if I'm right) that even the W. administration went for a limit on step-up out of distributional concerns.

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EP said...

Interesting post. I haven't been able to figure out how the proposed legislation will change our situation. My wife and I own a residential real estate company. Since we file as a S Corp and are employees it looks like we won't get the pass through rate. Is that how you see it?

yarmo81 said...

EP, he said real estate would be the winners. I would ask about if my wife and I, both in healthcare could create 2 S.Corps that we invest in each others' as passive income . IOWs, I would bank what she earns and she mine.

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