The “I’m My Customers’ Employee” Trick
From reader Terry Mellon:
I’m a supporter (time and money) of the FairTax effort, but under the heading of “too good to be true,” I’m starting to puzzle about weaknesses it might have. Given that I’m an independent consultant (i.e., I sell services), and given that under the FairTax I would have to collect/submit taxes on those services (right?), and given that if I were performing the same services as an employee I would not have to collect/submit taxes (right?), maybe I should try to devise a LEGAL way for me to do my work as an employee.
For this to work it would have to be possible for me to be hired as an employee with no more time, effort, expense, or committments by either the consumer (of my services) or by me than it would be to contract with as a consultant. Is that possible? For example, my consultant agreements generally have an “either party can terminate this agreement at any time for any reason or no reason” section. Is such a section allowed in an employer-employee arrangement?
If I’m OK so far, then my approach would be to offer my services to the consumer at a discount (say 10%) if the consumer will hire me as an employee, given that I would thereby be making 23%-discount% (say 13%) more than as a contractor.
Comments please. And keep in mind that I’m as interested in increaing my understanding of the FairTax as I am in devising a tax avoidance scheme. Assume I have no tax or economics expertise...because that’s true.
No FairTax taxes are paid on business-to-business transactions, so let’s assume all his consulting work is done for end consumers.
So here’s the rub. As pointed out, no business to business transactions are taxed, so if you are working as a consultant to a business then don’t have to collect FairTax on your services. You are in exactly the same tax position as an employee of that business.
Now lets consider the case where you are providing your consulting service to an end consumer. If you just charge them for your service, you must collect FairTax on that service. So what if instead they ‘employ’ you. For example, what if rather than pay a cleaning service to clean my private residence, I hire a ‘maid’ as an employee of mine. Well, the FairTax authors thought of that. In HR 25 (b) (2) it says:
“(b) Tax To Be Remitted by Purchaser in Certain Circumstances-
`(1) IN GENERAL- In the case of taxable property or services purchased outside of the United States and imported into the United States for use or consumption in the United States, the purchaser shall remit the tax imposed by section 101.
`(2) CERTAIN WAGES OR SALARY- In the case of wages or salary paid by a taxable employer which are taxable services, the employer shall remit the tax imposed by section 101.”
What this basically means is that if I as an end consumer try to ‘employ’ servants rather than ‘pay’ for their services, then I am responsible for collecting and paying the FairTax just as if I’d hired a service provider. This basically closes the loophole where one might have imagined the rich could have simply ‘hired’ servants to dodge the tax. In truth, they can’t. Effectively, it makes the choice of whether to ‘pay’ for a service or ‘hire’ an employee to provide that otherwise taxable service neutral in terms of their tax effect.
Joshua,
Thanks for posting my question. And thanks for your note at the end–it virtually answered my question which was, in fact, about business-to-business transactions (although I didn’t recognize that).
quadrupole,
Thanks for your reply, especially the citation into HR 25 which means I don’t just have to take you word it.
But now I have another question. Given that B2B transactions are not taxed, what’s to prevent everyone from becoming his/her own business so as to avoid the FairTax? I’m serious. I’m considered a business under the current Fed tax system because I woke up one morning and said “I’m a business,” and thereafter filed the appropriate business tax forms claiming all those lovely business deductions. No incorporation, no LLC–I just declared myself a Sole Proprietorship. The only requirement for me to be able to keep doing this is to be able to show a certain level of income.
So given that it is my filing of a tax return that enables the current tax system to determine whether or not I’m a business, and given that there won’t be any tax returns in the FairTax system, what defines a business in the FairTax system, how does that get recorded, and how does that get verified?
Darn...now I’ve got another question. The question is: In the FairTax, what’s the difference between a business and an end consumer? I can best illustrate my confusion with an example. Let’s say an independent consultant is paid by a business to give an after-dinner presentation on a new technology, and let’s say, for the sake of argument, that the business knows it will never use any of the information from that presentation. Is it really the case that the FairTax does not consider the business as having “consumed” that presentation service? In other words, is this type of transaction really considered B2B?
Terry,
Basically, both of your questions are answered in HR 25 Section 102 (b):
“(b) BUSINESS PURPOSES- For purposes of this section, the term `purchased for a business purpose in a trade or business’ means purchased by a person engaged in a trade or business and used in that trade or business–
`(1) for resale,
`(2) to produce, provide, render, or sell taxable property or services, or
`(3) in furtherance of other bona fide business purposes.”
There is no FairTax on money spent for a business purpose. So if your purchases are not for a business purpose and you are seeking FairTax exemption as such, you are in violation of the law. To give you some idea of the thinking there, the FairTax even has a notion of ‘Hobby Activity’ found in HR 25 Section 701:
“(a) HOBBY ACTIVITIES- Neither the exemption afforded by section 102 for intermediate sales nor the credits available pursuant to section 202 or 203 shall be available for any taxable property or service purchased for use in an activity if that activity is not engaged in for-profit.
`(b) STATUS DEEMED- If the activity has received gross payments for the sale of taxable property or services that exceed the sum of–
`(1) taxable property and services purchased;
`(2) wages and salary paid; and
`(3) taxes (of any type) paid,
in 2 or more of the most recent 3 calendar years during which it operated when the business activity shall be conclusively deemed to be engaged in for profit.”
Basically, the real litmus test is are you spending money to generate a product or service that eventually trickles down to an export or a retail sale. If you are, you are spending money for a business purpose, if you aren’t, you aren’t.
There are basically two checks on preventing you from trying to launder your personal purchases through a business. First, if you want to avoid paying the FairTax on your business purchases you have to register and receive a business certificate. Second, you are required to keep records “sufficient to determine whether said exemption was valid for a period of 7 years after the purchase of taxable property or services.” (HR 25 Section 509). Third, the business selling you goods or services without charging you the FairTax has to “keep records (including a record of all section 510 receipts provided, complete records of intermediate and export sales, including purchaser’s intermediate and export sales certificates and tax number and the net of tax amount of purchase)” (HR 24 Section 509). Basically, there’s a paper trail. It’s pretty much the same sort of paper trail that businesses are keeping already for state sales taxes. If you aren’t really a business but are claiming to be your going to look really strange on paper. Buying but never selling (even to other tax exempt businesses) is weird, and will attract attention.
quadrupole,
Brilliant. Your reply as well as the FairTax. And thanks again for citing HR 25 in your reply. Before I submitted these questions, I tried to find answers within HR 25 but didn’t have any confidences in what I found. Looking up your citations has helped me unravel HR 25 a little bit more.
Terry,
Legislation of all kinds can be confusing. The only reason I pretty much lnew were to look is I went through the exercise of answering the objections of a friend of mine who was SURE the FairTax was all a plot to allow the rich to escape taxes. He thought of LOTS of potential loopholes, and I went hunting through the legislation to find where all of them were closed.
Your questions so far have been very good, and I thank you for them.
[...] AFFT Director of Research Karen Walby sent us the following reply to The “I’m my Customer’s Employee” Trick. [...]
I support the fair tax because it is in fact much fairer then the income tax today. Wealthy people spend a lot more money then the low-income people. The FairTax taxes everyone one, not just certain people. I also believe that this FairTax is a good thing because individuals would have an extra incentive to work hard and earn income, leading to a far more productive nation then what our nation is today.