Is There a Gaping Hole for the Best Off in the House Bill’s Limitation on the Deduction for State and Local Income Taxes?
The House bill’s limitation on the deduction for state and local income taxes has generated plenty of commentary and controversy. However, one key issue has not received attention: Does the House intend to give a huge preference to owners of companies and even passive investors (think law firm partners or Donald Trump) over employees by allowing the owners and investors to write off their state and local income taxes, while employees can’t?
That seems to be the intention based on the description of the legislation offered by the Ways and Means Committee and also the Joint Committee on Taxation. The actual statutory text of the legislation is ambiguous, and so there is a mystery right now at the very center of what is perhaps the most important revenue raiser in the entire legislation. House Republicans need to provide a clear answer to this question, and they shouldn’t do what they seem to be attempting, according to their own descriptions.
And, credit where credit is due: The central insight on the possible unfair application of the limitation on the state and local tax deduction came from a conversation among my NYU law colleagues begun by Mitchell Kane and John Steines. Dan Shaviro, also part of our conversation, should also be blogging more on this soon (UPDATE: Dan’s blog his here). (But all errors are my own!) Thanks also to Catherine Rampell of the Washington Post for asking me about this problem to begin with.
Here’s what the Ways and Means Committee seems to be attempting: Employees wouldn’t be able to write off their state and local income taxes, while owners and investors would. Take a law firm partner or any other owner of a business (see Donald Trump) drawing a profit share from a company. If the company is a “pass through,” there is no tax directly on the company — only at the individual level on their profits. So, that owner pays state and local income taxes at the individual level and then, under the House plan, the owner apparently might still get to deduct the state and local income taxes. The law firm partner (and Donald Trump) would then be unscathed. By contrast, any employee paying state and local taxes on their wages wouldn’t get a deduction.
If that’s true, it makes no sense.
This has several important implications:
· First, there may be a basic unfairness lurking in how the deduction for state and local income taxes gets limited in the House bill. The owner of a company or even a passive investor in that company seems to be able to deduct her state and local income taxes that she pays on the company’s profits, while the company’s workers would not.
· Second, the limit is gameable if this is true. The lesson here: Don’t be an employee. Become an independent contractor; turn yourself into your own LLC. And, then, you probably get the deduction for state and local income taxes. Those high-income Americans who have the power to renegotiate their employment relationships and who are well advised should be able to largely avoid the limitation. For those following the tax debate, it’d be the pass-through loophole all over again.
· Third, there is a question for revenue estimators whether they are taking into account the possible giveaway here to firm owners and investors relative to employees and the fact that the limit will be gamed. If they are not and the bill actually does still give the deduction to firm owners and investors, then they are estimating too much in revenue — possibly much too much revenue — from this source.
Deductibility of State and Local Taxes
How is it possible that an individual business owner — including passive investors — could deduct taxes paid on the profits from that firm but workers could not under the House plan? I’ll here quote the Ways and Means Committee’s own description of the provision. A more technical walk through is at the back for those interested in true tax wonkery and why there’s ambiguity as to whether the provision has this massive hole (as apparently intended) or not. (We need answers!)
According to the Ways and Means Committee section-by-section: “Under the provision, individuals would not be allowed an itemized deduction for State and local income or sales taxes, but would continue to be entitled to a deduction for State and local income or sales taxes paid or accrued in carrying on a trade or business or producing income.”
There is a similar description from the Joint Committee on Taxation pasted at the end of this post.
Let me translate. Apparently, if you’re an individual paying taxes on trade or business income or income from an investment (“producing income”), you keep your deduction.
But, wait a moment. You might think that covers everyone, including employees. After all, employees are engaged in a trade or business — the trade or business of being an employee. (If that’s not intuitive, let me assure you that’s the treatment under the current tax code. Employees do have a trade or business, even if they don’t own a company.) So, maybe everyone gets to keep their deduction! Not so apparently.
The kicker is in section 1312 of the House legislation, which denies any deduction for employee business expenses (unless they’re specifically listed elsewhere as above-the-line deductions — and taxes aren’t listed). Translation: Yes — the employee is engaged in a trade or business, but the employee is out of luck because the employee can’t take deductions for business expenses.
We can have a debate about the deduction for state and local taxes and its wisdom. (I tend to believe that a partial deduction makes sense in the perfect world.) But, this way of denying the deduction would be deeply unfair and prone to gaming.
I can think of one possible justification for the line that tax writers are apparently attempting to draw: And that is business owners and investors may more often pay taxes in states where they don’t get commensurate benefits or, to the degree they get benefits, those benefits are taxable. But, that is a thin reed for this policy. The law firm partner (and treated under the tax code as a business owner) living in New York and paying New York income taxes should surely have the same treatment as the employee living in New York and paying New York income taxes. But, they don’t under this provision as apparently intended.
The provision would also gameable by the sophisticated. How do you get a deduction for state and local income taxes if the provision does what Ways and Means says? Well…don’t be an employee. Be an independent contractor. Form your own LLC perhaps. And, voila — deductible. Because you’re no longer an employee. You then own your own company. It’s a loophole made for the well-off who have good tax lawyers and an ability to restructure their employment relationships.
And, yes, if you think it sounds like the exact kind of gaming you’d expect due to the legislation’s “pass through” loophole (applying a special 25 percent rate on pass through profits), you’re right. It’d be the same problem, now aggravated. Except here, there are no apparent guardrails in the legislation — and plenty of reason to doubt that the guardrails work even in the context of the 25 percent rate.
In short, the limitation, if it does what the Ways and Means Committee suggests, seems deeply unfair and easily avoided by some of the richest, most sophisticated taxpayers. It’s one thing to deny the deduction for state and local income taxes. It’s another thing to basically deny it only for employees.
In the addendum below, I describe why it’s uncertain if the Ways and Means Committee has actually done what it apparently intended to do. Unlike the descriptions provided by Ways and Means Committee and the Joint Committee on Taxation, the statutory language is itself ambiguous on the treatment of business owners and investors.
The Ways and Means Committee Republicans need to provide answers. They should change the statutory text itself to clarify, and, in doing so, should avoid doing what they’re attempting.
If they stick with giving owners a better deal than employees, that will aggravate what is already a real problem in the legislation — better tax treatment of owners as compared to employees. The problems with regard to the special pass-through rate for business owners have at least been recognized, even if not adequately addressed. The issues with regard to deductibility of state and local income taxes have so far not received attention. They should. The limitation on deductibility of state and local taxes as it now stands in the House bill may be deeply and perhaps fatally flawed.
Addendum 1: A Walk Through of the Statutory Language and Its Ambiguity
I will now do a walk-through showing how the House bill may result in deductibility of state and local income taxes for owners but not for employees. And just to repeat again what I said at the top — credit to my colleagues Mitchell Kane and John Steines for concluding that there may be a real problem here. Owe them huge thanks and credit (with errors being my own).
I’m going to paste below two pieces of text. The first is 26 USC 164(a) — the provision allowing deductibility of state and local taxes (among other taxes) — as it now stands under current law. The second is the amendment from the House legislation, adding a set of restrictions on deductibility under 164(a).
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26 USC 164(a) (Current Law)
(a) General rule. Except as otherwise provided in this section, the following taxes shall be allowed as a deduction for the taxable year within which paid or accrued:
(1) State and local, and foreign, real property taxes.
(2) State and local personal property taxes.
(3) State and local, and foreign, income, war profits, and excess profits taxes.
(4) The GST tax imposed on income distributions.
In addition, there shall be allowed as a deduction State and local, and foreign, taxes not described in the preceding sentence which are 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). Notwithstanding the preceding sentence, any tax (not described in the first sentence of this subsection) which is paid or accrued by the taxpayer in connection with an acquisition or disposition of property shall be treated as part of the cost of the acquired property or, in the case of a disposition, as a reduction in the amount realized on the disposition.
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From the House Bill
SEC. 1303. REPEAL OF DEDUCTION FOR CERTAIN TAXES NOT PAID OR ACCRUED IN A TRADE OR BUSINESS.
IN GENERAL. — Section 164(b)(5) is amended to read as follows:
“‘(5) LIMITATION IN CASE OF INDIVIDUALS. — In the case of a taxpayer other than a corporation —
‘‘(A) foreign real property taxes (other than taxes which are paid or accrued in carrying on a trade or business or an activity described in section 212) shall not be taken into account under subsection (a)(1),
‘‘(B) the aggregate amount of taxes (other than taxes which are paid or accrued in carrying on a trade or business or an activity described in section 212) taken into account under subsection (a)(1) for any taxable year shall not exceed $10,000 ($5,000 in the case of a married individual filing a separate return),
‘‘© subsection (a)(2) shall only apply to taxes which are paid or accrued in carrying on a trade or business or an activity described in section 212, and
‘‘(D) subsection (a)(3) shall not apply to State and local taxes.’’
(b) EFFECTIVE DATE. — The amendments made by this section shall apply to taxable years beginning after December 31, 2017.
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Now, let’s walk through. Currently, state and local income taxes are deductible under 164(a)(3). For individuals, the House bill says the deduction under 164(a)(3) is no longer available (it remains available for corporations). Now, you might think that’s the end of it. Clearly, no individuals — owners, employees, anyone — are going to be deducting state and local income taxes.
Not necessarily. This brings us to the flush language in 164(a). It says (repeating from above):
“In addition, there shall be allowed as a deduction State and local, and foreign, taxes not described in the preceding sentence which are 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).”
If the income taxes are paid or accrued in carrying on a trade or business or otherwise producing income (investment), they may be deductible under this flush language. It seems to be a catch-all. Since the taxes are no longer deductible under 164(a)(3), they may be deductible based on this.
I emphasize “may.” The flush language says that the catch-all applies only to “taxes not described in the preceding sentence.” 164(a)(3) remains in the previous sentence and includes state and local income taxes. However, based on the new 164(b)(5)(D), 164(a)(3) does not apply to individuals, and so maybe the catch-all would apply. To sum up the question: Does the flush language apply to individuals and now encompass state and local income taxes?
To be clear, the Ways and Means Committee and the Joint Committee on Taxation appear to think the flush language applies. My colleagues and I are not sure how else they arrive at the conclusion that they do. And remember — this flush language wouldn’t encompass employees and give them the deduction because the new law specifically denies deductions for the trade or business expenses of being an employee (unless they are above-the-line deductions which this wouldn’t be).
Addendum 2: Ways and Means and Joint Committee on Taxation Descriptions
I am here pasting the Ways and Means and Joint Committee on Taxation descriptions of the current provision, and which suggest that the Republican tax writers intend there to be a large loophole for owners and investors.
Finally, and just to add to the mystery, I’m pasting the Joint Committee on Taxation description of a very similarly drafted limitation on itemized deductions in the 2014 Camp tax reform bill also produced by the Ways and Means Committee. The JCT description from 2014 suggests that there wasn’t the huge loophole in the very similarly drafted limitation. Under that, no individuals would be allowed a deduction for state and local income taxes according to JCT — flat out. It doesn’t seem to matter if the individuals are an owner, investor, or employee (as it should be).
The Ways and Means Committee under Chairman Brady now seems to intend something very different, even as they’ve adopted similar statutory text. I can’t explain the inconsistency, but it’s important here to emphasize that, if there’s ambiguity, this legislative history and the apparent intent of the current authors will be important — and the current authors apparently intend a large loophole for owners and investors (but not employees).
Ways and Means Committee Section-by-Section (Also Quoted Above)
“Under the provision, individuals would not be allowed an itemized deduction for State and local income or sales taxes, but would continue to be entitled to a deduction for State and local income or sales taxes paid or accrued in carrying on a trade or business or producing income.” (Emphasis added)
Joint Committee on Taxation Description
“The proposal provides the following in the case of an individual:
State, local and foreign taxes paid or accrued in carrying on a trade or business or an activity described in section 212 (relating to expenses for the production of income) remain deductible as under present law. In the case of other State and local real property taxes, the proposal limits the deduction to $10,000 ($5,000 in the case of a married person filing a separate return). Other foreign real property taxes and state and local personal property taxes are no longer allowed as a deduction.
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. The election to deduct State and local sales tax in lieu of State and local income taxes is repealed.” (Emphasis added)
Joint Committee on Taxation Description of 2014 Camp Tax Reform Bill with Similar Statutory Language
“The proposal provides that in the case of an individual, State, local and foreign property taxes shall be allowed as a deduction only when paid or accrued in carrying on a trade or business or an activity described in section 212 (relating to expenses for the production of income).
The proposal also provides that in the case of an individual, State and local income, war profits, and excess profits taxes are not allowable as a deduction.” (Emphasis added)
