As a Significant Potential Beneficiary of Trump's Tax Plan, I Will Say It Makes No Sense
Trump's tax plan makes little sense to me, and much of what I have seen written about it today is so full of misunderstandings about taxes and small businesses, I thought I would try to supply a bit of context for my contention that the plan makes no sense. As a caveat, Trump is seldom careful when he chooses words, so it could well be that I am working off of a media misinterpretation of his proposal.
I own an S-Corporation, which is the source of nearly all my personal income. In an S-Corporation, there is no corporate income tax per se. The corporation fills out an (extensive) set of tax forms, but the corporation does not write a check based on the corporate return. Instead, whatever amount is on the bottom line as taxable income in the corporate return passes through to my personal income tax return, where it is added to any other income I have (e.g. I pay myself a salary from the company, I get some interest income, etc) and I am taxed on that total based on my personal income tax rate.
For an individual owner, this structure makes a lot of sense, and this can best be understood by looking at the alternative, which is a traditional C-corporation. In a traditional C corporation, the corporation has a tax return just as in the S corp but, and this is a big difference, the corporation actually pays taxes based on this return on a corporate tax schedule. But the income is still sitting in the corporation. If the individual who owns the corporation wants this money, and presumably she does as why else be in business, then the corporation must dividend this money to the owner. The dividend triggers a second taxable event -- that dividend of the after-tax profits of the C corporation is then taxed again in the individual's tax return. I read today in the Wall Street Journal that "the appeal of becoming a pass-through business jumped after a 1986 U.S. tax overhaul set the top rate for individuals lower than the top rate for corporations." I don't think this is at all true -- the appeal was never one of differential rates, because to get income in an owner's pocket always has required it be taxed at individual rates. The appeal of the S corp is that the income does not need to be taxed a second time, at the corporation level.
In being the owner-operator of a C corp, one has to constantly worry about the double taxation problem. A popular solution is for the owner to simply pay himself the entire expected income of the corporation as a salary, this effectively eliminates the corporate level tax as there is no income left to tax, and so all the income is taxed on the individual's return as salary. Another popular dodge has been to lend rather than dividend the corporate income to the owners. This eliminates it being taxable on the individual return at the time the income is passed over, but this merely defers individual taxes until the loan is forgiven or until the company is sold or liquidated and the loan netted out.
S-corp owners like myself don't have to worry about all this mess -- the decision as to how much I pay myself in salary vs. how much I get paid in dividends is largely irrelevant to my taxes. If the company has income, before owner's salary, of $100,000 then my taxes are essentially the same whether I take $95,000 in salary or $5,000 in salary -- all $100,000 is going to get taxed at the individual rate on my 1040 whether I call it salary or corporate income -- this is true because on the income statement, the owner's salary is a deduction from income, so income goes up by the same amount that the owner's salary goes down. (Note that this is not exactly correct -- there is a small difference in that a higher salary increases payroll taxes somewhat that are not incurred on dividends).
I can't totally figure out how the Trump plan is intended to work, in part because one can argue that the S-corp corporate rate is already zero, so what does it mean to "lower" it to 15%? But my best guess is that he is saying that for pass-through entities like S-Corps, pass through income would only get taxed on the individual 1040 at a maximum of 15% while the rest would get taxed at the regular rate, whatever that is. There is a lot that is unclear - for example, for purposes of computing tax brackets for the rest of my income, does the pass-through income count? But assuming all this is sorted out, owners like myself would find ourselves with a strange set of new incentives. For example, depending on my tax bracket, my incentive would likely be to pay myself nothing in salary. Anything I pay myself in salary would be taxed at a higher rate, apparently, than anything that passes through as income.
My guess is that someone is confused here, either in communicating or putting together this plan (given Trump's haphazardness and lack of precision in communication, I would bet on the communication error). The WSJ described the pass-through rate being dropped to 15% in parallel with the C-C0rp max rate dropping to 15%, but those two rates are not at all parallel. The C-Corp rate is part of a double taxation chain. For that income to be useful to anyone, it has to pass through (either as dividends or higher equity prices) to individuals who pay individual taxes on the income as well. So in this plan as described, income in C-Corps that are then passed on to their owners as dividends are taxed at 15% + individual rate. But the income tax for S-Corp income passed to its owners about be 15% total.
Look, I will happily take this, but if this plan is really being described well, it is stupid and senseless. Someone doesn't really understand pass-through entities.
My alternative is still to get rid of the corporate tax code completely. Forget all the costs spent on corporate tax lawyers and all the distortive things corporations do to manage taxes. Tax everything once, when it reaches the 1040. Here is my plan I have proposed on a number of occasions (pass-throughs would be kept as-is, this is for C-Corps):
So here is my simply two-point plan
- Eliminate the corporate income tax. Entirely
- Tax dividends and capital gains as regular income on individual tax returns
Done. All corporate profits get taxed but only when they pass through to individuals as capital gains or dividends. I think this would actually raise more money but rates could be adjusted (or better yet deductions eliminated) if needs to keep it neutral.
kidmugsy:
"depending on my tax bracket, my incentive would likely be to pay myself nothing in salary. Anything I pay myself in salary would be taxed at a higher rate, apparently, than anything that passes through as income." That's the position we have in Britain. It's flattering that Trump should seek to copy it. Our own government, however, is keen to reform it on the grounds that Her Majesty's Revenue and Customs loses too much tax from people acting on these incentives.
I like your scheme, but I fail to see how it would lead to more jobs for civil servants or more power for politicians.
April 26, 2017, 11:10 ammx:
Aside from the fact that they fundamentally don't seem to understand how pass-through entities work, what they announced today simply isn't a tax plan. It's a Republican fantasy regurgitated into a set of detail-less bullet points.
They can't even say vaguely what this would mean in terms of savings for a median income family of four. If you haven't done that, you're simply not a serious person. You haven't actually done the work necessary to produce something coherent enough to be called a "plan." They can't even say what income levels the brackets will apply to. Nobody can look at this and have the slightest clue how it will change what they pay each year. Nobody can look at this and have the slightest clue what it will cost in revenue.
It's not that the proposals are good or bad, there's plenty of room to debate every one of them, but they're so vague that there's just nothing to see here.
April 26, 2017, 11:28 amPeabody:
I had seen this 15% pass through rate earlier and as an S-Corp owner was both thrilled and confused. I agree this has to be a communication mistake somehow or just a handwaving of stuff without thinking it through.
My tax plan is the same except for step 3 (which was mentioned in passing). Eliminate all personal deductions.
April 26, 2017, 1:07 pmPeabody:
In the US there are rules regarding paying yourself a reasonable salary as an S-Corp owner. There is obviously debate on what is reasonable based on your job duties. However, unless you are doing something like just cashing royalty checks for previous work, you can't pay yourself nothing in salary. (Edit: or you are making little to no profit)
April 26, 2017, 1:09 pmtewkewl:
The fact that you use the word dividend instead of distribution reduces your credibility regarding this topic enormously. The truth is that most S Corp owners make most of their money based on Equity distributions. Dividends are something else entirely and are not paid out by an S corp. The fact that he did not recognize this means that you do not understand the true tax benefit of having an S corporation. The 15% rate has to do with the tax that is paid on the distribution amount which is currently 20%. The distribution amount is considered long-term investment income. Long-term investment income is taxed at 20%. The trunk tax plan will reduce that to 15%. This means that S Corp owners stand to gain a tremendous amount bye having their distribution tax reduced by 5%. That is the benefit that we small business owners were looking for in the Trump plan.
April 26, 2017, 1:12 pmPeabody:
I did notice the incorrect usage of the term dividend, however, I don't find it too uncommon even amongst those knowledgeable in the area to incorrectly use dividend. But clearly they are very different.
However, I believe you are a bit mistaken in the taxing of distributions. Technically, distributions are usually not taxed. Rather, the owner is taxed at their individual rate for their proportional share of the S-corp profits. This is regardless of whether the profits are distributed or not, though typically most of the profits are distributed. Distributions can be taxed at the 20% long-term investment rate if they exceed the owner's basis in the company.
Aside from using the term dividend instead of distribution, I don't see anything wrong with Warren's understanding and analysis of S-Corp taxation.
April 26, 2017, 1:33 pmherdgadfly:
Corporations don’t pay the corporate income tax. Those who suffer from the existence of the tax are company workers, with lower wages, customers, with higher prices and shareholders, with lower profits. Abolishing the corporate income tax ) would have many extremely positive effects for the American economy such as repatriation of billions of dollars languishing overseas in foreign investments and corporations moving offshore to avoid taxes would cease. Increased cash for american companies begets an economic boost like no other as we would see increased capital investments here and higher pay for all workers.
Too bad that Trump is incapable of understanding free trade and freed-up cash as the real secrets of capitalism. Get the government out of the way and we will be fine going forward.
April 26, 2017, 3:30 pmmarque2:
Whatever, if it weren't Trump and were say Jeb!, Warren and you would be cheering, and complementary. Trump, wants to lower the tax rate and libertarians and liberals call him an idiot for no apparent reason. This reasoned blog post isn't any better than the "un-reasoned" one page preliminary tax proposal presented by the administration.
Libertarianism has certainly jumped the shark if this is what we get.
April 26, 2017, 3:59 pmFred_Z:
If corporate taxes were to be abolished some care would need be taken to consider taxing money dividended to foreigners, both resident and non-resident.
Abolishing the corporate tax would result in a yuuuuuuge wave of investment flow into the USA. That would not just be repatriated corporate subsidiary profit but new investment from all the world.
I am a Canadian resident in Canada and already own a lot of NYSE and NASDAQ stocks, so all of these things affect me as well. To put it mildly, I am intensely interested in the topic. I don't think there is any government in the world that as yet understands "Tax Incidence", the study of who actually pays a tax. I am much indebted to a British blogger, Tim Worstall (http://timworstall.com/) who explained the rudiments to me.
By the way, thanks Yanks for lately eating so much McDonald's, whose stock my wife ordered me to buy in 2001, after watching me and our two sons lovin' it.
April 26, 2017, 4:23 pmFred_Z:
Quite right, but don't forget that workers are just a type of supplier. All of the suppliers, not just workers, have to pay a piece too. The chain of payors goes back and back and back through corporations until it reaches the anchor - always a human being.
April 26, 2017, 4:26 pmmx:
Since you don't know me or my politics, I'm not sure how you would know that I would be cheering whatever hypothetical tax plan Jeb! might cook up.
But my point isn't even whether this plan is good or bad; it's that this isn't a plan. This is a document with the same level of specificity as the wishlist tax proposals of the average President of a College Republicans chapter. Actually, I suspect most of them could do better. A set of bullet points that doesn't even say approximately what income levels the rates applies to just doesn't cut it. This is the federal government, not a rinky-dink campaign operation. There were supposedly hundreds of staff working on this proposal. So what were they all doing? I'm not saying every fine detail of the legalese has to be worked out at this stage, but if you can't answer the basic question of "so how much am I going to have to pay?," you haven't actually produced a tax plan.
Libertarianism doesn't have to stand for things being done poorly just because the end goal is less government. A real plan would detail the actual rates, who they apply to, and the overall net change in government revenues. People could then evaluate the plan based on how it will impact themselves, how it will impact others, and how it will impact the deficit (taking into account whatever dynamic growth models they think are realistic), and then they can argue about it until they're blue in the face. It's impossible to do that here because they haven't bothered to produce a plan that is capable of evaluation.
April 26, 2017, 6:03 pmslocum:
Yep. If you try paying yourself nothing in salary and everything in distributions but you're actively working in the business, the IRS will come calling.
April 26, 2017, 6:51 pmJust Thinking:
Often, Warren is astute. But sometimes he is not. It matters a great deal whether S Corp owners pay themselves a salary or take DISTRIBUTIONS (not dividends). Although both S Corp distributions and salaries are taxed at the same income tax rate, the former is free of the 15.3% social security tax rate. Therefore, S Corp owners prefer distributions as opposed to salary. (Astute people know that social security taxes paid on salaries above $54000 have little impact on Social Security benefits received in retirement.) Of course, the IRS realizes the incentive to for distributions rather than salary, and therefore will challenge salaries that are abnormally low -- although the IRS is lenient on this issue in the first year or two of an S Corp's existence.
April 27, 2017, 12:48 amNevertheless, I am not sure what is meant by the phrase that Trump's plan will lower S Corp's tax rate to 15%. However, I see no reason to get excited about this phrase before seeing the actual proposal.
slocum:
Yep. Profits are taxed. Distributions aren't. Money left in business accounts can be distributed at any time without effect on your taxes. Of course, if you don't earn any profits, there won't be anything to distribute. But profits are what are taxed, not distributions.
April 27, 2017, 5:12 amCC:
I 100% agree with your proposal for multiple reasons. The double taxation makes US C corps very uncompetitive. It causes them to spend oodles of money doing accounting and tax preparers--not productive activities. There are incentives in the tax code for corps to do things that are not good for business or that are irrelevant to their business.
April 27, 2017, 9:04 amWhen people compare tax burdens between US and other countries, they often make a mistake. They count only fed taxes, not social security, medicare, sales, property and state taxes. The total tax burden is what is important. In Europe governments love the VAT (an accounting nightmare) because it hides the taxes from consumers.
One reason people want corps to pay taxes is they view corps as big guys who can afford it (ie, it is "not fair" if they don't pay). But if a business is healthy it can afford to hire, is less likely to go bankrupt, pays more dividends into people's retirement accounts, can more easily invest in new business etc. But these latter things are invisible.
TruthisaPeskyThing:
After reading a bit more on the issue, I have these comments. It appears that Trump's proposal is to replace the individual tax rate on business income with a business tax rate of 15%. I fully understand the stupidity of double taxation on corporate income, but this 15% tax rate on individual business income does not make sense to me. A progressive income tax will be part of our economic landscape, and enabling individuals to turn their income into business income taxable at 15% does not make sense to me.
April 28, 2017, 9:33 amAnother part of our economic landscape will be double taxation on corporate income. Yes, it is stupid, but given the economic illiteracy of the population -- and especially the illiteracy of the media and Democrat politicians -- we will have that double taxation. Perhaps a way to reduce the problem of that 2nd tax is to an idea that we abandoned many years ago, and that policy was to exempt the first $xxxx of dividends from individual tax. It would be easy to put that line back on Form 1040: for example, the first $5000 of dividends could be exempt from individual income tax. It would be a nice progressive tax feature.