My two cents on taxes

Many of you know I have practiced accounting and taxes for many years, even after taking a break to work with a start-up.  I work mostly with small business owners who have incredibly high hopes and dreams and who have never met an opportunity for zero taxes they haven’t liked.  I am also incredibly honored to be working with Doug McLain on our new start-up C.O.R.E. Services which focuses on condominium and homeowner association audits and reviews.

There are several aspects of the congressional tax debate I am struggling with.  First, does the current approach of taxing income need to be changed?  Second, will rewriting tax law address fundamental issues of fairness, competition and profitability in business?  Third, can reforming how we collect taxes address underlying social issues that will need to be addressed to move this wonderful country into a world where technology, not people, produce goods and services?

I am not an economist or a political type.  I am a practicing accounting and tax theorist.  And I doubt if my missive here will explore all the nuances of the three questions – at least in one post.  But I want to take a stab at it in hopes that my friends and colleagues around the US will weigh in before we take this plunge.

Does the current model of taxing income need to be changed?

I have argued for several years that the model of income taxation is problematic for a net consumption society.  What I mean by this is that the US overall consumes more than it produces domestically.  By taxing production through income taxes, the US continues to exempt internationally produced goods.  Which means that our legislators spend considerable effort trying to find new ways to capture taxes on these non-us produced goods.  It is not successful.

The problem with taxing income is that it relies upon someone defining the term.  Income, profit, is revenues less expenses.  Sounds simple.  But, what is revenue?  What is an expense?  If you think I am being rhetorical, the accounting profession has rewritten the rules of accounting for revenues under ASC 606.  There is no one simple definition of income and when legislators get involved, they try to pick winners and losers to society’s detriment.  Again, look at the current plan of allowing businesses to immediately write-off all business equipment purchased by supercharging section 179.  Small business can already write-off $250,000 of new equipment so who benefits from this?

It is probably time for the US to rethink its approach to the collection of taxes to pay for government spending.  So, reforming the concept of taxes is a good idea and it should address the fundamentals of how to simplify collection and reporting and probably even address what is the most effective way to ensure sufficient tax inflows to cover government’s spending plan.

Will the current attempt at tax reform lead to fairness, competition and profitability in business?

The problems I see in the current approach to tax reform is that there is no attempt at creating a truly level business playing field.  As a case in point, lets look at the claim that creating a new tax system for pass-through entities will enhance fairness, competition and profitability.

First, a basic primer on choosing an entity.  The primary choice for most operating businesses is the corporate structure.  In the US, we have two types of corporations – C corporations and S corporations.  The S Corporation has certain restrictions as to when it can be used and in return offers certain benefits to the owners.  The C corporation has minimal restrictions on its use and has certain costs to its owners.

The C Corporation pays taxes on its profits.  The S Corporation does not and instead passes the taxable profits to its owners who pay the tax as though it was earned by them.   Because the profits are taxed to the C Corporation, if it decides to issue dividends then those dividends are taxed by its owners.  This is the primary dreaded double taxation.  This can, at times, run to a combined tax of over 50%.  Not that any one person sees that though.  The S Corporation, on the other hand, can issue the dividend with no additional tax because the owners already paid tax on the income.  No double taxation.

So, while the two types of businesses operate and issue dividends, the S Corporation is tax advantaged as its earnings are taxed at a maximum 39.6% and C Corporation earnings at about 50%.

Getting to the point.  Today, any business which meets certain basic rules can be an S Corporation.  The current reform effort wants to change that so certain “professionals” such as lawyers, doctors and yes accountants, cannot be.

This is the antithesis of fairness and creating a level competitive playing field.  Again, I work with many small business owners all of whom spend far more hours at their company than I do and whose sole efforts make or break their small business.  How is that widget makers profits any more special than a doctors?

I and other tax professionals have disliked some aspects of the S Corporation tax law forever but this attempt to fix it seems worse than the original problem.  To be a little snarky, I do appreciate the opportunity for continued employment though as small businesses will spend considerable sums of money hiring professionals like me to help them avoid some aspects of any new tax law where certain professions are targeted; likely even more than they pay us now.

Finally, how do we reform tax law so that it puts the US on a path to ensure that our spending priorities are met in the future when production is something that has even less human intervention than it does today?

Obviously, the fly in the wine we should address is the fact that, at the federal level, the US spends $3.0 TRILLION annually and only taxes about $2.0 Trillion.  To be fair to America, tax reform should first address that the spending amounts agreed to by congress should be met with an equal amount of tax inflows.  Yes, I am in favor of some sort of balanced budget requirement – although I think it should be modified so infrastructure spending is not part of a current budget cycle as its benefit spans multiple years and decades.

But the important thing about this is, if legislators want to spend $3.0 TRILLION and we, as the voting public agree, then find a way to bring in tax inflows which equal that amount.  Get rid of the gimmicks and funky multi-year accounting games.

Next, we need to evaluate how wealth is generated in America and it should be taxed to support our social goals.  Sorry, but again the reality of taxing income likely needs to change which leaves us with few options.  The hard truth is, ensuring that lower and middle income citizens have discretionary cash flow benefits the wealthy, not the other way around.  So tax reform should focus less on people earning a wage and receiving wealth transfers and more on those who have the disposable wealth.

The current attempt at tax reform does not really address these issues, sadly.  Yes, tax reform is essential but even more important is eliminating the desire by politicians to spend today and tax tomorrow.  Tax reform must focus on how to ensure that our national goals (spending) are met by appropriate levels of inflows (taxes).  What we are witnessing is simply another way for our legislators to avoid making critical decisions about how to ensure that America is positioned to lead the world for the next 100 years.

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