Pass-Through Regulations:

Doubling Down on Arbitrariness and Breaks for the Top

The proposed pass-through regulations released today reflect the flaws of the deduction (Section 199A) that it’s implementing: arbitrary rules defining who wins and who loses and with a lot of those big winners at the very top.

There is much to be said about the specifics of the proposed regulations, and I’m still digesting.

But, here are a few things that stand out from a first read:

By reading “reputation or skill” narrowly, the IRS would allow many high-income service providers to get deduction — so long as they’re in the right lines of business and plan correctly. Section 199A limits the degree to which high-income service providers get the deduction by listing “bad” services that don’t (in health, law, consulting, and so on) and then also providing a catch-all category which doesn’t as well. The catch-all covers trade or businesses whose principal asset is the reputation or skill of the owners or employees.

Let’s start with the catch-all. As Lily Batchelder points out, the catch-all is important because, if it’s broad, there’s a lot less opportunity for high-income service providers to take advantage and it matters less if you’re in a specific prohibited category. Take architects, engineers, or ad executives — none of whom are in the listed, prohibited categories. Or, take even a health care professional who is trying to wiggle out of that category. If the reputation or skill provision covered all of them (since all of them seem to be about providing skilled services and so on), then the specific listed categories matter a lot less — and the health care professional would have little room to wiggle.

But, the IRS chose to read that narrowly. As the IRS itself says, they read this catch-all to apply to “a narrow set of trades or businesses.” Under the proposed regulations, the category is limited to such things as endorsements, licensing of images, and appearance fees. Not the architect, engineer, ad executive, and so on.

This means it really matters a lot if you’re in the prohibited categories. The surgeon doesn’t get the deduction, but the star architect does. And so does the health care professional who manages to wiggle out of the defined category.

That aggravates the disparate treatment of some services versus others. It will also put a lot of pressure on how those bad services get defined. What exactly are “health” services and so on?

Each of the definitions in the proposed regulation will get lots of attention and prompt plenty of planning. But, let’s take one, health care services, and begin to pressure test.

Health care services are defined as being provided “directly to a patient (service recipient).” This is somewhat consistent with previous IRS interpretation of the cross-referenced section where the IRS found that a lab testing service that did not directly interact with patients (other than in billing) wasn’t considered to be providing the “bad” kind of services.

So, what about radiologists? My understanding — subject to correction — is that radiologists often do not interact directly with patients and instead provide reports to the treating physician (with their distance from patients being a subject of some controversy). Does the distant radiologist — assuming the radiologist is a partner in a firm and not an employee — get the deduction but the treating physician does not? And, if a radiologist does directly talk to patients, would the deduction be threatened?

I don’t know. Seems like the radiologist has a shot at the deduction so long as she maintains her distance, again because the specific definition matters a lot as the catch-all wouldn’t catch much.

And all of this is insane. Architects, engineers, ad executives, maybe radiologists, maybe owners of medical laboratories get the deduction, but not surgeons, lawyers, athletes, and so on. Some of the unfairness and avoidance could have been reduced if Treasury had read “reputation or skill” broadly.

Cracking has to be real in many circumstances to get the tax benefit. A number of us previously considered some of the games that high-income service providers in the listed categories might play in order to get some of their income to be eligible. One of the strategies we called “cracking.” That involved cracking apart overhead and support services into separate firms — that were not in the business of providing legal or medical advice and so on — and then contracting back with the original firm. This would be to try to strip the ineligible profits out and into firms where the deduction can be taken.

The regulations make that strategy hard if not impossible to the degree that there is no substance to breaking apart — other than for being in separate entities. If the cracked firm providing support or other services/property has 50 percent or more common ownership with the firm offering prohibited services, there’s no deduction.

So, that stops an easy tax game. However, in doing so, it will encourage actual cracking. That is, these service firms that contract out their overhead and support services — copying, janitors, assistants, the building in which they’re housed — to other firms under separate ownership will get a tax advantage. That’s because the owners of those other firms, such as the owner of their office building, should be able to get the 20 percent deduction on their income streams — and that tax benefit can then be divided among the various parties. The same benefit wouldn’t be available if the service firm owned the property directly.

This illustrates a further perversity of Section 199A. Here, the IRS understandably insisted on economic substance. But, the result is a set of economic incentives — to really crack out support services and move out ownership of things like buildings — that is also hard to defend. The IRS is defending a line, as they should given what Congress wrote. But, the line itself is silly.

Going in house, or packing, still makes sense. Another approach that I and others previously discussed to avoiding the prohibition on listed services is to go “in house” at a firm engaged in other activities. And that still seems to work under the regulations. A firm can even offer the prohibited services to outside clients — and get a deduction on the income stream — so long as the gross receipts from those services is less than 5 percent of its total for a large firm or 10 percent for a smaller one under the proposed regulation. And, it’s not even clear in my first reading whether true “in house” law counsel, for instance, counts toward that 5 or 10 percent. If the in-house counsel — who is a partner in the firm — is simply providing advice to the firm of which she is a part owner, is any of the firm’s gross receipts considered attributable to her services? Maybe not.

Breaking employment relationships. In the proposed regulations, the IRS recognizes the pressure that Section 199A will put on employment relationships. Employees don’t get the benefit under any circumstances. Independent contractors and owners of pass through entities sometimes do.

So, the IRS tries to attack misreporting of people who really are employees as something that they’re not. The IRS principally attacks by creating a presumption — for purposes of section 199A, there will be presumption that someone who used to be an employee and then gets treated as an independent contractor or partner by the same person/entity as before is still an employee. The presumption can be overcome by showing that the relationship really has changed.

There are two problems:

First, this does nothing about new hires going forward. The presumption only applies on a backward looking basis. If Section 199A ends up being a permanent part of the code (I hope not!), the presumption will become less and less useful as firms misreport new hires rather than old ones.

Second, to the degree the IRS is really able to enforce the substance here, it still creates bad incentives. This is like the problem when it comes to cracking. The IRS should do its job in trying to make sure those who get the deduction really aren’t employees (per Congress’s instruction), but Congress has set up a bad distinction — there’s no reason to encourage people to split from firms, give up their employee benefits, and so on. There’s economic substance to it, but it’s substance we shouldn’t want to encourage. That sin is on Congress.

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My understanding of the regulations will certainly develop as I continue to digest and also read the analysis of others. In the end, many of the flaws here reflect implementation of a deeply flawed statute but, in some important cases — such as the narrow reading of “reputation or skill” —they represent Treasury using its discretion in a way that aggravates the underlying problems.