Since 2018, state legislatures have been helping the richest Americans evade billions of dollars of taxes every year in flagrant violation of federal law — and the Internal Revenue Service (IRS) under both Presidents Donald Trump and Joe Biden has rubber-stamped the scheme.
Now, amid a leadership shake-up at the IRS, Biden has an opportunity to finally end the tax loophole: just last week, he announced he’s replacing a Trump holdover as head of the IRS with his own appointee, who could end the tax giveaway with the stroke of a pen.
The loophole in question was created by new state laws, and allows people to use pass-through entities such as private equity firms, hedge funds, law firms, and medical practices to bypass a $10,000 limit on state and local tax write-offs. That limit, created by Trump’s 2017 tax bill, had the effect of raising taxes on the wealthy, especially in high-tax states. The state-created laws in response to this cap, experts say, are clearly illegal under the 2017 federal tax law.
According to New York University law professor Daniel Hemel, this so-called “pass-through entity tax scandal” will deliver an estimated $50 billion in tax breaks mostly to Americans who make more than $1 million per year by 2025. Hemel’s research represents the first comprehensive estimate of the size of the loophole.
“In effect, the IRS has created a special tax preference — unauthorized by Congress — for hedge fund managers, law firm partners, and other pass-through entity owners,” Hemel wrote in a recent law review article on the topic. “And the Biden administration, notwithstanding its professed commitment to tax fairness, has acquiesced in this massive giveaway to the rich.”
On November 10, Biden appointed Daniel Werfel, who served under both Presidents Barack Obama and George W. Bush, to be the next IRS commissioner. Biden said in a speech on the hundredth day of his administration that “[It’s] time for corporate America and the wealthiest 1 percent of Americans to just begin to pay their fair share. He added,“The IRS is going to crack down on millionaires and billionaires who cheat on their taxes.”
There has been little public scrutiny of this particular tax giveaway, likely in part because the loophole is highly technical and the tax code is rife with provisions benefitting the richest Americans. But Hemel says this giveaway stands out because it is clearly not sanctioned by Congress, and is costing the government far more money than other controversial loopholes for rich Americans.
“We should be furious,” said Hemel. “If a Republican and Democratic president decided to just dump $50 billion on rich pass-through owners, people would protest. And that’s what happened.”
An Illegal Giveaway
When Republicans took the presidency and both branches of Congress in 2016, they immediately got to work advancing a key donor priority: slashing taxes, mostly on corporations. By the end of 2017, they had come up with a bill which cut the corporate tax rate by 40 percent and lowered individual tax rates, especially for people at the top of the income distribution.
Republicans promised the tax bill would pay for itself by boosting economic growth, making up for the revenue lost by the tax cuts. But they also included a provision aimed at offsetting some of the lost revenue by limiting a tax write-off that mostly benefits rich people in states with progressive tax schemes — namely, blue states.
That provision was a cap on state and local tax (SALT) deductions, which limits the amount of state and local taxes that people can deduct from their federal taxes, increasing their taxable income.
The Trump tax cuts set the SALT cap at $10,000, which isolated its impacts to the top 15 percent of US taxpayers, and mostly increased the tax burden of the richest 1 percent. Conservative Democrats from high-tax states with lots of wealthy residents have moved to repeal the cap, but their efforts have been stymied by the progressive flank of the party and the huge budgetary cost of such a move.
In the meantime, states have quietly devised workarounds.
Twenty-nine states and New York City have passed laws allowing their wealthy residents to bypass the SALT cap by using a pass-through entity to pay their taxes, and more have laws in the works.
The various laws allow the pass-through entity owners to classify their state and local taxes as a business expense, rather than a personal income tax, allowing them to bypass the $10,000 cap.
For the states, such moves made political sense, explained Matt Gardner, a senior fellow at the Institute on Taxation and Economic Policy.
After the SALT cap passed, “the perception was that people would feel the impact of state taxes more acutely than they did before, even though the state taxes themselves hadn’t changed,” Gardner told the Lever. “So from one perspective, what we’ve seen happening since 2017 is a way for states to leverage federal tax rules to export as much of the state income tax liability to the federal government.”
The problem, Gardner added, “is that it does look like states that are doing this are flying in the face of the intent of the law. You can pretty clearly see that Congress doesn’t want states doing this, and so the interesting question is why the Treasury Department has written the regulations in a way that gives a wink and a nod to the states doing it.”
As Hemel outlines in his law review article, the legislative history of the bill shows that lawmakers in 2017 “considered whether the SALT cap ought to apply to state and local business income taxes and decided that it should.”
“The Republican chair of the Ways and Means Committee assured Democrats on the committee that they weren’t going to allow pass-throughs to deduct income taxes when others would be subject to the $10,000 cap,” Hemel explained. “The only plausible reading of the relevant statutes and regulations is that these pass-through entity taxes don’t work.”
Still, the IRS has decided to allow the practice.
“All They Need to Do Is Enforce the Law That Is on the Books.”
Days after the 2020 election, Trump’s IRS issued guidance indicated it would not object to the new loophole created by state laws.
“This notice was extraordinarily favorable to Trump himself and other pass-through business owners who are core supporters of the Republican Party,” said Hemel.
But when Biden took office months later, he let the guidance stand. And since there is no individual or entity with standing to sue the government over what experts say is an illegal position by the IRS, it remains up to the Biden administration to end the loophole.
“I don’t think the scandalous thing is the states trying to figure out ways for their taxpayers to get around the $10,000 SALT cap,” Hemel told the Lever. “What I think is scandalous is that the IRS, which had a bunch of different ways to strike this down, decided to bless it. And then the Biden administration takes over a few months later, and runs with the Trump administration’s position.”
In April 2022, a group of Democratic lawmakers from California, New Jersey, and New York called on the House Appropriations Committee to include language in the annual spending bill preventing the IRS from ending the pass-through entity loophole, claiming the loophole helps “small business owners.”
The language was not included in the committee’s draft appropriations bill, which has not yet been finalized by Congress.
Meanwhile, Democrats in Congress have declined to end a separate tax loophole for private equity and hedge fund managers — the carried interest loophole — while the private equity industry has poured money into the campaign coffers of Biden and congressional Democrats.
The SALT cap loophole, Hemel pointed out, is larger in scope than the carried interest loophole, which delivers about $18 billion per decade to hedge fund and private equity owners. Limiting the carried interest loophole, which must be done legislatively, proved to be impossible this summer after Senator Kyrsten Sinema (D-AZ), a major beneficiary of private equity industry cash, spiked a proposal to do so.
But ending this loophole is squarely the responsibility of the president, according to Hemel.
“All they need to do is enforce the law that is on the books,” he said. “This isn’t asking them to score some legislative shot from half court.”