January 7, 2023

By Gerald Scorse

President Biden’s landmark Inflation Reduction Act earmarks $80 billion over the next ten years for the Internal Revenue Service (IRS). According to the Treasury, most of the money will be going toward increased enforcement—specifically, stopping rich Americans from cheating on their taxes. 

Yet the same agency has strangely signed off on a huge tax loophole that could put another $50 billion in the pockets of the rich by 2025. Laws enacted in 29 states allow the owners of certain high-income businesses to fully deduct state and local income taxes on their returns. The laws, rubber-stamped by the IRS, give millions of the wealthy a made-up way to avoid the $10,000 deduction limit that applies to everybody else.

President Trump never challenged the laws, and himself became a major beneficiary when New York State adopted the loophole. Surprisingly though, President Biden has taken no action either—even though he’s repeatedly said that it’s time for America’s richest to pay their fair share.

It would take only a word from the IRS to end the giveaway, which effectively guts the deduction limit laid down by Trump’s 2017 tax bill. So far, the word hasn’t come; perhaps it will from Daniel Werfel, the president’s nominee to become the new IRS commissioner.

If Werfel acts, it won’t be any too soon for the alert academic who spotted what was happening, put it under the microscope, and blew the whistle. Daniel Hemel, a professor at the NYU School of Law, lays out his findings in The Passthrough Entity Tax Scandal, a 28-page research paper scheduled for publication in 2023 in the Florida Law Review.

The phrase “passthrough entity” is a technical, tax-related term for the most common types of businesses in America. They include sole proprietorships, partnerships, limited liability companies (LLCs), and millions of small businesses that operate as S-Corporations—doctors, lawyers, hedge fund managers and other high-income professionals. The IRS notice specifically exempts partnerships and S-Corporations from the $10,000 SALT limit.

Passthrough owners had already gotten a bonus in the Trump tax bill, a special provision allowing them to shield up to 20 percent of their income from federal taxes. In 2024, based on estimates from the Joint Committee on Taxation, the top 1 percent of households will reap 61 percent of the benefits of that provision—compared to just 4 percent for the bottom two-thirds. The numbers from the new handout likely won’t be much different.

Hemel’s analysis takes a deep dive into the weeds of tax policy and government bureaucracy. Here’s an everyman’s summary using material both from his research paper draft and from the online coverage it generated.

The paper sharply criticizes the IRS. The agency “has not provided a plausible legal rationale for its position.” It “doesn’t even pretend to reconcile its surprising conclusion with the relevant statutes and regulations.” Its position “contravenes any notion of tax fairness.” It’s “scandalous” and “astonishing,” and “it ought to elicit moral outrage.” To top it all off, the agency’s actions represent a “flagrant violation of federal law.”

It's flagrant, suggested one scholarly review, mainly because Hemel went about “meticulously analyzing the statutory text and the legislative history.” Post-analysis, passthroughs have no claim whatever to special treatment: the $10,000 SALT cap “plainly applies to state and local income taxes paid or accrued in carrying on a trade or business.”

Simply put, there’s no justification for allowing those taxes to be deducted as a business expense on tax returns—which is what the giveaway allows S-Corporations and partnerships to do.

Tax loopholes always have political roots; this one comes with a double dose of political irony as well. As Hemel points out, “the benefits of the passthrough entity workaround flow to a particularly powerful constituency within the Republican Party: high-income passthrough owners.” True enough, but the SALT limit was passed by Trump and the Republican Party to punish Democratic states. Second irony: Democrats also have a high-income constituency, and their efforts to overturn SALT have led to sharp divisions within the party.

The last word goes to the sleuth who uttered the first word. Hemel says it’s up to the errant IRS and the Biden Administration to end the $50 billion passthrough fiasco: “All they need to do is enforce the law (the SALT limit) that is on the books.”