A tax deduction that business owners love is set to expire in 2025 – Marketplace

Many provisions of the 2017 tax law are set to expire at the end of 2025. Advocates are already attempting to convince Congress to extend or make permanent key provisions, even as concerns about the growing budget deficit make policymakers look carefully at major tax exemptions, deductions and other breaks.

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. “Pass-through businesses includes your sole proprietorships, your small mom-and-pop shops, all the way up to large S corporations and partnerships that may also qualify for this deduction.”

Most businesses in the U.S. are pass-through businesses. That means rather than owners taking a salary or wages from the business, they take a share of the business’ profit as their own income. Prior to the 2017 tax changes, business owners had to pay regular income taxes on that money, but now there is a 20% deduction on some of it.

“Think about small companies, small businesses on Main Streets all across America,” said Neil Bradley, executive vice president and chief policy officer at the U.S. Chamber of Commerce. “As to who uses it, there are about 22.5 million pass-through entities who have utilized the 20% pass-through credit, and by the way, they employ about 50% of the entire private-sector, for-profit workforce.”

The chamber strongly advocates extending the tax deduction on pass-through income, warning that if the deduction were to expire, affected business owners could see their top tax rates jump from 29.6% to 39%.

The pass-through deduction exists because when Congress was trying to cut tax rates for businesses in 2017, lawmakers sought a way to give pass-through businesses a cut similar to the one for big 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 may be a migration from pass-through firms who may turn into C corporations legally to take advantage of that lower tax rate,” said Watson at the Tax Foundation. “And so in order to ensure that the tax rates were roughly at close to parity, they created this special deduction to ensure that folks were not changing business form 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 simplified IRS flow chart of this thing is 14 steps long, and the pamphlet that Congress’ official 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 top federal tax rate of just under 30%, compared to the up-to-37% tax rate for workers making regular wages or salaries. Huang said the complexity of the deduction has encouraged some business owners to game the system.

“For example, many high-income filers have some income from owning a share in a partnership, and they get some kind of compensation from the partnership, also for their labor services,” explained Huang. “After this new provision came into place, many of them stopped paying themselves income as a type of profit that is not eligible 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 distributed equally.

“It’s highly skewed to very-high-income businesses. Over half of the benefit goes to business owners who have more than $1 million of income,” said Samantha Jacoby, deputy director of federal tax policy at the Center on Budget and Policy Priorities.

“People with over $10 million in income who claim the deduction claimed a $1 million deduction, and that’s compared to an average deduction of $7,000,” she said. “So very wealthy people are just benefiting much more than ordinary people.”

Another concern for budget hawks is the cost of the deduction. It was originally projected to deliver upward of a $400 billion hit to federal revenue. If it’s extended for another 10 years, said Watson at the Tax Foundation, that’s another $700 billion.

“And while I don’t think there’s any firm conclusion, there’s not a lot of strong evidence that the deduction spurred an above-normal amount of investment or economic activity that would be surprising to people,” he said. 

As the provision’s expiration date at the end of 2025 approaches, Congress will have to decide if keeping the deduction is worth it.