In 2017, Congress passed the Tax Cuts and Job Act, which has been beneficial on the corporate side of tax reform. On the individual side, Congress allowed politics to get in the way of real reform, and that is inexcusable. The most egregious example of this was the elimination the miscellaneous itemized deduction.
The miscellaneous itemized deduction was truly the only legitimate deduction in the Internal Revenue Code (IRC). Its inclusion was absolutely necessary to maintain the integrity of the tax code. This deduction allowed taxpayers the ability to write off expenses that were incurred as part of the process to earn the income they are taxed on! For instance, under prior tax law, a person who earned $100K on an investment but had to pay $30K in legal fees, investment management fees, accounting fees, or other expenses to get it, would pay taxes on only the $70K net that was actually made during the process. With the new change now removing the miscellaneous itemized deduction, this person will have to pay taxes on the full $100K!
Let’s take a look at how this changes affects the little guy, the middle guy, and the wealthy guy in a fictitious New York setting:
The Little Guy: Here’s a fellow who is renting an apartment for his family and he has to deal with landlord security interest. For people who rent and have tenant security, their landlords pay them interest on it and the landlords are allowed to keep 1% per year, essentially as a fee for keeping track of the tenants. When interest rates are low (as they have been for the past few years), it’s not uncommon to have a rate of 1.25%, of which the landlord keeps 1%; this leaves the .25% to the tenant. For example, if the tenant had a $5K security deposit, his interest is $62.50. The landlord would keep $50, leaving $12.50 for the tenant. But the tenant will have to now pay tax on the full $62.50. Even at a modest tax rate of 25%, the tax would be $15.75; therefore the tenant earns $12.50, pays $15.75 in taxes, with a net loss of $3.25.
The Middle Guy: This person has filed a lawsuit to recover lost wages. In most lawsuits (except physical injury), the legal settlement is taxable. It is not uncommon that, between the lawyer and his fees, they keep 35% and the person keeps 65%. That means, if he wins $100K in his lawsuit, the lawyer gets $35K and he gets $65K. But now, under this change in the provision, his $100K win is taxed on the full amount even though he only actually received 65%. Not only is this unequitable, but it is likely to push him into a new tax bracket. That means he now pays $40K to the IRS (~ 40% tax bracket including federal and state taxes), plus the $35K to the lawyer, netting him only $25K out of the original $100K.
The Wealthy Guy: We have a hedge fund investor. When you have hedge fund investments, rather than reporting and paying taxes on profit, the IRS requires you to break it up into component parts. (Those component parts include interest, qualified and non-qualified dividends, short term gains, and long term gains.) These are all things that contribute to the positive side of calculation. On the negative side, you have operating expenses. The investor then profits from the net of the income, less the expenses. Prior to the change in the tax law, all of the other expenses that reduce profit – which, with hedge funds, include virtually all operating expenses to earn income, including fees to the managers – were required to be recorded as miscellaneous itemized deductions. Now, with the removal of the deduction, the hedge fund guy has to pay taxes on all of it. For instance say he earned a net profit of $2 million. It was reported to him as income of $3.5 million and operating expenses of $1.5 million, thus netting him the $2 million. Now, even though he earned $2 million, he now pays taxes on the full $3.5 million. The average tax rate for such a taxpayer may be approximately 40% (32% for federal + 8% NY taxes). This means he pays about $1.4 million in taxes. Therefore, hedge fund guy makes $2 million net, pays an actual effective tax rate of 70% (because he is taxed on the full $3.5 million) and gets to keep only $600,000. It should also be noted that if the hedge fund lost money, he would get little-to-no tax benefit as a result of that loss.
The loss of the miscellaneous itemized deductions affects all levels of taxpayers. Simply put, if you can’t deduct miscellaneous itemized expenses, you wind up paying taxes on income that you actually didn’t earn. That is simply outrageous — and unfortunately, it is now the case as a result of last year’s tax reform. Allowing such deductions is truly the construct for fair tax law; everything else is merely subsidies, politics, picking winners and losers. Congress must act to restore this equitable provision and restore confidence to the taxpayers.