Tax Reform – Unintended Consequences

Take-Away: We are told that the pending proposals to change the Tax Code will result in simplification for millions of Americans. That may well be the case with the doubling of the standard deduction that both the House and Senate Bills propose. But there may be a lot more ‘gamesmanship’ afoot if the Senate Bill takes center-stage with its proposals as well as a serious dent in the amount Americans give to charity each year.

Observations- Guesses:

• Dwindling Charitable Gifts: I mentioned last week. I really worry if charities are not going to be hit hard by virtue of the proposed tax reform. Taxpayers, even those charitably inclined, are motivated by income tax deductions to go along with their charitable giving. While both Bills propose to keep the charitable deduction in some form, there is a concern that if most taxpayers are no longer able to deduction state and local income taxes,  a ‘cap’ is imposed on mortgage loan interest paid, and the health and medical expense deduction disappears completely, about the only income tax deduction that many taxpayers can predictably claim is the deduction for any real property taxes  they paid- up to $10,000 a year. For a retired couple who own their home outright with no mortgage,  and who live primarily on social security and required minimum distributions, they will only have the real property taxes paid on their home as an available income tax deduction. The ‘doubled’ standard deduction is supposed to be $24,000 a year for a married couple. In this context, the retired couple will have to give a lot away to charity, when added to their real property taxes paid on their home, to get above the $24,000 standard deduction I a single tax year, to able to file an itemized income tax return  where the tax deduction for their charitable gifts will have an impact on the donors’ income tax liability. I worry that with no income tax deduction incentive, will the amount taxpayers give to charity each year dramatically drop.
• Enter the Independent Contractor: For the first time ever, the Senate Bill distinguishes taxable income by type of earnings, personal characteristics, or economic activities. In the past we all paid income taxes on our earnings, each facing the same income tax rates. But under the proposed Senate Bill, wage income is treated differently (subject to higher income tax rates) than business income. An employee will pay a higher income tax than an independent contractor or business that makes the same level of income. Because of this proposed distinction between wage income and business or independent contractor income, an incentive will exist to label income artificially, or to restructure or switch categories in the hunt for lower income tax rates. Implications? (i) some employees will switch to become independent contractors, to lower their ‘wage’ income; (ii) some professionals will incorporate, e.g. a dentist earning a high income and being exposed to a 39.6% federal income tax rate will incorporate since his/her professional corporation will be taxed at a 20% tax rate; adding an even greater incentive to incorporate is the fact that while individuals cannot deduct state and local income taxes paid on their income tax returns, businesses like professional corporations are permitted to deduct state and local income taxes paid on their income tax returns under the Senate Bill; and (iii) other professionals will either form, or lobby to become partners, e.g. a staff attorney who is an ‘employee’ will lobby to become a partner, as partnerships will qualify for a 23% tax deduction under the Senate Bill for ‘pass-through’ entities. Will every employee want to become an independent contractor to take advantage of the lower income tax rates imposed on ‘businesses.’ Will partnerships be formed solely to take advantage of the 23% tax deduction that was not previously available?

We obviously do not know what the final tax reform law will look like, but despite promises of its simplification, if the income tax rate and deduction distinctions between employment wages and business income become part of the new tax law, expect a lot of business formations arising from the ubiquitous hunt for lower income tax rates.