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Industry Groups Lobby to Broaden Pass-Through Deduction

October 19, 2018 at 1:30 PM

Realtors, veterinarians, and a range of other industry groups are pushing to dramatically expand the scope of the 2017 tax law’s “pass-through” deduction to allow their businesses to qualify. The wide range of requests, on full display at a recent IRS hearing, shows the creative ways that business owners and their tax planners will seek to stretch the deduction, which is essentially a giveaway to favored businesses with little policy rationale.

The new 20 percent deduction applies to certain pass-through income, which the owners of businesses such as partnerships, S corporations, and sole proprietorships report on their individual tax returns and which previously was taxed at the same rates as wages and salaries. Not all pass-through income qualifies for the deduction. The law includes “guardrails” intended to limit its scope, and the IRS’s proposed regulations on the deduction — the subject of the hearing — provide guidance on which activities breach the guardrails.

One of the first guardrails is that income earned by a “trade or business” can qualify for the deduction but income from a hobby or investment can’t. Yet it’s not always clear what that means because the law doesn’t define trade or business. For example, is a person who occasionally buys and sells stock operating a “business,” or is she an “investor”?

The proposed regulations say an activity is a trade or business if the taxpayer can claim deductions for business expenses. The real estate industry claims this standard is too narrow and not always clear for real estate investors. The National Association of Realtors (NAR), for instance, argued that the final regulations should say leasing real estate to tenants is always a trade or business, even if the landlord does nothing but receive rent. That would provide necessary certainty to taxpayers, according to NAR.

But this change would go far beyond providing clarity by allowing passive owners of real estate to benefit from a deduction intended to apply solely to active business income. Moreover, it would give the real estate industry yet another tax benefit, on top of those it received from the 2017 tax law as a whole and from the pass-through deduction in particular.

Another guardrail is that high-income taxpayers generally can’t claim the deduction for pass-through income from certain specified “service” businesses, such as law, health, consulting, and athletics. We’ve written about Major League Baseball’s attempt to enable professional sports teams owners to qualify for the deduction. Similarly, various industry groups at the hearing urged the IRS to revise the relevant part of the regulations to let more businesses qualify. For example:

  • The American Veterinary Medical Association argued that, because of differences between human and veterinary health care (for instance, animals are “property”), veterinary care should be removed from the definition of health services, which would allow veterinarians to claim the deduction.
  • The International Franchise Association said a franchise business (that is, a business that sells the right to use its brand) in the health care industry should qualify for the deduction because its business doesn’t directly perform health services.
  • Staffing firms, which provide temporary workers to other businesses, pushed for the regulations to explicitly let them claim the deduction, even if the businesses they service don’t qualify for it.
  • Banks argued that all of their income should qualify for the deduction; the proposed regulations exclude income from activities like providing financial planning and selling loans.

Such lobbying should come as little surprise. The guardrails invite them because they reflect arbitrary decisions by the law’s drafters about which activities are eligible for the deduction and which aren’t. The law simply picks winners and losers among industries, a problem that regulations can’t fix. The solution is for policymakers to repeal the deduction.

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