As Winston Churchill once said, “Never let a good crisis go to waste”.
This must have been the attitude of our tax code writers and the elected representatives who support them as the Coronavirus Relief, Aid and Economic Recovery Act (“CARES Act”) made its way through Congress.
According to the Congressional Joint Committee on Taxation, the total long-term cost of the tax cuts included in the CARES Act is $591 billion. As discussed in the prior article, $292 billion of this is relates to the Individual Recovery Rebate program, which sent $1,200/$2,400 checks to low and middle class taxpayers across the country.
The next five largest tax cuts, totaling $276 billion, or 47% of the total, are all for businesses and wealthy Americans. These will be explained below.
To understand the highway robbery going on with these tax code changes, a basic understanding of pass-through investment vehicles is required. Limited Partnerships, Limited Liability Corporations, REIT’s and Master Limited Partnerships are all pass-through vehicles. None of these legal entities are taxed. Instead, the income or losses from the business are “passed-through” to the shareholders in proportion to their ownership percentage. These are very common investment vehicles in real estate, oil & gas ventures and pipelines, to mention a few.
Most of these pass-through investment entities are designed to have losses of taxable income, but positive cash flow. This all works because the IRS allows taxable income to be reduced by non-cash charges such as depreciation of assets.
For example, apartment buildings can be depreciated over 27.5 years for IRS purposes. Lets say a limited partnership is set up to buy a $10 million apartment building. The individual shareholders put up $2 million of capital and borrow $8 million at 4%. Here are their losses for tax purposes:
Rent Revenue: $750,000
Interest Expense: 320,000
Maintenance and Repair: 100,000
Property Tax: 150,000
Total Expenses: $933,636
Taxable Income: ($183,636)
So, for tax purposes the partnership made a loss of $183,636. This loss would be “passed-through” to each of their individual investor’s tax returns.
However, the story doesn’t end here. The investment partnership actually had positive cash flow. Depreciation is a non-cash expense. If you take that out of the equation, the partnership has positive cash flow of $180,000. This can be paid out to the investors as a return of capital, which is not taxable income.
This type of investing is a very common in the USA allowing wealthy individual investors to make tax efficient investments.
Pass-Through Income Tax Code Change
The existing tax code allows individuals to use pass-through vehicle losses to offset other income, such as wages and investment income, up to $250,000 for an individual and $500,000 for a couple. The CARES Act amended this provision so pass-through losses can be used to offset other income on an unlimited basis. It also made this retroactive, covering 2018 -2020.
This change has little to nothing to do with COVID-19 economic stimulus. First and foremost, a couple filing jointly would need to have other income in excess of $500,000 to even benefit from the change. We’re talking about the top 1% here! The ability to do this retroactively so the government has to send these people tax refunds is simply adding salt to the wound.
So, how much money will the taxpayers be handing out to these wealthy individuals? According to the Congressional Joint Committee on Taxation, this provision will cost 30% of the total CARES Act tax cut cost, or $172 billion!
To put his in stark relief, the bottom 90% of American taxpayers get to share $292 billion of Individual Recovery Rebate payments and the top 1%, who don’t need the money, get to share $172 billion.
Net Operating Loss Carrybacks
The Tax Cut and Jobs Act of 2017 reduced corporate tax rates from 35% to 21%. To help justify this massive reduction in corporate tax, a number of tax provisions that previously allowed corporations to lower their effective tax rates were tightened or eliminated. One of these was the ability to take current year losses and use them to offset prior years profits and taxes. The Tax Cuts and Jobs Act eliminated the ability of a corporation to “carryback” net operating losses (“NOL’s”).
The CARES Act permits NOL’s from the 2018-2020 tax years to be carried back five years, all the way to 2013 for any operating losses incurred in 2018. For the many profitable companies that loose money in 2020 because of COVID-19, this provision will allow them to use those losses to recover a portion of the taxes they paid in prior years. No doubt this extra cash will help a number of struggling companies.
However, this new provision is available to all companies whether or not they have been adversely affected by the coronavirus pandemic. For the corporations that are unaffected or benefiting from the coronavirus crisis, this is just a gift at other taxpayer’s expense. Losses carried forward (which has been permitted) reduce income being taxed at 21%. Losses carried back before 2017 reduce income that was taxed at 35%. This provision allows corporations to pocket the differential.
Like the treatment of NOL’s, the Tax Cut and Jobs Act reduced the ability of corporations to deduct interest expense to 30% of a certain earnings parameter to justify the lower 21% corporate tax rate.. The CARES Act raised this limit to 50% for 2019-2020. The vast majority of companies that have this level of interest expense are leveraged buyouts owned by private equity firms. Really?
Payroll Tax Deferral
Any employer, whether affected by the crisis or not, can now defer the payment of 2020 Social Security payroll tax and repay it over the next two years. This is basically an interest free loan. It will help preserve cash flow for businesses under pressure, but is a gift for the unaffected.
Payroll Retention Tax Credits
This is the only business tax cut in the CARES Act specifically tied to the COVID-19 crisis. Employers that either 1) closed operations, or 2) lost half of gross receipts owing to COVID-19 are eligible for a refundable tax credit of up to $5,000 per employee that remains on the payroll. For employers with more than 100 employees, this tax credit can only be claimed for inactive employees. Smaller businesses can claim it for all employees.
This provision is clearly designed to keep people employed and off the unemployment rolls.
If our government assembled the best and the brightest to design an economic stimulus plan to address the COVID-19 crisis, it would probably not look much like the tax code changes outlined above. Handing out $1,200/$2,400 checks to individual taxpayers whether they need it or not may not be the best economic choice. Handing out tax breaks to businesses whether they need it or not is probably not the best economic policy. Handing our $172 billion under pass-through tax provisions to people that definitely don’t need the money is reprehensible.
As indicated above, the Congressional Joint Committee on Taxation estimated that the CARES Act tax code changes will add $591 billion to the federal deficit. Here is a brief summary of the costs.
|CARES Act Provision||Cost Estimate ($ billions)|
|Individual Recovery Rebate Program||292|
|Permitted Pass-Through Losses||172|
|Other Business Tax Code Changes||64|
|Other Individual Tax Code Changes||23|
Source: Derived for Congressional Joint Committee on Taxation
Remember, the CARES Act is adding over $2 trillion to a federal budget deficit that already exceeds $1 trillion per year. The conversation around the tax code could change materially in the not too distant future.