Is There a Trillion Dollar Hole in the Senate Tax Plan?
Funny things happen when you try to rewrite the Code on the fly
The Senate is moving at breakneck speed toward passage of a tax plan that is estimated to add $1.4 trillion to the deficit over the next decade. But it could cost a lot more than that. There appears to be a drafting error in the Senate plan that may allow millions more taxpayers to benefit from a new deduction designed for so-called “pass-thru” entities.
To understand the nature and scope of the error, it’s helpful to walk through the language of the proposed Senate bill (to follow along, click here and scroll to page 21). It’s a bit of a slog, but bear with me: If you’re a single person earning less than $300,000 a year or a married couple earning less than $600,000, you might be able to take advantage of this loophole yourself.
The proposed bill adds a new section 199A to the Internal Revenue Code. That section allows taxpayers to claim a deduction of 17.4 percent times the taxpayer’s “qualified business income” (QBI). The deduction is capped at 50% of the W-2 wages paid by the taxpayer in a qualified trade or business, but the cap is waived for taxpayers earning less than $250,000 a year ($500,000 for a married couple filing joint returns). The cap then phases in for taxpayers earning between $250,000 and $300,000 (or between $500,000 and $600,000 for married couples).
QBI is defined as “the net amount of qualified items of income, gain, deduction, and losses with respect to any qualified trade or business of the taxpayer.” §199A(c)(1). An item of income, gain, deduction, or loss counts as “qualified” if it is “effectively connected with the conduct of a trade or business within the United States” and “included or allowed in determining taxable income for the taxable year.” §199A(c)(3)(A). There are exceptions for capital gains, dividends, interest (in some circumstances), income from commodities transactions, foreign currency gains, and income from annuities (i.e., these items are not QBI). See §199A(c)(3)(B). Those exceptions won’t matter for our purposes.
The exception that will matter for our purposes is in the new §199A(c)(4). That provision says:
Qualified business income shall not include . . . reasonable compensation paid to the taxpayer by any qualified trade or business of the taxpayer for services rendered with respect to the trade or business.
The bill goes on to say that “[t]he term ‘qualified trade or business’ means any trade or business other than a specified service trade or business.” §199A(d)(1). The term “specified service trade or business” is defined (via cross-reference to I.R.C. § 1202(e)(3)(A)) to mean:
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 . . . .
Significantly for our purposes, the exception for specified service businesses does not apply to taxpayers earning less than $250,000 a year ($500,000 for a married couple filing jointly). In other words, taxpayers with income below the threshold can claim the 17.4% deduction with respect to income from the performance of services in health, law, etc. As with the W-2 cap, the exception phases in for taxpayers earning between $250,000 and $300,000 (or between $500,000 and $600,000 for married couples). So if you earn more than $300,000 a year ($600,000 for a couple), you can’t claim the QBI benefit with respect to income from a specified service business.
So where’s the hole? Well, let’s imagine a law firm associate earning $180,000 a year at Cravath, Swaine & Moore (or any of the other law firms paying $180,000 to newly minted law school graduates). The Tax Court has said dozens of times that “performance of services as an employee constitutes a trade or business.” See, e.g., Oatman v. Commissioner, No.13370–14, 2017 Tax Ct. Memo LEXIS 15, at *6 (Jan. 17, 2017); Kilpatrick v. Commissioner, No. 17242–13, 2016 Tax Ct. Memo LEXIS 165, at *46 (Aug. 29, 2016); Craft v. Commissioner, No. 2858–04, 2005 Tax Ct. Memo LEXIS 197, at *8 (Aug. 15, 2005); Kerr v. Commissioner, Docket No. 31392–86, 1990 Tax Ct. Memo LEXIS 179, at *24 (Mar. 22, 1990); accord O’Malley v. Commissioner, 91 T.C. 352, 363 (1988) (“[A] taxpayer may be in the trade or business of being an employee . . . .”); see also Primuth v. Commissioner, 54 T.C. 374, 377 (1970) (collecting cases in which “we have held . . . that a taxpayer may be in the trade or business of being an employee”). Other courts have said much the same thing. See, e.g., Trent v. Commissioner, 291 F.2d 669, 671 (2d Cir. 1961) (“[T]he performance of services as an employee is a trade or business where the statute does not so expressly negate it.” (alterations and internal quotation marks omitted)); Caruso v. United States, 236 F. Supp. 88, 91 (D.N.J. 1964) (“It has long been recognized . . . that the performance of services as an employee does constitute such a trade or business within the meaning of the income tax statutes. The employee is deemed to be in the ‘business’ of earning his pay.”); accord Noland v. Commissioner, 269 F.2d 108, 111 (4th Cir. 1959); Hartrick v. United States, 205 F. Supp. 111, 112 (N.D. Ohio 1962). Indeed, this conclusion is implicit in section 62 of the Code, which allows an above-the-line deduction for expenses “attributable to a trade or business carried on by the taxpayer, if such trade or business does not consist of the performance of services by the taxpayer as an employee.” §62(a)(1) (emphasis added). If the performance of services as an employee did not qualify as a “trade or business” in the first place, the italicized language would be superfluous.
Returning to our law firm associate: How much of the $180,000 salary counts as QBI? Well, all of it is qualified business income under §199A(c)(1) and (3): it’s earned in the United States; it’s part of your income for the year; and it’s not capital gain, dividend income, or any of the other items specified in §199A(c)(3)(B).
But what about the exception for “reasonable compensation”? Recall that QBI “shall not include . . . reasonable compensation paid to the taxpayer by any qualified trade or business of the taxpayer for services rendered with respect to the trade or business.” Now read that again. It speaks of “reasonable compensation paid to the taxpayer by any qualified trade or business of the taxpayer.” Is $180,000 paid to the associate by Cravath “paid to the taxpayer by a[] qualified trade or business of the taxpayer”?
Well, she is just a first-year associate — not a partner. Insofar as “of” indicates a “possessive relationship,” it doesn’t seem like Cravath is a trade or business “of” her. Sure, it’s a trade or business “of” the partners, but our first-year associate is at least eight years away from partnership.
Maybe one can argue that an employee always is “of” her employer. I might introduce myself at a conference as “Daniel Hemel of the University of Chicago Law School.” But is the University of Chicago Law School “a trade or business of me”? That’s certainly a strange way to use the word “of.”
If Cravath is not a qualified trade or business “of” the first-year associate, then is there anything else preventing her from claiming the 17.4% deduction for QBI? Not that I can find. Recall that the exclusion for specified service businesses does not apply to taxpayers earning less than $250,000 a year (couples earning less than $500,000), so unless the associate has a very high-earning spouse, she doesn’t have to worry about the fact that her trade or business involves the performance of services in the field of law.
You can see where this is going. If the Cravath associate can claim the 17.4% deduction for QBI, so can any taxpayer engaged in the trade or business of performing services as an employee, provided that they fall below the income threshold and aren’t owners of the business for which they work. And that’s a lot of people and a lot of money. Individuals with taxable income of less than $250,000 a year (couples under $500,000) earn somewhere north of $6 trillion in salary and wages each year; if they all are eligible for the 17.4% deduction, then we’ve just added (back of the envelope calculation) more than $100 billion a year to the cost of the bill. (I’m assuming an average rate of 10% multiplied by 17.4% and then by $6 trillion.) Multiply that by the eight tax years from 2018 to 2025 (when the pass-thru provisions sunset) and we’re at more than $800 billion a year in losses to the fisc (probably closer to $1 trillion if incomes rise).
Can anything be done to stop this? Well, for one, the Senate could amend the bill to make clear that QBI does not include income earned in the trade or business of performing services as an employee. And if they don’t do that by Friday, hopefully a House-Senate conference will fix this.
Second, Treasury and the IRS could try to use their regulatory authority to accomplish the same result. A new §199A(f)(4) would give the Treasury Secretary the authority to “prescribe such regulations as are necessary to carry out the purposes of this section, including regulations . . . for requiring or restricting the allocation of items and wages under this section.” But they’d better act fast: the new law — if passed — will go into effect on January 1, 2018.
Third, the IRS might concede that the performance of services as an employee is a trade or business, but might then argue that a taxpayer engaged in that trade or business is required to pay herself — out of the proceeds of her trade or business — “reasonable compensation,” which would roughly approximate her salary. This is more or less the approach that the IRS has taken with respect to S corporation shareholders who try to characterize service income as dividends in order to avoid self-employment tax (i.e., the Gingrich-Edwards loophole). But this approach involves a lot of case-by-case litigation and still results in a good deal of successful tax avoidance.
All of this serves to illustrate the point that tax reform on the fly leads to lots of unintended consequences. This one, if uncorrected, could be among the costliest. And it’s one more reason why congressional Republicans, if they care at all about America’s fiscal future, should slow down.
[Addendum: Kirk Stark points out a fourth way for the IRS to fight this: The new section 199A is framed as a deduction rather than a reduced rate, and since there is nothing in section 62 that would bring a deduction for employees “above the line,” it would seem to be an itemized deduction (i.e., “below the line”). But another section of the Senate bill eliminates most itemized deductions, and there is no savings clause for this one. On this view, what the Senate bill gives with one hand, it takes away with another.
This, of course, raises the question: Where do the intended beneficiaries of the new section 199A claim the deduction on their income tax returns? I guess the answer is that this becomes an above-the-line deduction that factors into the computation of adjusted gross income (AGI). But the funny thing is that the size of your deduction (and, specifically, the applicability of the W-2 wage cap and the specified services limitation) depends on your taxable income, which you don’t know until the end of your tax computation (long after you’ve figured out your AGI). Moreover, the new §199A(e)(1) says that “taxable income” for purposes of the $250,000/$500,000 thresholds depends on “taxable income . . . computed without regard to the deduction allowable under this section.”
This suggests that anyone claiming the deduction who falls anywhere near the $250,000/$500,000 thresholds will have to do the following: (1) calculate taxable income without accounting for section 199A; (2) calculate the deduction allowed under section 199A in light of the taxable income thresholds; and (3) now go back to step 1 of your income tax calculation, recompute your AGI taking into account the qualified business income deduction, and do everything all over again. Remember when Republican leaders were advertising the fact that their “unified framework” would eliminate the alternative minimum tax and so free taxpayers from having to “do their taxes twice”? Well, that was September; this is November.
Meanwhile, even if our Cravath associate can’t claim the 17.4% deduction, those of us with labor income other than salary and wages still can. For law professors, this means that textbook royalties, speaking honoraria, consulting income, etc., is eligible for the 17.4% rate, even if we don’t bother to form a pass-thru entity. And the IRS will spend the next eight years fighting battles over worker classification, with much higher stakes than before.]
