Senate Finance Chair Ron Wyden is proposing to limit a tax break for “pass-through” business owners by phasing it out for individuals making more than $400,000.
The Oregon Democrat released a bill Tuesday morning that would simplify and curtail a deduction for owners or partners of subchapter S corporations, sole proprietorships, partnerships and other pass-through structures used by businesses as an alternative to traditional C corporations.
Unlike C corporations, pass-throughs aren’t subject to an initial layer of corporate tax on their earnings; instead, their owners are taxed once, at individual income tax rates. Republicans established the 20 percent deduction for “qualified business income” in their 2017 tax overhaul as a way to reduce taxes on pass-through businesses so they wouldn’t be left out of the benefits enjoyed by corporations, such as that law’s reduction of a then-35 percent corporate rate down to 21 percent.
But Democrats charge the benefits of the pass-through deduction have mainly accrued to well-off households and larger firms, rather than the small businesses they were billed as helping. The Joint Committee on Taxation has estimated that taxpayers earning more than $1 million have claimed more than half the deduction’s benefit, for instance.
“What was done in 2017 wasn’t fair, and we’ve got a proposal that we think will help more people, particularly those who especially need the boost,” Wyden said Monday.
The changes will help more people for a smaller price, he said.
Wyden’s proposal would phase out the deduction starting at taxable income of $400,000 per year and deny the break altogether to anyone making more than $500,000. It would allow a deduction of 20 percent of the lowest of either taxable income, $400,000 or taxable income reduced by a taxpayer’s net capital gains for the year.
President Joe Biden has pledged not to raise taxes on people who make less than $400,000 annually, a restriction that Democrats say they’ll abide by as they seek offsets for a $3.5 trillion budget reconciliation package to implement proposed expansions of child care, clean energy, education, housing and other benefits.
During a call with reporters on Tuesday, Wyden stressed that the $400,000 threshold where the deduction starts phasing out is in line with Biden’s pledge. While the Small Business Administration generally defines a business’s size by revenue or number of employees, Wyden said the $400,000 figure is right for the deduction because it ultimately applies to individuals’ income tax.
Wyden said he’ll make the case for including the changes to the pass-through deduction in the reconciliation package and that he’s encouraged by discussions with fellow Senate Democrats on the matter.
Biden suggested a similar restriction of the pass-through deduction during his presidential campaign, but it wasn’t included in his budget request. Treasury officials who described the president’s budget request during a background call on May 28 said not everything from the campaign made it into the proposal.
“Some needed more policy development in order to kind of get to a place people felt comfortable with,” the Treasury officials said. “Others are likely to show up in future budgets.”
A revenue estimate from the JCT, the chief budget scorekeeper for lawmakers on tax legislation, wasn’t immediately available. The Tax Policy Center, a joint project of the Urban Institute and Brookings Institution think tanks, estimated during the campaign that Biden’s proposal to phase out and eliminate the pass-through deduction for those earning more than $400,000 annually would generate about $143 billion over a decade.
The cost of expanding the deduction for some pass-through owners below the $400,000 line would be modest, and the proposal on the whole would raise billions of dollars, Wyden said.
The tax break is already scheduled to expire fully after 2025. Wyden’s changes would apply to the next four years, starting with the 2022 tax year, assuming enactment later this year.
Size and simplicity
In a summary, Wyden said his goal was to not only limit the break for upper-income and larger businesses but also to make the deduction easier to claim for owners of small to midsize pass-through businesses.
His plan would get rid of restrictions on the type of businesses that can currently qualify for the deduction, with professional services-related firms currently ineligible if they earn more than a certain amount. For those business owners, they would become eligible for the deduction up to the new $400,000 earnings threshold regardless of what trade they’re in.
Wyden’s bill would also get rid of special rules determining the amount of the deduction based on W-2 wages paid to employees, with an exemption for firms like real estate developers that may invest a lot of capital but not have many workers on payroll. Instead, there would be only the definition of eligible income and the $400,000 income limitation.
The measure includes some special rules for agricultural and horticultural cooperatives, and it would clarify the treatment of business income in Puerto Rico. It also would appear to preserve the eligibility of income from two pass-through investment vehicles: real estate investment trusts and publicly traded partnerships. It would clarify that regulated investment companies, or mutual funds, that pay out dividends including REIT or publicly traded partnership income can qualify as well.
The Wyden proposal would also prevent securities traders who opt for “mark to market” treatment under the tax code, where the fair market value at the end of the calendar year of any paper gains or losses is treated as having been sold, from claiming the deduction. The IRS in early 2019 said such income would be eligible.
House Ways and Means ranking member Kevin Brady, R-Texas, defended the current deduction in a call with reporters on Tuesday. He said current law empowers small businesses to invest and hire workers.
“Republicans have been warning that Democrats in Congress and the White House are coming after small businesses, and we are right,” Brady said.
Wyden said on Tuesday’s call that the way Republicans structured the pass-through break in the 2017 law favored the wealthy, and that the GOP is now trying to “rebrand megamillionaires as small businesses.”
He hosted business owners and advocates on the call from left-leaning small business groups. Anne Zimmerman, an Ohio accountant who co-chairs the Small Business for America’s Future coalition, said the Wyden bill would level the playing field for smaller businesses to compete with larger counterparts.
Lindsey McPherson contributed to this report.