F. Pass-through Taxation

 Download FISCAL FACT No. 593: Reforming the Pass-Through Deduction (PDF)

Summary:

• The Tax Cuts and Jobs Act of 2017 created a deduction for households with income from pass-through businesses – companies such as partnerships, S corporations, and sole proprietorships, which are not subject to the corporate income tax.
• The pass-through deduction allows taxpayers to exclude up to 20 percent of their pass-through business income from federal income tax. The deduction is subject to several limits, intended to prevent abuse, which are based on the economic sector of each business, the amount of business wages paid, and the original cost of business property. These limits only apply to upper-income taxpayers.
• The design of the pass-through deduction leaves room for improvement. The rules for claiming the deduction are relatively complex, and will arbitrarily favor certain economic activities over others. Meanwhile, it is unlikely that the current limits on the deduction will be sufficient to prevent abuse. Finally, several features of the provision’s design will diminish its economic effect.
• Lawmakers should consider reforming the pass-through deduction, in order to make the taxation of pass-through businesses less complex, less prone to abuse, more neutral, and more economically efficient.
• One option for reform would be to limit the pass-through deduction based on how much businesses have invested and whether the investment costs have already been deducted. Under this proposal, businesses would only be able to claim a larger pass-through deduction if they invest more – which would likely make the pass-through deduction less prone to abuse and more economically efficient.

Introduction

One of the most controversial parts of the Tax Cuts and Jobs Act of 2017 was the creation of a deduction for pass-through business income.

Known as the “pass-through deduction” or “Section 199A,” this provision will reduce taxes for more than 17 million households that receive income from pass-through businesses – companies that are not subject to the corporate income tax.[1] The deduction is expected to lower federal revenue by $414 billion over the next 10 years.[2]

Supporters of the deduction argue that it delivers much-needed tax relief to American businesses and helps put the pass-through sector on an equal footing with the largest multinational corporations. Opponents of the provision contend that it creates an arbitrary tax preference for pass-through business income over other sources of income, and that it overwhelmingly benefits wealthy households.

This paper does not aim to resolve the debate over whether the creation of a deduction for pass-through business income was justified. Rather, it focuses on the design of the new pass-through deduction – the rules that determine which businesses and households see the largest tax benefits under the provision.

There are at least four criteria by which the design of the pass-through deduction can be evaluated:

1. Simplicity: Are the rules for computing the deduction simple and straightforward, or will they add more complexity to the tax filing process?
2. Administrability: Will only bona fide business income benefit from deduction, or will the deduction be used by households to avoid taxes on nonbusiness sources of income?
3. Neutrality: Will the deduction provide evenhanded tax treatment for all economic activities, or will it create tax preferences for certain forms of income?
4. Economic Efficiency: Does the structure of the deduction encourage business investment and growth, or is it unlikely to have a large economic effect?

On each of these criteria, the design of the pass-through deduction leaves room for improvement.

The complexity of the pass-through deduction will vary widely for different groups of taxpayers. On the one hand, the deduction will be relatively simple to compute for most lower- and middle-income households. However, upper-income households will face substantial complexity in determining how large a deduction they can claim.

Administrability is likely to be a key challenge for the pass-through deduction in coming years. The deduction creates a strong incentive for taxpayers to categorize as much income as possible as “pass-through business income,” to maximize their tax benefit. While the deduction includes several limits intended to discourage this sort of creative accounting, it is unlikely that the current rules will be sufficient to prevent abuse of the provision.

In terms of neutrality, the deduction will add new tax preferences for certain economic activities over others. For example, the deduction distinguishes between specified service businesses (such as lawyers and doctors) and non-service businesses (such as manufacturers and farmers), limiting the tax benefit for the first category.

Finally, the economic effect of the pass-through deduction will likely be limited, due to several design features of the provision. For instance, the deduction will actually increase marginal tax rates on some upper-income households, who will see their tax benefit shrink with each additional dollar they earn. In addition, the size of the tax benefit that businesses receive is not always related to the amount they invest, which will limit the ability of the deduction to encourage business investment and growth.

All in all, it is clear that the design of the pass-through deduction deserves further examination by lawmakers. In this paper, we describe the major features of the provision, as well as evaluating its strengths and shortcomings. We conclude with a discussion of potential reforms to make the pass-through deduction less complex, less prone to abuse, more neutral, and more economically efficient.

Description of Current Law

Section 199A of the federal tax code allows taxpayers to deduct up to 20 percent of certain business income.[3] This provision, known as the “pass-through deduction,” was created by the Tax Cuts and Jobs Act of 2017, and is intended to reduce taxes for households with income from pass-through businesses – companies that are not subject to the corporate income tax.[4]

The rules for calculating the pass-through deduction are complex. While most sources of pass-through business income are eligible for the deduction, some do not qualify. Moreover, upper-income households face a number of limitations on the deduction, which are intended to prevent abuse of the provision. One limit restricts the deduction for specified service businesses, such as law firms and medical practices. Another limit restricts the deduction based on the amount of wages paid by each business and the original cost of each business’s property.

It is important to note that, as of the publication of this paper, the Internal Revenue Service (IRS) has not yet issued many key regulations pertaining to the pass-through deduction.[5] As a result, there are still a number of important unresolved questions about how the pass-through deduction will function in practice. However, the major elements of the provision are clear enough to be described and analyzed.

An Overview of Pass-Through Businesses

To understand the pass-through deduction, it is useful to begin with a discussion of pass-through businesses and their role in the U.S. economy.

Pass-through businesses are companies that are not subject to the corporate income tax. Rather than paying income taxes on the business level, these businesses “pass” their income “through” to their owners, who report the income on their personal tax returns. As a result, income from pass-through businesses is taxed under the individual income tax.

The vast majority of companies in the United States are pass-through businesses: 28.3 million out of the 30.8 million private business establishments that operated in the United States in 2014. Pass-through businesses account for over half of business income in the United States and employ over half of the private-sector workforce.[6]

Pass-through businesses fall into three categories. Sole proprietorships are unincorporated businesses owned by a single individual, typically self-employed. Partnerships are unincorporated businesses with multiple owners. S corporations are incorporated businesses that must satisfy several requirements in order to qualify as pass-through businesses.

The tax rate that applies to pass-through business income depends on who the business owners are. Pass-through businesses with owners in higher tax brackets generally have their income taxed at higher rates, while those with owners in lower tax brackets are subject to lower rates.

Computation of the Pass-Through Deduction

The deduction created by the Tax Cuts and Jobs Act lowers taxes for taxpayers with income from pass-through businesses (as well as certain other business income, as discussed below). While many aspects of the provision are quite complex, the actual computation of the deduction is relatively straightforward.

To determine a household’s pass-through deduction, the following two amounts are compared:

• 20 percent of the household’s eligible business income
• 20 percent of the household’s taxable ordinary income (calculated before taking the pass-through deduction into account)

A household’s pass-through deduction is equal to whichever of these two amounts is smaller.[7]