Tuesday, December 12, 2017

An added thought about passthroughs: is it supposed to be about having "employees"?

In my last post, I inquired into what "guardrails" might mean, in the context of the passthrough rules, given the lack of any underlying theory for who gets the benefit and who doesn't. But a further thought that occurs to me is, are the rules trying to incentivize having employees?

Evidence in favor of discerning such an intent might be that having employees may potentially make it easier to avoid materially participating under the House bill, and that the Senate bill in some settings limits the benefit to 50% of one's wages paid. And maybe the thing is about encouraging the growth of businesses that will provide jobs (?).

But here's an odd aspect of the passthrough rules, even at the level of "theory" (scare quotes because it's rather kind to say that there's a theory at work here). I'm being encouraged by the passthrough rate to run a business with employees instead of myself being an employee. But the people I might hire as employees are being encouraged to do the same thing, rather than being my employees. So for people who are actually weighing the choice between these two models - and note, of course, that it can be a purely formalistic choice via the claim of being an independent contractor, etc. - it seems to contradict itself. An employment relationship takes two to establish, the hirer and the hiree. One is being pushed towards it, the other is being pushed against it (other than being pushed merely not to call it an employment relationship).

Anyway, having employees doesn't do a great deal of work under the provisions, as a formal matter, anyway. In the House bill, you maximize your benefits by avoiding material participation, which is very different from hiring vs. not hiring, or hiring more vs. fewer people, or hiring employees rather than independent contractors.

In the Senate bill, the wages-paid "guardrail" (if that's what it is) can be met by my paying wages to oneself. E.g., say I earn $100,000 through a business that I'd like to get the 23% deduction for qualified business income, but it's just me. Not to worry, I pay myself $32,000 of reasonable compensation wages. Now my qualified business income is $68,000, and I can deduct 23% of that ($15,640) so long as it doesn't exceed half of the wages ($16,000). So I get the full 23% deduction, which, if my marginal tax rate is 38.5%, saves me $6,000 of tax for no obvious reason.

In sum, the idea of having employees, which ostensibly might relate to a policy rationale of encouraging job growth, doesn't do much to add the coherence to the passthrough rules that they would need for one to figure out what the "guardrails" are supposed to keep out.


marktheknife said...

The push for a passthrough tax seemed based on some sort of odd understanding by members of Congress regarding "fairness" between passthrough businesses and C corps. I think there's a sense that corporate E&P is (ignoring the fact it isn't really "income") capital income par excellence, and income from passthroughs which is like E&P should receive the special rate.

So if I were to say what the theory behind the guardrails is intended to be, it's: If this passthrough were a business operating as a C corporation, would a particular allocation of income be retained (or allowed to be retained) in earnings and profits? If so, it deserves the special rate. Else, it should get the regular rate.

You can then see the two bills as focusing on a different problem--the House hates that labor income could be disguised as "E&P-like" income, and the Senate is aimed at attacking passthroughs that are the equivalent of corporate pocketbooks (a sort of personal holding company rule, but one that determines classification by looking to employment by a holding company instead of its income).

I don't think this is a terrific theory by any means, and certainly each bill deviates in some way from this theory, but it's my best shot at a cohesive theory thus far.

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