The tax reform plan currently being debated in Congress is a complicated endeavor with many moving parts, and it can be hard to grasp what it ultimately means for the average American.
To get a better understanding of areas as disparate as brackets, the alternative minimum tax, and S corporations, we sat down with Stanley Veliotis, Ph.D., an associate professor of accounting and taxation in the Gabelli School of Business.
Full transcript below:
Patrick Verel: What are your general thoughts on the tax reform plan that’s being debated in Congress right now?
Stanley Veliotis: One thing I like is that they are attempting to go towards simplification. There are a lot of provisions they’re trying to get rid of that will simplify the tax return, and probably do get to the point where they can have that little postcard that more and more people could file. I’m still sort of up in the air as to what the true redistribution of wealth part will be. As a teacher of tax, as a person that writes about this stuff, I like the complication because it makes me feel important and powerful, knowledge being power, but in the end it is very inefficient for people to be spending more money on a particular tax bit of advice.
Patrick Verel: One of the key features of this tax bill being debated is a reduction of the tax brackets from seven to four. Why does this actually make tax planning harder, though?
Stanley Veliotis: When you go from having the seven or eights we have now, which start at 10 percent and slowly get up to 39.6, with chunks of income progressing from 10 to 15 to 25 to 28, a person can get used to their tax bracket. So if they work a little bit of overtime, they’ll know, okay, I’m probably still gonna pay the same marginal tax rate on the next bit of overtime that I make, or a bonus that I get if I’m a Wall Street banker. If you start having longer and longer tranches of income subject to a rate, and then all of a sudden the next tranch of income is taxed at double the rate as you go from 12 to 25 percent, it’s pretty dramatic.
Because if all of a sudden I work enough overtime or make a bonus that’s big enough to then throw me into that next tax bracket, let’s say going from 85 to 95,000 is where the rates jump from 12 to 25 percent, all of a sudden I’m getting a bonus that I thought would have been taxed at 12 percent based on my common experience. Under the new law all of a sudden its being taxed at double the rate. Sometimes people don’t want to work a little bit harder if they’re not going to keep as much of the money as they’re used to keeping. Of course, the comeback is well, just having three or four rates is much more simple for people, but in the end that’s a trivial marginal benefit to people, because we have software that calculates the stuff, the forms have all this built in. I don’t like the drastic 12 to 25, 25 to 35, I like slight increments.
Patrick Verel: You’re also not a fan of creating a repatriation holiday that allows U.S. corporations to bring home overseas earnings, which I understand is also a feature of the proposed legislation.
Stanley Veliotis: So the way the law works now and for many, many years, the U.S. multinational corporations based in the U.S., they don’t consolidate their foreign operations on their U.S. tax return when the report to the I.R.S., they only report their U.S. activities. The foreign corporations that these big companies have overseas, that income’s taxed by the U.S. only when it’s brought back as a dividend, the so-called repatriation, the money comes back home. So what all these companies are doing is, they don’t want to bring the money back home ’cause they don’t want to pay the U.S. tax on it. So they park it overseas.
About 13 years ago there was a holiday put in, a one year tax reduction if you brought back these monies we’d give you a very low tax rate. I think it was about 10 percent compared to the normal 35 percent. Low and behold, all these companies bring back, I don’t know, a trillion dollars, and people thought that will help stimulate the economy. They’ll use this money to invest in more labor, and increase the manufacturing capacities here. And in the end a lot of the money went to things like buying back stock, executive bonuses.
So if we do another holiday now or a reduced rate when the money comes back, are we basically tempting these corporations to keep leaving the money overseas and then waiting for this form of amnesty. Now this conversation’s much more complicated than we’re letting on here, because there is talk of stopping the taxation of overseas earnings for perspective earnings. So when I complain about where we’re going to set these people up for this addiction to a holiday every 10, 20 years, their comeback could be, well, we don’t plan to tax future earnings anyway, it’s a one-time thing. Then fine, then let the past earnings wait to be taxed when they come home and we’ll get the full up to 35 percent, versus this holiday rate.
Patrick Verel: Why, in this current plan, is the Alternative Minimum Tax and the Estate Tax potentially also on the chopping block?
Stanley Veliotis: The Alternative Minimum Tax, the A.M.T., it’s been considered for repeal for many years because first of all, it complicates tax returns dramatically. I talked to some C.P.A.’s that have trouble understanding it. I finally have gotten my hands around it. But it’s also unfair. The A.M.T. basically disallows certain deductions on our tax returns, so for example, people in the heavily taxed states like myself in New York, Connecticut, New Jersey, we cannot deduct our state taxes for purposes of A.M.T.
Instead of just disallowing these state tax deductions for everybody and being open and honest about it in Congress, they do this alternative calculation where people don’t even understand why they’re paying A.M.T., they just know they have to pay it. When they first put A.M.T. in, it was put in because they wanted to capture these couple hundred rich people in the late ’60’s, early ’70’s, that were not paying taxes of all these exotic tax shelters. So when they put it in, they disallowed certain items and said, okay, we’re not going to allow these, but then again we’re only going to worry about people that make a lot of money, so we’re going to give a big, fat exemption of about, I don’t know, 30-40,000 dollars. So that covered 95 percent of the world, of the U.S., so no one paid it except for very few rich people.
The exemption of that 40-50,000 number was not indexed for inflation until very recently, so every year it started capturing more and more people as salaries for a C.P.A. went from 5,000 a year to 50,000 to 75,000 a year. So it was very unfair that the intent of it was to get the rich, rich, rich where benefiting from sexy tax planing and a lot of this transactions, and then by not having the exemption big enough it started capturing “innocent” people like myself who’s just living their life, working for a living, owning a home.
So getting rid of it, to me, at least makes it fairer for people like me … Again, maybe I sound selfish ’cause it’s about me, but a lot of people are like me. This is the one chapter in the course that I teach where the students are trembling. They’re trembling because … And then I told them today, I won’t put it on your final exam because I have a feeling it might go away, and I could see the sigh of relief because they had heard about this being the most difficult chapter in the tax class.
So Estate Tax, the theory behind why people say it’s unfair to defend it … to defend the repeal, I would say, it is sort of double taxing the same income. An Estate Tax is levied on your final net worth. Whatever’s left over, you try to leave to your family and meanwhile, that other third or half of it gets chopped away in taxes. I can see why people argue it’s sort of one last painful bite at you when you’re literally dead and you can’t defend yourself. And an example they keep throwing up is it’s not just for the super rich that it’s unfair, how about the practical problems it causes for the family farm.
You hear about the family farm case, we’re out in the Midwest, you’ve … your grandpa years ago was running this farm, and those 200 acres was successfully growing corn or whatever, and then he left the home to the three kids, and those three kids now have 20 grandkids. The 20 grandkids are now inheriting the farms from their parents … the farm from their parents, and now that real estate is worth $200 million, or $100 million. To make them pay almost half of it in Estate Tax means that they have to liquidate the farm. The problem with the way its being couched here is a lot of this is meant to be helping the common person to try to build out the middle class. No middle class person is paying this tax, because the Estate Tax doesn’t apply until you get up to the $6 million or higher number.
Patrick Verel: The central point of the plan seems to be that the middle class and the rich will benefit in the beginning, once it’s passed. But as time goes by, the benefits to the middle class are going to go away, while the benefits to the rich will live on. Is that a fair way to think about this?
Stanley Veliotis: I think it is. Well, one thing is the Estate Tax. Clearly the Estate Tax being reduced will benefit the wealthy forever and ever and ever, whereas the poor don’t get any benefit from that ’cause they’re not paying it. The second part, the concern is in the short run, some of the people on the lower end of the income scale will benefit from having a doubling of their standard deduction and getting this Child Credit credit, so they might save a little bit of money in the long run … in the short run. But as the years go by, that standard deduction will go up only with a limited form of inflation, so we’re talking that 2012 … that $24,000 standard deduction in five, six years might only be about 25, 26,000.
But when you look at the wealthy who basically you’re going to see their corporate earnings, the corporations have their tax rate cut dramatically and a lot of wealthy people own a lot of stock, so they indirectly benefit from their corporations paying almost half the tax rate. They’re also going to benefit to the extent that they have these what they call Flow Through Entities, these investments in pass-through, flow-through partnerships, Limited Liability companies, as corporations. These would be the investments they have in businesses that throw off income, that’s not taxed at the corporate rate, instead the income passes through to the owners and they’re taxed on it immediately. And currently they’re taxed, these millionaires, are taxed at the highest rate, 39.6. They put in this preferential rate a cap of 25 percent for a big chunk of it.
So you see a lower income level person saving a couple of thousand a year. Meanwhile you have people that, every year, make more and more and more money ’cause they’re very successful with successful businesses, paying no more than 25 percent on a lot of this flow-through income. Plus if they have income in these corporations that trade on Wall Street, then they pay tax at half the rate from before. The numbers are staggering in terms of the difference.
Patrick Verel: You mentioned something that, it was fascinating, that I read about this S corporation. If this all goes through, you could potentially see individuals basically form their own corporations that are just themselves to take advantage of those lower rates.
Stanley Veliotis: Right. They do have an exception for personal services companies, so they were worrying about that. For example, a baseball player just forming a Limited Liability Company or an S corporation, and says pay that money to this corporation of which I’m the only employee. Right? There’s a provision of this that talks about. However, if a personal service is … professional services are what this entity is doing, then the regular rate applies.
But I’m glad you mentioned that because I forgot to say … Going back to complexity, the desire to make thing easier. This came up yesterday during the testimony from the Ways and Means Committee. One of the Democrats said we’re looking at all these big, fat regulations here, we’re trying to reduce them. Don’t you realize that once you put in this new 25 percent cap on past year income, the concern that you have right there is now gonna say we need regulations to determine what counts as services? You’re basically trading some complexity that goes away with other nice things we’re hearing getting rid of on Schedule A, for example, but now we’re going to need a whole bunch of regulation on trying to avoid the scam that you’re basically put your finger on and you’re not even a tax person.
Patrick Verel: Now Lee Zeldin, a Republican Congressman from Long Island, recently told New York Times that it would be impossible for him to vote for the bill in its current form. He called it a “Geographic redistribution of wealth,” because it eliminates the deductions that residents of states like New York rely on to cushion the pain of local taxes. How common is it for this kind of regional clashing, if you will, when it comes to tax reform?
Stanley Veliotis: As it happened before … Mentioning taxes in Florida, maybe about 10 years ago those states started complaining, wow, you people up North and out West get to deduct your state taxes, we don’t have any here, therefore, we don’t get the benefit you get of being able to deduct them. Now of course, they’re not paying them so I’d rather be in a position where I’m not paying them at all then paying them and deducting them. But I can see their point. So instead, they got a sales tax deduction put in. So the current law says, here, we’ll look at your Schedule A, there’s an election. I’m going to deduct state and local income taxes, or my state and local sales taxes. The greater of the two people pick.
So in the Northeast our income taxes are obviously, much higher. But in the South … Well, Florida taxes and other states that don’t have an income tax, all the people there are electing the sales tax. So that’s an example of how they lobbied for something that they normally wouldn’t have cared about, but because they saw these other states benefiting from deducting your state and local income taxes … Hey, why don’t you give us something, give us state and local sales taxes. So that happened, in a sense, before.
Now getting rid of this deduction also will, ironically, bother them because they’re losing their sales tax deduction, but not as much as it hurts the people up here, because sales tax is a small number.
