Fixing the Loophole in the House Limit on Deductibility of State and Local Income Taxes
This post reflects joint analysis by Mitchell Kane, Daniel Shaviro, John Steines, and me. All of us are Professors of Law at New York University School of Law. Thanks also to Daniel Hemel at University of Chicago — and co-blogger here — for some key insights.
The House Ways and Means Committee is now rushing toward passing its tax overhaul legislation. Even as it does, one of the largest revenue raisers in the legislation — the elimination of the itemized deduction for state and local income taxes — seems to have a huge loophole for pass-through business owners and investors (but not employees) that probably was not taken into account in the revenue and distributional estimates. Yesterday, Representative Blumenauer demanded answers from Chairman Brady and the Joint Committee on Taxation (JCT) staff on this topic (see here and look to the 3 hr 38 minute mark).
In light of that exchange, we wanted to review some key outstanding questions for both Chairman Brady and JCT, and explain why the legislative text likely needs to be revised for this limit to raise approximately what JCT now says it does — and to avoid the fundamental unfairness of business owners and investors being able to deduct their state and local income taxes even as employees cannot. As we explain in the Addendum, the legislative language needed to address this problem is simple, even as the difference in policy is significant.
Key Outstanding Questions
· First, under the legislation, is there a loophole in the proposed limit on deductibility of state and local income taxes allowing investors and pass-through business owners (partners in law firms or private equity firms or Donald Trump himself) to take an itemized deduction for the state and local income taxes they pay on their profits, even as employees cannot?
Our assessment: Based on the current legislative text and the descriptions of the legislation so far offered by Ways and Means staff and some JCT written materials, we believe the answer to this is “yes” — the best reading is that there is such a loophole.
· Second, do the current revenue and distributional estimates from JCT take this “pass-through” loophole into account?
Our assessment: Based on what we have seen so far and comparing the JCT revenue estimate to others, we believe the answer is likely “no” and that JCT, contrary to what the bill seems to do, has assumed that no state and local income taxes are deductible as an itemized deduction — whether paid by a business owner, investor, or employee.
· Third, do the revenue and distributional estimates take into account how states and localities could restructure their income taxes to preserve deductibility for trade and business owners (but not employees), even if the itemized deduction really is barred? We explain later in this post exactly how this restructuring would work to essentially preserve deductibility of state and local income taxes for pass-through business owners.
Our assessment: Again, our best guess is that the answer is “no” and that the JCT estimates are much too optimistic for this reason alone.
The Problem and How to Fix It, If the Committee Wants To
At issue is likely hundreds of billions of dollars of revenue from some of the highest income Americans, and so a bill which is intended to cost $1.5 trillion might actually cost significantly more than that and be more regressive than is now estimated. Either the text of the legislation should probably change or the revenue and distributional estimates probably should.
If the Committee wishes to actually raise roughly the same amount of revenue as it now does under JCT estimates, there is a “fix” for the legislative text of the bill: Bar the deductibility of state and local income taxes to all individuals, irrespective of the source of their income. (We suggest legislative text in the Addendum.) As we have said before, there are strong arguments both for and against the deductibility of state and local income taxes, but there is no good rationale for offering the deduction to only investors and pass-through business owners but not employees — generating both significant unfairness and substantial revenue loss as compared to what JCT appears to be assuming.
Reviewing Why Owners and Investors Probably Keep Their Deduction
We will now briefly review why we believe that the best reading of the current legislation is that it keeps the itemized deduction for state and local income taxes for owners and investors but not employees. Much of this is a review of arguments we’ve presented before.
The legislation amends section 164 of the Code by eliminating the current provision (164(a)(3)) granting deductibility of state and local income taxes to anyone irrespective of the source of their income. However, deductibility of some state and local income taxes paid by individuals remains.
Specifically, what remains seems to be governed by the flush language of section 164(a), which suggests that the following state and local income taxes would be deductible: “those paid or accrued within the taxable year in carrying on a trade or business or an activity described in section 212 (relating to expenses for production of income).”
Both Ways and Means and the Joint Committee on Taxation seem to also believe this flush language from 164(a) governs since they repeat the language in their descriptions of the effects of eliminating 164(a)(3). For instance, JCT writes: “State and local income, war profits, and excess profits taxes paid or accrued, other than those paid or accrued in carrying on a trade or business or an activity described in section 212, are no longer allowed as an itemized deduction.” (Emphasis added)
A natural reading of the flush language of 164(a) is that business owners (regardless of choice of pass-through entity) and investors get to continue to take an itemized deduction for their state and local individual income taxes paid by them on the income from those businesses and investments.
To illustrate, let’s start off with what seems like a relatively easy case: a sole proprietor (sole owner of a business) whose only income comes from that trade or business. For federal tax purposes, there is no distinction between the sole proprietor and her business (in tax speak, the business entity is “disregarded” and the owner is the only person/entity involved). This sole proprietor pays state and local individual income taxes on her income. The sole proprietor has a strong argument that she is paying those taxes “in carrying on a trade or business” — the taxes apply to her and she is the trade or business, with no separate entity even being involved.
The same logic relatively naturally extends to pass-through businesses with multiple owners (partnerships or S-corporations in tax lingo), even though there are separate entities involved. In these cases, the business income “passes through” the entities to the business owners, and the federal government and most state and local governments then tax the profits at the individual level. Thus, taxes paid by the pass-through owners would seem to be paid “in carrying on a trade or business” — with the profits simply showing up on the individual returns and being taxed there.
The same would go for state and local individual income taxes paid on investments — again, that would seem to be paid in “carrying on” the investment activity.
Note, however, that employees would not enjoy the same deduction. Employees do have a trade or business — the trade or business of being an employee. However, the House legislation explicitly bars deductibility of any employee trade or business expenses that aren’t explicitly listed as above the line deductions, and taxes aren’t on that list. Because of that new prohibition, employees would be denied the write-off.
What Could JCT Be Thinking?
During questioning on Monday, Thomas Barthold, Chief of Staff of JCT, suggested that pass though owners would not be able to enjoy an itemized deduction for state and local individual income taxes paid on their business income. Similarly, he further stated that, under the legislation, no individual would be allowed to take state and local income taxes as an itemized deduction under Schedule A (the form for itemized deductions). This was even as he said that some state and local income taxes would be deductible.
What could JCT be thinking? In a previous post on this topic, one of us expressed bafflement, but, since then, Daniel Hemel has helpfully suggested what might explain some of Barthold’s answers. (Many thanks to Daniel for illuminating this line of thinking.)
Specifically, JCT might be looking to a set of doctrine that arose under section 62. That section, the earliest version of which was enacted in 1944, established the concept of “adjusted gross income” — and differentiated some deductions that could be taken “above the line” (to arrive at adjusted gross income) from those that could only be taken “below the line” (subtracted from adjusted gross income to arrive at taxable income). Above-the-line deductions can be taken in addition to the standard deduction, while below-the-line deductions can only be taken instead of the standard deduction — meaning that it is better to take a deduction above the line than below the line.
What does this have to do with state and local taxes? Well, 62(a)(1) pulls above the line any deductions allowed by other sections that are “attributable to a trade or business carried on by the taxpayer.” And, when legislating the original version of this section, Congress addressed in a committee report whether state and local individual income taxes paid on business profits would be allowed as an above the line deduction or not. In legislative history at the time, Congress said that the answer was “no.” The Senate committee report, describing what would be allowed as an above-the-line deduction, said: “The connection contemplated by the statute is a direct one rather than a remote one. For example, property taxes paid or incurred on real property used in the trade or business will be deductible, whereas State income taxes, incurred on business profits, would clearly not be deductible for the purpose of computing adjusted gross income.” The House committee report had similar language.
Soon after enactment of 62(a)(1), Treasury issued a regulation echoing this language from the committee report and pertaining to 62(a)(1) only, and new iterations of the regulation have continued to use similar language (see 1.62–1T(d), now in effect). Over the decades, there have been numerous cases litigated featuring taxpayers trying to deduct state and local individual income taxes under 62(a)(1) rather than as itemized deductions below the line (and so trading off against the standard deduction), and they have failed. The courts have consistently deferred to clear legislative history and Treasury regulation in barring deductibility under 62(a)(1).
There are, however, some now very limited state income taxes that are deductible under 62(a)(1). These are taxes imposed specifically because the income is being earned by the trade or business (though there is actually a very thin line between this and pure individual level taxation). For example, in New York City, there is the Unincorporated Business Income Tax imposed on the income of unincorporated entities. Such taxes — since they are imposed specifically on unincorporated business income — are considered to be sufficiently directly connected with the trade or business as to be deductible under 62(a)(1) by the individual owners of the pass through.
JCT may very well be assuming that the way to determine what it means to pay taxes “in carrying on a trade or business” under the flush language of 164(a) is to look to the doctrine of 62(a)(1) and what it means to have expenses “attributable to a trade or business.” This would then read in the various requirements previously specific to 62(a)(1) and determining whether a deduction is allowed above the line into the flush language under 164(a) as to what is as a below-the-line itemized deduction. In this way, JCT may be reaching the conclusion that, under the House bill, the only income taxes that are deductible are those few taxes now eligible for an above-the-line deduction under 62(a)(1).
To be clear, this is all somewhat informed speculation. What JCT is actually thinking with respect to how the law works and how that is reflected in the revenue estimated remains unclear.
Why JCT Is Likely Being Too Optimistic, Perhaps Way Too Optimistic
However, there are two problems with JCT probably assuming in its revenue estimate that the House plan will eliminate all of the state and local income taxes now being deducted below the line as itemized deductions:
· The first is that, that absent much clearer legislative history and, even better, a change to the text of the proposed legislation, a better reading of the law is that it allows below-the-line itemized deductions for state and local individual income taxes paid on business or investment income. The 62(a)(1) restrictions would not apply.
· The second is that, even if the deductions are restricted to those under 62(a)(1), states and localities are very likely to respond by changing the structure of their income tax systems to maintain deductibility of the taxes for business owners.
Why Deductions for State and Local Income Taxes May Not Be Limited to Those Now Allowed Under 62(a)(1)
We believe that absent much clearer legislative history and, even better, a change to the text of the proposed legislation, it is a major leap of logic to assume that the restrictions on what is deductible above the line under 62(a)(1) will naturally translate to restricting what is deductible as an itemized deduction under the flush language of 164(a). In fact, based on what has transpired so far, we think that is a strained reading and would not be surprised if the IRS were to lose litigation if it were to try to take that position.
This is for several reasons.
· As discussed earlier, it requires a somewhat counter-intuitive reading of the language of 164 to conclude that state and local individual income taxes paid by a sole proprietor, for instance, are not paid in “carrying on” a trade or business per the language of 164(a).
· Congress provided crystal clear legislative history upon enactment of 62(a)(1) to help illuminate what it meant to be “attributable” to a trade or business — and all of the later regulations and case law were informed by that. The same is not the case here in terms of the meaning of “carrying on” under 164(a), a different phrase in a different section. Based on the last several weeks, we have a confused legislative history that, on the whole, tends to point toward full deductibility as an itemized deduction. Nowhere in any of the descriptions so far of the House bill’s amendments to 164 is there any reference to the restrictions under 62(a)(1), nor description of the very limited types of taxes deductible under 62(a)(1). Yes, Barthold in his testimony has suggested that the itemized deductions would be denied. However, that happened even as a Ways and Means spokesman issued a statement to a New York Times reporter interpreted by that reporter as confirming our previous analysis explaining how there’s a large pass-through loophole (see below for the tweet from Jim Tankersley). It’s possible that the spokesman’s statement was misinterpreted by the New York Times, but, if so, the Ways and Means Committee Republicans so far have made no apparent effort to correct the now very public record. The descriptions of the bill from JCT, our own previous analysis, the Ways and Means Committee response, and the statement to the New York Times have so far established a legislative history that seems very much in contrast to that for 62(a)(1).
· 62(a)(1) can logically be read as simply setting a higher bar for above-the-line deductibility than for below-the-line deductibility when it comes to taxes paid by a trade or business. 62(a)(1) does not separately authorize deductibility of any trade or business expenses. Rather, it acts to pull above the line certain trade or business expenses authorized by other parts of the code. So, in this case, it was pulling above the line some trade or business expense (for payment of taxes) where the root authority lay elsewhere. And, the legislative history and the regulation therefore can be read to suggest that 62(a)(1) was pulling above the line only some of the taxes related to trade or businesses that were authorized as deductible elsewhere — that 62(a)(1) was setting a higher bar than the underlying root authority (here, probably 164). The legislative history nowhere says that such expenses simply aren’t trade or business expenses flat out for any part of the code, which it potentially could’ve. Rather, it is written in a way that can be reasonably interpreted as applying a higher bar specific to above-the-line deductions.
Are there plausible arguments that could lead to the opposite conclusion — that the restrictions of 62(a)(1) apply to the flush language in 164(a)? Yes. But, that in some sense isn’t what’s important at the moment. What’s important is that — if Congress simply leaves the record and legislative language much like it is now — a court could very well find otherwise, with massive effects on both equity and government revenue.
Why Even If the Deductions Are Restricted to Those Now Allowed Under 62(a)(1), JCT Is Probably Substantially Over-Stating Revenue
Further, even if at the end of the day the state and local income tax deduction for businesses is actually limited to what is now deductible under 62(a)(1), JCT is likely substantially over-stating revenue.
That’s because states and localities will almost certainly be put under immediate pressure from business owners to change their tax systems to maintain deductibility of state and local income taxes. And, the way to do it seems straightforward. Impose taxes like the NYC Unincorporated Business Income Tax and in place of traditional individual level income taxes. For instance: A state or locality could impose an unincorporated business income tax of whatever rate and then make that tax fully creditable against an owner’s normal individual income tax. The unincorporated business income tax would be deductible, while the normal individual income tax (which would be reduced for every dollar paid in unincorporated business income tax) would not be deductible. Via this relatively simple set up, states and localities could probably achieve full deductibility of state and local income taxes for business owners, even if the IRS fought hard and managed to restrict people to deducting under 62(a)(1). And, note that states and localities could not try a similar scheme for employees because a deduction for employee business expenses is barred outright by the new legislation. The inequity would remain.
For those who think that this sounds far-fetched, we bring you the existing NYC Unincorporated Business Income Tax. For NYC residents, it is already partially creditable against their regular individual income tax. For those with the highest incomes, the credit rate is 23 cents on the dollar (for each dollar of Unincorporated Business Income Tax, the regular individual income tax is reduced by 23 cents), and the credit rate is even higher for those with lower incomes. And, yet, the Unincorporated Business Income Tax is wholly deductible above the line. The game is already afoot. Just wait until the incentive becomes much, much larger.
In sum, states and localities have a seemingly easy route toward achieving full deductibility for business owners, even if the House legislation doesn’t do it directly (as we think it probably does based on the current record). In scoring legislation, both JCT and CBO frequently make best guesses at how states and localities change their laws in response to federal policy; the same should be the case here. And, here, there would be a very strong incentive for states and localities to restructure their income tax systems in a way that costs them no revenue while effectively cutting the federal tax rate on business owners in their jurisdiction.
Getting to a Fix
There are at least three possible routes forward, the first two of which should probably involve JCT significantly revising upward the cost and regressivity of the legislation absent other changes:
· First, no further clarity could be provided. In that case, our best reading is that state and local income taxes would remain fully deductible for business owners and investors as an itemized deduction, but not for employees. As compared to current estimates, revenue and taxes for the highest income Americans could be lower by hundreds of billions over the next decade relative to what is now being assumed.
· Second, Ways and Means could clarify that the deduction is restricted to what is now permissible under 62(a)(1) (taxes like the NYC Unincorporated Business Income Tax). But, again, even if Ways and Means does that, JCT should probably still revise downward its revenues significantly — reflecting the likely reaction of states and localities under pressure from business owners to maintain deductibility. States and localities, working with business owners, could eventually achieve something close to the equivalent of having maintained deductibility of all state and local income taxes for business owners to begin with.
· Finally, Ways and Means could rewrite the legislation to outright bar any deduction for individuals for paying state and local income taxes. We believe this is likely the one route that would come closest to maintaining the same amount of revenues and the same distribution as now being estimated for the legislation. Below we have suggested a simple amendment to the Code that would accomplish this result. (The result should in fact probably be a bit more revenue than currently estimated, simply because it would bar deductibility of what is now a small category of taxes like the NYC Unincorporated Business Income Tax.)
In this rush to legislate, policymakers should not be able to escape the consequences of their changes to the tax law. The limitation on the deductibility of state and local income taxes is among the largest revenue raisers in the entire legislation. Congress should not be allowed to create its own through-the-looking-glass world where the revenue and distributional tables reflect one policy while the actual legislation seems to be doing something very different.
Addendum: How to Amend the Code to Close the Loophole
If the Ways and Means Committee wants to shut down the loophole that it is now creating and to, in all likelihood, be most consistent with current revenue and distributional estimates, we believe this could be accomplished with a simple amendment to the Code.
Specifically, Section 275 (describing “certain taxes” that aren’t deductible), could be amended by adding a new subsection (b) that would read: “For an individual, no deduction shall be allowed under this Title for state and local income taxes.”