Work-Related Distortions in the Tax Reform Bills: Understanding the New Proposed Provisions (Part 1 of 2)
Shu-Yi Oei is an Associate Professor of Law at Boston College Law School. Diane Ring is a Professor of Law and The Dr. Thomas F. Carney Distinguished Scholar at Boston College Law School.
The New York Times ran a piece on December 9, 2017, entitled “Tax Plans Might Give Your Co-Worker a Better Deal Than You.” The article highlights ways in which the proposed tax reforms (some in the House bill, some in the Senate bill) would draw new tax distinctions among workers, creating problematic and inequitable tax discontinuities. Specifically, the article makes a few key observations:
Same job, different tax bill: Two workers doing the exact same job may be subject to a different tax rate depending on how each is classified, with independent contractors/business owners getting a better rate.
The tax rate turns on not looking like an employee: In contrast to the current law, proposed reforms would draw much more extensively on taxpayer characteristics such as worker classification, use of business entity, occupation, level of engagement in the activity, and entity type to determine the tax rate. Losers in this move are employees; winners are those who provide labor as a non-employee, or those who are owners of businesses. The New York Times article suggests that this might be a new “move to single out employee compensation from other earned income.”
The rationale for the new regime: Supporters of the new tax regime expect that taxpayers who fall on the “right” side of the line and get the lower tax rate will be the ones whose activities will stimulate economic growth in the new economy
The goal of this two-part blog post is to summarize for a labor law audience how the proposed tax legislation creates these outcomes and to highlight the important policy issues that observers and commentators might be concerned about. This Part 1 focuses on the statutory provisions, and Part 2 will discuss the key policy conversations that are taking place.
Before We Get to the Technicalities, Here are the Key Takeaways:
A quick tour through the elements of proposed §199A and related provisions designed to give preferential treatment to certain business activities illustrates just how complicated these new tax provisions are. The broad policy goals are not unclear: Very generally, the proposed statutory scheme is designed to incentivize certain types of economic activity on the expectation that it will result in economic growth.
The problem for the policymaker who buys into this type of regime is how to design it so that not every single taxpayer is able to claim eligibility for the new rate. This is what the many complex definitions and carveouts in the statute are trying to do. The term “qualified business income” and other defined terms are stitched together in attempt to carve out certain types of business activities (e.g., lawyering, investing, mining) as well as the performance of services as an employee. However, the statute also creates generous exceptions to these carveouts, including high-dollar threshold amounts.
In trying to draw these lines, the statute becomes horrifically complicated, both in the policy goals its expresses and in its technical drafting. In Part 2 of this post, we will summarize the key policy concerns that arise regarding how the new provisions may shape work and enterprise decisions. But first, the statute itself:
Understanding the Proposed Statutory Changes
The House and Senate tax bills favor somewhat different groups of taxpayers in their re-design of business tax rates, although traditional employees would lose out under both bills. Obviously, we don’t yet know what the final legislation will look like. There has also been a substantial amount of commentary among tax experts about the loopholes the new bills will create, and it’s possible this may affect the final legislation. As between the House and Senate legislation, it appears that the Senate version is more likely to survive, so it’s worth taking a closer look at exactly what that proposal does.
(Note: It’s complicated.)
A first key change in the Senate provisions is the creation of a 20% flat tax rate for corporations (proposed § 11), which is far below the top individual tax rate under the new Senate bill (38.5%).
A second key change in the Senate proposal is to create a new deduction for non-corporate taxpayers that meet certain requirements. We outline the provision here, underlining the defined terms and highlighting in bold the key substantive takeaways. This detailed description shows exactly where the guardrails against tax planning abuses are, how such guardrails are likely to fail, and how the structure of work is likely to be affected.
Proposed new §199A (§11011 of the Senate bill) provides a new deduction for taxpayers other than corporations (i.e., partnerships, S corporations, and sole proprietorships). A new tax deduction is good news for taxpayers, right? The problem is making sure not everybody gets the deduction. Here is how the proposed legislation tries to do that:
The new §199A deduction is limited to the lesser of (1) the “combined qualified business income” of the taxpayer OR (2) an amount equal to 23% of the excess of the taxpayer’s taxable income over the taxpayer’s net capital gain for the taxable year. §199A(a)(1), (2).
“Combined qualified business income” is likely to be the more important limitation, so let’s focus on that.
“Combined qualified business income” is defined as the sum of the following:
First, the LESSER OF (a) 23% of the taxpayer’s “qualified business income” (defined separately with respect to each “qualified trade or business” in which the taxpayer is engaged) or (b) 50% of W-2 wages with respect to the “qualified trade or business.” W-2 wages are essentially those amounts paid by the taxpayer subject to wage withholding or certain deferred compensation rules. §199A(b)(4). The 50% of W-2 wages limitation doesn’t apply where a taxpayer’s taxable income doesn’t exceed a threshold amount for the year ($250k filing single/$500k married filing jointly). §199A(b)(3)(A), (e). In such cases, the “combined qualified business income” definition will be applied without regard to the W-2 wage limitation. If a taxpayer’s taxable income does exceed the threshold, then the 50% of W-2 wages limit phases in gradually. §199A(b)(3)(B).
Second, 23% of qualified REIT dividends and qualified corporative dividends of the taxpayer. §199A(b).
A particular pressure point is how the definition of “qualified business income” in proposed §199A(c) is circumscribed and defined. This definition is instrumental in delineating who gets the deduction, who does not, and who will be best able to game the law in order to plausibly claim the deduction:
“Qualified business income” is defined to mean, for any taxable year, the net amount of qualified items of income, gain, deduction, and loss with respect to any qualified trade or business of the taxpayer.” §199A(c).
“Qualified items of income, gain, deduction, and loss” is in turn defined in §199A(c)(3) generally to mean such items that are includible in taxable income and are effectively connected with the conduct of a U.S. trade or business (defined by cross reference to existing international tax provisions, with modifications). Certain types of passive, investment-type income are carved out of this definition—the drafters don’t want you to get the deduction just by passively investing. §199(A)(c)(3)(B).
“Qualified trade or business” is defined in §199A(d) to mean “any trade or business other than a specified service trade or business or the trade or business of performing services as an employee.”
So, if you’re working as an employee, you don’t get the deduction. There lies your incentive to not be an employee (in order to get the deduction).
But wait! There’s more!
“Specified service trade or business” is in turn defined as “any trade or business involving the performance of services described in section 1202(e)(3)(A),” including certain securities investing, trading, and dealing and other activities. §199A(d)(2). Existing §1202(e)(3)(A) begins by stating that it includes “any trade or business” but then immediately carves out those involving performance of services in certain fields, such as health, law, engineering, architecture, accounting, athletics, banking, insurance farming, leasing, investing, farming, certain extractive industries, and the running of a hotel, motel, restaurant, or similar industry.
Thus, the statute carves out activities in certain fields from being eligible for the deduction. What the statute giveth, however, the statute also taketh away: This “specified service trade or business” carveout does not apply if the taxpayer’s income doesn’t exceed a certain, high, threshold amount (generally $250k or $500k for joint filers, plus a top-up amount). This means that those operating in the above fields may nonetheless qualify for the deduction, as long as their income isn’t too high.
There are other limitations, including a limitation based on “reasonable compensation”: “Qualified business income” does not include the “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.” § 199A(c)(4). But it’s not entirely clear what “reasonable compensation” means.
In short, the proposed statute provides guardrails and limitations that limit who can take the new deduction. Part 2 of this blog post will address how effective these limitations are and what concerns these new proposed regimes raise.
This post is part of a two-part series. The second part is available here.