Some implications of the New Tax Law that are not being discussed

[DarterBlue]

So we have heard a lot about the tax cuts to: corporations, individuals, and estates. We have seen debates over the fact that is estimated the passage of the new legislation will add between at least $1 trillion to $2 trillion to our national debt over the next ten years. We have even heard from those that argue that as a result of 4% projected growth, the legislation will actually pay for itself (not add to the national debt) due to the effects of the Laffer Curve, that beloved theoretical construct of Supply Side Economics.

However, there are other effects of this legislation that will have a much more immediate impact on the common man or woman in the street that have received very little attention, either because of ignorance of the law and its potential effects; ignorance of income taxes in general; or, perhaps, more insidiously, because some of its implications may end up having profound effects on working Americans, and not necessarily in a good way, I might add.

The biggest provision that will impact average Americans more than they now think has to do with the special treatment afforded pass through entities (Sub S Corporations, LLCs, and other related types of pass through entities). Under this special treatment, the first 20% of net income earned (subject to certain income limitations for certain occupations) would be exempt from Federal Taxes. For those that don't know, a pass through entity is one that does not pay Federal Income Taxes itself, but rather passes its net income or loss on to its owners (shareholders, members, etc.), who reflect the results of this activity on their own tax returns (1040s in the case of individuals). Thus, if Jack and I are 50/50 owners of a Sub S corporation, and its net income is $100,000, $50,000 of this income would currently be reflected on my return with the same amount reflected on Jack's return. Of course, if Jack and I are also employees of this Sub S corporation, then we would also reflect any W-2 wages earned on a separate line of our 1040s. Also, payroll withholding taxes including FIT and FICA, would be withheld from such wages, but not from our share of the profits ($50,000 each in this example).

Historically, small business owners have used Sub S corporations to reduce their total tax liability since the profits have been exempt from FICA taxes. Thus, they would take smaller salaries than the positions justified and would have a concomitant increase in their net income which would avoid the payroll taxes, even though it would be subject to Federal Income Taxes on the 1040. Nothing wrong with this when you are running a legitimate business. You are making the bet that you can save and invest the savings to earn a better return than the reduced social security benefits would provide. 

In the case of LLCs, the situation becomes even more interesting. Under current law, subject to certain caveats, LLCs can chose to be taxed as: Corporations, Partnerships or Individuals (dis-regarded for Federal Tax purposes). Many small business chose to use the simplicity of just reporting the LLC income on Schedule C of their individual 1040s. This income would be treated as ordinary income and used to be taxed at the individual's individual rate. It was also subject to FICA at 15.3% subject to an above the line adjustment for the related expense. Well, now, it would be stupid for an LLC owner to go the individual Schedule C route. Far better to treat the entity as a Partnership and enjoy the benefits of a 20% profits exemption and avoid the burden of FICA taxes. 

The immediate consequences of the three paragraphs immediately above, is that there will be a flood of incorporations, as small business and individuals seek to reduce/avoid taxes. And, anyone that has the bargaining power with his/her employer may seek 1099 status, so as to have his "regular pay" avoid FIT and FICA withholding as he/she chooses to pass this income through his/her newly incorporated status. Certainly from a tax standpoint this would seem to make sense. Of course, the former employee may be giving up valuable benefits such as health insurance, 401k, vacation and just regular job security. But in the rush. may be tempted to do so without fully thinking this through. 

As a consequence of this, even if we do attain 3%+ economic growth for the next ten years, it is very unlikely that our national debt will not explode, probably by a lot more than the $1 to $2 trillion increase projected as a direct consequence of the legislation (bear in mind we were already on track for a $6.67 trillion increase before the legislation based on current expenditures in relation to current taxes). More scarily, the rush to S Corp status and the consequent avoidance of/reduction in FICA tax collections will put both Social Security and Medicare in even more jeopardy than they are already in, unless there is a raising of the cap or a raising of the age requirements. This comes right in the heart of the Baby Boom exodus from the world of the employed as more and more of them retire. The sad irony of all this, is that our demographics, longer term could have bailed the system out for at least the next 40 to 50 years due to the large size of the millennial generation. Of course, this presupposes that these youngsters had good jobs (which has become far less likely in the era of Globalization).  

Another provision with immediate consequences not being discussed, is the elimination of personal and dependent exemptions. Doubling standard deductions is all fine and dandy. However, for mid sized to large families, what the Government giveth, is immediately taken back in the vanishing personal exemption. In fact for those that itemize, it is not clear that the increase in the standard deduction was even a benefit since they would have taken the itemized expenses instead of the standard deduction, as their itemized expenses may have already been close to or in excess of the additional standard deductions. For a country that wants to curb immigration (and I am not necessarily against this), this is a rather odd tax change as it will provide a disincentive to procreation. And in the case of lower middle income individuals and the working poor, it will also provide a disincentive to help out less fortunate family members who may have fallen on hard times. 

Whether the above was done intentionally or not, is moot. And I will leave each of you to judge based on your own ideological lenses. However, it will have a profound impact on: government, employment, and, perhaps our entire social structure over the next decade.   

[TheMaximumHornetSting]

4 hours ago, DarterBlue said:

So we have heard a lot about the tax cuts to: corporations, individuals, and estates. We have seen debates over the fact that is estimated the passage of the new legislation will add between at least $1 trillion to $2 trillion to our national debt over the next ten years. We have even heard from those that argue that as a result of 4% projected growth, the legislation will actually pay for itself (not add to the national debt) due to the effects of the Laffer Curve, that beloved theoretical construct of Supply Side Economics.

However, there are other effects of this legislation that will have a much more immediate impact on the common man or woman in the street that have received very little attention, either because of ignorance of the law and its potential effects; ignorance of income taxes in general; or, perhaps, more insidiously, because some of its implications may end up having profound effects on working Americans, and not necessarily in a good way, I might add.

The biggest provision that will impact average Americans more than they now think has to do with the special treatment afforded pass through entities (Sub S Corporations, LLCs, and other related types of pass through entities). Under this special treatment, the first 20% of net income earned (subject to certain income limitations for certain occupations) would be exempt from Federal Taxes. For those that don't know, a pass through entity is one that does not pay Federal Income Taxes itself, but rather passes its net income or loss on to its owners (shareholders, members, etc.), who reflect the results of this activity on their own tax returns (1040s in the case of individuals). Thus, if Jack and I are 50/50 owners of a Sub S corporation, and its net income is $100,000, $50,000 of this income would currently be reflected on my return with the same amount reflected on Jack's return. Of course, if Jack and I are also employees of this Sub S corporation, then we would also reflect any W-2 wages earned on a separate line of our 1040s. Also, payroll withholding taxes including FIT and FICA, would be withheld from such wages, but not from our share of the profits ($50,000 each in this example).

Historically, small business owners have used Sub S corporations to reduce their total tax liability since the profits have been exempt from FICA taxes. Thus, they would take smaller salaries than the positions justified and would have a concomitant increase in their net income which would avoid the payroll taxes, even though it would be subject to Federal Income Taxes on the 1040. Nothing wrong with this when you are running a legitimate business. You are making the bet that you can save and invest the savings to earn a better return than the reduced social security benefits would provide. 

In the case of LLCs, the situation becomes even more interesting. Under current law, subject to certain caveats, LLCs can chose to be taxed as: Corporations, Partnerships or Individuals (dis-regarded for Federal Tax purposes). Many small business chose to use the simplicity of just reporting the LLC income on Schedule C of their individual 1040s. This income would be treated as ordinary income and used to be taxed at the individual's individual rate. It was also subject to FICA at 15.3% subject to an above the line adjustment for the related expense. Well, now, it would be stupid for an LLC owner to go the individual Schedule C route. Far better to treat the entity as a Partnership and enjoy the benefits of a 20% profits exemption and avoid the burden of FICA taxes. 

The immediate consequences of the three paragraphs immediately above, is that there will be a flood of incorporations, as small business and individuals seek to reduce/avoid taxes. And, anyone that has the bargaining power with his/her employer may seek 1099 status, so as to have his "regular pay" avoid FIT and FICA withholding as he/she chooses to pass this income through his/her newly incorporated status. Certainly from a tax standpoint this would seem to make sense. Of course, the former employee may be giving up valuable benefits such as health insurance, 401k, vacation and just regular job security. But in the rush. may be tempted to do so without fully thinking this through. 

As a consequence of this, even if we do attain 3%+ economic growth for the next ten years, it is very unlikely that our national debt will not explode, probably by a lot more than the $1 to $2 trillion increase projected as a direct consequence of the legislation (bear in mind we were already on track for a $6.67 trillion increase before the legislation based on current expenditures in relation to current taxes). More scarily, the rush to S Corp status and the consequent avoidance of/reduction in FICA tax collections will put both Social Security and Medicare in even more jeopardy than they are already in, unless there is a raising of the cap or a raising of the age requirements. This comes right in the heart of the Baby Boom exodus from the world of the employed as more and more of them retire. The sad irony of all this, is that our demographics, longer term could have bailed the system out for at least the next 40 to 50 years due to the large size of the millennial generation. Of course, this presupposes that these youngsters had good jobs (which has become far less likely in the era of Globalization).  

Another provision with immediate consequences not being discussed, is the elimination of personal and dependent exemptions. Doubling standard deductions is all fine and dandy. However, for mid sized to large families, what the Government giveth, is immediately taken back in the vanishing personal exemption. In fact for those that itemize, it is not clear that the increase in the standard deduction was even a benefit since they would have taken the itemized expenses instead of the standard deduction, as their itemized expenses may have already been close to or in excess of the additional standard deductions. For a country that wants to curb immigration (and I am not necessarily against this), this is a rather odd tax change as it will provide a disincentive to procreation. And in the case of lower middle income individuals and the working poor, it will also provide a disincentive to help out less fortunate family members who may have fallen on hard times. 

Whether the above was done intentionally or not, is moot. And I will leave each of you to judge based on your own ideological lenses. However, it will have a profound impact on: government, employment, and, perhaps our entire social structure over the next decade.   

 

[DarterBlue]

Was not sure whether I should have given you the smiley face or the sad face. But, yes, the position in the cartoon probably says it all.