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No one’s sure who qualifies for this $415B tax deduction

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Congressional Republicans created a juicy new tax break for clients when they rewrote the U.S. tax code late last year. Three months later, hundreds of thousands of them still don’t know if they qualify.

The IRS has said it will provide guidance detailing exactly who’s allowed to take the so-called pass-through deduction. With billions of dollars at stake, business groups are lobbying for the agency to open the doors to the deduction as widely as possible.

Some high-earning groups — such as construction contractors, massage therapists, executive headhunters and restaurateurs — could be excluded if the IRS writes the rules too narrowly. The agency plans on issuing guidelines by June. But that deadline has been questioned by a former top Treasury official given the vagueness of the legislation and complexity of the task.

The 20% deduction is aimed at pass-through businesses, whose income is reported on their owners’ personal tax returns. Congress tried to bar wealthy owners of service businesses from getting the break — leaving out many doctors, lawyers and hedge fund managers unless they can find a loophole.

By trying to exclude those service businesses, though, Congress ended up asking the IRS to settle some rather absurd philosophical and semantic conundrums. What, for example, is an entertainer? Are humans the only species who get “health care,” or do animals count too? How do you tell a broker from a salesperson, or an interior designer from an interior architect?

“We want to make sure that real businesses that are generating real economic activity get to take advantage of the deduction,” says Chris Smith, executive director of Parity for Main Street Employers, a new group formed to lobby the IRS and Congress on behalf of pass-through businesses. “You should be able to organize your business for business reasons, and not have to restructure because of quirks in the tax code.”

The challenge ahead for the IRS, which has been struggling with limited resources and faces a possible restructuring by Congress, is monumental. The agency must write coherent rules, and then be ready to make judgments on every business in the U.S. And the IRS can be challenged by taxpayers and second-guessed by courts, a process that could take years to play out.

A spokesman for the IRS didn’t respond to a request for comment.

A lax interpretation of the pass-through rules would please businesses, but also could blow a hole in the U.S. Treasury. The nonpartisan Joint Committee on Taxation estimates that the pass-through deduction, which expires at the end of 2025, would cost about $415 billion over the coming decade. The tax break could be even more expensive if IRS regulations can’t keep gamesmanship to a minimum.

This much is clear: If clients are considered a pass-through business owner earning less than $157,500, or $315,000 for a married couple, they get full access to the deduction no matter what. Above those thresholds, the deduction fades for certain “service” industries specified in the law including health, law, consulting, athletics, financial and brokerage services.

Bloomberg News