Intended upside-down marginal tax rates?

If high-income “business owners” manage to use aggressive tax planning that ensures they will pay lower tax rates than many of their own employees under the tax bill, is that a feature or a bug? The more closely you look at the Republican tax bill, the more it looks like the former – i.e., as something that is consciously intended (albeit hidden, to a degree, from clear public view).

A case in point that I have in mind is the personal service corporation (PSC) rules. These rules, which have been in the Code for many years, seek to limit the tax benefits that service providers, if they are independent contractors rather than employees, might otherwise get from incorporating.

For example, under present (pre-2017 bill) law, one might think of incorporating one’s personal service business in order to lower one’s marginal tax rate from 39.6% (the top individual rate) to 35% (the corporate rate), as well as to avoid the 2% floor that applies to certain “miscellaneous itemized deductions,” etc.

Now, at present this is a fairly small-bore game. One generally tends not to save a whole lot of tax liability, and one subjects oneself to the potential of facing two levels of tax, since withdrawals that aren’t within “reasonable compensation” may be taxed as dividends. So the main thing that the PSC rules now do is force one to face the full 35% corporate rate on even the first dollar of one’s PSC income, rather than getting the rate graduation benefits that current (pre-bill) law offers to smaller corporations.

Under the pending tax bill, it seems clear that the drafters, if they were acting in good faith as defined by their stated premises for the legislation, would have wanted to think seriously about using the PSC rules to go after bigger game. After all, the tax rate difference is now quite large – 21% corporate versus 37% individual – and even with the second level of tax there is almost no possible downside to earning one’s income through a PSC rather than directly (at least, once one’s tax rate gets far enough above 21%).

Plus, one would think that the main rationale for the 21% corporate rate was global tax competition, along with the idea of reating returns to saving more favorably than under present law, in the hope of increasing investment. Neither rationale applies when someone is using a PSC to lower the tax rate on his or her earnings from the provision of personal services.  Thus, the use of a PSC, although perfectly lawful, could readily be defined as having the potential to yield unintended tax avoidance if tax policy was being made in good faith (as defined above).

In the House bill, they actually made the PSC rate 25%, as opposed to 20% for C corporations generally. But apparently even that was too harsh for the Senate to tolerate. So there they made the PSC rate the same as the general C corporation rate.

In conference, the House “receded” (and I suspect it didn’t fight very hard). So the PSC rate in the bill is 21%, just like the C corporation rate generally. Let the tax games begin!

Now, it is true that this is formally consistent with the approach taken under prior law, in the sense that there, too, the PSC rate equaled (rather than exceeded) the general corporate rate, and the 35% rule served only to eliminate use of the lower corporate rate brackets by PSCs. (Lower-tier corporate rates are now gone.) But this is not what Congress would have done if it had meant to confine the benefit of the lower corporate rate to instances where the public rationale for it actually applied.

This is a real tell (as they say in poker). It suggests that the bill’s proponents are comfortable, and perhaps even affirmatively happy, with an upside-down rate structure under which business owners will frequently pay lower tax rates than the people who are working for them. I suppose one could call this “Kansas justice,” in honor of Sam Brownback.

Under the conference bill, as soon as your taxable income reaches $45,000 if you are single, or $90,000 for a married couple, your marginal tax rate rises to 25%. Starting in 2018, there will be a whole lot of incorporated “business owners” who will be paying lower marginal tax rates than many of their employees.