Senior Tax Legal Analyst
The already overburdened IRS “may face challenges ensuring compliance” with certain parts of the 2017 tax law, a Government Accountability Office (GAO) report finds, particularly the 20 percent deduction for certain “pass-through” business income. That’s one more reason why policymakers should boost funding for IRS enforcement and operations to offset nearly a decade of significant budget and staffing cuts.
Even before the 2017 law, tax filers’ underreporting of pass-through income (income from sources such as S corporations, partnerships, and sole proprietorships, which overwhelmingly flows to wealthy households) made up the largest single part of the “tax gap” — the $441 billion-a-year gap between what taxpayers owe and what they voluntarily pay on time. But the 2017 law added complexity to the tax code and arbitrary distinctions between how it treats different kinds of income, which may make it even harder for the IRS to police pass-through tax evasion. Given the steep funding cuts and audit rate drop over the last decade, the IRS may lack the resources to effectively enforce this and other parts of the 2017 law, GAO warns.
The pass-through deduction cut the top tax rate on qualifying income to 29.6 percent, well below the 37 percent top rate on wages and salaries. That gives wealthy taxpayers a big incentive to shift as much of their wage and salary income into pass-through entities as possible. As we’ve noted, pass-through owners can easily exploit the distinctions between income that qualifies for the deduction and income that doesn’t to minimize their taxes.
For instance, the law prohibits the deduction for high-income doctors but may allow it for similarly compensated medical researchers. In another example, the law prohibits the deduction for high-income taxpayers engaged in “brokerage services,” but later Treasury regulations allow real estate brokers, insurance brokers, and banks to qualify for it.
Taxpayers self-report much of the information the IRS needs to determine whether income qualifies for the deduction (for example, whether the taxpayer is a doctor who isn’t eligible or a medical researcher who is), the GAO report points out. In general, pass-through income faces far less third-party information reporting — that is, information the IRS can use to independently verify information in tax returns — than other types of income, like pensions and Social Security benefits. That makes tax evasion easier: “compliance is far higher when income items are subject to information reporting,” according to the IRS.
Without robust reporting, the IRS must rely on costly audits to determine whether taxpayers are complying with the pass-through deduction and other parts of the 2017 tax law. But nearly a decade of budget cuts since 2010 have severely depleted the IRS’ enforcement function. Enforcement funding is down by roughly a quarter in inflation-adjusted terms, and enforcement staff have dropped by more than 30 percent. Meanwhile, audit rates have plummeted, especially for high-income people and large corporations.
These trends make auditing pass-through businesses particularly difficult. Accounting Today’s recent roundup of “10 major trends in IRS audits” advises, “Want your business to escape audit? Be an S corp or partnership,” adding that “audit rates for S corps and partnerships are both 0.22 percent — or, put another way, one in every 455 passthrough entities were examined in 2018.”
In a promising development, there’s growing bipartisan support for reversing the IRS cuts. The President’s 2020 and 2021 budgets proposed a multi-year budget mechanism to provide added enforcement funding that wouldn’t count against the annual caps on overall non-defense appropriations; the House last year adopted a similar proposal.
Policymakers should act on this support. They should also close tax loopholes that invite pass-through owners to push the boundaries of tax avoidance — and they can start by repealing the pass-through deduction.