Many provisions of the 2017 tax law are set to expire at the end of 2025. As concerns about widening deficits cause policymakers to carefully consider key tax exemptions, credits and other tax breaks, advocates are already trying to convince Congress to extend or make permanent key provisions.
One such provision is the pass-through deduction for certain businesses.
“It’s a 20% deduction on certain qualified business income from pass-through businesses,” explains Garrett Watson, senior policy analyst at the Tax Foundation. “Pass-through businesses, which include sole proprietors and small mom-and-pop shops to large S corporations and partnerships, may also qualify for this deduction.”
Most companies in the United States are pass-through corporations, which means that instead of receiving a salary or wages from the corporation, the owners receive a portion of the corporation’s profits as their own income. Before the 2017 tax reform, company owners had to pay ordinary income tax on that money, but now they get a 20% deduction on some of it.
“Think about the small businesses on Main Streets across America,” said Neil Bradley, executive vice president and chief policy officer at the U.S. Chamber of Commerce. “And who’s using it? There are roughly 22.5 million pass-through entities that take advantage of the 20 percent pass-through deduction, and by the way, these entities employ about 50 percent of the entire private, for-profit sector workforce.”
The chamber has strongly advocated for an extension of the tax credit for pass-through income, warning that if the credit expires, affected employers’ top tax rates could jump from 29.6% to 39%.
The pass-through deduction exists because, when Congress sought to lower corporate tax rates in 2017, lawmakers looked for a way to give pass-through companies the same tax breaks as large corporations called C corporations, whose tax rate was reduced from 35 percent to 21 percent.
“And there was concern that with such a steep cut in tax rates, pass-through businesses might legally convert to C corporations to take advantage of the lower tax rates,” said the Tax Foundation’s Watson. “So this special deduction was created to make sure that people didn’t change their business structure to get a tax advantage, so that the tax rates would be roughly equivalent.”
But the deduction is incredibly complicated, said Chi-Ching Huang, executive director of the Tax Law Center at New York University.
“The IRS’s simplified flowchart for the system has 14 steps, and there’s a 15-page pamphlet written by an official congressional researcher summarizing how it works for members of Congress,” she said.
Employers who take advantage of the pass-through credit face a top federal tax rate of just under 30%, compared with 37% for workers who receive regular wages or salaries. The credit’s complexity has led some employers to abuse the system, Huang said.
“For example, many high-income filers derive income from owning partnership shares and also receive some compensation from the partnership for labor services,” Huang explained. “Since the new provision went into effect, many of them have stopped paying income to themselves as nondeductible benefits and instead started paying themselves in the form of a deductible return.”
Tax experts are quick to point out that the benefits of the deduction are not distributed evenly.
“This is skewed toward very high-income earners; more than half of the benefit goes to business owners making more than $1 million,” said Samantha Jacoby, deputy director of federal tax policy at the Center on Budget and Policy Priorities.
“People who make over $10 million who claim the credit claim $1 million of the credit, but the average credit is $7,000,” she said. “So the very wealthy are getting a lot more than the average person.”
Another concern for budget hawks is the cost of the credit, which was initially projected to hit federal revenues by more than $400 billion, and Watson of the Tax Foundation says extending the credit for another 10 years would result in an additional $700 billion loss.
“I don’t think there are any firm conclusions, but there isn’t a lot of strong evidence that the deduction has spurred more investment or economic activity than normal that would surprise people,” he said.
As the provision’s expiration date in 2025 approaches, Congress will have to decide whether the deduction is worth preserving.
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