To fully appreciate how skewed the impact of the Republican tax bill would be, consider what it could mean for baseball superstar Bryce Harper if he were to sign a 10-contract with the Washington Nationals, as many of us in Washington are hoping.
The Nats, known for making creative deals with players, might agree to pay the right-fielder an annual salary of $30 million, which sounds like a lot, but actually isn’t for a franchise player with the star power of Harper. So to reflect that star power, let’s assume the team would pay Harper another $20 annually for use of what tax practitioners would call his “intellectual property” – his name, his face, his reputation — in the form of royalties that the team would earn from its TV contracts and sales of paraphernalia to fans. Add to that $10 million in royalties a year that Harper could probably earn independently from product and other endorsements.
So you add it all up and Harper would have an annual income of $60 million split evenly between salary and royalties. Figure his $30 million salary would be taxed as ordinary income at 48 percent, combining both federal and Virginia state tax. That would leave him with an after-tax salary income of $15.6 million. Now let’s figure he sets aside $2.5 million to live like a young sports star might live, and invests the balance, roughly $13 million, in an S&P stock index fund.
As for the $30 million in annual royalty income, he’d probably do something like sell the intellectual property that generates the royalties each year to a partnership that also operates another business suitable for a professional athlete, such as a chain of fitness clubs. As a result of the sale, he would pay a 30 percent state and federal capital gains tax, and then use the money from the sale of the royalty income to buy an ownership stake in that very same partnership that had bought the rights.
In other words, he sells the stream of royalties from his intellectual property to a partnership in which he himself then becomes a partner. The partnership, in turn, allocates to Harper each year his pro rata share of its profit, which for tax purposes flows through to his personal income. Under the Republican bill, this partnership income would be taxed at an effective rate of 31 percent, for federal and Virginia.
Assuming historical rate of return on the salary income invested in the stock index fund, and a somewhat higher rate of return on his investment partnership, under the bill passed by the House of Representatives, Harper would wind up at the end of the 10-year contract with combined individual and partnership assets worth about $560 million.
Today, under current law, his effective tax rate on his salary would be 45 percent, slightly lower than in the new law because local taxes are deductible. But his combined tax on his partnership income under current law would be much higher, about 43 percent. Using the same assumptions about income and investment returns, that same 10-year contract would only generate assets worth about $520 million.
So he would actually wind up with $40 million more under the new Republican tax plan.
In case you are wondering, I didn’t do these calculations myself. The assumptions and calculations come from someone who has a deep professional understanding of tax law, who in turn checked it with someone whose tax expertise he respects. Given their status in the tax world, both offered these calculations on the condition of anonymity.
This little exercise is just one example of the ways that athletes, rock stars and inventors could game the tax code that the Republicans want to put in place, by turning some of Harper’s salary into capital gains (that’s the royalty gambit) and then running those royalties through a tax-advantaged “small business partnership” to avoid paying a corporate profits tax. And this is a relatively simple example that, by the standards of tax shelters, isn’t particularly aggressive. The number of variations is limited only by the creativity of high-priced accountants and tax attorneys. And it would all be perfectly legal.
Not unmindful of this problem, Republicans have tried to include what they call a set of “guardrails” to limit such games-playing, but because they have rushed the bill through the legislative process, tax experts warn of the high risk that those guardrails won’t prove effective. Add to that the deep cuts Republicans have been making in the IRS budget and you can be fairly confident that very few of these clever tax-avoidance schemes would be caught by the IRS and successfully challenged. And even if they were to be, the understaffed agency would likely settle for a partial recovery of lost revenue.
A badly needed tax cut for all those plumbers and forklift drivers and coal miners? Not exactly.