By Ryan Ellis
In the last couple of days, a rumor has swirled around the tax world that a special eleventh hour windfall was given to real estate in the new tax reform conference report. The idea was planted by David Sirota, a liberal writer/activist that used to work for Senator Bernie Sanders of Vermont. It’s already been taken on by more responsible tax journalists at Bloomberg, who while acknowledging that real estate owners can benefit also walked through the real intent of the provision–to not exclude capital intensive flow through firms from tax rate relief.
So what’s all the hullabaloo about?
Tax reform cuts the corporate income tax rate from 35 percent to 21 percent. Most businesses, however, are not taxed as corporations. They are taxed as “flow through firms” where profits are not paid by the business, but by the business owners. In order to give these companies tax relief, too, Congress went through several iterations of cutting the tax rate substantially on business income without cutting tax rates that aggressively in general (which would be a far more expensive undertaking and swallow up the rest of tax reform).
This creates an obvious gaming problem–savvy taxpayers will want to turn in their W-2s for 1099-MISCs, and–voila!–become small business owners taxed at lower effective rates. So one of the first things each chamber did was to exclude white collar professional business services (think law, lobbying, medicine, etc.) from the lower business rates.
The House then created a special 25 percent top business rate. However, if an owner actively and materially participates in her business, only three-tenths of her business profit was eligible for the rate, the other seven-tenths being taxed at ordinary rates. This was done in order to recognize that, for active business owners, much of their business activity was in fact labor activity for them. It was also to recognize that some of their activity was a return on capital investment. If a business owner wanted to assert a different labor vs. capital ratio, they could do so and work it out with the IRS.
The Senate took a different approach. There, 23 percent of business profits could be deducted from taxable income. But there was a test involved for businesses of a mature size. The deduction was limited to the lesser of 23 percent of business profits, or half the W-2 payroll the business paid out. That way, the deduction was limited to businesses that had a good number of employees, a clear sign of an actual business and not a tax shelter.
The Conference report adopted the Senate approach, but introduced a second test. Besides the “half of W-2 salary” limit on the 20 percent flow through deduction (the deduction went down along with the top marginal rate in the conference report), there was a second, alternative test one could opt for. Under this test, the deduction is limited to the lesser of 20 percent of business profit, or the sum of one-quarter W-2 wages PLUS 2.5 percent of the original basis of business assets.
This second test allowed flow through firms which are very capital intensive but not as labor intensive to qualify for the lower rate. Picture a manufacturer with a small workforce and most of the manufacturing done by expensive robot machines. The business might own the factory and the very expensive robots, but only have a small workforce to manage the operation day to day. That’s clearly a real business, but it would not have been eligible for the full rate relief under the original Senate version.
The complaint heard recently is that real estate owners can also use the second (wages/assets) test. They don’t have much in wages, either, but they do have business assets–real estate. 2.5 percent of their assets could be substantial. So, is this a last minute payoff to Donald Trump and his real estate friends? I think not:
- The same conference report that created the payroll/asset test also harmed real estate investors in another section. Under the Senate bill, the depreciable life of commercial real estate was reduced from 39 to 25 years. In the conference report, this was reversed back to current law’s 39 years. If the goal was to give a windfall to real estate, this is an odd thing to have done to them.
- The depreciable basis of real property does not include land, only structures. So much of the value of real estate holdings (as much as half the value, depending on the property) will not be eligible for the 2.5 percent asset valuation.
- The asset valuation is based on the original value of the property. If the real estate has grown in value over time, that won’t help for purposes of this test.
- Any real estate which has already been fully depreciated is not eligible for the asset valuation.
So will some real estate benefit from the payroll/asset test? Without a doubt this is true. But to not provide the payroll/asset test would be to deny rate relief to capital-intensive small and midsize firms which are clearly bona fide businesses.
If there’s any gaming or abuse, the IRS is empowered to adjudicate them through rulemaking, audit, and the Tax Court. Should any shelters emerge that were not Congressional intent and beyond the scope of IRS oversight, Congress will tighten up those loopholes by statute. But fear that people will try to game rate relief for flow through firms (and they certainly will) is no reason to shy away from extending that relief.
This objection should be dismissed as the last minute ideological grenade it clearly is–not serious, and even bordering on fake news. Both the Senate Finance and House Ways and Means committees have held hearings and taken meetings on this for well over a year. The JCT analysis of the House product–which includes an ability to assert that a business is capital intensive and deserving of the 25 percent rate on most profits–has been out there since Halloween. The House product actually allowed a far more generous capital asset test than the Conference report does–the report is therefore a true melding of House and Senate approaches to this issue, and one which has been in legislative dialectic since the Obama Administration.
Senate Finance Committee Chairman Orrin Hatch (R-Utah) lays all this out in a very animated letter this morning to colleague and Senator Bob Corker (R-Tenn.), who has been smeared by Sirota and others as somehow orchestrating a windfall for real estate.
It’s been awhile, but this is how Conference reports are supposed to work–reconcile the differing approaches of each chamber, approaches which have been publicly vetted and adjudicated in each body.
What we actually see here is the working out of a Congressional tax policy goal–to respect the fact that business activity is a mixture of labor return for the owners, and capital return for the owners. Capital must be recognized in the taxation of business profits. To pretend that there is not a return on capital in there is inaccurate. This recognition can either be done by a rate blend with an asset assertion, as the House does, or via an asset test, as the Conference report introduces.
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