Who Wins and Loses, as Democrats Look to Curb Tax Breaks for Pass-through Businesses

You already know that a tax overhaul is in the works, putting wealthy Americans and corporations on notice of higher rates. But a new proposal out of Washington aimed at tweaking incentives for “pass-through” entities is on the table, too.

On Tuesday, Senate Finance Committee Chair Ron Wyden (D-Ore.) proposed phasing out the Section 199A qualified business income deduction for taxpayers with incomes of more than $400,000. Qualified business income is defined as money generated through the normal course of running a company and does not include capital gains. The bill, dubbed the Small Business Tax Fairness Act, would also widen the eligibility for businesses that are not currently afforded full access to the provision, which is often referred to as the “pass-through deduction.” A pass-through business is typically a limited liability company or a sole proprietorship which passes income tax liabilities onto their individual owners instead of paying corporate income taxes.

Currently, the provision, which was authorized under the 2017 Tax Cuts and Jobs Act (TCJA), allows certain types of pass-through businesses to offset up to 20 percent of their qualified business income from their taxable income. In other words, the provision allows for, say, individual shareholders of an S Corp to take the deduction but the S Corp itself may not take the deduction. 

But there are quirky limitations and exclusions. To name one: Businesses including lawyers, accountants, dentists, and other professional services firms may take the deduction but only up to the prevailing income threshold, which currently stands at $164,900, or $329,800 for joint filers. Any income generated above this amount would not be eligible for the deduction. There are also limitations based on W-2 wages paid and qualified investments. So some pass-through businesses that have little to no tangible property and no employees with W-2 wages may not qualify at all.

What’s more, bigger businesses are pilfering the provision, say Democrats. As written, “the 20 percent pass-through deduction disproportionately benefits the wealthiest Americans,” Wyden said in a statement, noting that plenty of pass-through businesses aren’t small. Pass-through businesses account for 58 percent of all businesses with more than $50 million in receipts, and those filers received 61 percent of the 2017 benefit, according to the statement.

Should this proposal get taken up under the proposed $3.5 trillion economic bill as expected, there will be winners and losers, says Garrett Watson, senior policy analyst at the Tax Foundation, a conservative-leaning think tank in Washington, D.C. “It’s one of those proposals that really depends on the details of your business.”

To wit, under the revised tax break, complicated categories and calculations used to determine which partnerships, limited liability companies, and other pass-through businesses qualify would be ditched. That then “opens the deduction potentially to more businesses,” says Watson. But, he adds, “For a lot of folks, who are currently under the thresholds, not much would change.”

While it’s unclear whether Biden favors this proposal, Watson notes that the structure of the bill adheres to the president’s longtime promise to not raise taxes on filers with incomes under $400,000. Plus, many of the elements of the TCJA — including this 199A deduction — are seen as fair game among tax experts. Bill Smith, managing director for CBIZ MHM’s National Tax Office in Bethesda, Maryland, previously told Inc. that he expected this provision would get some attention.

Of course, Biden could also just let the whole thing expire in a couple of years. “Other than the corporate tax reduction, virtually everything else expires after 2025,” says Smith, who notes that simply letting the cuts expire would raise revenue, which Biden will need to help fund his agenda.

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