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Pass-Through Deduction Regulations Reflect Industry Lobbying

In finalizing its regulations governing the 2017 tax law’s 20 percent deduction for “pass-through” income recently, the Treasury Department retained, and in some cases expanded, the overly generous business giveaways of its draft regulations.

The hastily crafted 2017 law made arbitrary, flawed policy choices to let certain industries and income types qualify for the deduction based on little policy rationale, encouraging companies to game the rules so they can secure the deduction. Regulations can’t completely fix this problem but, in this case, they likely made it worse: Treasury set industry-friendly standards early in the regulatory process and extended them in the final regulations. It apparently did so, at least in part, due to a large and successful lobbying effort by business interests.

The 20 percent deduction applies to certain pass-through income, which the owners of firms such as partnerships, S corporations, and sole proprietorships report on their individual tax returns and which previously was generally taxed at the same rates as wages and salaries. The 2017 law includes various “guardrails” intended to limit the deduction’s scope. For example, owners of certain “service” businesses, such as law firms, health care practices, and athletics businesses, can’t claim the deduction above certain income thresholds. But the law gave Treasury substantial leeway to formulate the scope of the guardrails, which explains why industry lobbyists focused so much on shaping the regulatory process.

By law, Treasury must generally issue proposed regulations, let the public provide written comments, and then finalize those regulations and explain why it did or didn’t incorporate the suggestions from certain comments. The process is intended to provide transparency to the process and legitimacy to the final regulations. But nothing prohibits Treasury from engaging with lobbyists outside of the regular notice-and-comment process — as it often does — before it issues its proposed regulations. And no laws govern such interactions or require Treasury to disclose them.

A study of late last year examined how this kind of lobbying, conducted outside recognized procedures and largely without oversight, influenced how Treasury crafted the pass-through regulations before it issued them in proposed form. The authors found that this lobbying effort, while perhaps not unusual, effectively set the agenda for the entire regulatory process related to the deduction — a process in which Treasury significantly expanded the scope of businesses that may qualify for the deduction.

For example:

  • The regulations significantly expanded the scope of businesses that qualify by narrowly interpreting a provision in the law that disqualifies a business whose principal asset is the “reputation or skill” of its owners or employees. Under the regulations, only owners who specifically earn endorsement, licensing, or appearance fees — for example, a chef who earns a fee for endorsing a product — are disqualified from taking the pass-through deduction. In fact, the income that a chef earns from a restaurant could qualify for the 20 percent deduction on pass-through income even if the main reason for the restaurant’s profitability is the chef’s reputation.
  • Treasury also granted a request to exempt real estate brokers and insurance brokers from the definition of “brokers,” who generally don’t qualify for the deduction above certain income levels.
  • And the regulations exempt banking from the definition of “financial services,” making owners of such businesses eligible for the deduction, compared to owners of other financial service businesses who are disallowed from claiming the deduction above certain income levels.

Treasury’s final regulations do deny some requests from business interests, including from Major League Baseball owners, to expand the scope of the regulations even further. But the final rules largely cement in place the industry-friendly rules of the proposed regulations.

The final regulations also include various industry-friendly clarifications. For instance, Treasury granted lobbyists’ request that franchising businesses (that is, businesses that sell the right to use their brands) can qualify for the deduction, even if they sell brands related to ineligible businesses, like health care providers. Similarly, Treasury confirmed that staffing firms, which provide temporary workers to other businesses, can claim the deduction even if the businesses they service don’t qualify. These clarifications could exacerbate problems associated with the rise in contracting and franchising over traditional employment, which can harm workers.

In other words, industry lobbying at every step of the process likely generated final regulations with favorable exceptions for certain industries, at a huge cost to taxpayers; that’s because the more that industries can take advantage of the deduction, the more it will drain federal revenues. It’s just one more reason why policymakers should undo this serious policy mistake and repeal the pass-through deduction at their first opportunity.