Ever since my household gave up its cable package and switched to streaming TV, we watch things when we want. That flexibility opened the door to “binge-watching,” i.e., watching an entire season of a series over a few days.
The latest binge-watch in the Bauman household is an oddball series called BrainDead. A meteor fragment arrives at the Smithsonian in Washington, D.C., just as a budget impasse shuts down the government. The scientists are forced to go home, whereupon space bugs emerge from the unattended space rock and start infecting the brains of politicians and staff on Capitol Hill.
The bugs can do one of two things. One is to make both Republicans and Democrats even more intransigent than they usually are.
The other is to make a person’s head explode … something I fear might happen to me every time I delve into the U.S. tax code.
In The Bauman Letter, I often write about “pass-through” corporations as a key element in an asset-protection strategy. For example, in July 2015, I wrote about a strategy to vest ownership of your rental properties in a single “series” limited liability company (LLC) and protect each of them, and yourself, from liability suits.
“Pass-throughs” — LLCs, partnerships, S corporations, and sole proprietorships — comprise 95% of all U.S. businesses, employ over half of the private sector workforce and pay over one-third of all business taxes.
One of the great advantages of pass-through businesses is that they’re subject to a single tax on net income, whether or not it’s distributed as profit. There’s no corporate tax. Instead, a pass-through business’ income and expenses are reported by its owner on his or her individual tax return. Net business income is combined with income from other sources and subject to individual income tax.
Another advantage is that business losses are also passed through to the owner, where they may be used to offset income from other sources. Many people run loss-making businesses in order to reduce their overall taxes.
For this reason, in the pass-through business sector — half of the U.S. economy — it’s the individual tax rate that influences the decision-making and economic health of businesses, not the corporate tax rate.
Unintended Consequences
Unlike the bug-addled politicians in BrainDead, real-life Democrats and Republicans in D.C. agree that corporate tax reform is a priority in the U.S. No matter who wins the presidential election, I predict action on this front in the next few years.
The current U.S. corporate tax regime is globally uncompetitive and ridiculously convoluted. The nominal rate is 35%, but very few U.S. corporations actually pay that. Instead, they employ legions of tax lawyers to take advantage of various “business tax expenditures” (deductions), such as accelerated depreciation allowances, R&D expenditure credits, inventory-sales source rules and so on.
One proposal is to lower the corporate tax rate to 25% (making it competitive with much of Europe) and make up lost revenue by eliminating or limiting such business tax expenditures. Every corporation would pay a flat 25%. Simple! (But not so great for tax attorneys.)
Except, of course, for all those pass-through businesses, which would keep paying tax at the individual rate of up to 39% … but lose all those business tax deductions.
Reforming corporate tax without touching individual tax rates would therefore impose a massive tax hike on U.S. businesses. The nonprofit Tax Foundation estimates that revenue-neutral corporate tax reform would reduce the size of the economy by 0.5% in the long run. Hardest hit would be pass-through businesses in agriculture and mining, followed by construction and retail trade, and then manufacturing, finance and insurance.
Here’s Your Plan
From conversations and correspondence with readers, I know many of you own pass-through entities. In the face of a calamity like corporate-only tax reform, I recommend two things.
First, pay close attention to the looming debate about tax reform. After November, I predict that both parties will try to take advantage of the first year of a new presidency to ram through corporate tax reform. Be aware that if individual rates are not adjusted too, as a pass-through business owner, you will suffer. Don’t let the inevitable corporate propaganda about “job creation” blind you to the consequences if they get what they want and you don’t.
Second, start exploring the advantages of an offshore business structure.
Depending on the nature of your business, you may be able to structure things in a way that reduces your U.S. tax liability considerably. It may even be possible to defer income tax on retained profits indefinitely. In fact, we’ll be talking about such strategies at the upcoming Total Wealth Symposium in Bermuda in September.
Research shows that the preferences of the average U.S. voter have no impact on legislative outcomes. Deep-pocketed corporations get what they want almost every time … and if you’re unprepared for corporate-only tax reform, it may be enough to make your head explode.
Kind regards,
Ted Bauman
Editor, The Bauman Letter
