Section 199A Pass-Through Deduction Changes

The 2017 TaxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities.
Cuts and Jobs Act (TCJA) introduced a new, temporary 20 percent deduction for pass-through businesses, effectively reducing the marginal tax rateThe marginal tax rate is the amount of additional tax paid for every additional dollar earned as income. The average tax rate is the total tax paid divided by total income earned. A 10 percent marginal tax rate means that 10 cents of every next dollar earned would be taken as tax.
on noncorporate business income. The deduction is scheduled to expire after the end of this year, but the recent House-passed tax bill would make the deduction permanent and expand it in three key ways. Rather than permanently enhancing the deduction, lawmakers should make proven tax reforms like bonus depreciation and research and development (R&D) expensing permanent features of the tax code.

Lawmakers included the deduction in the 2017 TCJA to, in their view, achieve parity with the law’s reduction in the statutory corporate tax rate. However, most research suggests that rather than enhancing parity, the deduction instead continues to provide a tax advantage for noncorporate income over corporate income.

Unfortunately, the deduction does not live up to its intent of enhancing tax parity, but it does significantly complicate the tax code and add to compliance costs.

The Section 199A deduction today allows taxpayers to exclude up to 20 percent of their pass-through business income from federal income tax. Upper-income taxpayers face several limits to their deduction based on the economic sector of each business, the amount of business wages paid, and the original cost of business property.

To calculate the deduction in 2025, taxpayers first compare 20 percent of their qualified business income (QBI) and 20 percent of their taxable ordinary income, using whichever of the two is smaller.

When income exceeds a threshold of $394,600 for joint filers and $197,300 for all other filers, limitations begin to phase in and they apply in full when income exceeds $494,600 for joint filers and $247,300 for all other filers.

To determine if the wage or capital investment limits apply, taxpayers compare whichever amount is larger: 50 percent of W-2 wages paid by each business or 25 percent of W-2 wages paid by each business plus 2.5 percent of the unadjusted basis in tangible property held by each business. If that amount is smaller than the 20 percent deduction of qualified business income, taxpayers take that smaller amount instead.

A total disallowance of the deduction for specified service trades or businesses (SSTBs) phases in over the same range of income, preventing the deduction altogether for businesses in disallowed industries such as law, accounting, and health.

Altogether, the Joint Committee on Taxation (JCT) estimates the Section 199A deduction will reduce federal tax revenue by $66.1 billion in fiscal year 2025.

The House bill would make three key changes to the deduction, increasing its generosity and revenue cost.

First, it would permanently extend the deduction at a higher rate of 23 percent and inflationInflation is when the general price of goods and services increases across the economy, reducing the purchasing power of a currency and the value of certain assets. The same paycheck covers less goods, services, and bills. It is sometimes referred to as a “hidden tax,” as it leaves taxpayers less well-off due to higher costs and “bracket creep,” while increasing the government’s spending power.
adjust the threshold amounts beginning after 2025. The current deduction effectively lowers the top marginal tax rate from 37 percent to 29.6 percent, while the House bill would lower it further to 28.5 percent.

Second, the bill would replace current limitations based on W-2 wages, capital investment, and industry with a new two-step process for taxpayers with income above the thresholds. The first step would use the same W-2 and capital investment tests for each qualified trade or business, but with no phase-in. The second step would, separately, reduce the 23 percent deduction for qualified business income for all trades or businesses (including SSTBs) by 75 percent of the excess income above the threshold. Taxpayers would take whichever deduction is greater.

Imagine a single filer with $250,000 in qualified business income, $350,000 in adjusted gross incomeFor individuals, gross income is the total pre-tax earnings from wages, tips, investments, interest, and other forms of income and is also referred to as “gross pay.” For businesses, gross income is total revenue minus cost of goods sold and is also known as “gross profit” or “gross margin.”
, and $315,000 in taxable incomeTaxable income is the amount of income subject to tax, after deductions and exemptions. For both individuals and corporations, taxable income differs from—and is less than—gross income.
. The filers’ share of the business’s W-2 wages is $80,000 and of the unadjusted basis in tangible property it is $120,000.

Under current law, before any limitations, the filer’s deduction would be $50,000 (0.2 * $250,000). But the filer would be subject to the wage and capital limitations, limiting the allowable 199A deduction to the larger of 50 percent of W-2 wages ($40,000) or 25 percent of W-2 wages and 2.5 percent of capital investment ($23,000). Rather than a $50,000 deduction, the filer would be able to take a $40,000 deduction. If the filer’s income were entirely from an SSTB, however, they would not be eligible for any deduction.

Under the proposal, the filer’s deduction before any limitations would be $57,500 (0.23 * $250,000). Step one would apply the same wage and capital limitations, resulting in deductions of $40,000 or $23,000. But if the filer’s income were entirely from an SSTB, the allowable deduction under step one would be $0 because none of their income would be from a qualified trade or business. For step two, the taxpayer would take 23 percent of their QBI ($57,500) and reduce it by 75 percent of how much their taxable income exceeds the threshold amount ($315,000 – $247,300 = $67,700 * 0.75 = $50,775), resulting in an allowable deduction of $6,725 ($57,500 – $50,775).

Taxpayers would take the larger of the deductions from step one or step two. For a taxpayer with income from a qualified business, the allowable deduction would still be $40,000, and for a taxpayer with income entirely from a SSTB, the allowable deduction would increase from $0 under current law to $6,725 under the proposal.

The effect of the change is to slow the phase-in of the limitations, avoiding large increases in marginal effective tax rates for filers subject to the limitation thresholds.

The third change the bill proposes for the deduction is to permit dividends from business development companies (BDCs) registered as regulated investment companies (RICs) to qualify for the deduction, aligning with the treatment of dividends from real estate investment trusts (REITs) that are currently eligible for the deduction. BDCs are investment companies that typically invest in small, developing, and financially troubled businesses; for that reason, they are riskier and tend to offer higher returns than typical investments. While BDC dividends would typically be taxed as ordinary income, the House bill would reduce the marginal tax rate of qualifying BDC dividends by allowing them to qualify for the 23 percent deduction.

An earlier JCT estimate of the House bill projected that, over 10 years, extending the existing Section 199A deduction would reduce federal revenue by $705 billion. Increasing the deduction rate to 23 percent would cost an additional $104 billion, modifying inflation indexingInflation indexing refers to automatic cost-of-living adjustments built into tax provisions to keep pace with inflation. Absent these adjustments, income taxes are subject to “bracket creep” and stealth increases on taxpayers, while excise taxes are vulnerable to erosion as taxes expressed in marginal dollars, rather than rates, slowly lose value.
would cost $678 million, and extending the deduction to qualifying BDC dividends would cost $10.7 billion. In contrast, modifying the phaseout rules was estimated to raise $369 million. In the most recent score, JCT combines all the Section 199A modifications into one score, finding the changes reduce federal tax revenue by $820 billion from 2025 through 2034.

Tax Foundation estimates the deduction in the House bill would boost long-run economic output by 0.6 percent. However, lawmakers could boost growth in a much more cost-effective, neutral, and simple way by choosing to make four key business provisions in the House bill permanent, rather than sunsetting them after five years as the bill does now. Permanence for the cost recoveryCost recovery is the ability of businesses to recover (deduct) the costs of their investments. It plays an important role in defining a business’ tax base and can impact investment decisions. When businesses cannot fully deduct capital expenditures, they spend less on capital, which reduces worker’s productivity and wages.
provisions would boost long-run economic output by 1.0 percent and add around $500 billion to the total conventional revenue cost of the package.

Rather than permanently expanding a complicated, nonneutral tax break, Congress should prioritize permanence for the most neutral and pro-growth policies like bonus depreciation and R&D expensing.