Treasury says some banks are not financial-services firms, giving them a new tax break

Reporting from Washington —  It’s practically a dictionary definition to say that banks provide financial services. But when it comes to the new tax law, that’s not how the Treasury Department sees it.

Officials there have decided that nearly 2,000 banks are not financial services firms and therefore their owners qualify for a lower tax liability under the $1.5-trillion Republican tax-cut legislation that took effect Jan. 1.

The determination, sought by the banking industry, was one of dozens in 184 pages of proposed regulations issued this week by the Treasury’s Internal Revenue Service that will allow high-income owners to claim a new tax deduction as part of an expansive interpretation of who gets the break designed for so-called pass-through businesses.

Daniel Hemel, an assistant law professor at the University of Chicago, said the determination was a head-scratcher.

“Most of us had thought that banks are financial services. The House Financial Services Committee regulates banks. The Financial Services Roundtable represents banks,” he said.

“It does lead to a bad headline for Treasury and the IRS,” he said. “This so-called middle class tax break goes to those who own banks.”

The tax cuts for corporations were simple and straightforward: The rate was slashed to 21% from 35%. But the calculations are much more complicated for pass-through businesses whose owners file through the individual code. Those include mom-and-pop operations, privately held manufacturers and large partnerships such as law firms and hedge funds.

Under the tax law, those owners now get to deduct 20% of their business income if they make less than $315,000 for married couples filing jointly — no matter what field they are in. The new deduction phases out at an income of $415,000 for couples filing jointly for some types of businesses.

For other types of businesses, the deduction doesn’t phase out at all. The new regulations, released Wednesday, specified which businesses are excluded above the income threshold. In most cases, the regulations expand the numbers of high-income taxpayers eligible for the new 20% deduction.

“Pass-through businesses play a critical role in our economy,” Treasury Secretary Steven T. Mnuchin said in releasing the proposed regulations. “This 20% deduction will lead to more investment in U.S. companies and higher wages for hard-working Americans.”

But that statement doesn’t comport with an analysis by Congress’ nonpartisan Joint Committee on Taxation, which estimated this spring that the break would provide the most benefit to wealthy taxpayers. About 44% of the benefit this year would go to taxpayers with annual incomes of at least $1 million. That figure rises to 52% in 2024.

The new regulations probably expand the benefit of the deduction to those high-income business owners.

“These new rules confirm that the fortunate few win and mom-and-pop shops lose under Trump’s tax law,” said Sen. Ron Wyden (D-Ore.). “Tax planners are already scouring through the nearly 200 pages of regulations in search of new ways to keep wealthy clients from paying their fair share.”

Bankers were among the big winners.

When Congress passed the tax cut legislation, it referred to a provision in the Internal Revenue Code that listed types of business income that would be excluded from the new tax break for high-income owners. Among those were businesses involved in health, law, engineering, performing arts, athletics and financial services, as well as “any trade or business where the principal asset … is the reputation or skill of one or more of its employees or owners.”

The banking industry balked.

As of the end of last year, about 2,000 of the nation’s roughly 5,700 banks were pass-throughs. Known as subchapter S corporations, those banks are set up like partnerships and the banks’ shareholders pay taxes on their income through the individual tax code.

Most are small banks, with nearly two-thirds having assets of less than $200 million.

In April, three industry trade groups — the American Bankers Assn., the Independent Community Bankers of America and the Subchapter S Bank Assn. — wrote to the Treasury Department urging that banks not be included in the financial services category.

They argued that banks already are highly regulated and that Congress opted not to reference another provision of the Internal Revenue Code that specifically refers to banking. The groups said that after extensive discussion with lawmakers and staff last year about the matter, “we were assured repeatedly that S Banks would qualify” for the pass-through tax break.

The regulations released Wednesday, which will be the subject of an Oct. 16 public hearing before becoming final, sided with the banking industry view.

They said that Treasury and IRS officials agreed that “financial services should be more narrowly interpreted.” The regulations define financial services as those performed by financial advisors and investment bankers, not traditional banking services such as “taking deposits or making loans.”

“This does a little bit of violence to the English language and it does a little bit of violence to revenue collection,” Hemel said of the interpretation of financial services. “It will cost the Treasury probably billions of dollars over the course of a decade.”

He couldn’t estimate a precise figure, but the Joint Committee on Taxation estimated in December that the pass-through deduction overall would reduce federal tax revenue by $415 billion through 2027.

Steven Rosenthal, a senior fellow at the nonpartisan Tax Policy Center, said the regulations showed “Mnuchin wanted to be Santa Claus in August.”

“This just highlights the arbitrariness of the whole exercise,” said Rosenthal, who had expected banks would be excluded from financial services in the regulations. “For Republicans who are supposed to be free-market advocates to arbitrarily create winners and losers depending on whether you like some types of businesses is crazy to me.”

The regulations also clarified how some of the other excluded fields would be treated.

In health, people who directly provide medical services, such as physicians, dentists, psychologists, pharmacists, physical therapists and veterinarians, are not allowed to claim the tax break above the income thresholds. But those who don’t directly provide medical services, such as the owners of health clubs or spas, are allowed to claim the break above the thresholds.

Similarly, in performing arts, people such as actors, singers, musicians and directors are excluded from claiming the break above the income thresholds. But those who operate cameras and other equipment do get the break because those services “do not require skills unique to the creation of the performing arts,” according to the regulations.

Before the tax law, the IRS code categorized some pass-through businesses as having as their principal asset the reputation or skill of one or more of its employees. The tax cut added the owners of those businesses to that provision.

However, Treasury and IRS officials opted to narrowly interpret the provision, limiting it only to businesses that receive endorsement income, license an owner’s or employee’s image, voice or other identifying symbols, or receive appearance fees for those people.

“If a restaurant’s big selling point is a celebrity chef, does that mean that its trade and business is the skill and reputation of one or more of its owners or employees?” Hemel said. “Those are really, really hard-line-drawing questions and the IRS basically took the position that, except in unusual circumstances, we will not consider you to be a skill or reputation business unless you fall into one of a few specific statutory categories.”

So a restaurant run by a celebrity chef appears to be eligible for the break above the income thresholds, Hemel said. The same would be true for hotels and golf courses owned or managed by President Trump that bear his name.

“Arguably Trump’s D.C. hotel’s principal asset is that its owned by the president of the United States,” Hemel said. “The IRS basically said we’re not going to make that argument.”

jim.puzzanghera@latimes.com

Twitter: @JimPuzzanghera