by Alexis Leondis
President Joe Biden proposes to impose steep new taxes on high earnings and lucrative investments to help pay for expanded child care and other social programs. But if he’s serious about requiring wealthy Americans to pay more, he missed one of the most obvious places to start.
That would be by curtailing a gift to business owners granted by the 2017 Republican tax law: a special deduction that gives owners of partnerships and limited-liability companies a way to pay less than others who earn just as much money.
Business owners are allowed to deduct up to 20% of the income they receive from a pass-through business (so-called because the businesses’ profits pass through to owners directly and are taxed at the individual level) from their overall taxable income. That means a marginal tax rate as low as 29.6% instead of 37% for the highest earners.
To try to limit abuse, there are income thresholds in place for who can qualify for the full 20% deduction: $163,300 for single filers and $326,600 for married taxpayers filing jointly. But the statute was poorly written and includes several exceptions, which has resulted in a lot of tax avoidance. The attempted workaround techniques even have colorful names, like “crack and pack,” where lucrative businesses split up into smaller units to game the system.
Above the income thresholds, lawyers, doctors, investment bankers and some others who qualify as “service professionals” are limited from taking the full deduction. Taxpayers who aren’t involved in what the Internal Revenue Service has defined as service businesses or trades can still take the full deduction, provided they pay a certain amount in employee wages or have invested in capital such as real estate. It’s complex, with arbitrary definitions — never a good thing when it comes to tax policy — and too much time and money has been wasted on outfoxing the tax authorities.
Not surprisingly, 66% of the provision’s benefits in 2019 were estimated to flow to those above the income guardrails, according to the nonpartisan Joint Committee on Taxation. By 2024, 61% of the benefits will go to the top 1% of households.
A better approach would be to allow the deduction only for people earning less than $400,000. That approach would fit nicely with Biden’s pledge not to raise taxes on anyone in that income category.
Making the pass-through deduction off-limits for wealthy business owners would also help to narrow the gap between the amount of money that is technically owed, but doesn’t get paid to the IRS.
Everyone who receives wages or a salary is generally subject to automatic withholding by an employer, which in turn gets reported to the IRS. Income from pass-throughs isn’t subject to the same treatment, which means it’s easier for business owners to get away with underreporting income. The incentive to underreport income is even greater when there’s a 20% deduction at stake.
At a recent hearing, IRS Commissioner Chuck Rettig said tax evasion in the U.S. may total $1 trillion a year thanks to new tactics, including underreporting from pass-through businesses.
A separate study released in March shows that the top 1% of earners underreport 21% of their income in part because of the use of pass-through businesses. Just collecting that money would increase tax collections by $175 billion a year.
It’s odd that Biden, who says he wants to give the IRS more money to end tax dodging by the wealthy, would forget about one of the prime tax-dodging structures, and a deduction that makes for an even sweeter deal.
Bizarrely, Biden’s tax plan targets two loopholes that pass-throughs often use to lower their tax bills — writing off excessive business losses and avoiding a Medicare tax — but is silent on the pass-through deduction itself.
Also, remember that the reason the pass-through deduction was included in the 2017 tax law was because lawmakers were under pressure to give business owners a break after slashing the tax rate for corporations. That could be a moot point now that Biden wants to increase the corporate rate.
The president has said he wants to increase the top ordinary income tax rate to 39.6%. A deduction is worth more to people who earn more, so the incentive for business owners to try to reap the benefits from a 20% write-off will only increase if he’s successful.
Alexis Leondis is a Bloomberg Opinion columnist covering personal finance.
