Federal Tax Act Pass-Through Provision: What a Mess!

Tax laws should be simple and direct. Taxpayers should be able to understand and comply with them without the assistance of an army of attorneys and accountants. The treatment of pass-through income in the new federal tax law passed late last year—the so-called “Tax Cut and Jobs Act” (TCJA)—fails miserably by this standard. Specifically, the new qualified business pass-through income deduction is not only difficult to comprehend and administer, but also creates new inequities and gives taxpayers an incentive to game the system to obtain tax breaks.  If Minnesota conforms to this provision, it will cause a significant revenue loss for the state.

Income earned by a “pass-through entity” is considered pass-through income. Pass-through entities include sole proprietorships, partnerships, some forms of limited liability companies (LLCs), and S corporations. These entities do not pay corporate income taxes; instead, they pay taxes on business profits as if it were personal income. Pass-through income is occasionally referred to as “small business income,” although this is a misnomer. While the majority of pass-through businesses are small, in 2014 “almost 83 percent of all sales and 81 percent of profits accrued to businesses with more than $10 million in total receipts,” according to The Brookings Institution.

The TCJA is premised on trickle-down economics. The cornerstone of the TCJA’s trickle-down approach is the huge reduction in corporate tax rates from a high of 35% to a single flat rate of 21%. However, the corporate rate reduction provides no relief to pass-through businesses. To level the playing field, framers of the TCJA felt compelled to enhance the tax break for pass-throughs.  Under the approach Congress stumbled upon:

…a taxpayer other than a C corporation [is allowed] a deduction for the taxpayer’s proportionate share of “qualified business income” [QBI] from a pass-through entity. Qualified business income is the net, taxable income earned by a pass-through entity in a qualified trade or business. Qualified business income excludes reasonable compensation, i.e., salary, paid by a pass-through entity to its owner(s). Qualified business income also excludes investment income realized by a pass-through entity, such as (1) any item of short-term capital gain, short-term capital loss, long-term capital gain, or long-term capital loss; (2) any dividend, income equivalent to a dividend, or payment in lieu of a dividend; or (3) any interest income other than interest income which is properly allocable to a trade or business.

Even if you accept the need to match exorbitant trickle-down corporate tax cuts with exorbitant pass-through tax cuts, the TCJA’s convoluted approach bypassed simpler alternatives. For example, Congress could have reduced the individual income tax rate—which is paid by owners of pass-throughs—to the same degree as the corporate rate. True, this would further increase the federal deficit (although many once-proud deficit hawks abandoned their disdain for red ink when they voted for the budget-busting TCJA). However, Congress could have avoided further explosion of the deficit simply by providing a more modest reduction in both the individual and corporate rates.

To treat pass-through income differently from regular wage and salary income raises questions of tax fairness. Should a person who structures their work in the form of a pass-through business necessarily be given tax treatment more favorable than a person doing the same work as an employee of a company? The new QBI deduction provided to pass-through businesses creates an incentive for workers to restructure their work so that they are no longer employees, but contractors, and thereby eligible for the pass-through tax break.

In an attempt to avoid this eventuality, the TCJA creates yet another new tax concept: the “specified service trade or business.” This category consists of “any trade or business involving the performance of services in the fields of health, law, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners, or which involves the performance of services that consist of investing and investment management trading, or dealing in securities, partnership interests, or commodities.” Businesses in this category are subject to income limitations in determining the pass-through QBI deduction under the TCJA.

No one knows if creation of the “specified service trade or business” category will solve the problem of workers who game the tax code to get pass-through tax breaks. However, two things are clear.

First, the new category further muddies an already complicated federal tax code. Even more complexity arises from the various income requirements, caps, and other factors involved in the QBI calculation. A report from the Tax Policy Center gives a good overview of the can of worms that is the TCJA’s QBI pass-through provision. A plethora of revenue agents will be needed to properly enforce this new provision. The only alternative to increased enforcement is increased tax cheating, even greater reduction in federal revenue, and further erosion in public confidence in the fairness and efficacy of the federal tax system.

Second, the “specified service trade or business” criteria will treat some legitimate pass-through entities differently than others. If there’s anything worse than exorbitant and irresponsible tax cuts, it’s exorbitant and irresponsible tax cuts doled out in an arbitrary and unfair fashion.

If Minnesota conforms to the TCJA QBI tax deduction, the state will lose an estimated $800 million in tax revenue by the end of fiscal year 2021*—and many businesses that were handsomely rewarded through the TCJA will receive another tax relief windfall.

Conservative claims that pass-through business tax breaks will generate increased state revenue should be treated with skepticism. This expectation—rooted in Laffer curve supply-side economics—has consistently gone unrealized in previous pass-through tax breaks. For example, pass-through tax reductions enacted in Kansas in 2012 contributed to recurring state budget deficits and are believed to be responsible for sub-par economic performance; as a result, Kansas recently reversed most of these tax breaks.

While conforming to the TCJA’s QBI pass-through tax break will drain state revenues, conforming to the TCJA’s corporate tax provision will enhance them. We will explore this topic in part 2 of this series.

 

*The $800 million total estimate and the individual fiscal year estimates in the graph represent the combined effect of conforming to (1) the deduction for qualified business pass-through income and (2) the disallowance of active pass-through losses over $500,000 for married-joint filers and $250,000 for other filers. Estimates are based on a preliminary analysis prepared by the Minnesota Department of Revenue.

 

This article was revised on March 21 to reflect new technical information on the TCJA’s QBI deduction.