Many provisions of the 2017 tax law are set to expire at the end of 2025. Advocates are already trying to persuade Congress to extend or make key provisions permanent, even as concerns about rising budget deficits have policymakers scrutinizing exemptions and major tax deductions and other holidays.
One such provision is the pass-through deduction for certain businesses.
“It’s a 20% deduction for certain qualified business income from pass-through businesses,” explained Garrett Watson, a senior policy analyst at the Tax Foundation. “Conducted businesses include your sole proprietorship, your small mom and pop shops, to large S corporations and partnerships that may also qualify for this deduction.”
Most businesses in the US are broadcast businesses. This means that instead of the owners receiving a salary or wages from the business, they receive a portion of the business’s profit as their income. Before the 2017 tax changes, business owners had to regularly pay income tax on that money, but now there is a 20% discount for some of it.
“Think about the small companies, the small businesses on Main Street across America,” said Neil Bradley, executive vice president and chief policy officer at the US Chamber of Commerce. “In terms of who uses it, there are about 22.5 million pass-through entities that have taken advantage of the 20% pass-through credit, and by the way, they employ about 50% of the entire gainful private sector workforce.”
The chamber strongly advocates extending the pass-through income tax deduction, warning that if the deduction were to expire, affected business owners could see their top tax rates rise from 29.6% to 39%.
The pass-through deduction exists because when Congress was trying to lower business tax rates in 2017, lawmakers sought a way to give pass-through businesses a break similar to that given to large corporations, known as C corporations, which saw their rate drop from 35% to 21%.
“And there was some concern that with that sharp reduction in that tax rate, there might be a migration from pass-through firms that can legally convert to C corporations to take advantage of that lower tax rate,” Watson said at the Tax Foundation. . “And so to make sure that the tax rates were pretty close to parity, they created this special deduction to make sure that people didn’t change the form of business to get a tax advantage one way or the other.”
But the deduction is very complex, said Chye-Ching Huang, executive director of New York University’s Tax Law Center.
“The IRS’s simplified flow chart for this thing is 14 steps long, and the pamphlet that the official congressional researchers wrote for lawmakers, trying to summarize how it works, is 15 pages,” she said.
Business owners who take the pass-through deduction end up with a higher federal tax rate of just under 30%, compared to a tax rate of up to 37% for wage or salary workers. Huang said the complexity of the deduction has encouraged some business owners to game the system.
“For example, many high-income employees have some income from owning a share in a partnership, and they receive some kind of compensation from the partnership, also for their work services,” Huang explained. “After this new provision went into effect, many of them stopped paying themselves income as a type of profit that does not qualify for the deduction and instead paid themselves in a form that is eligible for the deduction.”
Tax policy experts are quick to point out that the benefits of the deduction are not evenly distributed.
“It’s very biased towards very high-income businesses. Over half of the benefit goes to business owners who have more than $1 million in revenue,” said Samantha Jacoby, deputy director of federal tax policy at the Center on Budget and Policy Priorities.
“People with more than $10 million in income claiming the deduction claimed a deduction of $1 million, and that compares to an average deduction of $7,000,” she said. “So the very rich are benefiting much more than ordinary people.”
Another concern for budget hawks is the cost of the discount. It was originally projected to take a $400 billion hit to federal revenue. If extended another 10 years, Watson said at the Tax Foundation, that’s another $700 billion.
“And while I don’t think there’s any strong conclusion, there’s not a lot of hard evidence that the discount spurred an above-normal amount of investment or economic activity that would be surprising to people,” he said.
As the provision’s late 2025 expiration date approaches, Congress will have to decide whether keeping the deduction is worth it.
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