A Really Bad Tax Cut Idea

Treasury Secretary Steve Mnuchin

President Donald Trump thinks income generated by privately held Palisades Hudson Financial Group should be taxed at the same rate as income generated by Alphabet Inc., Google’s publicly traded parent company. And he thinks the rate for both businesses should be an attractively low 15 percent.

You might expect me to be delighted by this news. I am a Republican, and we Republicans generally believe tax rates should be as low as possible. I also happen to be the owner of Palisades Hudson Financial Group. And I would be delighted with Trump’s proposal, except for one thing: It’s a phenomenally bad idea.

To be more specific, Trump’s proposal that all business income be taxed at the same (low) rate makes rhetorical sense, but not logical sense. To see why, consider the two companies I just mentioned.

Alphabet is what tax nerds call a C corporation. It pays its own income taxes and then, when it distributes remaining income to shareholders in the form of dividends, that income is taxed again at the shareholders’ rate. This means that by the time a single dollar of Alphabet’s pretax income reaches a shareholder, federal taxes have reduced it to as little as 52 cents.

But Palisades Hudson is not taxed that way. Like nearly all owner-operated businesses, it does not pay its own taxes as a separate entity. Instead, its net income is included on the owner’s tax return and is only taxed once. This is what is meant by a “pass-through” entity. Cutting my taxes on Palisades Hudson’s net income to 15 percent would mean my income would be taxed at half the rate of the wages I pay many of my employees, or even less. And this would be the case for many firms nationwide under the proposed rules, including some much larger than mine.

Imagine this hypothetical conversation at a large law firm. A managing partner summons a senior associate to a private meeting. “Congratulations, Throckmorton,” says the senior partner. “You’re a terrific attorney and we’re promoting you to junior partner. You will now get a share of the firm’s immense profits. It won’t be a big share – in fact, it will be lower than the wages you’re getting now as an associate. But don’t worry. Since this is business income, taxed at only 15 percent, your after-tax take-home pay will reflect your exalted new position. Just don’t tell the receptionist that your tax rate is now lower than hers.”

Treasury Secretary Steven Mnuchin indicated yesterday that the administration will fight such abuses through some unspecified means. I can promise you one thing: It will be a nasty and ultimately doomed fight. The administration would have to ask the Internal Revenue Service to determine what a reasonable salary would be for someone like me to pay himself. The IRS would then need to tax that hypothetical, unpaid salary at the higher tax rate applied to wages. Imposed across millions of pass-through business entities in this country, this would be an impossible task, one that would turn taxation into an arbitrary guessing game. Such an approach is also completely unnecessary.

There is a great argument for lower corporate tax rates: to prevent companies from fleeing U.S. jurisdiction in favor of friendlier tax climes abroad. There is also no reason a foreign shareholder of a U.S. corporation should owe American taxes on income the corporation generates outside this country. Moving the corporate tax rate down to 15 percent would take us from the highest corporate rate to one of the lowest among major industrial countries.

In a perfect world, the corporate tax rate would be 0 percent, and all taxes would be paid at the level of the human beings who demand the government services those taxes fund. In the real world in which we live, a suitably low corporate tax rate addresses the objective of generating more economic activity and encouraging investment that will raise productivity and ultimately lift everyone’s living standards. But there is no economic or policy rationale for taxing the income of a business owner at a rate far lower than that of similarly compensated employees who work alongside her. Trump’s plan also calls for cutting the top tax rate on wages, but from 39.6 percent to 35 percent.

I don’t think this part of the president’s proposal has much chance of getting through Congress. But if it did, some people who are cheering it now might change their tune when they inevitably watch their best employees go into business for themselves instead.

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About Larry M. Elkin 564 Articles

Affiliation: Palisades Hudson Financial Group

Larry M. Elkin, CPA, CFP®, has provided personal financial and tax counseling to a sophisticated client base since 1986. After six years with Arthur Andersen, where he was a senior manager for personal financial planning and family wealth planning, he founded his own firm in Hastings on Hudson, New York in 1992. That firm grew steadily and became the Palisades Hudson organization, which moved to Scarsdale, New York in 2002. The firm expanded to Fort Lauderdale, Florida, in 2005, and to Atlanta, Georgia, in 2008.

Larry received his B.A. in journalism from the University of Montana in 1978, and his M.B.A. in accounting from New York University in 1986. Larry was a reporter and editor for The Associated Press from 1978 to 1986. He covered government, business and legal affairs for the wire service, with assignments in Helena, Montana; Albany, New York; Washington, D.C.; and New York City’s federal courts in Brooklyn and Manhattan.

Larry established the organization’s investment advisory business, which now manages more than $800 million, in 1997. As president of Palisades Hudson, Larry maintains individual professional relationships with many of the firm’s clients, who reside in more than 25 states from Maine to California as well as in several foreign countries. He is the author of Financial Self-Defense for Unmarried Couples (Currency Doubleday, 1995), which was the first comprehensive financial planning guide for unmarried couples. He also is the editor and publisher of Sentinel, a quarterly newsletter on personal financial planning.

Larry has written many Sentinel articles, including several that anticipated future events. In “The Economic Case Against Tobacco Stocks” (February 1995), he forecast that litigation losses would eventually undermine cigarette manufacturers’ financial position. He concluded in “Is This the Beginning Of The End?” (May 1998) that there was a better-than-even chance that estate taxes would be repealed by 2010, three years before Congress enacted legislation to repeal the tax in 2010. In “IRS Takes A Shot At Split-Dollar Life” (June 1996), Larry predicted that the IRS would be able to treat split dollar arrangements as below-market loans, which came to pass with new rules issued by the Service in 2001 and 2002.

More recently, Larry has addressed the causes and consequences of the “Panic of 2008″ in his Sentinel articles. In “Have We Learned Our Lending Lesson At Last” (October 2007) and “Mortgage Lending Lessons Remain Unlearned” (October 2008), Larry questioned whether or not America has learned any lessons from the savings and loan crisis of the 1980s. In addition, he offered some practical changes that should have been made to amend the situation. In “Take Advantage Of The Panic Of 2008” (January 2009), Larry offered ways to capitalize on the wealth of opportunity that the panic presented.

Larry served as president of the Estate Planning Council of New York City, Inc., in 2005-2006. In 2009 the Council presented Larry with its first-ever Lifetime Achievement Award, citing his service to the organization and “his tireless efforts in promoting our industry by word and by personal example as a consummate estate planning professional.” He is regularly interviewed by national and regional publications, and has made nearly 100 radio and television appearances.

Visit: Palisades Hudson

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