The TCJA's Pass-Through Deduction Was Misguided From the Beginning


The Tax Cuts and Jobs Act’s (TCJA) special 20% individual income tax deduction for pass-through businesses such as partnerships and sole proprietorships was misguided—and probably doomed to fail--from the beginning. Newly proposed Treasury rules attempt to address some of the law’s most wrong-headed features but, as written, the statute probably is unfixable.

On one hand, lawmakers understood that allowing the deduction to anyone who claimed to be a pass-through business would open the door to an historic raid on the Treasury. But their solution—a set of self-described guardrails that aimed to limit the number of claimants—has sent the entire enterprise skidding off the road and into the deep ditch of picking economic winners and losers.

[...] Congress granted the new deduction to pass-through businesses owners with taxable income of less than $157,500 for singles ($315,000 for joint filers), no matter the nature of their business. But for those with higher incomes, the deduction was available only to owners of certain kinds of businesses. And that is where it all went south.

Failing simplification and fairness

Once Congress started down the road of granting the pass-through deduction to some business owners but not others, it put government in the role of picking very specific winners and losers. A cardinal rule of tax policy is horizontal equity—treating taxpayers in similar circumstances in roughly the same way. Another is that the tax law should be as simple as possible. The TCJA’s pass-through provision scores a resounding “F” on both measures.

The TCJA itself disqualifies from the deduction businesses “in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, [or]brokerage services.”  It also denies the deduction for a trade or business “where the principal asset is the reputation or skill” of its employees or owners.

But what does all that mean? As often happens, Congress dumped the job of sorting it out on the Treasury which last week proposed 182 pages of rules intended to explain which businesses would qualify for the deduction and which would not.

“Only limited by our imaginations”

On Monday, Marty Sullivan, the estimable columnist for the journal Tax Notesdescribed just some of the uncertainty  (paywall) created by the new law. Marty, who looks more favorably on Treasury’s effort than I do, nonetheless points out how potentially inconsistent the law is.

For example, the statute and the proposed Treasury guidance try to sort out which businesses are “specified,” that is, which are disqualified from taking the deduction.

Relying on older regulations that apply to another statute (Sec. 448), Treasury concluded that physical therapy businesses are ineligible for the deduction. But occupational therapy businesses still may be OK. Dental practices are out, but optometrists may be good. Similarly, actors are disqualified as performing artists, but news readers or disc jockeys may not be. As Marty writes, “the list is only limited by our imaginations.”

Then there is the matter of banks. You may think a bank is in the financial services business. But if the bank is structured as an S Corporation, you would be wrong—at least for the purposes of Sec. 199A of the Internal Revenue Code. Owners of these banks, unlike many other financial services businesses, are qualified to take the deduction. Why? There is no policy reason. Rather it is because community banks have outsized influence with members of Congress. They are important businesses in most congressional districts and are politically well-connected.

Blundering into the swamp

Not to put too fine a point on it, but picking winners and losers through the tax code is nuts. It is the inevitable result of a congressional decision to prevent a run on the Treasury. But it makes no sense as a matter of tax policy.

The pass-through rule resulted from four mistakes. First, Congress felt it had to cut taxes for “small businesses” that did not benefit from the TCJA’s significant corporate tax cut. Then lawmakers chose to do so with a preferential deduction for pass-through businesses (many of which are not small businesses at all). Then Congress chose to hold down the cost by limiting access to the deduction. Finally, it chose to do so in part by disqualifying certain kinds of businesses from the special tax treatment.

Inevitably, each of these choices sent Congress down the road of picking winners and losers. By doing so, it blundered into a legislative and regulatory swamp from which there is no exit, short of repealing –or at least rewriting--the statute.