Tax planning experts working for wealthy clients are already developing strategies to take advantage of the 2017 tax law’s new 20 percent deduction for certain pass-through income — or income that owners of businesses such as partnerships, S corporations, and sole proprietorships claim on their individual tax returns instead of paying the corporate tax. As one expert recently advised a conference for personal financial advisers:
This is, without a doubt, one of the biggest areas of planning that we can have under the new law. This is why, in large part, they should have just renamed the [2017 tax law] the tax professional, lawyer and financial advisor job security act of 2017.
The [pass-through] deduction leaves a gaping hole in the tax code, and the goal by the end of the presentation today is to make you guys the bus drivers, or the truck drivers, to drive right through that hole with your clients.
Sixty-one percent of the deduction’s benefits will flow to the top 1 percent of households in 2024, and it’s projected to cost more than $50 billion per year and make up more than a fifth of the tax law’s overall cost beginning in 2021. Widespread abuse like what the tax advisor describes could tilt the deduction even more to the top and cost more revenue than previously estimated. New York University law professor David Kamin has dubbed it “one of the worst provisions that’s been added into the tax code in the last several decades.”
The deduction is a prime example of the tax law’s three fundamental flaws: it’s heavily tilted toward the wealthy, loses much-needed revenue, and opens massive new avoidance opportunities that weaken the integrity of the tax system. It creates an incentive for high-income individuals to convert labor income such as wages into pass-through income to take advantage of a more than 10 percentage point drop in the top individual tax rate when claiming the deduction. The law contains complex “guardrails” to prevent this type of abuse, but they’re poorly designed and, when combined with an underfunded IRS, practically invite abuse from wealthy taxpayers.
The deduction is fundamentally flawed, and policymakers should repeal it.