The Games They Will Play:
An Update on the Conference Committee Tax Bill
December 18, 2017

Reuven Avi-Yonah, Irwin I. Cohn Professor of Law, University of Michigan Law School
Lily Batchelder, Frederick I. and Grace Stokes Professor of Law, NYU School of Law
J. Clifton Fleming, Ernest L. Wilkinson Chair and Professor of Law, J. Reuben Clark Law
School, Brigham Young University
David Gamage, Professor of Law, Maurer School of Law, Indiana University
Ari Glogower, Assistant Professor of Law, The Ohio State University Moritz College of Law
Daniel Hemel, Assistant Professor of Law, University of Chicago Law School
David Kamin, Professor of Law, NYU School of Law
Mitchell Kane, Gerald L. Wallace Professor of Taxation, NYU School of Law
Rebecca Kysar, Visiting Professor of Law, Fordham University School of Law, and Professor of
Law, Brooklyn Law School
David Miller, Partner, Proskauer Rose, LLP
Darien Shanske, Professor of Law, UC Davis School of Law
Daniel Shaviro, Wayne Perry Professor of Taxation, NYU School of Law
Manoj Viswanathan, Associate Professor of Law, UC Hastings College of the Law

As with our previous joint report, this update reflects insights from many tax scholars,
practitioners, and analysts. The primary drafters are Ari Glogower, David Kamin, Rebecca
Kysar, and Darien Shanske. All errors are our own.

1

 Contents

I. Introduction

3

II. An Update: Tax Games, Roadblocks, and Glitches

6

A. Using Corporations as Tax Shelters

6

B. Pass-Through Games

8

C.

Restructuring State and Local Taxes (SALT) to Maintain Deductibility

15

D. International Games, Roadblocks, and Glitches

17

E.

Other Games

23

F.

Other Glitches

26

III. What Comes Next?

27

Appendix: Summary of Key Provisions in the Conference Bill

29

2

 I.

Introduction

Earlier this month, we posted a report identifying key weaknesses in the Senate and House tax
bills.1 Unfortunately, many of the same basic weaknesses still exist in the newly released
conference bill (also known as the Tax Cuts and Jobs Act or TCJA). While some issues were
addressed, others were made worse, and the new bill introduces fundamental—and in our view
insurmountable—structural problems to the income tax.
The legislation is still likely to cost more than the current estimates of over $1 trillion, to
advantage the well-advised (and their advisors) in ways that are both deliberate and inadvertent,
and to face legal roadblocks like WTO non-compliance that could undermine key components of
the legislation. Finally, the bill includes glitches that could lead to haphazard and unexpected
results that could arbitrarily favor or penalize taxpayers.
The most serious structural problems with the bill are unavoidable outcomes of Congress’s
choice to preference certain taxpayers and activities while disfavoring others—and for no
discernible policy rationale. These haphazard lines are fundamentally unfair and inefficient, and
invite tax planning by sophisticated taxpayers to get within the preferred categories. It’s a
substantial blow to the basic integrity of the income tax. 2
These problems will only be substantially addressed by fundamentally changing or rolling back
the relevant provisions. In several cases, as we describe, forward-leaning IRS action will be key
to stanch the bleeding—however, such action will require leadership from the Trump
administration and will be hindered by the years of budget cuts that have hit the IRS.
In other cases—and in particular, when it comes to the deduction for state and local taxes—some
of us view state and local responses to avoid the limitation as expected and justifiable. Such
moves, however, would entail considerable additional costs to the federal Treasury that have not
been accounted for in revenue estimates of the bill.
The Conference Committee released its legislation last Friday evening, and the conference bill is
expected to receive a vote in the coming week in both the Senate and the House. A
comprehensive analysis of the new provisions—and how they’ve changed from the prior bills—
is not possible within such a condensed time frame. However, with votes scheduled for this
week, we offer an update of our report, based on our analysis over the weekend and on
commentary from other tax experts. In fact, the questions we have about the basic working of

1

Avi-Yonah et al., The Games They Will Play: Tax Games, Roadblocks, and Glitches Under the New Legislation
(Dec. 7, 2017), https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3084187 [hereinafter “The Games They Will
Play”].
2
For a description of the conference bill’s disregard for the basic principles of income taxation, see Daniel Shaviro,
Apparently Income Isn’t Just Income Anymore, Start Making Sense (Dec. 16, 2017),
https://danshaviro.blogspot.de/2017/12/apparently-income-isnt-just-income-any.html.

3

 key provisions—including new ones just introduced—demonstrate the irresponsibility of moving
so quickly to a vote on this legislation.
Specifically, the conference bill allows for the following basic planning opportunities:
•

Using corporations as tax shelters. C-corporations will be used to shelter income from
the top ordinary income rate, with no further protections added to the bill to avoid this
outcome. As we described in our prior report, the use of corporations as tax shelters can
result in labor income only being taxed at the preferential 21% rate, and entirely
eliminate the “second layer” of tax when an individual receives a dividend or sells the
corporate stock (for example, through the through step-up in basis at death). The
incentive to use corporations as tax shelters is slightly reduced under the conference bill
relative to the prior version as a result of the slightly higher corporate rate and lower top
individual rate, but the tax savings could still be considerable. Pre-existing safeguards to
avoid these kinds of consequences are already inadequate and will be even more so in
light of the planning incentives that this rate differential creates.

•

Pass-through games. The conference bill will allow well-advised taxpayers to
circumvent the limitations on eligibility for the special tax treatment of pass-through
businesses. The pass-through provision allows eligible taxpayers to reduce their taxable
business income by 20%, and the complex rules involved will invite plenty of gaming
opportunities. There is no particular logic to who clearly fits into the preferred
categories, and the game will be to get within the haphazard lines.
In fact, the conference bill, while adopting much of the Senate’s proposal, worsens
matters along an important dimension. The conference bill allows owners of firms with
no wages whatsoever, and just certain kinds of property, to take advantage of the lower
rate. This change both expands the availability of the pass-through deduction and
encourages firms to game the rule by increasing their ownership of qualifying property
(for example, by owning instead of leasing)— and possibly even by replacing workers in
the process.
Further, service providers will be able to take a number of steps to try to qualify for the
pass-through deduction. Any married employee with taxable income less than
$315,000—a lower threshold than set initially in the Senate bill but still high enough to
cover many highly paid professionals—will have an incentive to be a partner or an
independent contractor rather than employee, and appear to get the full benefit in that
case. Higher-income law partners, doctors and other professionals will likely be able to
engage in strategies to access the special rates, such as buying their buildings and owning
them in a separate entity, or going in-house at firms that are not in restricted fields. The
IRS should try to restrict these opportunities, but the agency will be constantly challenged

4

 as a result of its lack of resources, the ambiguous lines that are drawn, the lack of
principle underlying those lines, and the tax benefits at stake.
Finally, in another important loophole, pass-throughs may be able to largely bypass the
new limitation on interest expense, and public corporations can then use pass-through
subsidiaries to do the same. Similarly, public corporations can potentially even avoid the
162(m) provision restricting the deductibility of compensation for highly paid executives
by again using a pass-through subsidiary.
•

Restructuring state and local taxes (SALT) to maintain deductibility. The conference
bill permits states to pursue three of the four strategies we outlined in our previous report
to avoid the $10,000 cap set by the bill, and to preserve the deductibility of state and local
taxes beyond this amount. All three strategies rely on replacing state taxes that are no
longer deductible over this cap with other taxes or sources of revenue (such as charitable
donations or employer-side payroll or franchise taxes) that will remain deductible.

•

International games, roadblocks, and glitches. The conference bill will invite a variety
of tax planning and avoidance opportunities for taxpayers with international operations.
For instance, taxpayers may seek to claim the lower export rate when they sell products
abroad even when those products are sold right back into the United States.
Furthermore, the World Trade Organization problems we described in the initial report
still remain, especially with regard to the lower rate on exports. The obstacles under our
system of bilateral income tax treaties have been alleviated to a degree since the
Conference Committee chose the inbound Senate provisions over the more troublesome
House provisions, although this issue is by no means resolved. Very little has been done
to alleviate the perverse incentives created by the new system to offshore real business
operations and income.

Part II of this report update describes in greater detail these games, roadblocks, and glitches
arising from the conference bill. Part III follows with an agenda for future work by the IRS and
Congress to protect the integrity of the tax system if the conference bill is passed this week.

5

 II.

An Update: Tax Games, Roadblocks, and Glitches

A.

Using Corporations as Tax Shelters

The conference bill taxes C-corporations at a 21% rate beginning in 2018. As a result, taxpayers
would still be able to use corporations as tax-preferred savings vehicles through the strategies
described in our prior report. The conference bill does not strengthen in any way the anti-abuse
rules that would be necessary to prevent these games, and that are inadequate under current law,
even as the pressure on these rules will dramatically increase.3
The slight uptick in the corporate tax rate (from the 20% proposed in the House and Senate bills)
coupled with the slight decrease in the top statutory rate on ordinary income (from 39.6% to
37%) would reduce the benefit from using corporations as tax shelters on the margins, but would
not significantly affect the calculus for taxpayers seeking to shield their labor and investment
income from the higher individual rates, 4 particularly since individuals cannot deduct state and
local taxes, but corporations can. 5 The rate disparity between individual and ordinary income
will put much larger pressure on the system than under current law, where the rates are much
closer to each other (a 35% top corporate rate versus an individual rate of about 40%).
For greater detail on the specifics of the following games, see the discussion in our prior report at
Part II.A and the Appendix. 6

3

In particular, these include judicial principles such as assignment of income and the economic substance doctrine,
the possible recharacterization of undistributed profits as salary, statutory provisions such as § 269A (personal
services corporations), § 482 (allocation of income and deduction among taxpayers), § 531 (accumulated earnings
tax), and § 542 (personal holding companies). As we note in our prior report, these anti-abuse rules could discourage
the most severe abuses, but are notoriously porous and easy to evade, and would be difficult for a resourceconstrained IRS to enforce. See The Games They Will Play, supra note 1, at 7 n. 1.
4
For example, consider the effect of these rules in the “Stuffing the C Corp” example below. Assume that a
taxpayer has a bond that pays $100 of interest income. At a top individual rate of 40.8% (37% plus 3.8% NIT), the
individual would pay $40.80 of tax in the current year, and would be left with $59.20. If the same bond is held by a
corporation, the corporation would pay only $21 of tax in the current year. If the corporation distributed the
remaining $79 to the taxpayer immediately, the taxpayer would pay an additional individual-level tax of $18.80
(23.8% of the $79), and would be left with $60.20. The benefit of holding the bond through the corporation will
increase, however, if the taxpayer is able to keep the bond in the corporation for longer, and thereby defer the
individual-level tax.
5
For example, if the individual in the prior example was a California resident in the highest bracket, he or she would
pay an additional $13.30 in state taxes, for total taxes of $54.10, and would be left with $45.90. The corporation
would pay $8.84 in California taxes, but could deduct the state taxes from its federal taxes and pay $19.14 in federal
taxes or $27.98 total, and would be left with $72.02, $26.12 more than the individual. This difference of $26.12 is
$6.32 more than the $19.80 in the prior example.
6
See also Shawn Bayern, An Unintended Consequence of Reducing the Corporate Tax Rate, 157 Tax Notes 1137
(Nov. 20, 2017); Michael L. Schler, Reflections on the Pending Tax Cut and Jobs Act, 157 Tax Notes 1731 (Dec. 18,
2017); Adam Looney, Brookings Institution, The Next Tax Shelter for Wealthy Americans: C-Corporations, Up
Front Blog, (Nov. 30, 2017), https://www.brookings.edu/blog/up-front/2017/11/30/the-next-tax-shelter-for-wealthyamericans-c-corporations/. For formative works on the use of a C-corporation as a tax shelter, see generally Steven
A. Bank, From Sword to Shield: The Transformation of the Corporate Income Tax, 1861 to Present (2010); Edward

6

 •

Stuffing the C-corp. The simplest strategy is for a taxpayer to invest through a
corporation, so her investment income is taxed at the lower corporate rate. This strategy
is most beneficial with respect to fixed-income investments generating ordinary income,
but would also be available for domestic equity investments that pay dividends, because
dividends received by the shelter corporation would benefit from the 50% dividends
received deduction.

•

You, Inc. Taxpayers will be able to shield their labor income from tax by simply setting
up a corporation and having their income accrue in the form of corporate profits. As a
result, income that would have been taxed at the high individual rates is instead taxed at
the low corporate rate (in addition to avoiding employment taxes as is commonly done
today). As described in our prior report, current law is inadequate to effectively police
this game.
There is really no downside to this game, since the “double tax” on both corporate and
individual earnings is less than the top individual rate. And if a taxpayer changes their
mind at any time, they can simply convert their C-Corp to an S-Corp that is taxed as a
pass-through.

•

Salaries in closely-held corporations. For the same reason, shareholder-employees in
closely-held corporations can reduce their wages paid out by the firm, and through this
strategy can increase the corporation’s more lightly-taxed profits.

•

Avoiding the second layer of tax. The games above describe opportunities to shield both
labor and investment income from tax by using corporations as tax shelters. Of course,
corporate profits will be taxed too at the individual level when distributed out as
dividends or when the stock is sold. Taxpayers can use a corporation, however, to supercharge their tax gaming and completely avoid this individual level of tax through a
variety of strategies:
o Step-up in basis. If a taxpayer holds her interest in the corporation for her entire life
and the corporation does not pay dividends, the individual level tax on the corporate
profits is completely eliminated due to the “step-up” in basis.
o Roth retirement accounts. If a taxpayer holds her shares in the corporation through
a Roth retirement account, the individual level tax is completely forgiven. This
strategy will be most beneficial for a taxpayer who holds shares in a closely-held
corporation in her Roth account.

Kleinbard, “Corporate Capital and Labor Stuffing in the New Tax Rate Environment” (March 21, 2013),
https://ssrn.com/abstract=2239360.

7

 o Lower tax rates in retirement. A taxpayer can wait to receive a distribution of
corporate profits in a year when she does not have other taxable income, and will be
taxed at a low rate on corporate profits that were earned in prior periods (when the
taxpayer might have been taxed at a much higher rate).
o Other strategies. There are also other strategies for avoiding the second layer of
tax—such as the partial exclusion for gains on investment in certain “small business”
stock.
B.

Pass-Through Games

The conference bill grants a 20% deduction for certain qualified business income, which in effect
reduces the top tax rate from 37% to 29.6%. The amount of the deduction is reduced slightly
from the 23% in the original Senate bill, but still provides a tremendous incentive for taxpayers
to shoehorn their income into the “qualified” category. Some of the games we discussed in our
initial report have been restricted—but much mischief remains that could be played, and some
entirely new games have been introduced.
A significant (and surprising to many analysts) giveaway in the conference bill weakens the
requirement for high-income owners to pay employee wages to be eligible relative to what was
in the original Senate bill. The provision otherwise largely follows what was in the Senate
legislation. This addition will expand the ability of highly paid owners in certain industries—and
particularly those heavy in property but light in employees, like real estate—to qualify for the
pass-through deduction.
For more background on the relevant provisions in the conference bill, see the Appendix. For
more detail on the basic planning games described here, see the discussion in our prior report at
Section II.B. and the Appendix.
The heart of the problem is the absence of a policy justification for the deduction; it draws
formalistic lines favoring some groups and industries but not others, some of whom benefit and
others who do not. And those are lines across which taxpayers will play.7
•

Sitting at the center of the loophole. Some people reap the pass-through windfall
without the need for games. For them, the only game is to be themselves. This category
includes owners of firms that don’t provide listed, “disfavored” services, or owners of
firms that provide “favored” services, or owners of forms that provide any services but
with low enough incomes.

7

As before, we are grateful to Mike Schler for his many insights on the pass-through games. See Schler, supra note
6, at 1734-1741.

8

 Some professionals, such as architects and engineers, have been moved in the conference
bill from the “disfavored service” category to the “favored service” category. As a result,
they are now most likely excepted from some restrictions on service providers, and so
can be very highly paid and still get a partial or full deduction. 8 There is no clear policy
explanation for why these services are “favored” services, while, say, doctors or those in
the performing arts are still in the “disfavored” category.
And, as discussed above, owners of firms in “favored” businesses paying no wages
whatsoever can now benefit from the special deduction. Whereas the previous Senate bill
restricted the benefit to owners of firms that paid W-2 wages, the new bill extends the
benefit to firms that don’t pay wages but that own and use depreciable tangible property
(like buildings or automated machines that replaced their employees). Moreover, the
benefit is based on the original undepreciated cost of the property, and lasts for the
greater of 10 years or the normal depreciable life of the property. Real estate firms with
high original basis and few employees should be able to more easily access the
preferential rate (adding to another loophole that already gave real estate firms
preferential treatment), and the same is true of other industries with similar profiles.
The games then come about for those who aren’t yet among the favored, but can use
various strategies to join their ranks.
•

John Doe, independent contractor (or partner)—but definitely not an employee. The
pass-through deduction is still denied to anyone who is an employee. This is good news
to anyone who can quit their job and become an independent contractor (and so
considered a “sole proprietor”) or a partner in a firm. The game is clear: Don’t be an
employee, instead be an independent contractor or partner in a firm. Don’t be John Doe,
employee. Be John Doe, independent contractor (or partner in an LLC, receiving a profit
share rather than wages).
Individuals who provide “specified services” (such as lawyers and doctors) must have
taxable income of less than $315,000 for a married couple (or half that for a single
individual) to be fully eligible—with the benefit phasing down over the next $100,000.

8

The status of engineers and architects under the new section 199A, providing for the 20% deduction, is somewhat
murky. The House and Senate versions included (by way of cross-reference to section 1202(e)(3)) a list of per se
specified service trades or businesses whose eligibility for the special rate would be limited (Senate version) or
eliminated (House version). The conference report removes engineering and architecture from that list (which now
include health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, and
brokerage services). However, the definition of specified service trades or businesses in the conference report still
includes (via cross-reference) “any trade or business where the principal asset of such trade or business is the
reputation or skill of 1 or more of its employees.” As that catch-all phrase would seem to capture most engineering
and architecture businesses, the removal of engineering and architecture from the list of per se specified services
may prove to be futile. Much will depend on how the IRS and the courts interpret the new language. In any event,
engineers and architects still will be subject to the provision that caps qualified business income on the basis of W-2
wages and/or capital investment.

9

 But keep in mind, taxable income is calculated after taking into account other deductions,
like the standard deduction or itemized deductions. As a result, individuals with even
more actual economic income could still fully qualify for the deduction.
Originally, we had described this game as the Law Firm Associates, LLC loophole.
Given the new income restrictions, it probably won’t as broadly cover the highest paid
law firm associates, but it still should apply to plenty—who will all be incentivized to
form their own separate Associates, LLC firm. For instance, median base salary for a
fourth year associate this year was $155,000, 9 an income level that would still qualify for
the pass-through deduction.
The technique would also apply, without any income limit, to any “favored” business—
like real estate—that is willing to turn an employee into a junior partner in the business.
That is so long as the business pays sufficient W-2 wages or has enough original tax basis
in depreciable property.
The bottom line is that these techniques will cover a wide swath of relatively highincome people who are now employees. The IRS already faces challenges enforcing the
tax distinction between employees and independent contractors (since employers already
have some incentive to characterize workers as independent contractors),10 and this
pressure will increase hugely with the added tax gaming incentives. And, if an employee
can’t easily be recharacterized as an independent contractor, they can always become a
partner to access the preferential treatment. 11
•

Doctors and lawyers are now in the real estate business, and celebrities should sell
face cream. The highest paid doctors and lawyers (and those in other professions that are
specifically listed) would not be directly eligible for the 20% write off since they are in
restricted “specified service” industries, which covers certain listed professionals above
the income threshold. Other professionals who are not on the list are also denied the passthrough deduction if the “principal asset” of the business is their “reputation or skill.”
This category could affect celebrities and other public figures.

9

See Sarah Ramirez, NALP, Associate Salaries Rise in Some Market, But National Median Remains Unchanged
(June
1,
2017),
https://www.nalp.org/uploads/Research/AssociateSalarySurveyReportPress
Release.pdf.
10
For the basic difficulties in distinguishing between employees and independent contractors for tax purposes, see
David A. Weisbach, Line Drawing Doctrine and Efficiency in the Tax Law, 84 Cornell L. Rev. 1627, 1632 (1999).
11
The IRS might try to restrict this game of simply recharacterizing employees as independent contractors or
partners by arguing that the deduction does not apply to the degree that profits represent “reasonable compensation”
for services. They’d have at least some statutory support for doing so. See IRC 199A(c)(4). However, as we
explained in the Appendix to our last report, the legislative history suggests that the “reasonable compensation”
restriction applies only in the case of S-Corporations (and not partnerships or sole proprietors), with other easily
gamed restrictions (under IRC 707) applying to partnerships and maybe no such restrictions at all applying to sole
proprietorships.

10

 Restricted professionals can potentially still game these rules through two basic
strategies. To borrow from the terminology of gerrymandering strategies, let’s call them
“cracking” and “packing.”
o Cracking. The first strategy is to “crack” apart the revenue streams from the service
partnership, so as much income as possible can qualify for the deduction. This is
probably the preferred route for those in the “listed” professions.
To do this, doctors and lawyers (and others listed professionals) would set up separate
companies. As Victor Fleischer has pointed out, the ideal arrangement from a tax
avoidance perspective would involve a real estate investment trust (REIT), which is
automatically eligible for the pass-through rate, without any requirement that the
REIT pay W-2 wages.12 (This is the other big real estate loophole.) Then, the REIT
should charge the law firm the maximum rent they can get away with in order to
qualify some of the service income for the pass-through rate. The REIT strategy is
limited by the fact that REITs must have at least 100 beneficial owners, 13 but there
are currently ways of adding additional owners with relative ease and giving them
only a very small share of any profits. 14
Similarly, doctors and lawyers might try to form separate firms owning ancillary
services that aren’t providing the forbidden kinds of services. That includes firms
handling their accounting, document management, software, and so on. Again, the
game would be to essentially overcharge the main firm for these ancillary services—
though, unlike with the REIT, this game would immediately be restricted by the need
to pay sufficient W-2 wages from the new businesses.
The IRS can and should try to crack down on these kinds of arrangements in at least
two ways. First, the IRS could seek to apply rules similar to those used to define
personal service corporations under existing law. Under those rules, the performance
of administrative and support functions incident to a service trade or business are
considered to be part of the performance of the service trade or business. 15 (This
approach would most easily reach the ancillary services described above, but
probably not the separate real estate firm.) Second, the IRS could try to attack the
mispricing that could strip income out of the service firms. However, these kinds of
transfer pricing games among related parties have proven very difficult to stamp out
in other contexts.
12

Victor
Fleischer
first
described
something
like
this
arrangement
here:
https://twitter.com/vicfleischer/status/926294879998758912
13
§ 856(a)(5).
14
A typical private REIT will hire a service to find it 100 preferred shareholders who each will pay $1,000 and
receive a 10% annual return. That comes at a $10,000 annual cost, but that is relatively small as compared to
potential tax savings.
15
Temp. Treas. Reg. § 1.448-1T.

11

 o Packing. The second strategy is to “pack” other qualifying businesses into the service
partnership, to transform the combined entity into one that is not primarily providing
services.16 The IRS may be able to attack this strategy in the case of listed
professionals (and we encourage the IRS to do so quickly) but would have a harder
time dealing with other professionals who blend their reputation or skill with other
business activities. As a result, “packing” will be particularly advantageous to
taxpayers in this category.
Here’s the form that may be hardest for the IRS to attack: Non-listed professionals
blending their reputation or skill with other businesses. For example, say you’re
Gwyneth Paltrow, a celebrity with a generally positive reputation. Now consider her
“lifestyle brand” goop, which sells $125 face creams, among other products. Does
goop rely too much on Paltrow’s reputation, or is it just another business? A business
like this (if it were not incorporated, as is the case with goop) would almost certainly
qualify for the special pass-through deduction, notwithstanding the centrality of the
owner’s reputation. We would expect to see more goop-like business to appear. It’s
not just Gwyneth Paltrow. Imagine a certain real estate mogul and reality TV start
who might want to combine a business based on his reputation (and associated
licensing deals) with real estate investments.17 Once the business operations are
packed together, it would be harder for the IRS to argue that reputation is still the
principal asset.
For listed professionals (lawyers, doctors, and others), the availability of the packing
strategy is more complicated. First, there is a question whether provision of any
forbidden service to customers means that the entire trade or business cannot qualify
for the deduction, even if it includes qualifying activities as well. If it does, then
packing won’t work—they’re stuck with cracking. But, if the IRS were to allow
provision of qualifying services to cleanse the operation, then you can expect similar
games. Real estate lawyers might both provide legal advice and manage real estate
and so on to get the pass-through deduction for the whole operation, trying to mix the
businesses so that the IRS can’t effectively distinguish.
When it comes to the listed professionals, the IRS has more flexibility, which it
should use to disallow such packing by them. 18 But, when it comes to others—the
16

Thanks to Adam Looney for pointing out this strategy.
Thanks to Steve Rosenthal for this insight on “packing” by the real estate mogul.
18
Specifically, when it comes to the listed professionals, the IRS should avoid using the approach under IRC 448,
which also restricts a similar list of professionals from certain tax benefits. Under that code section, the question is
whether “substantially all” the activity come from those services. And so based on the Code and regulations there,
packing clearly works. See IRC 448(d)(2) and 1.448-1T(e)(4). But, 199A (the pass-through deduction) reads
differently than IRC 448, and the IRS thus should have authority to attack the “packing” strategy for listed
profiessionals. Collapsing cross-referenced sections, the conference report provides that “[t]he term ‘qualified trade
or business’ means any trade or business other than . . . any trade or business involving the performance of services
17

12

 goops or reality TV stars of the world—it will be much more difficult for the IRS to
attack such strategies..
•

Go in-house (or be an architect or engineer). Another route for service partners is to
simply work at a firm that is not in the business of providing the restricted services. They
can go in-house (as a partner) at a partnership engaged in another line of business and get
the full deduction. For example, a lawyer becomes a partner in a real estate firm. Or, if
doing work at all related to construction/development, they may categorize themselves as
“architecture” or “engineering” firms in order to avoid definitely being classified as a
disfavored trade or business.19

•

Athlete’s Brand, LLC—a game denied, or not? Our prior report (and an earlier
Washington Post article), 20 explained how highly paid services providers like doctors,
lawyers and athletes might be able to access the business deduction by spinning off their
“brand” into a separate firm. This new firm would not provide services but instead would
manage the brand and therefore avoid the restrictions on professionals. (This may also be
useful for, say, a reality TV star whose main source of income is royalties.)
It is unclear whether or not the conference bill allows this game. The conference bill
specifies that, if the principal asset of the firm is the “reputation” of the owner (and not
just “employees” as in the prior version of the legislation), then this source of value also
falls into the denied “service” category.
This addition to the conference bill probably kicks out the law firm trying to spin off its
reputation as a brand. However, if an athlete or someone in the performing arts (also
listed) assigns the right to actively license his or her image and name to a pass-through, it
would be the pass-through’s intellectual property (the right to license the image), and not
the reputation of the owner that would be its principal asset. So, this is yet another way
that an athlete or entertainer could access the pass-through rate—in addition to the
packing strategy discussed above. Argue that the source of value isn’t reputation in the
first place.
Would this argument ultimately succeed? We don’t know the answer, and will read future
cases on these issues with interest. In at least some circumstances in the past, the IRS has

in the fields of health, law, [etc.] . . . .” Cf. § 1202(e)(3)(A). Thus, a trade or business that involves both the
performance of legal services and the management of real estate is, on a straightforward reading, still “a trade or
business involving the performance of services in the field[] … of law.” On this view, “packing” would be
ineffective because any trade or business that involves a specified service and another enterprise still “involv[es]”
the specified service.
19
The degree to which architects and engineers get favorable treatment is unclear as a result of drafting problems in
the conference bill. See supra note 8.
20
See The Games They Will Play, supra note 1, at 11; Steven Pearlstein, The Bryce Harper Tax Relief Act,
Washington Post Wonkblog (Dec. 1, 2017), https://www.washingtonpost.com/news/wonk/wp/2017
/12/01/the-bryce-harper-tax-relief-act-of-2017/?utm_term=.7dafde70c44b.

13

 not been particularly strict in its application of the rules defining when a firm’s principal
asset is the reputation or skill of its employees. 21
To be sure, even if the spin-off game still works, that separate firm would need to pay
sufficient W-2 wages (or own enough depreciable property) 22 to preserve eligibility, but
this barrier could be overcome since managing these brands often involves services from
others. Further, even if there aren’t many employees, the firm could pay some W-2 wages
to the original service providers (like the athlete) in order to get the deduction on the rest
of the income running through the firm.
•

Property counting toward the pass-through deduction—game or a glitch or both? In
the new conference bill, pass-throughs can take the special 20% deduction now without
paying any wages. They just need property. What kinds of property count? That’s
ambiguous. Apparently, for these purposes, property includes any kinds of tangible
property that’s in theory subject to depreciation. The initial cost of any such property
gets counted for a minimum of ten years.
First, this allowance generates several bad incentives and loopholes. Businesses are
incentivized to own tangible property within the firm in order to take advantage of the
pass-through deduction. Do not rent from others if the limitation on deductibility is
having any bite. In fact, you could own very old property (like an old building) that has
been depreciated over decades, but you count it as it were a brand new property, at its
original cost. And, again, it is possible to do this and access the pass-through deduction
even in the absence of any employees or W-2 wages paid.
Basing eligibility for the pass-through deduction on depreciable property and wages can
even incentivize businesses to engage in money-losing operations (making investments or
paying employees) just to access the pass-through deduction.23 This particular formula
may even encourage businesses to replace employees with equipment in some cases.
Second, the conference bill is ambiguous as to what property actually counts for these
purposes—and taxpayers can play games here as well. Does computer paper count (so
long as you keep the documents around the firm)? How about paper clips? They are both

21

See Private Letter Ruling 201717010 (finding that a lab testing service qualified under section 1202 and neither
provided a forbidden service nor had the skills or reputation of its employees as its primary asset).
22
This is because even a “good” business with high income must meet the W-2 or asset basis test.
23
Daniel Shaviro provides the following example: Assume a pass-through has no employees, and therefore no W-2
wages. The business buys a debt-financed asset for $100, with zero cash out of pocket. The asset earns a 6% rate of
return, but the business pays 7% annual interest on the debt. Absent tax considerations, this would be a net money
loser. Under the pass-through rules, however, the business can apply 2.5% of the cost of new asset ($2.50) towards
the pass-through deduction, thereby reducing their taxable income by $3.50 per year (when added to the net $1
interest expense). At a 37% rate, this deduction will reduce the taxpayer’s final tax liability by approximately $1.30,
which is more than the economic loss from the money-losing investment. Shaviro describes some of these details
in a recent blog post: http://danshaviro.blogspot.com/2017/12/under-new-tax-bill-lose-money-before.html.

14

 forms of tangible property—in theory, subject to depreciation (if they weren’t
immediately expensed as business supplies). And, what about improvements to property?
The provision says that you use “unadjusted basis” in this calculation allowing the
deduction; improvements are an adjustment to basis. Do you get no credit for that?
Should you buy improved property then rather than improve the property yourself in
order to become eligible for the deduction? The questions go on, and the IRS has its work
cut out for it.
In all of these cases, the fundamental problem is the lack of any underlying logic in deciding who
benefits from the pass-through deductions, and who does not. Independent contractors and
partners benefit, but not employees. Why? An owner of real estate through a REIT benefits, but
not the doctor in the building. Why? An architect benefits in some ways that a lawyer does not.
And so on. For each of these formalistic and seemingly arbitrary distinctions, there is a game to
be played to fall within the favored category. The IRS should try to staunch the bleed in
revenue—and action here is far better than nothing—but it will naturally be an uphill battle. The
much better answer would be to simply eliminate the provision.
C.

Restructuring State and Local Taxes (SALT) to Maintain Deductibility

The conference bill caps the SALT deduction at $10,000, but permits a combination of taxes in
order to reach that cap. For example, a taxpayer could deduct both property and income taxes up
to this combined amount.
Some taxpayers will now find themselves at or below the cap and thus not directly affected by
the partial repeal. 24 In many parts of the country, however, taxpayers pay state and local taxes
well in excess of $10,000. This is why even a partial repeal of SALT remains such a significant
revenue raiser.25 For the same reason, affected states will still have ample incentive to respond
creatively to the changes in federal tax law.
In our prior report, we described four possible responses by states and municipalities to
restructure their revenue collections and preserve the SALT deduction. Three of these four
strategies remain available to states under the conference bill. All involve transforming state
taxes no longer deductible over the cap into economically equivalent payments to the
government that remain deductible. Furthermore, although all of these strategies involve some

24

These taxpayers, just like taxpayers who will no longer itemize at all because of the doubling of the standard
deduction, might still be paying more under the conference bill. A lot depends in particular on how the taxpayer is
impacted by the repeal of the personal exemption, increased child tax credit etc.
25
Presumably the capping of the SALT deduction represents the lion’s share of the $668 billion projected savings
from the partial repeal of SALT, changing the mortgage interest deduction, eliminating non-casualty losses and
miscellaneous expenses. For some analysis of the numbers of taxpayers who will be affected by partial SALT
repeal, see https://itep.org/compromises-under-discussion-for-the-state-and-local-tax-deduction-do-not-fix-flawedtax-bills/.

15

 administrative complexity, they are all built on systems that are well understood and that are
already in use in some states and localities.
•

Property taxes. Both the House and Senate bills originally capped the SALT deduction
at $10,000 and limited it to property taxes. One strategy was therefore to increase
property tax liability while commensurately reducing state income tax liability. This
strategy is no longer available under the conference bill, which allows deduction of both
property and income taxes up to the combined $10,000 cap.

Nonetheless, the $10,000 cap remains, even if state and local jurisdictions have greater flexibility
in the mix of taxes that can be deducted up to this amount. Collecting state and local revenues in
excess of the cap, however, can still be accomplished through one of the remaining three
strategies:
•

Employee payroll taxes. The conference bill does not alter the analysis as to the
potential shift to employee payroll taxes. Taxes imposed on a business are still
deductible. Therefore states can shift from non-deductible over-the-cap state income
taxes to still-deductible employer-side payroll taxes. It is important to repeat that that
states already impose a payroll tax for unemployment insurance purposes, and many
localities impose an additional payroll tax as well—and employers currently can claim a
deduction for their portion of these taxes.

•

Charitable gifts. The conference bill does not alter the analysis that the new law would
permit the shift from use of non-deductible over-the-cap state income taxes to deductible
charitable contributions to state and local governments. One point bears further emphasis:
Many states already have laws in place granting state income tax credits for donations to
certain funds, and the IRS has allowed taxpayers who take advantage of these credits to
deduct their payments as charitable contributions rather than as state taxes.26

•

Business “franchise” taxes on pass-throughs. State and local taxes, possibly including
income taxes imposed on a business, remain deductible by pass-through businesses—so
long as they are imposed on the entity itself rather than the individual. 27 As a result, state
and local jurisdictions can impose a deductible tax on pass-throughs that approximates an
individual income tax, while reducing individual income taxes that are no longer
deductible.28 Imposing such taxes might be appealing for reasons beyond the continued

26

See Carl Davis, ITEP, Tax Bill Would Increase Abuse of Charitable Giving Deduction, with Private K-12 Schools
as the Biggest Winners (Dec. 2017), https://itep.org/wp-content/uploads/vouchersheltersalt1217.pdf.
27
See in particular footnote 170 of the conference report (page 79).
28
As an administrative matter, this reduction would presumably be in the form of a credit against state personal
income taxes for the entity-level tax. A 100% credit could arguably undermine the deductibility of the entity-level
tax, but a similar argument did not prevail in the charitable contribution context. In any event, a state looking to
these kinds of taxes to maintain deductibility and recapture some of the tax benefit that wealthy pass-through owners

16

 deductibility of these taxes. The conference bill retains special low rates for many passthrough businesses; a state that imposes a new—or higher—tax on pass-throughs can
capture some of this gain. 29
•

A new one-time opportunity. By design, many taxpayers will pay state and local taxes
in 2018 that they would have been able to deduct in 2017. But tax year 2017 is not over.
Perhaps then a winning strategy would be for individual taxpayers to pay some of their
2018 taxes in 2017 and deduct them before there is a cap. The conference bill anticipates
this and attempts to prohibit it directly (more on this in a moment), but only as to income
taxes. This suggests that prepayment of other taxes, and in particular property taxes, 30
may still be deductible in 2017.
Also, as pointed out by Victor Thuronyi, the prohibition on accelerating income tax
payments may not actually work as intended by Congress. Because of a possible drafting
error in the conference bill, the prohibition appears to only apply to taxable years
beginning with 2018. As a result, there might be no prohibition with respect to 2017,
despite what they seem to have intended.31

D.

International Games, Roadblocks, and Glitches 32

The international tax provisions in the conference bill present numerous gaming opportunities,
adverse consequences under international law, and undesirable incentives to locate investment
and assets abroad. Nearly all of the issues we identified in the initial report are still present. One
has been mitigated, but the statutory fix creates taxpayer unfriendly results.
For greater detail of these issues, see the discussion in our prior report at Part II.D. and the
Appendix.

will enjoy would not impose a simple 100% credit. A less than 100% credit that is greater for lower-income
taxpayers is less likely to pose a problem for the entity-level tax.
29
There are multiple other avenues available to states that are looking to recapture such gains or raise revenue for
some other purpose—perhaps even for the purpose of making whole those taxpayers who lose on account of the
partial repeal of SALT. State personal and corporate income taxes broadly conform to their federal counterparts, and
thus states must decide whether or not to conform to the changes in federal law. These conformity choices can be
made strategically. For instance, a state can choose to conform to the new provision limiting the deductibility of
interest payments made by a business. Conforming in this instance can mean additional revenue for the state.
Alternatively, or in addition, a state can choose to piggyback on the various new tax taxes created by this bill in the
international arena.
30
In California, for example, taxes are due in April and December. Many property owners have therefore received a
property tax bill due in April 2018.
31
See Victor Thuronyi, Whatever Source Derived, A Mistake in the Rule That Says You Can’t Deduct State Income
Tax Prepaid in 2017 (Dec. 17, 2017), https://medium.com/@vthuronyi/a-mistake-in-the-rule-that-says-you-cantdeduct-state-income-tax-prepaid-in-2017-ae6f55865e04.
32
This section on international tax mainly reflects work by Rebecca Kysar, who has benefited greatly from
discussions with multiple international tax experts over the last several weeks, in particular Reuven Avi-Yonah,
Cliff Fleming, Mitchell Kane, Ed Kleinbard, Mike Schler, and Stephen Shay.

17

 1. Problems with the minimum tax on global intangible low-taxed income (“GILTI”)
•

The minimum tax formula induces companies to locate assets and investment
offshore. The conference bill imposes a minimum tax on global intangible income that is
intended to stop U.S. corporations from shifting profits out of the United States. The
base-shifting problem is exacerbated under the planned switch from a worldwide system
(where the income of foreign subsidiaries earned abroad is merely deferred) to a
territorial system (where it is exempted altogether).
The minimum tax, as structured, is highly problematic. The conference bill exempts from
the tax a deemed 10% return on tangible assets abroad, measured by tax basis. This rule
encourages U.S. firms to locate tangible assets (and accompanying jobs) overseas. 33
There is no regulatory fix since this is a policy decision made in the bill. 34 The
conference report suggests that certain non-economic transactions be disregarded in this
context, however this language will not discourage firms from locating real assets
offshore in order to reduce the minimum tax since such transactions will produce real
economic consequences.35
The deemed return on tangible assets is also set relatively high at 10% as compared to
similar provisions in the code, which set returns a few percentage points above the riskfree return on Treasury yields. This allows a great deal of a company’s return on
investments in real assets abroad to be completely exempt from U.S. taxation. 36

33

Perhaps the conferees thought that the location of tangible assets to avoid the minimum tax is a real response and
therefore, since it has nontax consequences, is not abusive. The offshoring effect, however, is still present even if the
activity has non-tax effects and indeed carries more severe consequences to the United States than if income is
simply shifted in paper transactions. Additionally, a taxpayer may move tangible assets abroad, even if there is some
diminution in pre-tax profits (that is, profits after foreign taxes but before U.S. taxes), in order to reduce U.S. tax
liability by a greater amount than the loss of pre-tax profit. This analysis comes from discussion with Reuven AviYonah and Dan Shaviro.
34
The conference report also changes the rules governing where income is sourced when it comes from inventory
that is partly produced in the United States and partly produced abroad. Current law allows taxpayers to effectively
allocate half of the income to foreign sources by designating title to pass abroad. The new provision simply looks at
location of production, which, like the minimum tax formula, may further incentivize firms to locate real production
activities abroad. Thanks to Cliff Fleming for this point.
35
The report goes further to state that “the conferees expect the Secretary to prescribe regulations to address
transactions that occur after the measurement date of post-1986 earnings and profits under [the provision on onetime repatriation], but before the first taxable year for which [the GILTI provision] applies [2018], if such
transactions are undertaken to increase [qualified business asset investment].” This language is aimed at transitional
planning tactics like those identified by Stephen Shay rather than the asset shifting problem we identify. Stephen
Shay, Tax Reform—Process Failures, Loopholes, and Wealth Windfalls (Nov. 21, 2017 draft), at
https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3076151&download=yes.
36
Consider a firm that invests $10 million in a plant abroad that will generate $1 million of income. It will get to
exempt all of that income through the deemed 10% return, or $1 million, so that there is no U.S. tax. In contrast, a
firm investing in a $10 million plant in the United States that will generate $1 million of income pays U.S tax of
$210,000 (21% of $1 million). Note that the rate on the income from the U.S. plant would be lower if such income
was export income, which is effectively taxed at a 13.125% rate in the conference bill. Where there happens to be

18

 Furthermore, because the conference bill applies the minimum tax on a global basis
(rather than country-by-country), firms are also incentivized to locate investment in lowtax countries and blend that income with income from high-tax countries. The trade-off
then is tax at 21% for investment in the U.S. versus no marginal U.S. tax liability for an
offshore investment. These incentives are fundamental to the structure of the legislation
and cannot be cured by regulation.
•

The minimum tax can no longer be fully avoided through leveraging, but the
statutory fix produces taxpayer unfriendly results. As we mentioned in our prior
report, under the Senate bill, a firm could borrow to buy tangible assets abroad, and the
interest expense would shield intangible income from taxation. The tax benefits of this
planning opportunity have been mitigated, but the statutory fix presents problems of its
own.
New rules in the conference bill limit arbitrage opportunities because they require that
interest expense reduces the income that is exempt from the minimum tax regime rather
than reducing the income subject to the minimum tax regime. 37 This mechanism
effectively causes interest expense to reduce the 10% tax-free return on tangible assets. 38
However, the new rule may produce an anti-taxpayer result by stacking all interest
expense first against the fixed tangible return rather than by using a pro rata allocation
against tangible and intangible income. If a firm borrows to buy an intangible asset, the
interest expense reduces the exempt return rather than nonexempt income. 39

2. Problems with the reduced rate on export income (foreign-derived intangible income or
FDII)
•

The reduced rate on export income can be gamed through resale transactions. The
conference bill effectively grants export income a favorable 13.125% rate. As we
mentioned in our prior report, under one interpretation of the statute, taxpayers may be
able to take advantage of this rate in “roundtripping” transactions, selling to independent

non-exempt return to tangible assets (return in excess of 10%), this is taxed by the minimum tax regime but at a
lower rate than the rate on domestic income. The minimum tax in this case might also be zero if the taxpayer pays
enough overall foreign taxes.
37
Specifically, the conference bill reduces the related foreign corporation’s income from tangible assets by interest
expense to the extent such expense exceeds the interest income properly allocable to that interest expense that is
taken into account in determining the firm’s share of the related foreign corporation’s income.
38
Under the Senate bill, if a firm borrowed $100 at 4% to buy an asset with no return, the firm could reduce the
income subject to the minimum tax by $14 at a cost of $4. Under the conference bill’s new rule, the firm can only
reduce the income subject to the minimum tax by $6 (the $10 (10%) deemed return minus the $4 of interest
expense). Thus, a firm can still reduce the income subject to the minimum tax by using leverage, but this is a
function of the 10% deemed return, not the reduction of that baseline by the interest expense. In other words,
taxpayers can still use borrowing to generate a tax benefit (the 10% tax-free deemed return), but the conference bill
limits the arbitrage opportunities in creating deductible interest expense from borrowing that generates otherwise
exempt income. This analysis comes from discussion with Mitchell Kane and Mike Schler.
39
Thanks to Mike Schler for this point.

19

 foreign distributors, perhaps with strings attached over advertising, marketing, and price,
who then resell back into the United States. Although the bill provides that the taxpayer
has to establish to the satisfaction of the Treasury Secretary that the goods are sold for
use abroad,40 taxpayers will take the position that the intent of an initial sale to a foreign
business is sufficient (like in a VAT regime). Treasury should address such transactions
in regulations.41
•

The reduced rate on export income likely violates WTO obligations. The greater the
U.S. taxpayer’s income from exports, the more of its income gets taxed at the 13.125%
rate (as opposed to the 21% corporate rate). As we stated in our prior report, this regime
is likely an illegal export subsidy in violation of WTO agreements. 42 This serious concern
remains. Taxpayers should expect instability in this area, and the United States should
prepare for WTO litigation. The most likely outcome is that the U.S. will abandon the
export subsidy regime under threat of sanctions. Indeed, since our initial report, the
foreign finance ministers of Britain, France, Germany, Italy, and Spain sent a letter to
Treasury Secretary Mnuchin warning him of the possible violations in this regime. 43

Footnote 1522 of the conference report (page 497) states that “if property is sold by a taxpayer to a person who is
not a U.S. person, and after such sale the property is subject to manufacture, assembly, or other processing…outside
the United States by such person, then the property is for a foreign use.” This presumably allows for roundtripping
so long as there is some degree of foreign processing since otherwise this rule would not be necessary. It is possible
that, by negative implication, the conferees aimed to imply that a sale for reimportation would not be for foreign use
in the absence of further foreign processing. Even if this interpretation of the negative implication is correct, there
will be enormous pressure on the minimum amount of foreign processing necessary to qualify as foreign use,
allowing reimportation into the United States. Regulations to address this point will be necessary, although it is
questionable how effective they can be given the fact-intensive nature of the inquiry. Thanks to Mike Schler for
discussion of this point.
41
For instance, Treasury might use rules similar to those that determine destination under the base company rules to
determine whether a sale is for foreign use. See Treas. Reg. 1.954-3(a)(3)(ii). Problems with these rules, however,
illustrate the difficulties in addressing the roundtripping issue. For one, the base company regulations mandate that
corporations determine the country of ultimate use “if at the time of a sale of personal property to an unrelated
person the controlled foreign corporation knew, or should have known from the facts and circumstances surrounding
the transaction, that the property probably would not be used, consumed, or disposed of in the country of
destination.” This leaves substantial wriggle room for there to be no duty for U.S. firms to determine which property
will be resold into the United States when they sell property to an independent foreign party for resale. In light of the
statutory requirement that taxpayers show to the satisfaction of the Treasury that the property is exported for foreign
use, Treasury should use its regulatory authority to impose an interpretation of the statute that requires U.S.
manufacturers to do a real investigation of how much the foreign party will sell back into the United States, although
given the fact-intensive nature of the inquiry it is unclear how effective any such regulations will be.
42
For further discussion, see Rebecca Kysar, The Senate Tax Plan Has a WTO Problem, Medium (Nov. 12, 2017),
https://medium.com/whatever-source-derived/the-senate-tax-plan-has-a-wto-problem-guest-post-by-rebecca-kysar31deee86eb99.
43
EU Finance Ministers Warn Against Proposed U.S. Tax Measures, Tax Analysts Worldwide Tax Daily (Dec. 11,
2017). The finance ministers note that the export regime is different from accepted patent box regimes in that it
applies to intangible assets other than patents and copyright software, such as branding and other market-based
intangibles.
40

20

 Another possible outcome—the tax measures pursued in this bill may destabilize the free
trade order, and there is already indication that this is occurring.44
•

The reduced rate on foreign derived intangible induces firms to sell to foreign (and
not domestic) manufacturers and does not alleviate the offshoring problem with
respect to IP. The export subsidy rate incentivizes firms to sell unfinished products to
foreign manufacturers since these sales qualify for the lower rate whereas sales to
domestic manufacturers do not. In our initial report we also recommended equalizing the
minimum tax rate on GILTI (now taxed at 10.5% under the conference bill) and the
reduced rate on exports (now taxed at 13.125%) since the rate differential punishes the
activity we want to encourage (exports) and encourages the activity we want to punish
(GILTI) where there are little or no foreign taxes paid. This issue is still a problem in the
conference bill. 45

3. Problems with the Inbound Provisions (BEAT)
•

Problems with inbound provisions meant to prevent earnings stripping using
foreign affiliates, especially by non-U.S. corporations: WTO and tax treaty noncompliance. The conference bill imposes additional tax liability on deductible payments
between a U.S. subsidiary and a related foreign entity. It does this by adding back certain
related party payments and imposing additional tax liability on this expanded base,
effectively ensuring that at least a 10.5% tax is imposed on such income. As we discussed
in our initial report, this presents WTO problems and may be viewed as a forbidden tariff
or discriminatory. Under the letter from the European finance ministers to Secretary
Mnuchin, mentioned above, however, WTO concerns were not mentioned explicitly in
connection to BEAT (although the letter did mention “unfair trade practice”). This
omission may be because the level of WTO-covered import activity subject to increased
taxation is not sufficient to raise the ire of our trading partners. 46

44

World Trade Order in a Wobble as Washington Snubs WTO Status Quo, Reuters (Dec. 15, 2017),
https://www.reuters.com/article/us-global-economy-outlook/world-trade-order-in-a-wobble-as-washington-snubswto-status-quo-idUSKBN1E91GY.
45
The conference report states the lower minimum tax rate under GILTI is justified because only 80% of the foreign
tax credits are allowed to offset minimum tax rate. (13.125% equals the effective GILTI rate of 10.5% divided by
80%.) As we stated in our initial report, however, this justification does not hold if no or low foreign taxes are paid
(for example, in tax havens), which are precisely the circumstances at which the GILTI regime is aimed. In such
cases, firms will pay a 10.5% rate in the U.S. (or close to it). Given the goal of using the export rate to encourage
firms to bring intellectual property back home, this policy choice is questionable. At minimum, a rate somewhere in
between 10.5% and 13.125% could have been chosen to account for the tax haven problem. This is a policy problem
in the bill, and there is no regulatory fix for it.
46
Interest and royalties do not create a WTO issue, so only imports of depreciable property from related parties and
imports from certain inverted corporations will implicate the agreements. Reuven Avi-Yonah, Tit for Tax: How Will
Other
Countries
React
to
the
Tax
Cuts
and
Jobs
Act?
(draft
Dec.
17,
2017),
https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3089052.

21

 As discussed in our initial report, the Senate’s inbound rules were less problematic than
the House’s with respect to our obligations under the double tax treaty regime. The
conference bill largely adopts the Senate’s approach. That being said, we noted that our
treaty partners will likely still argue that the regime violates the nondiscrimination
requirement in the treaties. That is still the case under the conference bill. Indeed, in the
letter from the European finance ministers to Secretary Mnuchin mentioned above, the
foreign ministers argue that the regime results in double taxation by taxing foreign
payments in the recipient jurisdiction without allowing for full deductions in the United
States.47 The United States shall anticipate the erection of similar regimes by our trading
partners applicable to U.S. multinationals 48 and also subsequent pressure from our treaty
partners to scale back the inbound regime on a bilateral basis.
•

Additional planning opportunities and unintended consequences. Since issuing our
initial report, we have had the chance to analyze further planning opportunities and
problems with the House, Senate, and final conference bills:
Royalty payments from a U.S. firm to its foreign affiliate, which holds intellectual
property, would be included in the expanded base. If a foreign affiliate incorporates the
foreign-held intellectual property into a product and then sells the product back to a U.S.
affiliate, this could be considered cost of goods sold that is not captured by the inbound
regime.49
Note also that the conferees did not respond to legitimate concerns that BEAT captures
non-abusive commercial transactions, such as repos and securities lending, while
excluding derivatives. 50 BEAT also captures routine transactions such as a foreign
finance affiliate borrowing for the group and on-lending at cost around the group. As a
result, taxpayers may be penalized under BEAT for non-abusive transactions. 51

47

Id.
Many countries, however, may be limited in their ability to retaliate because, unlike in the United States, their
constitutions prevent treaty overrides by domestic statute.
49
Thanks to Ed Kleinbard for this point. See also David L. Koontz & Jeffrey M. Kadet, Internet Platform
Companies and Base Erosion—Issue and Solution, Tax Notes (Dec. 4, 2017) (discussing how the inbound regime
misses a lot of profit-shifting).
Also note that there are incentives for firms to expatriate given that they can avoid the minimum tax regime postexpatriation and can avoid BEAT by structuring transactions with unrelated parties even if the expatriated firm is a
“surrogate foreign corporation” under 26 U.S.C. § 7874 (or by using the cost of goods sold with related parties tactic
if not). Thanks to Reuven Avi-Yonah for this point.
50
Telis Demos, Wall Street Journal, In Tax Plan’s Fine Print, Banks Find a Problem (Dec. 13, 2017).
51
The conference bill also contains taxpayer-unfavorable glitches. A firm may not pay the minimum tax on GILTI
because they have paid foreign tax. In measuring BEAT, however, the firm has to include GILTI because foreign tax
credits are not allowed in the calculation. Thanks to Ed Kleinbard for this point.
48

22

 4. International Tax Competition
Supporters of the conference bill sometimes assume that lowering the statutory rate to below the
OECD average of 25% will result in considerable investment into the United States, but other
countries will likely respond to the changes enacted by the conference bill by engaging in tax
competition.52 For instance, other countries may cut their foreign tax rates further below the new
U.S. rate of 21%.53 They may also adopt patent boxes in response to the lower rate on exported
intangibles or may impose greater taxation on U.S. subsidiaries of their own multinationals
through rules similar to our controlled foreign corporation rules. 54 All of these realistic responses
might reduce the dynamic growth effects of the conference bill and interfere with the intended
aims of the new regime.
E.

Other Games

There are many other games to be played under this legislation, undermining revenue collection
and the integrity of the tax code—and leading to inefficient behavior. Here are several additional
opportunities:
1. Arbitrage money machines.
The tax bill creates opportunities to use rate differentials and ill-considered transitions to engage
in transactions that serve to basically pump money out of the Treasury and into the pockets of
well-advised taxpayers. Some of these can be done by just the taxpayer; others involve finding a
counterparty with a different set of characteristics. For instance:
•

Sell that old equipment: Get a windfall!55 The conference report adopts the House’s
more generous expensing provision, which allows an immediate write-off for the cost of
certain investments. Specifically, the provision applies not just to purchases of new
property but also to old property. The key problem is that this includes old property
already purchased before expensing took effect. So, what does that mean? It means that
old property can still get the benefit of expensing, but only if it is sold to another party. If
the original owner holds it, they have to depreciate according to the old rules; if they sell

52

A classic example of tax competition is the 1984 U.S. abolishment of a withholding tax on foreign residents who
earned portfolio interest. This sparked a “race to the bottom” among governments across the globe, leading to the
current state of affairs whereby most countries do not tax interest on debt held by foreign persons.
53
This point comes from discussion with Dan Shaviro. Note that predictions of an uptick in inbound investment are
in tension with fact that we continue to exist in a low interest rate environment in which corporate CEOs report that
capital access presents no constraints on undertaking projects at the margin. However, even if there are no capital
allocation effects, the perception by other countries will be that the US has made a strong tax competitive move
here. The rates in other counties may well come down in response. This will aggravate the new incentive we have
created to move tangible assets out of the United States, as discussed under the GILTI regime. This point comes
from Mitchell Kane.
54
For further discussion, Reuven Avi-Yonah, Tit for Tax: How Will Other Countries React to the Tax Cuts and Jobs
Act? (Dec. 17, 2017 draft), https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3089052.
55
For further discussion of possible games with expensing, see Schler, supra note 6, at 1734.

23

 it to another party, then suddenly the full cost is eligible for expensing, and the net effect
is an immediate deduction of the existing tax basis of the asset. The parties can split the
resulting surplus.56 It appears that the buyer of the asset could even lease it back to the
existing owner, so that the property doesn’t even have to go anywhere.57 It’s a further
generous, and unjustified, hand out to existing investment.
•

The pass-through loss game. As in the previous Senate and House bills, the conference
bill continues to allow pass-through losses to be deductible against ordinary income taxed
at higher rates—even as income generated by the pass-through would get the lower rate.
This then reduces the future ability to take the pass-through deduction, but, since they
don’t strictly basket the losses with the income of the same character, it creates a possible
arbitrage across the rates, especially if transactions are arranged to generate income
upfront with losses after.

2. Avoiding the Interest Limitation with a Pass-Through
Following the House and Senate bills, the conference bill caps business interest expense
deductions at 30% of an adjusted measure of profits. The cap excludes interest earned by the
business, which may be fully offset by interest paid. This interest limitation is considered a
necessary rule to prevent a business from deriving a double benefit from the purchase and
expensing of debt-financed property.58
However, for pass-throughs, there is a way out of the limitation, as Daniel Hemel has
described.59 Specifically, transform the payment from an interest payment into something very
similar that is considered to be a payment on an equity interest in the partnership. A corporation
could try the same maneuver directly, but will not find any tax benefit since dividends are not
deductible to the corporation. The same is not true for profit shares paid out of partnership,
which will now be taxed preferentially relative to debt financing. They are essentially deductible
to the partnership, and only taxed once at the individual level. Not only that—but investors who
hold preferred equity-like interests in these partnerships potentially would be eligible for the new
20% deduction. So, the basic game for a partnership is to pay out preferred returns on equity
instead of interest. As it turns out, corporations can get access to the same arrangement, but by
stacking entities as described below.
56

If the purchaser is a flow-through, the purchase may also allow its owners to qualify for the flow-through
deduction under the new rule that allows the deduction up to 2.5% of the acquisition cost of tangible depreciable
property.
57
Of course the arrangement would have to be structured as a true lease for tax purposes. For a discussion of this
additional planning opportunity, see Schler, supra note 6, at 1734.
58
For more detail on the benefit of expensing debt-financed property, see Chris Sanchirico, Expensing and Interest
in the GOP Blueprint: Good Idea? Bad Idea?, 155 Tax Notes 339 (April 17, 2017).
59
See Daniel Hemel, How to Skirt the Cap on Interest Deductions in the GOP Tax Plan . . . and to Make Some
Money While You’re at It, Whatever Source Derived (Dec. 13, 2017), https://medium.com
/whatever-source-derived/how-to-skirt-the-cap-on-interest-deductions-in-the-gop-tax-plan-bca62fc58a4f.
These
strategies were suggested to the author by a lawyer specializing in structured financial transactions.

24

 The IRS may try to attack this by recharacterizing partnership preferred equity as debt under
section 707(d), which applies to guaranteed payments by a partnership. However, section 707(d)
applies only for the purposes of specific sections and subsections of the Code, and does not apply
to the cap on interest deductions under the proposed section 163(j).
3. Games with Stacked Entities (the Up-C Structure)
Another set of games involve stacking a corporation on top of a pass-through to generate better
tax results (sometimes called the Up-C structure)—and especially to bypass some of the
restrictions that would most affect corporations alone, like the limitations on deductibility of
interest and executive compensation. The Up-C structure—which provides a workaround—
involves a public C-corporation being a partner in a partnership that owns all of the assets of the
business.
This structure could allow taxpayers to avoid key provisions in the conference bill through the
following games:
•

Allowing corporations to avoid the interest limitation. Just like a partnership, the UpC could finance itself with what is essentially fully deductible interest, as Hemel also
describes.60 Specifically, the partnership would issue the preferred equity and bank the
full deduction at the partnership level. Thus, the corporation itself never borrows; it’s the
partnership doing the quasi-debt financing (via preferred equity), and getting the full
deduction as a result. (And, again, if the corporation tried to do this directly, it wouldn’t
save taxes since dividends aren’t deductible to it.)
In theory, Treasury and the IRS could use their broad power under section 385(a) of the
Code to “prescribe such regulations as may be necessary or appropriate to determine
whether an interest in a corporation is to be treated . . . as stock or indebtedness.”
However, those section 385 powers would seem not to apply in cases when the subsidiary
partnership of the corporation (rather than the corporation itself) issues debt-like
preferred equity.

•

Allowing corporations to avoid the deduction limitation on executive
compensation.61 The Conference bill amends section 162(m) to further limit public (and
certain private) companies’ ability to deduct certain salaries in excess of $1 million, and
limits businesses’ ability to deduct interest expense. Again, the Up-C can avoid a
deduction limitation. Make the executives partners in the partnership and not necessarily
employees of the corporation. The executive could receive their compensation in the

60

See id.
For more on this, see David Miller, “Tax Planning Under the Tax Cut and Jobs Act: Flow Throughs Are the
Answer to Everything”
(December 13,
2017),
https://papers.ssrn.com/sol3/papers.cfm?abstract_id
=3070662.
61

25

 form of allocations of income via the partnership. This would not be salary or wages, and
thereby would avoid the section 162(m) limitations, and would additionally provide the
executive with the pass-through rate.
F.

Other Glitches

Our prior report described glitches in both the House and Senate bills that would unduly penalize
taxpayers, such as the reintroduction of the Corporate AMT in the Senate bill and the rules for
capital contributions to corporations in the House bill.
The conference bill eliminated both of these glitches, but other potential problems remain. Some
of these could inadvertently raise revenue, while others could be costly. Here are a few:
•

Paying taxes on legal settlements that go to the lawyers, not to the victim. The
conference bill entirely eliminates “miscellaneous itemized deductions.” As Gregg
Polsky points out, these deductions are already restricted under current law, but, in some
cases, can still provide important—and appropriate—write offs. For instance,
contingency fees for lawyers in legal settlements in cases involving such issues as
defamation, intentional infliction of emotional damage, and punitive damages are now
only deductible as miscellaneous itemized deductions. With that eliminated, there would
be no deduction—and a victim would be taxed on income that she doesn’t actually have
(even as the lawyer is also taxed on the contingency fee being paid). For a 1/3
contingency fee, the result would be a 70% after-tax reduction in the recovery (since for
$100 of recovery, the tax would be $37 and $33 would go to the lawyer.) 62

•

Heads you lose; tails you lose. The Conference bill adds a new section 451(b) that
provides that, for an accrual method taxpayer, the “all events test” is met with respect to
an item of gross income when the item is taken into revenue on the taxpayer’s 10-K or
audited financials. Let’s assume that the taxpayer is a mutual fund that reports its income
on a mark-to-market basis for GAAP purposes. Half of the mutual fund’s securities go up
by $10 and half go down by $10. The all events test is deemed met for the half that went
up, but not the half that went down. The all events test is the trigger for tax liability.
Therefore, the unhappy mutual fund has taxable “phantom” income for the half that went
up, but no economic income (because the other half went down), and no cash (because
none were sold). This is not what the drafters meant (and they tried once to fix it), but the
words say what they say.

We expect that, with more time and analysis, many more such problems will be identified.

62

Thanks to Gregg Polsky for this insight, sent to us by e-mail.

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 III.

What Comes Next?

We are deeply concerned by the challenges ahead for the tax system and its admnistration over
next several years. Treasury and the IRS are being handed a herculean task of immediately
implementing a large number of complex and ambiguous provisions in just a few short weeks.
Moreover, the new pass-through deduction will likely result in a massive restructuring of
employment and service arrangements across many industries.
The immediate priority is for the IRS and Treasury to be granted substantial latitude to issue
preliminary guidance, in order to reduce uncertainty and to warn of games that will not be
allowed—to be followed with new rulemaking. Especially since Trump’s appointed Assistant
Secretary for Tax Policy is now serving as Acting IRS Commissioner as well, these actions will
depend on the Trump administration not avoiding rulemaking as they have in many other areas.

We expect 2018 to be something of a “wild west” for well-advised taxpayers and their advisors,
who will rush to create “facts on the ground” that would hinder IRS efforts to reverse some of
the gaming—making swift action from Treasury and the IRS all the more important.
A second priority is to give the IRS the resources it needs to issue such rules and to enforce
them. The IRS is unfortunately well behind what it should be. Since 2010, IRS funding fell 18%
in real terms. The number of IRS employees in enforcement has fallen by over one-quarter, and
the Trump Administrations FY18 budget proposed yet another reduction. This trend will take
27

 time to reverse, but it will be all the more important to do so with this new bill in place. Put
simply, with so many new games to play, large amounts of revenue could depend on the IRS’s
capabilities in shutting them down.
Finally, there should be an agenda to fundamentally overhaul—and, in many cases reverse—the
changes that would be made by this new law. As we said at the start, the haphazard lines and the
ways in which this legislation differentiates between winners and losers for no discernable policy
reason ultimately undermines the basic integrity of the income tax. Unfortunately, there is only
so much that the IRS can do to protect the tax system; much of the damage will need to be
corrected through future legislation.

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 Appendix: Summary of Key Provisions in the Conference Bill
The conference bill roughly follows the provisions in the Senate bill[, while incorporating some
features from the House bill. In particular, the conference bill would make the following changes
to the tax law that are relevant to the analysis in this report (this summary is simplified for the
purposes of the discussion):
•

Taxation of individual ordinary income. Individuals will be taxed on their ordinary
income (such as wages) at a top statutory rate of 37% through the year 2025, which is a
reduction of 2.6% from the current top rate of 39.6%. The 3.8% tax on net investment
income is preserved, as well as additional payroll and Medicare taxes, resulting in a top
possible marginal rate of 40.8%.

•

Taxation of C-corporations. All C-corporations are taxed at a flat 21% rate beginning in
2018, including “personal service corporations” which are taxed differently under current
law.
The “dividends received deduction” for dividends from an unaffiliated domestic
corporation is reduced from 70% to 50%. As a result, such dividends will be taxed to the
payee corporation at a 10.5% rate.63

•

Taxation of pass-through income. A taxpayer may deduct 20% of “qualified business
income” earned through a partnership, S-corporation or sole proprietorship. A taxpayer’s
qualified business income does not include amounts paid by an S-corporation or a
partnership that are characterized as compensation.
Qualified business income is capped at 50% of the wages paid by the business to its
employees. Capital intensive businesses without significant wage income (such as real
estate and automated manufacturing) can instead apply a cap that is the sum of 25% of
wages paid plus 2.5% of the cost of certain qualified business property.
Certain activities are excluded from the category of qualified businesses, including may
professions such as law, financial services, and athletics. Taxpayers below a threshold
amount ($315,000 of taxable income for a joint return) are not subject to the wage cap
nor the exclusion of certain activities.

•

63

Deduction for state and local taxes. All individual taxpayers have a choice whether to
itemize their deductions or take the standard deduction. The conference bill doubles the
standard deduction and so reduces the number of itemizers. The suspension of the Pease
limitation on itemized deductions, however, could increase their value for higher-income
taxpayers.

50% of the 21% corporate tax rate.

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 State and local taxes (SALT) for individuals can still be itemized and deducted, but only
up to $10,000. The $10,000 cap can be reached through a combination of property and
income taxes (or sales taxes instead of income taxes).
•

International Tax. The basic structure of the international reform has four key elements:
o Exemption of foreign income of U.S. corporations from taxation in the United States
(a territorial system)
o Backstopping the new territorial system with a 10% “minimum tax” on foreignsource intangible income (the “global intangible low-taxed income” or GILTI regime)
o A special low rate on export income in the United States (the foreign-derived
intangible income or “FDII” regime); and
o Targeting profit-stripping by foreign firms operating in the United States (the “base
erosion and anti-abuse tax” or BEAT regime).

30