The Passthrough Entity Tax Scandal

43 Pages Posted: 29 Jun 2022 Last revised: 18 Jun 2024

See all articles by Daniel J. Hemel

Daniel J. Hemel

New York University School of Law

Date Written: June 21, 2022

Abstract

More than three dozen states have enacted laws since 2018 that are designed to provide passthrough entity owners with an unlimited federal tax deduction for state and local business income taxes. These “passthrough entity tax” regimes respond to the December 2017 federal tax law, which imposed a $10,000 cap on the state and local tax deduction. The new state laws generally allow passthrough entities to opt into paying an entity-level state income tax in exchange for a dollar-for-dollar benefit on their owners’ state personal income tax returns. The optional tax has proven to be immensely popular among passthrough entity owners across the country.

But there is a problem with the passthrough entity tax concept: Under the plain text of the Internal Revenue Code, the workaround does not work. The December 2017 law clearly precludes passthrough entities and their owners from deducting state and local income taxes beyond the $10,000-per-individual cap. And the legislative history of the December 2017 law—read in context—aligns with the statutory text.

Surprisingly, the Internal Revenue Service has chosen to permit passthrough entity owners to utilize the workaround anyway. The IRS has not provided a plausible legal rationale for its position, but no one has standing to challenge the IRS’s position in court. Meanwhile, the IRS’s decision to allow the workaround is likely to cost the federal government more than $50 billion by the end of 2025, with most of the federal tax benefits flowing to passthrough owners with incomes of $1 million or more.

In effect, the IRS has created a special tax preference—unauthorized by Congress—for hedge fund managers, law firm partners, and other passthrough entity owners. And the Biden administration, notwithstanding its professed commitment to tax fairness, has acquiesced in this massive giveaway to the rich. The Biden administration and the IRS should reverse course immediately and apply the $10,000 state and local tax deduction cap to passthrough entity owners. As long as they permit passthrough entity owners to take advantage of the workaround, the Biden administration and the IRS will be abdicating their duty to enforce the law.

Keywords: passthrough entity taxes, state and local taxes, state and local tax deduction, Internal Revenue Service

JEL Classification: k34

Suggested Citation

Hemel, Daniel J., The Passthrough Entity Tax Scandal (June 21, 2022). 26 Florida Tax Review 87 (2023), NYU Law and Economics Research Paper No. 23-01, NYU School of Law, Public Law Research Paper No. 23-01, Available at SSRN: https://ssrn.com/abstract=4142575 or http://dx.doi.org/10.2139/ssrn.4142575

Daniel J. Hemel (Contact Author)

New York University School of Law ( email )

40 Washington Square South
New York, NY 10012-1099
United States

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