Under the new tax bill, lose money before tax but make money after-tax

Our revised Tax Games report should be out within a day or two. (The original is still here.)

But one hallmark of the new tax bill that I want to highlight right here and now - because, in the new report, it will be just one of very many things that we will be pointing out - is the incentive to engage in transactions that reduce one's tax liability, even if these transactions lose money before tax.

A quick prediction - there will be many billions of dollars worth (at least as reported for tax purposes, although many of them may be quasi-fake beyond the paper-shuffling) of such transactions. The opportunities to make money after-tax - in effect, to drive large trucks right up to the Treasury vaults and start siphoning out loose cash - are simply too great. People will have manifold incentives to do things that lose money before-tax, due to the larger after-tax savings that they will see they can reap.

One obvious example pertains to people who pay tax at a 37% marginal rate, but who can engage in transactions with companies they own that pay tax at only a 21% marginal rate. Set the tax lawyers and accountants loose, and there will be plenty to do along this margin.

But here's another - the passthrough rules. Say I earn $100X through a passthrough, but am temporarily blocked from claiming the full 20% passthrough deduction (i.e, up to $20X) because I don't have any W-2 wages paid or capital assets through the business.  But I can deduct the $20X so long as it doesn't exceed (a) 50% of W-2 wages paid by the business (including to myself), or alternatively (b) the sum of 25% percent of such wages paid and 2.5% of the original cost basis of tangible assets used in the business.

Case 1, pay a new employee $20X, in the expectation that this will increase my gross revenues by $15X.  I am down $5X before tax, but my taxable income declines by $15X, since I can now deduct an amount that is up to half of the wages, or $10X.  Result: at a 37% marginal tax rate, I reduce my tax liability by 37% of $15X, or $5.55X.  So I am $5X behind before tax, but $.55X ahead after-tax.

Case 2, I buy a machine for $100X, fully debt-financed. I get to expense this and claim an immediate $37X reduction in tax liability, but let's ignore that here since a full analysis would require dealing also with the back end, where I repay the debt and might have recapture income (and/or a pretax loss from the purchase plus disposition). While it seems to me that there is rich tax gaming potential here, given its requiring a fuller analysis let's ignore it for now, and just focus on the annual cash flow.

Say I pay 8% annual interest on the loan, and earn $7X per year from using the machine.  Since I (or rather my attorneys) are not fatally dim or inept, I can deduct the entire annual interest expense, without worrying about the tax bill's interest deduction limits. Even so, I am $1X per year in the hole before tax. But not to worry, due to the extra passthrough deductions (I can now annually deduct up to 2.5% of my $100X cost), my taxable income from doing all this is actually minus $3.5X per year. Given my 37% tax rate, I reduce my tax liability by $1.295X per year. So I am a net of .295X per year ahead after-tax, despite losing $1X before tax.

Given all the many opportunities that the tax bill offers for turning pre-tax losses into after-tax gains, in many cases it will be prima facie malpractice by the tax planners if a high-income taxpayer (as determined in actuality) cannot gin up enough tax losses (in excess of any actual economic losses) to escape from that bracket. And for some, the games will keep going beyond this point.

Leaving aside purely sham tax shelter transactions, which anyone with low ethics and a taste for risk can try (albeit, subject to the risk of being caught by a severely under-funded IRS), it will often depend on how conveniently one's particular business activities happen to set one up for finding pre-tax money-losing transactions that happen to have a plausible link to these activities. But of course, creative tax planners will be looking for ways to gin up these links.

There is going to be a lot about this in the press over the next few years, once the deals start happening.