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Pass-through Taxation and C-corp election; Schumpeterian motivations; politics; the financial accounting problem for earnings definition

January 2nd, 2018 Leave a comment Go to comments
​​  This is quite a technical post, but some people will be interested.

On Mon, Jan 1, 2018 at 1:02 PM, Someone wrote me about the question of whether the Passthrough tax cut isn’t a big deal ,because even without it, if we slash the rate of taxation on C-Corporations a partnership could elect to be taxed AS IF it was  a C-corporation.  It turns out there are interesting complexities involved.

He wrote to me:

. . . You’re right that taxpayers can get some of the same benefits by electing CCorp status and reinvesting the earnings.  And it’s a great point.  But:
— (1) Stepped-up basis gets you out of the capital gains tax on your CCorp shares; it doesn’t get you out of CCorp-level tax on gains within the CCorp.  (Whether a one-time tax of 29.6% + 3.8% is better than a two-time tax of 21% will depend on how much the relevant asset appreciates.)
— (2) There is a largely forgotten section of the Internal Revenue Code — Subchapter G — that’s supposed to prevent me from piling up earnings in a CCorp: https://www.law.cornell.edu/uscode/text/26/subtitle-A/chapter-1/subchapter-G/part-I.  The IRS hasn’t had much of a need to enforce it for the past several decades, so we’ll see how much good Subchapter G does.  In theory, it should prevent me from running a consulting business through a CCorp and keeping the $$$ inside the corp until I die.
— (3) One criticism of the passthrough deduction is that no one really knows its contours.  Consider in particular the definition of “specified service.”  “[A]ny trade or business involving the performance of services in the fields of health, law, 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.”  Is Alinea a specified service?  (Its principal asset is arguably the reputation and skill of its head chef.)  If the Washington Post reorganized as a passthru, would it be a specified service?  (It’s principal asset is arguably the reputation and skill of its reporters and editors.)
— To which you might respond: But the definition of “reasonable needs of the business” in § 537 is fuzzy too.  So with the cut to the CCorp rate, we were bound to end up in a morass; the passthru deduction is simply a different route to the same morass.  (And isn’t almost everything in tax law — from the definition of gross income onwards — fuzzy at the edges?)
— (4) If we imagine a future in which the CCorp rate rises to 28%, then accumulating earnings in the CCorp becomes much less attractive.  And that seems like a plausible outcome in 2021.
— But in any event, I think the general claim is correct: The passthru deduction isn’t such a great break if CCorps can be used to accumulate earnings, taxpayers are reasonably confident that the low CCorp rate will stick, and individuals are interested primarily in passing on wealth to their kids.
 I wrote back with my thanks and with a few other thoughts on other aspects of the tax cut:  possible public policy motivation, who wins and loses, and  assorted thoughts on how tax rate changes should affect financial accounting earnings:

 

(1) I think the vague idea behind the passthrough tax cut is to  encourage non-public  businesses that aren’t pure services—manufacturing, construction, retail, and suchlike, but not finance, law, clinics, insurance, etc.

 

Why do that? Again, it’s vague, but the idea would be that when these businesses are created or expand they help the economy more than when a pure-service business grows. They have some kind of positive externality. They are more likely to be “entrepreneurs” in the Schumpeterian sense of exploiting  a new opportunity instead of just adding to “the circular flow” like mere employees do.

That may actually be true, even though it is false in the standard economic model, because we have a hard time understanding innovation, especially “soft” innovations like starting the first Chinese restaurant in town. It is like Keynesian stimulus— a plausible idea, very attractive, sort of common sense, but very hard to make sense of once you go into it deeply with a formal model. So, as with Keynesian stimulus, my own view is that public policy shouldn’t act on the idea, because while it may possibly be true, it very certainly is attractive for the bad reason that it’s an excuse to use government power to transfer wealth to influential voting groups. In both cases, the construction industry, which is notoriously corrupt, comes out a big winner.

(2)  It should be noted, though, that the tax bill is NOT a giveaway to the wealthy. We can call it a giveaway to a certain group of wealthy people, but not to the wealthy in general. It’s mostly tax cuts, so in that sense it helps everyone, but my casual take is that it has mainly shifted the burden of taxes from rich small businessmen to rich employees and from itemizers to non-itemizers. It’s  fair to say that it’s shifting taxes from rich Trump voters onto rich Clinton voters too

(3) I want to encourage you to think about  how the tax bill SHOULD affect earnings.  The ACTUAL effect is something Peter Reilly has written about.  It’s a hard and important question that more-than-normally requires a  mix of practitioner and theoretical knowledge.

    The basic question is how financial accounting should reflect changes in future taxes when it comes to the crucial summary number, “earnings”, which is supposed to measure profit in a given year. It is part of the bigger problem of what to do when a “stock”, an asset or liability, has a one-time change in value that actually reflects changes in flows over various years.  I was writing up some notes yesterday. They’re confused, and I gave up, but I want to encourge thought on the issue, and  a tax practirtioner to find some tax professor, accounting professor, or finance professor to talk about it with.

  FAILED NOTES: 

How SHOULD earnings reflect tax rate cuts? It is a stock vs. flow problem. SUppose currently the company has 100 million in loss carryforwards, and the tax rate is 40%. Those are valued as a $40 million tax asset. Now the tax rate is cut to 20%, so those $100 million will only save $20 million taxes.  The company’s stock is worth more than before, because its future taxes are lower, but its accounting assets have fallen by $20 million on the balance sheet, the accounting statement of the firm’s   value   based on past events.  How should this be reflected in the accounting statement of the firm’s “flow” value— its earnings in 2017?

   What if we said it had no effect? It’s true that nothing happened in 2017 to reduce the firm’s value, so saying it lost $20 million is misleading that way. But this has a couple of problems:

A. This firm DID lose value relative to other companies. Other companies, with no loss carryforwards, get $20 million more future value out of the tax cut than our company does. Imagine a firm that never had to pay income tax. If there is an income tax cut, all the other company’s stock prices should rise, but not the no-tax firm. So, our  company ought to look like it didn’t have as good a year as the others.

B.  Back a few years earlier, when the company had the actual losses, its earnings were adjusted UP to reflect the fact that it could carry forward the losses and save on future taxes. So back then, viewed from what we know now, we valued the earnings too high, and now we ought to compensate by “taking back” that mistake. It’s like when  a company has invested $40 million in a new factory and then it turns out to be a failure and is sold for scrap for $20 million, so there is a $20 million loss. We take the entire loss in the current year, even though the mistake was made several years back when the factory was built and the company in effect threw away $20 million by a bad investment.

    Still, 2017 earnings are going to be misleading. I don’t know what should be done. 

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