Saturday, November 11, 2017

Yet another problem with the House's (and Senate's?) special tax rate for passthroughs

Things are happening too fast in Washington tax "reform" for one to keep full track of all the snafus and scandals that are likely to be hidden in all the weeds. But here's one more that a friend brought to my attention.

There's nothing better than getting to make "heads I win, tails you lose" bets. So here's one, when you get a special 25% tax rate for certain income from pass-throughs, as under the House bill. What about losses?

The ideal, from the taxpayer's standpoint but not anyone else's, would be to include profits from the favored activities at 25%, while still getting to deduct losses at 39.6%, if one is rich enough to reach the top bracket. So what does the House bill do to prevent that?

(Similar question, what does the Senate bill do to prevent this in their version of the passthrough tax break? Answer, at this stage nothing so far as we know, but we haven't seen the statutory language yet.)

I'm currently on an Amtrak with relatively limited access to the things one could look up in one's office. But, as I recall, what it does is require a limited species of recapture, that fails to reach all cases.

Suppose you are in an activity that would generate profits at 25%. In Year One, it instead generates losses, and indeed you get to deduct them at 39.6 percent. What the bill appears to try to do is require "recapture" of this income at the full rate. So in Year 2, you wouldn't get the special rate until you had reversed out the prior loss deduction.

(What if the activity changes status under the rules from year to year? Let's not even go there yet. It may turn on what the passive loss rules have to say about "former passive activities" - at least, leaving aside the case where one only gets the special rate for 30% of the income.)

Suppose that provision works properly within its four corners, although I haven't as yet had the chance to look it over carefully. (I am posting now, rather than waiting, because speed is of the essence given their timetable.)

It still isn't good enough to do the job. Case 1, risky activity that now ex ante faces a 25% rate on the income if it comes out heads, and a 39.6% reimbursement rate via deductions if it's tails. So heads I win, tails you (the Treasury and other taxpayers) lose.

Case 2, income first and deductions/losses later. Normally, due to the time value of money, taxpayers want to accelerate deductions and defer income. But here, if doing it the other way around creates a huge tax rate disparity, there are strong incentives, and no doubt when well-advised means, of flipping it around. So you pay tax at 25%, and then the next time you deduct the losses at 39.6%. I don't believe there's a carryback for losses into prior tax years - which would of course complicate things still more.

True, it might be somewhat of a one-time gain given that the recapture might get you again further down the line, but still potentially well worth doing if the payoff is large enough.

Same question as in my last post about the problems with the deferred corporate rate cut in the Senate bill: Is this issue properly reflected in the Joint Committee of Taxation revenue estimate? I bet not, as their process has been so rushed and you need time to think in order to start locating all these things

And I'm only focusing on a couple of the areas that I happen to know something about. There are plenty of other portions of the House and Senate bills that might raise similar or analogous issues


Schedule A said...

Professor Shaviro,
Do you have any analytical comments about the slaughter of Schedule A deductions now occurring on both the Senate and House tax bills? These deductions are the backbone of most middle class tax filers and aside from SALT are hardly mentioned in media accounts. The Senate bill is particularly ruthless, eliminating all miscellaneous deductions subject to the 2% floor.
Doug Myers

Daniel Shaviro said...

Yes, that's a big issue, but I've been trying to focus on the particular ones as to which I feel I can add the most value.