Tax Reform: Some Thoughts on Simplification and Passthrough Income

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This past week saw the release of the outline of the next big push for tax reform. Titled a “Unified Framework For Fixing Our Broken Tax Code” the Trump Administration and the majority in the Senate Finance and House Ways and Means Committees discuss in 9 pages basic principles and  major changes, including corporate and individual rate reductions, a new top rate for some passthrough entities lower than the top individual rate, an expansion of the standard deduction, elimination of many personal deductions, and a shift to a territorial system of taxation.


We try to stay in our lane of tax procedure and tax administration on this blog. I will state the obvious and note that tax reform is a heavy lift, and there is likely to be some serious legislative give and take over the next few months.

Just this past week the National Taxpayer Advocate blogged on her vision of tax reform, in Tax Reform: Hope Springs Eternal This Fall. The NTA, while noting many policy goals around tax reform, picks one issue for emphasis: the need for simplification. Stating that if she had to sum up everything she has learned in her tenure as NTA, it is that the “root of all evil in the tax system is the complexity of the Internal Revenue Code.”  To that end, the NTA discusses sources and effects of complexity and offers a number of suggestions that she has discussed in past reports as a way to meaningfully simplify the Code. Those include streamlining the Code’s myriad savings and education incentives and consolidating civil penalties and family status provisions. As someone who has thought about tax reform for a long time, the NTA makes sensible substantive suggestions that I hope Congress considers as it moves forward.

There have been many articles discussing complexity in the tax system: they often define differing levels of complexity; some suggest that simplification in a meaningful sense is often diametrically opposed to other goals we also care deeply about, like equity (itself a loaded term) and the need for certainty. (For a good example see a 2013 article in the Wyoming Law Review by Jeffrey Partlow). It is easy to see how other goals soon run smack into and conflict with the shared stated goal of simplifying the tax code.

Consider one of the Framework’s proposals: a lowering of the top rate on small and family owned business income from passthroughs to 25%, a rate lower than the top individual rate. Now it does not take a law professor to consider the possibility for mischief from such a proposal: people with labor income will be incentivized to funnel their work into a small business passthrough format to try to game the rate differential. We already see that to an extent in existing law (for much less at stake), as individuals use S Corp structures to try to avoid paying employment taxes on what might otherwise be compensation income.

The proposal addresses that mischief by noting that the framework “contemplates that the committees will adopt measures to prevent the recharacterization of personal income into business income to prevent wealthy individuals from avoiding the top personal tax rate.”

I have not deeply thought through the ways that legislation could achieve that anti-abuse goal, but I suspect that any measure will require greater IRS attention to this structure (already we have discussed in PT the heavy resource lift of IRS  trying to determine on audit whether S Corps are paying shareholders a reasonable compensation). The Center on Budget and Policy Priorities in a report that predates the current proposal discusses some of these challenges, including discussing how some estimate that over 30% of the cost of this change would come from high earners trying to shift income into this structure to game the system and the challenges IRS would likely face in trying to stem the abuse[Ed: note that the CBPP discussion looks at an earlier proposal with an even lower passthrough rate].


It is far too early in the tax reform season to know where things will land. I note that the Trump Administration’s “first principle” of tax reform is to “make the tax code simple, fair and easy to understand.” The passthrough proposal suggests the potential for significant administrative complexity. As IRS struggles with resources (like we learned this week as IRS has confirmed that it has suspended its ASFR program, at least temporarily), Congress should explicitly consider whether it will give the IRS the resources it needs to police a program that at first blush is one that is susceptible to abuse.



Avatar photo About Leslie Book

Professor Book is a Professor of Law at the Villanova University Charles Widger School of Law.


  1. We are about six weeks away from the expiration of IRS Commissioner Koskinen’s term, and so far no nomination of a successor has started the confirmation process. I wonder who will provide the leadership in making the case that greater complexity requires more IRS resources.

    But what if IRS could also make the argument, that more funds for tax compliance would help cover the cost of the proposed cuts? There is nothing yet for CBO to score, but some estimates are that the deficit would increase by $150 billion or more each year for the next ten years. Meanwhile, the federal tax gap is estimated at more than $400 billion a year. If IRS could collect just half of this, the tax reform “plan” would be revenue neutral.

    Legislators, however, are convinced that IRS is so unpopular that they will lose votes by supporting IRS. They are not convinced that the 90% of taxpayers who comply with tax law want to see something done about the 10% who don’t. So instead, we have the intellectual dishonesty of voodoo economics, claiming that “dynamic scoring” will do for the country what it did not do for Kansas.

    Blogs are fine, but maybe someone could make this point somewhere it would be read, like the op-ed page of a major national newspaper.

  2. In the NTA blog linked to in this post it states “I have long believed, and continue to believe, that comprehensive tax simplification is achievable by following the model of the landmark Tax Reform Act of 1986.” I agree with this. My experience with the ’86 act was that with a new single tax rate on both capital gain and ordinary income much of the incentive to game the system was gone. Since that time we have moved in the opposite direction, creating all kinds of income categories. Just look at how much effort is generated around the rules regarding passive income and losses. The current proposal to create a separate rate for business income is just more of the same. Maybe we should be celebrating. If enacted, this will be another full employment act for tax professionals.

  3. Les – This was a timely post for me. I’ve never gotten involved with tax legislation, but when I got in this morning I wrote down some thoughts I had on the train about how the proposed lower rate on income of “small family-owned businesses” might be targeted to the intended beneficiaries without huge windfall tax savings to the truly wealthy and high-income taxpayers. I was thinking about “running it up the flagpole to see if anyone salutes” [to use a no-longer-politically-correct expression] – possibly by circulating it on some tax list serves and asking some of my tax policy wonk connections. When I saw your post a short while ago, I decided to post them as a comment and see what others think about how this proposal could be made viable.


    This morning on the train I was thinking about how this proposal might be structured so as to benefit the owners of truly “small” businesses without giving huge tax-saving windfalls to high-income or wealthy taxpayers, regardless of the number of owners or the amount of profits of the particular business. So far, I’ve only seen suggestions about excluding certain kinds of service business taxpayers [i.e., doctors, lawyers, accountants, etc.] from qualifying for the lower rate. This is probably a good idea, and there are existing provisions in the Code that could be adapted for that purpose. BUT that approach would do nothing to prevent huge windfalls to taxpayers who [for the most part] don’t need such tax benefits. In light of what I understood to be the President’s pledge not to allow this provision to produce tax savings for wealthy taxpayers, I tried to come up with a starting point for targeting most of the savings from the proposal to the intended beneficiaries.

    The only idea I’ve come up with so far is to limit the amount of income eligible for the reduced rate in any taxable year for each individual and members of his/her family [including trusts and controlled entities]. The dollar limit could be something like $500,000 per year, or whatever seems large enough to provide a real benefit to “small and family-controlled businesses” but not so large that it creates excessive windfalls for those not in the intended group of beneficiaries. The benefit could then be phased out beginning at certain levels of income, such as the lowest of [a] the income from the business itself for the taxable year or [b] the taxpayer’s taxable income for the year or [c] $______ . Obviously, constructing the anti-avoidance rules wouldn’t provide “simplification,” but there are already a lot of provisions in the Code that limit certain tax benefits based on “family attribution” and “controlled groups” defined with various “attribution of ownership” rules. [I also wouldn’t want to base the benefit on the number of family owners – for any given business, the amount of the tax reduction shouldn’t depend on the number of “family members” who own or work in the business – this would permit manipulation that would enable greatly expanding the tax savings for any given “small business.”] It seems to me that such limitations would be justified, despite the complexity, if the true goal of the pass-through tax proposal is to limit the benefit of this lower tax rate to “small and family-owned businesses.”

    On the other hand, it also seems to me that the failure/refusal to impose some kind of effective limitation to prevent a windfall to wealthy/high income taxpayers could be viewed as demonstrating almost conclusively that the reduced rate proposal is, at its core, primarily a device to benefit the wealthiest and highest income taxpayers. There are so many high-profile wealthy families and family-controlled businesses in the United States that it should be fairly easy to demonstrate – even to average voters in any public discussion or debates on the proposal – how easily the reduced rate could be used to produce large and unfair windfall tax savings to taxpayers who are demonstrably outside the class of targeted beneficiaries. I recognize that there’s a great deal about tax legislation that’s over my pay grade. On the other hand, maybe this can be a starting point for trying to figure out how the proposal could work rather than allowing the debate to descend into expressions of extreme positions on either side of the issue.

    1. Would this limitation proposal be in addition to the carve outs for lawyers etc? In light of the existing provisions limiting certain tax benefits for professional service businesses, I thought that provision could be used to include the reduced small business rate reduction to those tax benefits presently limited. But I didn’t think too much about this aspect of check the language of the present limitations. If as a tax policy matter it was determined to provide some limited benefit to owners of service businesses, I assumed that could be handled by tweaking the existing provisions that affect this group of service businesses. To me the bigger issue is how to prevent the reduced rate from applying – based solely on the form of ownership – to taxpayers who are owners of sole proprietorships or pass-through entities where the businesses in question produce very large amounts of taxable income. The income could come from real estate partnerships, LLC’s that own closely held but immensely profitable businesses in the fields of oil and gas, high-tech, venture capital, etc. – the list could be endless. To me, the key factor is to limit the amount of income that gets the reduced rate, regardless of the form of entity or nature of the business being conducted. And I don’t want to increase the amount of income that gets the reduced rate for Business A that happens to be owned and operated by 10 members of the same family compared with the level of favored income derived from competitive Business B that’s owned by a single individual or a married couple. There’s a lot of room for compromise/tweaking to try to wind up with something “fair.”– I’m just trying to provide a starting point for a potentially workable way to prevent most of the benefits from flowing to “the rich.”
    2. Is the 500K limitation based on overall taxpayer income or does it only provides a reduced rate for up to 500K of passthrough business income notwithstanding other sources of taxpayer income? When I wrote the limitation language, I intended to craft a limit based on the lowest of the 3 items. The $500,000 number was just a number pulled out of the air – how much should be subject to the limit would be more of a policy issue on which I don’t have an opinion at this point. If we assume a 35% top rate for “ordinary income,” a $500,000 cap would “only” produce a $50,000 tax saving. I guess some would consider this a big benefit, and some others would consider it minor. As to my factor based on a taxpayer whose income for the year is lower than the $500,000 or other limitation, then I’d expect something like the present capital gains tax limit to apply.

    But these are all “details” that are above my pay grade. I only intended to put something out there for discussion purposes. I hope to learn a lot from the reactions of others.

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