Jim de Bree | The Burden of the Pass-Through

Jim de Bree
Jim de Bree

Readers of my previous columns know that I am not big fan of the Tax Cuts and Jobs Creation Act. One of my biggest complaints is that, unlike Reaganomics (which cut rates and broadened the tax base for everyone, letting the marketplace determine where capital should flow), the 2017 tax legislation picks winners and losers.

One of the most discriminatory provisions is the so-called “pass-through deduction.”

The centerpiece of the overall tax legislation is the reduction of corporate tax rates from 35 percent to 21 percent. However, a huge job-creating component of American business operates in non-corporate form. Because the corporate tax cuts did not apply to those businesses, Congress had to devise a mechanism to give them some sort of tax break.

Instead of cutting tax rates for these business owners, Congress created a pass-through deduction equal to 20 percent of the income derived from the business, subject to many complex limitations.

One of the most basic restrictions is that many service businesses do not qualify for the deduction. This apparently ignores the fact that we live in a service-based economy driven by technology that is every bit as transformative as the industrial revolution was 150 years ago. Our tax code needs to evolve with our economy.

The rules were hastily written by Congress and do not appear to be based on an understanding of the business practices in many industries. Furthermore, a few trade associations, such as architects and engineers, successfully lobbied for special provisions ensuring that they qualified for the deduction. Other professions that are critical parts of our economy are not so-called “qualified businesses” eligible to claim the deduction.

There are many unanswered questions about these rules. Taxpayers who are business owners have been awaiting guidance from the Treasury Department before next tax season.

In early August, the Treasury Department issued the first of three sets of regulations dealing with the pass-through deduction. The published materials, in proposed form, are 184 pages long. In spite of their voluminous character, the recently issued regulations still leave many taxpayers without guidance to many questions they will face when preparing their 2018 tax returns. To make matters worse, for taxpayers whose returns are examined by the IRS, the penalties imposed for incorrectly claiming a pass-through deduction are steeper than penalties for other understatements of tax.

The Treasury Department has requested input from interested parties in order to understand the underlying business and economic concerns to several key issues before finalizing the regulations.

To provide an idea of the complexity of the materials, the Treasury Department estimates that those affected by the regulations will spend 25 million hours annually complying with them. The IRS estimates that the hourly cost of compliance will vary from $39 to $53. Thus, according to IRS estimates, taxpayers will spend between $975 million and $1.325 billion annually complying with these regulations.

To the extent that tax professionals are involved, the cost is likely to be substantially greater than $53 per hour. Furthermore, because of tax reform, the demand for tax professional services has increased, which means professionals will raise billing rates.

These regulations make it clear that many businesses — particularly small businesses — will have an increased record-keeping burden if they want to claim the deduction.

The estimated 25 million hours pertain only to complying with the first of three sets of regulations. Undoubtedly when the other two sets of regulations are issued, the hours devoted to compliance will increase commensurately.

We hear a lot about how the pro-business Trump administration wants to loosen the regulatory burden on business. Yet, complying with the pass-through deduction rules — a critical component of tax reform — is likely to be extremely burdensome for many businesses. It seems as though the term “tax simplification” is an oxymoron.

Jim de Bree is a semi-retired CPA who resides in Valencia.

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