A Loophole, Legislative Chaos, and Big Questions About the House Bill
I yesterday put up a post describing how the House tax overhaul package might be only denying the deduction for state and local income taxes to employees — and still permitting the deduction to individual business owners (receiving income through pass-throughs) and investors. This was based on analysis by me and several fellow NYU colleagues. If true, this major loophole would result in deep unfairness and plenty of gaming. It would undermine one of the largest revenue raisers in the entire package, raising about $1 trillion over the coming decade.
Today, Ways and Means Republicans released a statement confirming that this loophole really does exist — per my post yesterday — and that pass-through owners (partners in law firms and private equity funds and, yes, Donald Trump) would be able to take their state and local income tax deduction even as others couldn’t.
However, Thomas Barthold, Chief of Staff to the Joint Committee on Taxation (a non-partisan staff which helps draft and analyze the legislation and who was testifying today), also had something to say on the matter in the Ways and Means mark-up hearing today. When asked, he said the loophole doesn’t exist and that owners and investors wouldn’t be able to take the deduction for state and local income taxes, though he conveyed this in a confusing fashion.
So, whose word to believe? It seems clear that Ways and Means Republicans intend to write a loophole into the limitation on the state and local income tax deduction — or have us believe they are. They’ve said so. Repeatedly. Over time. And the statutory language, though ambiguous, could get them there.
What JCT believes is another matter.
This post updates yesterday’s discussion and also gives a window into what seems like legislative chaos that is undermining policymaking and raising big questions about the House bill. A key issue: Does the bill actually cost more than the $1.5 trillion that the JCT now says? If JCT has the understanding conveyed by Barthold but Ways and Means is actually doing what they are saying in building in the loophole, JCT would be estimating too much revenue from the limitation of the state and local income tax deduction.
Ways and Means Says the Loophole Is There!
Following up on my and Dan Shaviro’s posts yesterday (based on analysis done by a group of NYU law professors also including Mitchell Kane and John Steines), reporters asked Ways and Means whether we were right — right that business owners, with profits flowing to them through entities like partnerships and s-corporations, could continue to deduct state and local individual income taxes paid on those profits even as employees could not.
Ways and Means answered and said that was the correct interpretation. I bring you their response courtesy of The New York Times’s Jim Tankersley on Twitter:
Before you read on, I have to say a few words on calling the beneficiaries “small business owners.” That is really the Committee saying that it applies to pass throughs (what they like to call “small businesses”) which don’t have to be small at all and with most of the income flowing to the very top of the income spectrum. “Small business owners” is code for any and all pass through owner.
Case closed. That + the description in the section by section + the description in the Joint Committee on Taxation summary of the legislation = giant loophole.
Barthold Says There Isn’t a Loophole But Is That Right?
In the mark-up today and just as Ways and Means was releasing its statement, Barthold under questioning suggested that there was no such loophole. However, his own answers lacked clarity. Barthold made several comments on the issue, which I will do my best to paraphrase based on notes — the transcript will hopefully be available soon and I can double check. If inaccurate in any way, I apologize. (Note that these remarks were made in response to questions from Representatives Blumeneauer and Chu. I didn’t see any other statements on the matter, but could have missed.)
· First, Barthold repeated some version of the language that everyone keeps saying: under the legislation, state and local income taxes that are paid in carrying on a trade or business or production of income may still be deducted by individuals.
· Second, he said that if someone tried to simply turn themselves into a pass-through — the basketball coach becoming the LLC — that person wouldn’t be able to get a deduction for state and local income taxes. He said the same was true of someone working as a partner at a private equity firm; the deduction is denied to them too, according to Barthold. In both cases, Barthold seemed to relate the denial of the deduction for state and local income taxes to the fact that they wouldn’t be eligible for the special 25 percent rate available to certain pass throughs in the legislation since they are simply service providers — and service providers don’t get the 25 percent rate.
· Barthold also suggested that state and local income taxes deductible under Schedule A (the schedule for below the line itemized deductions) would be denied to everyone, irrespective of the source of the income subject to state and local tax.
Let me break this down and point out some problems with these statements:
· First, Barthold agrees that some state and local income taxes remain deductible to certain individuals — namely, the income taxes paid by individuals in carrying on a trade or business or production of income. (But, remember employees are denied the deduction because the law eliminates the deduction for unreimbursed employee trade or business expenses.) Ok — so if this doesn’t refer to income taxes paid by individuals on their pass through income and investments, what exactly does it refer to? I can’t think of a satisfying answer.
· Second, Barthold suggests that service providers in pass-throughs couldn’t take this deduction because they’re service providers. But, I’m not sure why. Section 164 — which authorizes the deduction for taxes — does not distinguish owners of firms who provide services from those that don’t.
Barthold is right that the new 25 percent rate provision does deny the preferential rate to such service providers. But, there is no linkage between the 25 percent rate and deductibility of state and local income taxes. There are a complex set of rules applied to who can get the 25 percent rate; if they wanted such limits on deductibility for state and local income taxes, they’d need to write them or cross-reference the new ones they’re adding.
So, this can’t explain why the basketball coach (forming his own LLC) or private equity partner wouldn’t get the deduction.
· Third, Barthold says that the legislation is intended to bar the deduction of any state and local income taxes on “Schedule A” (the schedule for itemized deductions). By this, I take him to mean that there would no longer be allowed a below the line itemized deduction for any individual for state and local income taxes — only state and local income taxes that are deductible as an above the line deduction for businesses or investors would be available.
But, this statement runs straight into 1.62–1T(d) — a provision pointed out to me by Alan Viard. That regulation bars any above-the-line deduction (as opposed to a below-the-line itemized deduction) for “state taxes on net income … even though the taxpayer’s income is derived from the conduct of a trade or business.”
So, if state and local income taxes paid on carrying out a trade or business aren’t deductible above the line and aren’t deductible below the line, then the deduction seems to be entirely disallowed to individuals — and this contradicts Barthold’s own claim that some of these taxes are deductible and of course the Ways and Means statement which is even clearer.
Chaos and Questions
I’m sure that JCT and Barthold are trying to do their best in impossible circumstances. But, that’s what they are: impossible. The denial of the deduction for state and local income taxes is among the largest revenue raisers in the bill. It has a significant effect on the distribution of the legislation and affects millions of Americans. And, with the bill approaching a vote in committee, there is no clarity on how the provision works — perhaps only clarity that Ways and Means intends for there to be a loophole.
What other gremlins might be hiding in the legislation? And, importantly, does the legislation really cost $1.5 trillion or is it more? Specifically, in estimating the revenue raised from limiting the deduction for state and local taxes, did JCT assume that (some?) pass through owners and investors still got the deduction, which is the apparent intent of Ways and Means?
Your guess is as good as mine, and, as the House pushes rapidly toward voting on a complete overhaul of the tax code, they are questions that deserve answers.