Clint Wallace1Clint Wallace is an Assistant Professor of Law at the University of South Carolina School of Law. The author thanks Lad Boyle, Ari Glogower, Daniel Hemel, Greg Polsky and Steve Rosenthal for discussion and feedback. He also thanks Madison Rinehart for assistance with research, and Matthew Reade and his colleagues at the University of Chicago Law Review for their attentive editing. Other work by the author is available here.

When the CARES Act was signed into law in late March 2020, it looked to be an appropriately extraordinary legislative response befitting the extraordinary public health and economic challenges presented by the COVID-19 pandemic. The headline features of the new law included cash payments to most Americans in unprecedented amounts,2Individuals received $1,200 each and married couples received $2,400 each, with an additional $500 for each child, all of which phased out for households with incomes over $75,000 for individuals and $150,000 for joint filers. See CARES Act Title II, Assistance for American Workers, Families, and Businesses, § 2201. In contrast, the rebate checks issued in 2001 were in the amounts of $300 per person, plus an additional $200 for single parents, and were limited to people who had positive income tax liability in the prior year. hugely increased unemployment payments,3The CARES Act provided a temporary increase in unemployment compensation of $600 per week.  See CARES Act, Title II, Assistance for American Workers, Families, and Businesses, § 2104. In contrast, during the 2009 recession, Congress enacted an increase of $25 per week. See American Recovery and Reinvestment Act of 2009, Pub L. No. 111-5, 123 Stat. 115 (2009) (codified as amended in scattered sections of the U.S. Code). and a massive forgivable loan program designed to help keep employees on employers’ payrolls.4See CARES Act, Title I, Assistance for American Workers, Families, and Businesses, § 1102. These were the three most expensive elements of the legislation: the Paycheck Protection Program was expected to cost $377 billion (later increased by another $321 billion), the recovery rebates $293 billion, and the expanded unemployment insurance provisions $268 billion. But these striking provisions concealed other elements of the legislation that on closer examination look more like business as usual for Congress—in the worst of ways.

This Essay dissects § 2304 of the CARES Act, which temporarily suspends § 461(l), a limitation on deducting certain business tax losses.5CARES Act § 2304 suspends the deduction limitation in 26 U.S.C. § 461(l) for 2018, 2019 and 2020. I use the term “unlimited pass-through deduction,” but note that this is distinct and separate from the qualified business income deduction provided under § 199A for certain pass-through entities. Enacted by Congress less than three years ago as part of the 2017 Tax Act, § 461(l) prevented individuals from deducting business losses from pass-through entities against more than $500,000 of other ordinary income. The suspension of this provision in the CARES Act, which I refer to as the “unlimited pass-through deduction,” allows taxpayers with extremely high incomes to deduct tax losses and thus to reduce or even totally zero out their income tax liability, including retroactively. Combining distributional estimates of other provisions of the CARES Act with distributional estimates of the unlimited pass-through deduction, I show that the unlimited pass-through deduction inverts the perceived progressivity of the cash rebates that were the primary individual-focused element of the federal government’s response to the COVID-19 crisis. I detail how the deduction operates, including how it interacts with other provisions of the CARES Act and other provisions of the Tax Code, in particular bonus depreciation. I also examine the legislative backstory of how the limitation came to exist as part of the 2017 Tax Act and how it came to be repealed in the CARES Act.

The context explored here sheds light on the current political economy of federal tax legislation generally, and in particular on the political economy of hastily enacted tax legislation, which should perhaps be viewed as a regular mode of tax legislating.6Steve Rosenthal and Aravind Boddupalli wrote a thoughtful summary of the unlimited pass-through deduction and other adjustments to business loss rules shortly after the legislation was enacted, the title of which, Heads I Win, Tails I Win Too: Winners from the Tax Relief for Losses in the CARES Act, summarizes their analysis. The haste with which the CARES Act was enacted is similar to the Tax Cuts and Jobs Act (it took months, but in comparison the Tax Reform Act of 1986 took years), but there are recent counter examples as well, such as the SECURE Act enacted on a bipartisan basis in December 2019 (as part of a government funding bill) after extensive committee work and debate in Congress. The high-income beneficiaries of the unlimited pass-through deduction will receive cash refunds in 2020 based on tax losses they realized long before the COVID-19 crisis hit, as detailed below, and there are no particular indicators that these taxpayers have faced special challenges due to COVID-19 or are in any current need regardless of the cause. Further, the deduction payouts are not conditioned on taking any future actions or using the funds received in a way that might have positive spillover effects for the broader economy or for populations that are particularly vulnerable to the negative economic consequences of COVID-19.7This is a stark contrast with the justifications and requirements for other COVID-19 response provisions, including increased unemployment insurance (only available to people who have lost their jobs or have severely reduced hours, and not available once they are welcomed back to their job) and the Paycheck Protection Program loans (to receive loan forgiveness, recipients must confirm need and maintain pre-COVID-19 payrolls). Thus, the unlimited pass-through deduction cannot be justified as a targeted response to circumstances created by the spread of COVID-19. And, it is definitively not a minor technical fix that should be accepted as necessary or ignored as inevitable given the circumstances.

I. An Introduction to the CARES Act’s Unlimited Pass-Through Deduction

The unlimited pass-through deduction made it into the CARES Act at least in part because it is shrouded in complexity. The title of the provision—“Modification of limitation on losses for taxpayers other than corporations”—perhaps suggests something innocuous. The provision was initially described in media reports as allowing greater flexibility for businesses to claim losses, which may have seemed to make sense at a time when many businesses were facing huge unexpected losses.8In the first few weeks following the enactment of the CARES Act, the unlimited pass-through deduction was often elided in summaries of the legislation (which mostly focused on the rebate checks). This was typified by the New York Times describing it as one of the “esoteric provisions” of the CARES Act. A few weeks later a subsequent New York Times article filled in some further detail, including distributional effects of § 461(l) and other lesser-known provisions of the CARES Act.

The loss limitation at issue previously prevented investors and business owners who used pass-through entities from claiming exceptionally large losses from those entities.9The now-suspended limitations under § 461(l) were applied after the passive loss and at-risk limitations. 26 U.S.C. §§ 469, 465. The passive loss rules distinguish between passive activities in which the taxpayer does not “materially participate,” portfolio or investment activities, and active business activities; losses from passive activities cannot be used to offset income from investments and active businesses. The at-risk limitations limit the extent to which losses derived from activities financed by non-recourse debt can be used to offset income from other activities, although there are significant exceptions to these rules, including an exception for certain non-recourse real estate loans. Further, “excess business losses” under former § 461(l) could arise only to the extent losses are allowed to a partner or member (in a partnership or LLC taxed as a partnership) or shareholder (in an S corporation) who has sufficient basis in their interest in the entity.  26 U.S.C. §§ 704(d), 1366(d). The way pass-through entities work, the income and losses incurred by a partnership or an LLC appear on the individual tax returns of the owners and investors in the business. Before the CARES Act, these owners and investors could deduct “only” up to around $500,000 of tax losses from pass-throughs each year.1026 U.S.C. § 461(l) (prior to amendment). The limitation amount was $500,000 in 2018 for a married couple filing jointly, inflation adjusted to $510,000 in 2019 and $518,000 in 2020. For a single filer the 2018 limit was $250,000, the 2019 limit was $255,000, and the 2020 limit was $259,000. If an investor couple had ordinary gross income of $5 million (ordinary income generally means income earned as wages) in 2018, and they owned part of a business that had tax losses of $5 million, they could only use a small part of those losses—up to the $500,000 limit—to offset their ordinary income. As a result, the couple would still have paid income tax on nearly $4.5 million of ordinary income. The disallowed remainder was deemed an “excess business loss,” and was carried forward as a net operating loss (NOL) to be used in future years.1126 U.S.C. § 461(l)(2). Converting the excess business loss to a NOL means that those losses are deferred, not necessarily disallowed. If the taxpayers in this example had $5 million of ordinary income and $5 million of pass-through loss deductions in each of 2018 and 2019, they would have carried forward $4.5 million as NOLs from 2018, and then in 2019 they would have had $4.49 million of excess business losses based on gross income ($5 million loss reduced by the $510,000 inflation adjusted excess business loss limitation), but could have applied the carried forward NOLs to reduce taxable income to $0, and again carry forward NOLs of $4.5 million ($10,000 of NOLs from 2018, and $4,490,000 of new excess business limitation NOLs from 2019).

The unlimited pass-through deduction temporarily eliminates the cap. That initially sounds logical: in a time when businesses are losing huge amounts of money, it might seem vindictive to prevent investors or business owners from deducting their losses. Further, requiring the taxpayers described above to pay tax on $4.5 million of income if they’ve actually lost $5 million in their business could result in a cash crunch: if the taxpayers actually earn no other money and the $5 million of income is in fact reduced by the $5 million loss, but the taxpayers faces a tax bill of around $1.7 million (the 37 percent rate applied to $4.5 million), they may not have liquid assets available to pay their tax liability.

But these sorts of problems are highly unlikely. Indeed, the particulars of how the CARES Act now permits such losses shows that economic hardship generally and COVID-19 related economic hardship in particular are ill-addressed by allowing the unlimited pass-through deduction.

II. The Pitfalls of the Unlimited Pass-Through Deduction

To understand the pitfalls of the CARES Act’s unlimited pass-through deduction, consider the following three aspects of the Tax Code and other CARES Act provisions that give rise to the so-called losses that the unlimited pass-through deduction allows taxpayers to claim.

A. Taxpayers Who Benefit Are Not Those Most in Need of Relief

First, because the deduction is permitted retroactively back to 2018, there is a disconnect between (i) the economic distress caused by the COVID-19 crisis, and (ii) which taxpayers benefit from the unlimited pass-through deduction. The immediate beneficiaries—taxpayers who will receive cash payments directly from the government this year—will do so in the form of refund payments based on previously disallowed tax losses from 2018 and 2019 under the old limitation.12See 26 U.S.C. § 6511(a) (allowing up to three years to file a refund claim). For example, if a married couple in 2018 had $5 million of ordinary income, and a pass-through business that generated $10 million of net tax losses, their tax return for 2018 prior to the CARES Act would have reflected business loss deduction limited to $500,000, $4.5 million of ordinary income net of that deduction, as described above, and an excess business loss of $9.5 million.13Under prior law, the entire $9.5 million excess business loss was carried forward indefinitely as a net operating loss, meaning that the taxpayer could have applied that entire amount against any other income in 2019, or 2020 or beyond. The CARES Act modified the NOL rules in addition to the § 461(l) limitation, so that NOLs can once again be carried back to prior years. These two changes together mean that in addition to the § 461(l) refund for 2018, the taxpayer at issue can apply any NOLs (in other words, business losses not subject to the excess business loss limitation that are in excess of all other income) from 2018 to five earlier years, including years prior to 2018 when marginal rates were higher. 26 U.S.C. § 172(b)(1)(D). Thus, this NOL carryback will further increase refund amounts available to taxpayers who are now benefitting from the unlimited pass-through deduction. Although the NOL carryback is likely also regressive and is also a reversal of the tax policy adopted in the 2017 Tax Act, I find it to be less objectionable on general tax policy grounds than the unlimited pass-through deduction because: (1) it is more widely available and less regressive than the unlimited pass-through deduction, because the beneficiaries include anyone with NOLs, not just taxpayers with ordinary income in excess of $500,000; and (2) eliminating the NOL carryback as part of the 2017 Tax Act represented a break from past policy that allowed some carryback, and in so doing significantly undermined the general NOL policy of income smoothing. (The excess business loss limitation did the same thing but was consistent with other tax policy in that it targeted high-income taxpayers, thus slightly offsetting some of the intentionally regressive business tax cuts in the 2017 Tax Act.) That taxpayer can now file an amended return for 2018, reducing their 2018 income by $4.5 million (to offset the remainder of their ordinary income), and receiving an immediate refund of up to $1.7 million.14This example sets aside other above-the-line and below-the-line deductions for which the taxpayers might qualify (the § 461(l) limitation is based on gross income and so is calculated before other personal deductions), and also sets aside the possibility of some income in prior years qualifying for the 20 percent qualified business income deduction under § 199A. The tax liability is thus calculated as $4,500,000 multiplied by the 37 percent top marginal rate (which applied to income over $500,000 for a married couple in 2018). Because the excess loss deduction was carried forward to 2019 as a NOL, if the taxpayers have ordinary or business income in 2019 (in contrast to the example in note 10 in which the taxpayers have more business losses in 2019 without accounting for NOLs), they could use the NOL in that year instead.

Congressional staff released an analysis estimating that unlimited pass-through deduction will give 43,000 taxpayers earning over $1 million an average benefit in 2020 of $1.6 million per taxpayer. To be sure, these taxpayers have very high current year income even without the unlimited pass-through deduction. Converting the tax benefit into taxable income, the analysis shows that the average taxpayer who benefits from the provision will be in a very similar situation to the example described above: they will be able to take an average additional deduction of around $4.3 million. That means that the average taxpayer in this group has earned at least $4.3 million of ordinary income in 2018 and/or 2019—and would have netted $2.7 million after taxes (i.e., paying $1.6 million on income of $4.3 million). Now, that taxpayer will receive a refund for the $1.6 million previously paid.15This calculation disregards the lower marginal rates—if a taxpayer earns only $4.3 million, their benefit from the provision will be less than $1.53 million on account of the progressive tax rates below $622,050 (for a married couple filing jointly). That $1.6 million average benefit for taxpayers with income over $1 million adds up to $70.3 billion of lost tax revenue in 2020.

B. Tax Losses Can Occur Without Out-of-Pocket Expenditures

The second aspect of the unlimited pass-through deduction that reveals how ill-suited it is as a response to COVID-19 is how it interacts with other tax rules that can divorce tax deductions, and thus tax losses, from current economic reality.

In many circumstances, a tax loss can occur without any out-of-pocket expenditure. For example, say that in 2017 a real estate investor purchased $50 million of property that is financed in part from money contributed by the investor and in part from bank loans. If the investor brings in $5 million of rent each year from leasing the properties and pays $2 million for maintenance along with overhead and staffing, the business would seem to have a healthy $3 million of income (equal to net cash flow) that would pass through to be included in the investor’s taxable income. But federal income tax rules allow this sort of investment to be very beneficial to investors who are actively involved in real estate business activities.16The rules limit the extent to which passive investors can use tax losses to offset ordinary income and treat any rental businesses as passive. 26 U.S.C. § 469(c)(2). But these rules are loosened for real estate professionals, allowing people who devote more than 50 percent of their work time and at least 750 hours a year to real estate business activities (including property development, management, leasing, acquisition, and so on) to treat real estate losses as active business losses. 26 U.S.C. § 469(c)(7). There are also exceptions for real estate to the loss limitations in § 465.  The real property might generate $2 million or more in depreciation deductions each year, and these deductions are available even if the depreciable assets are, in fact, appreciating in value, as buildings often do.17For example, depreciation of $35 to $40 million in residential rental property over 27.5 years would yield an annual deduction of $1.25 million up to nearly $1.5 million. 26 U.S.C. § 168(c). The remaining investment amount might be divided between property depreciated more quickly (for example, five-year, ten-year or fifteen-year property, such as improvements to land or personal property associated with the real estate), or not at all (for example, some of the price would be allocated to non-depreciable land). Further, real estate loans can be structured provide that the interest amount accrues but does not have to be paid until some later date, say in five or ten years. The tax rules allow the investor to deduct the interest expense now, even though it is not paid until later.18See Treas. Reg. §§ 1.461-1(a)(2); 1.446-1(c)(1)(ii) (accrual accounting). See also 26 U.S.C. § 267(a)(2) (disallowing deductions for accrued interest owed but not paid to a related cash-method taxpayer). As a result, if the interest charged on the borrowed money amounts to $2 million each year, the accrual of expenses gives the firm a deduction of $2 million.1926 U.S.C. § 163(a) (deduction for interest expense). Approximated as 4.5 percent annual interest on $45 million. The 2017 Tax Act introduced limitations on interest deductions available to some large businesses, but similar to the loss limitations addressed here those limitations were loosened by the CARES Act. See 26 U.S.C. § 163(j). Together, the investor has deductions each year of $4 million that are not associated with current expenditures, which make a positive cash flow of $3 million per year convert to a tax loss of $1 million per year. Whereas previously the investor would have been limited to deducting around $500,000 against ordinary income, the unlimited pass-through deduction in the CARES Act allows the full $1 million to be deducted.

C. Tax Losses May Not Reflect Actual Economic Losses

The third disconnect between the unlimited pass-through deduction and COVID-19 is that, even if deductions are associated with current expenditures, the tax losses that result may have nothing to do with actual economic losses. Because of changes made to the Tax Code in late 2017, this disconnect has been especially prevalent in the years to which the unlimited pass-through deduction now retroactively applies.20Tax losses are distinct from economic losses when viewed through the lens of the annual accounting convention: tax deductions generally align with some real or possible future economic loss and are accompanied by basis adjustments and other special rules to track and recapture gains in the future. See, for example, 26 U.S.C. § 1016 (reducing basis to reflect depreciation deductions); 26 U.S.C. § 1245 (setting recapture at ordinary rates of depreciation deductions previously claimed). The primary culprit as of late is so-called bonus depreciation,2126 U.S.C. § 168(k), (k)(2), (k)(6) (allowing 100 percent depreciation deduction in the year placed in service from late 2017 through 2022 for all depreciable property with a recovery period of twenty years or less. Even when bonus depreciation was less potent (like in most years from 2002 to 2017, when it provided a depreciation boost in the year placed in service, rather than full expensing), accelerated depreciation and depreciation of real estate that did not reflect real depreciation in economic value, and the recapture rules—particularly for depreciable real estate used in a trade or business—provide a significant tax benefit to business owners. See generally Richard L. Schmalbeck & Jay A. Soled, Unifying Depreciation Recapture, 48 Conn. L. Rev. 531 (2015) (critiquing § 1250 recapture (and, relatedly, preferential rates applied to “unrecaptured section 1250 gains”), describing its history, and identifying its existence as a result of successful lobbying efforts by the real estate industry). which applies to, for example, office furniture and equipment (such as desks, chairs and file cabinets), most manufacturing equipment (including machines for producing everything from furniture to fabric to food), and construction equipment.22Office furniture is categorized as seven-year property and thus qualifies for bonus depreciation as depreciable property with a recovery period of twenty years or less; other office equipment like computers, printers and so on are generally five-year property; various machinery is categorized as three-year to fifteen-year property. IRS Rev. Proc. 87-56 (describing asset classes 00.11 (office furniture and fixtures), 00.12 (computers and certain communication equipment), 15.0 (construction equipment), 20-23 (a variety of specific types of manufacturing equipment)). See generally Wolters Kluwer, U.S. Master Depreciation Guide (2020). If the couple described above contributed $5 million of cash to their business in 2018, and the business in turn purchased $5 million in equipment, the transactions simply convert the individuals’ cash into assets that can produce income in the future. For tax purposes, however, bonus depreciation allows that investment to be fully deductible by the individual in 2018. As a result, if a business starts the year with $5 million of cash and ends the year with $5 million of income-producing assets—but has no current-year income—then the owners would be able to report a tax loss of $5 million.

But that loss is clearly not an economic loss. If the business owners have $5 million of ordinary income from other sources and a $5 million deductible business expense that is an investment in future earnings, it seems only reasonable that they should be taxed on the current income: if the expected future income is not actually produced, that results in a loss in the future, not right now.

Bonus depreciation also applies to certain property associated with real estate, including land improvements—such as sidewalks, certain elements of lighting and electrical systems, and other assets that are said to be distinct from the real property and have a shorter recovery period under other IRS guidance.2326 U.S.C. § 168(k). See also Gerald J. Robinson, Federal Income Taxation of Real Estate ch. 5 (5th ed. 1988) (describing accelerated depreciation rules for personal property, land improvements and other categories under IRS guidance and case law). Returning to the real estate example above, if the transaction was completed in 2018 and $10 million of the $50 million investment was allocated to property with a recovery period of 20 years or less, then those amounts would be immediately deductible that year.24Allocating 20 percent of the purchase price of residential real estate to depreciable property that would qualify for bonus depreciation may well be justifiable. Consider Amerisouth XXXII Ltd. v. Commissioner, T.C. Memo. 2012-67 (taxpayer purchased $10.25 million of residential real estate and attempted to depreciate $3.4 million as fifteen-year or five-year property, much of which was disallowed, at least in part due to poor recordkeeping and failure to contest part of the case in court). In the example above, items with shorter depreciation periods could easily yield another $1 million in annual depreciation. These allocations are justified by cost segregation reports prepared for the taxpayer with the specific purpose of maximizing speedier depreciation deductions.25See Wolters Kluwer, at ¶ 127 (cited in note 21) (“Cost Segregation: Distinguishing Structural and Personal Property Components of Buildings”). Wolters Kluwer, at ¶ 127B (cited in note 21) (“Cost Segregation: Determining Depreciation Period of Personal Property Components of a Building”). Greg Polsky helpfully pointed out that real estate investors in particular are often very attentive to these allocations, to ensure that each element of the property can be depreciated as quickly as possible. See Robinson, at ch. 5 (cited in note 22) (describing accelerated depreciation rules for personal property, land improvements and other categories under IRS guidance and case law).

* * *

Combine the potential for bonus depreciation, regular depreciation, and interest deductions, and voila: a hypothetical investor who had a cash outlay in 2018 of $5 million, paid no actual money in interest and had no actual loss on property, could generate deductions of $10 million or more that year.26Calculated as: $5 million invested and $45 million borrowed to facilitate the purchase, yielding $10 million in bonus depreciation, $1.2 million in regular depreciation of the building, and $2 million in accrued interest. With the CARES Act’s unlimited loss deduction, that entire amount is deductible against other ordinary income, and tax liability paid in 2018 could be refunded immediately upon the filing of an amended return.

III. The Unlimited Pass-Through Deduction Exhibits Congressional Pathologies in Tax Policymaking

The existence of the unlimited pass-through deduction reveals how tax policy is made in Congress these days. As mentioned above, this year, the unlimited pass-through deduction is expected to provide more than $70 billion in benefits to some the highest income families in the country, those expected to earn more than $1 million. As the foregoing makes clear, for calendar year 2020, the deduction has nothing to do with anything that has happened with COVID-19—rather, it is entirely contingent on the taxpayer’s having tax losses and high other income before the crisis. Yet, that $70 billion in direct payments are more than any other income band received from the CARES Act rebates—for comparison, the 47 million people who earn less than $20,000 received less money in rebate payments.27The beneficiaries of the unlimited pass-through deduction are also receiving more than the rebates provided to the 35 million taxpayers who earn between $20,000 and $50,000, and more than the 24 million who earn between $50,000 and $75,000, and about the same as the 42 million who earn between $75,000 and $200,000. Thus, even though the rebate is phased out to focus on middle- and lower-income people, the unlimited pass-through deduction gives people at the very highest end of the income spectrum a greater benefit overall. The Appendix Table shows the combined distribution estimates from the two CARES Act provisions targeting individuals.

Because these highest income taxpayers benefitting from the unlimited pass-through deduction in 2020 are not in need (at least not as a class) and because the tax rules work so that the losses at issue aren’t necessarily real, current economic losses, the case in favor of the unlimited pass-through deduction is hard to muster. The only colorable arguments in favor of the unlimited deduction rule are based on (i) incentive or efficiency effects, or (ii) an idealized notion of taxable income whereby losses should always be permitted to offset gains.

For efficiency, an advocate of the unlimited pass-through deduction might say, we should incentivize business investments, and to do that investors need to know that their other sources of income can be offset by losses and deductible expenditures. But that justification simply does not mesh with the retroactive effect of the deduction. Investors making decisions in 2018, 2019, and into 2020 did so with the understanding that their personal loss deductions would be limited. They made investments, and if they had losses, they knew they could not use the full amounts to offset their income. Now, the CARES Act is retroactively giving them back those previously disallowed deductions.

The second argument is that limiting the use of non-business income against business losses is contrary to a normative conception of income and violates the general policy of pass-throughs.28See Steven Z. Hodaszy, The Curious Case of Section 461(l): Why This Unclear and Unwise New Rule Should be Construed as Narrowly as Possible, 73 Tax Law. 61 (2019). On this view, suspending § 461(l) is a move towards a more fundamentally sound tax regime for pass-throughs and closer to the Haig-Simons definition of income where losses should offset gains without limitation. But that idealized income argument disregards the reality that corporate losses cannot be used to offset the unrelated business income of a corporate shareholder—so in that sense, disallowing losses to pass-through owners is consistent with a broader, though admittedly contested, policy in business taxation. And it disregards the realities described above of bonus depreciation and other aspects of the Tax Code that significantly diverge from an idealized measure of income. Further, the unlimited pass-through deduction nonetheless does not fit the current policy moment, nor the recent historical circumstances that led to the existence of this limitation.

Regarding the unlimited pass-through deduction, the Joint Committee on Taxation’s explanation of tax provisions in the CARES Act provides no statement of purpose for unlimited pass-through deduction: it was not made clear to the JCT staff, and they apparently could not determine—based on their understanding of how the provision works and who it will affect—what legislative purpose it serves. In contrast, the modifications to the net operating loss provisions in § 172 are described as intended to provide businesses with liquidity to weather the COVID crisis.29The Committee explained that the NOL carryback provisions are intended “to provide taxpayers with liquidity in the form of tax refunds and reduced current and future tax liability.” The NOL provision is intertwined in some respects with the excess business loss limitation. Presumably because the unlimited pass-through deduction is so narrow, the same liquidity argument cannot be advanced as a way to help the broader economy.

Both the purist argument and the efficiency angle reveal inconsistencies in the deduction’s political sponsors’ reasoning and the excess loss limitation regime that preceded it.30Both provisions—in 2017 and in 2020—were added by the Republican-controlled U.S. Senate, although I have not succeeded in tracking down who exactly in the Senate Republican caucus originated the initial proposal in 2017. SeeH.R. Rep. No. 115-466 at 57 (Conf. Rep.) (specifying that § 461(l) was a Senate amendment). See also Alana Abramson, The Real Estate Industry Pushed for $160 Billion in Tax Breaks in the CARES Act, Disclosure Filings Show (Time, May 18, 2020) (analyzing drafts of precursors to the CARES Act to reveal that Senate Finance Committee Chair Chuck Grassley first proposed the suspension provision, after the provision was targeted residential real estate lobbyists). In simplistic terms, the strongest incentive effects in tax are thought to be connected to high tax rates and to differential taxation of similar things. Thus, prototypical tax reform consists of lowering tax rates by broadening the tax base—the tax system is thought to be generally more efficient when more of the base is taxed at a lower rate, without exceptions or distinctions. Although there was little explanation of the original excess business loss limitation at the time of enactment as part of the 2017 Tax Act, it seemed to be designed in the opposite way. By increasing the taxable income of a small number of pass-through owners with losses, Congress was able to make the budget numbers work for the special § 199A deduction for certain pass-through businesses. This is a tell: if tax policy purity and efficiency were real goals, then the excess business loss limitation would never have existed (and the § 199A deduction or some other revenue-reducing aspect of the 2017 Tax Act might have been designed to be less costly).31See generally Joint Comm. on Taxation, JCS-1-18, General Explanation of Public Law 115-97, Part II (Dec. 20, 2018) (pairing § 199A and § 461(l) in the congressional explanation of the 2017 Tax Act). Section 199A gives certain pass-through business owners the benefit of a lower top effective rate of 29.6 percent (as compared to around 37 percent for distributions from corporations—21 percent at the corporate level and 20 percent at the shareholder level).

If anything, the notable incentive effect at play here would seem to be in the political arena: the victory of unlimited pass-through deduction is that the tax-cuts-no-matter-what caucus in Congress has succeeded in making bad tax policy in the name of maximizing tax cuts. They enacted § 199A and § 461(l) to begin with, in 2017, and then, a few years later, they again maximized tax cuts in the name of fixing bad tax policy that they had only recently enacted. The overall effect of this type of iterative tax policy making, where the beneficiaries mostly win and then win some more, with the same goal persisting regardless of the circumstances, is that other taxpayers who lack such organized and persistent advocates end up losing again and again. 


All of this makes clear what the unlimited pass-through deduction really is: a giveaway, similar to the means-tested rebates paid to most Americans, but distributionally inverted to benefit a tiny sliver of investors and business owners. It puts extra cash in the hands of the wealthiest investors and business owners, and, because the limitation was based on income, only those who have very high incomes. The suspension of that limitation in the CARES Act was not constructed to help only those people who have real losses or who face economic calamity because of COVID-19; rather, it pushes in the opposite direction. If any group does not need help at this moment, it is 43,000 or so taxpayers who will have extremely high ordinary income in 2020 and had extremely high income in 2018 or 2019.32The § 461(l) mechanism requires this, because it only limited business loss deductions to the extent other income was at least $500,000 for a joint-filing couple. Further, the small number of beneficiaries and large revenue estimate indicate that taxpayers who were limited had income far in excess of $500,000.

In addition to being regressive, the unlimited pass-through deduction is a staggeringly irresponsible use of public funds. The deduction’s total cost of $135 billion (including the $70.3 billion to top earners this calendar year and more in years ahead) is enough to pay for another round of rebates for every family earning under $50,000.33Joint Comm. on Taxation, JCX-11R-20 (note that this is an updated revenue estimate that reduces the ten-year cost to $135 billion; previously it was estimated at $170 billion). See also CARES Act, Title II, Subtitle C, Business Provisions, §§ 2303, 2304. The unlimited pass-through deduction along with the NOL changes are expected to cost $167 billion over ten years. Cong. Budget Office, Preliminary Estimate of the Effects of H.R. 748, the CARES Act, Public Law 116-136, Revised, With Corrections to the Revenue Effect of the Employee Retention Credit and to the Modification of a Limitation on Losses for Taxpayers Other Than Corporations (Apr. 27, 2020) (“CBO, Revised CARES Act Cost Estimate”). See also Paycheck Protection Program and Health Care Enhancement Act, Pub. L. 116-139, H.R. 266 (Apr. 24, 2020). The initial cost estimates put the cost of these provisions at $195 billion, but that was adjusted downward about a week later. See Cong. Budget Office, Preliminary Estimate of the Effects of H.R. 748, the CARES Act, Public Law 116-136 (Apr. 16, 2020);Joint Comm. on Taxation, JCX-11R-20, Estimated Revenue Effects Of The Revenue Provisions Contained In An Amendment In The Nature Of A Substitute To H.R. 748, The “Coronavirus Aid, Relief, And Economic Security (‘CARES’) Act,” As Passed By The Senate On March 25, 2020, And Scheduled For Consideration By The House Of Representatives On March 27, 2020 (Apr. 23, 2020) (explaining that the updated estimate reflects that the out years (after the suspension ends) should see increased revenue rather than decreased revenue; although they did not issue updated distributional estimates for 2020, it does not appear that the out-year revenue changes should change the prior current year distributional analysis). Applied to actual needs in this crisis—masks and medical equipment, hospital support and health care infrastructure, or broad-based economic relief—$135 billion could do so much good.

There simply is no public purpose, and certainly no purpose that justifies the scale of the giveaway. Further, the public detriment is enormous. Already it appears that the unlimited pass-through deduction may have a detrimental effect on other recovery efforts.34This assessment is supported in part by two developments. First, Representative Lloyd Doggett and Senator Sheldon Whitehouse introduced legislation to repeal the suspension of the limitation, and that provision was included in the Health and Economic Recovery Omnibus Emergency Solutions (HEROES) Act recently passed by the House of Representatives. Second, opponents of that legislation and of other proposed responses that directly address COVID-19 issues have begun to make the argument that increasing the national debt further is not justified. But beyond that, it provides further confirmation that the tax policymaking process is broken, even at a moment when we might have hoped that national tragedy would at least summon the better angels of our policymaking nature. If Congress has any sense of fiscal and social responsibility, it will repeal the unlimited pass-through deduction and put the money to some other, more targeted use. Basically, anything would be a better response to COVID-19 than this.35A repeal of the unlimited pass-through deduction was included in the HEROES Act passed by the House, along with other relief and response measures. As of June 18, the Senate has not yet acted on the bill.

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Clint Wallace is an Assistant Professor of Law at the University of South Carolina School of Law. The author thanks Lad Boyle, Ari Glogower, Daniel Hemel, Greg Polsky and Steve Rosenthal for discussion and feedback. He also thanks Madison Rinehart for assistance with research, and Matthew Reade and his colleagues at the University of Chicago Law Review for their attentive editing. Other work by the author is available here.

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Featured photo credit: Foist.


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