Treasury’s New Pass-Through Rules Double Down On The Deduction’s Regressivity


The Tax Cuts and Jobs Act (TCJA) contains a special 20-percent individual income tax deduction for owners of pass-through businesses that was always going to disproportionately benefit the wealthy. The Joint Committee on Taxation projected that half the benefits of the provisions would go to millionaires and only a small fraction would help taxpayers making less than $200,000. But now Treasury has proposed new rules to fill in key details for the pass-through deduction, which make it harder for moderate-income employees to lower their taxes by becoming a contractor while making it easier for many high-income owners of service businesses to shrink their tax bill.

Under the TCJA, many workers potentially could lower their taxes by shifting from being an employee to independent contractor, as long as their taxable income is less than $157,500 for singles or $315,000 for joint filers. But this isn’t necessarily a simple decision. Employers would need to permit the change in status. And employees might lose valuable benefits like retirement contributions, health insurance, and unemployment and workers’ compensation coverage. Still, it was a tempting—and seemingly available--option.  

By contrast, Congress expressly denied the 20-percent deduction to many high-income owners of specified service businesses:  health, law, accounting, actuarial science, brokerage, financial services, performing arts, athletics, and consultants. Even if a business was not disqualified by name, any other trade or business where the principal asset is the “reputation or skill” of its owners also was excluded, which appeared to exclude many additional businesses. 

But in its proposed guidance, Treasury put a further thumb on the scale in favor of well-to-do owners of pass-through businesses. First, Treasury placed a hurdle in front of moderate-income workers by saying that if a worker was treated as an employee prior to the passage of the TCJA she is presumed to remain an employee, and cannot become an independent contractor for doing substantially the same work for the same employer. Thus, she’d be ineligible for the 20-percent deduction. She could rebut the presumption but it would not be easy—and would invite a review by the IRS. Thus, Treasury closed the door to widespread reclassification of workers as contractors.

By contrast, Treasury seemingly has walked back Congress’ wider disqualification of businesses that are based on reputation or skill.  According to Treasury, this final category only excluded business owners who earn endorsement, licensing, or appearance fees based on their reputation or skill. Thus, a celebrity chef may not deduct any portion of royalties from the sale of kitchen knives that carry his name.  But the same celebrity chef could deduct 20 percent of the income from his restaurant chain, even if the primary reason for its profitability is his skill or reputation.

Similarly, any owner of a business not explicitly identified on Congress’ original list of disqualified service businesses is eligible for the new 20 percent deduction. Nearly all owners of businesses such as advertising and web-design firms, auto mechanics, plumbers, electricians, restaurants, etc. would be free to take the deduction. 

Treasury strained to narrow the catch-all category of ineligible businesses relying on reputation or skill, which appears contrary to Congress’ intent. In the TCJA, as well as in prior tax bills, Congress added catch-all categories because it knew it could not identify every business that should be excluded from the new preferential tax treatment and anticipated that new businesses may emerge in the future that should also be excluded. However, Treasury’s new regulations effectively freeze Congress’ original list of excluded businesses.

Moreover, the expanded relief for service businesses only helps owners with taxable income of more than $157,500 for singles or more than $315,000 for joint filers. Owners of all pass-through businesses with less income already were permitted the 20 percent deduction. So, the new relief benefits only very high-income owners.

As a result, under Treasury’s proposed pass-through regulations, most employees are out of luck and many high-income owners of service businesses will get an unexpected tax break. This just adds to the perception that this new tax provision primarily benefits high-income taxpayers. So much for helping the middle class.