The House-passed tax bill proposes three significant Section 199A Deduction Changes aimed at making the deduction permanent and, in many cases, more generous:
Increased Deduction Rate and Inflation Adjustment
The first key change is to permanently extend the Section 199A deduction at an increased rate of 23 percent, up from the current 20 percent. Furthermore, the bill proposes to begin inflation-adjusting the threshold amounts after 2025. This increase in the deduction rate would further reduce the effective top marginal tax rate on qualified business income. Currently, with a top marginal rate of 37 percent, the 20 percent deduction effectively lowers it to 29.6 percent. Under the House proposal, the 23 percent deduction would further decrease it to 28.5 percent.
Overhauling the Limitations: A New Two-Step Process
The second, and perhaps most intricate, change involves a complete overhaul of the limitations based on W-2 wages, capital investment, and industry. The House bill proposes a new two-step process for taxpayers with income above the thresholds:
- Step One: This step retains the current W-2 wage and capital investment tests but applies them to each qualified trade or business separately and without any phase-in. This means that once a taxpayer’s income exceeds the threshold, these limitations apply in full immediately.
- Step Two: Separately, for all trades or businesses (including SSTBs, which are currently entirely disallowed above the threshold), the bill would reduce the 23 percent deduction for qualified business income by 75 percent of the excess of the taxpayer’s taxable income over the threshold amount.
Taxpayers would then be allowed to take whichever deduction is greater between the amount calculated in step one and the amount calculated in step two.
Let’s revisit the example provided in the source article to illustrate these Section 199A Deduction Changes:
Imagine a single filer in 2026 (after the proposed changes take full effect) with:
- $250,000 in qualified business income (QBI)
- $350,000 in adjusted gross income (AGI)
- $315,000 in taxable income
- $80,000 share of the business’s W-2 wages
- $120,000 share of the unadjusted basis in tangible property
Under the House proposal (using the 2025 threshold for simplicity, as 2026 would be inflation-adjusted):
-
Step One:
- Before limitations: 23% of $250,000 = $57,500
- Wage Limitation (50% of W-2 wages): 50% of $80,000 = $40,000
- Wage & Capital Limitation (25% of W-2 + 2.5% of Capital): (25% of $80,000) + (2.5% of $120,000) = $20,000 + $3,000 = $23,000
- The step one deduction would be the smaller of $57,500 and the larger of $40,000 or $23,000, which is $40,000.
- Crucially, even if this income were from an SSTB, the step one limitation would still apply based on wages and capital.
-
Step Two:
- 23% of QBI: $57,500
- Excess taxable income over threshold ($247,300 for single filers in 2025, assumed for this example): $315,000 – $247,300 = $67,700
- 75% of excess: $67,700 * 0.75 = $50,775
- Step two deduction: $57,500 – $50,775 = $6,725
-
Allowable Deduction: The taxpayer would take the larger of step one ($40,000) and step two ($6,725), resulting in a deduction of $40,000.
The key impact of this change is to slow the phase-in of the limitations. Under current law, the SSTB in this example would receive no deduction. Under the proposal, they would receive $6,725. This avoids the sharp increases in marginal effective tax rates that can occur under the current phase-in rules.
BDC Dividends Now Eligible
The third significant Section 199A Deduction Changes involves allowing dividends from Business Development Companies (BDCs) registered as regulated investment companies (RICs) to qualify for the deduction. This aligns the treatment of BDC dividends with that of dividends from real estate investment trusts (REITs), which are currently eligible. BDCs are investment companies that typically invest in smaller, developing, and financially distressed businesses, often offering higher returns to compensate for the increased risk. Under the House bill, these typically ordinary income-taxed dividends would see a reduced marginal tax rate by qualifying for the 23 percent deduction.
The Price Tag: Revenue Implications of the Proposed Changes
The proposed Section 199A Deduction Changes come with a significant revenue cost. Earlier estimates from the JCT projected that simply extending the existing Section 199A deduction would reduce federal revenue by $705 billion over 10 years. The proposed enhancements add to this figure:
- Increasing the deduction rate to 23 percent is estimated to cost an additional $104 billion over 10 years.
- Modifying inflation indexing is projected to cost $678 million.
- Extending the deduction to qualifying BDC dividends would cost $10.7 billion.
- Interestingly, modifying the phaseout rules (the new two-step process) was estimated to raise $369 million over 10 years, likely due to the full application of limitations in step one above the threshold.
The most recent JCT score combines all the Section 199A modifications and finds that the proposed changes would collectively reduce federal tax revenue by an estimated $820 billion from 2025 through 2034.
Economic Impact and Alternative Priorities
The Tax Foundation estimates that the Section 199A Deduction Changes in the House bill would boost long-run economic output by 0.6 percent. However, they argue that Congress could achieve a more significant economic boost in a more cost-effective and neutral manner by prioritizing the permanence of other key business provisions currently set to sunset after five years in the House bill, such as bonus depreciation and R&D expensing. Making these cost recovery provisions permanent, for instance, is estimated to boost long-run economic output by 1.0 percent, with a revenue cost comparable to the proposed Section 199A expansions.
The Tax Foundation highlights that permanently expanding a complicated and somewhat nonneutral tax break like Section 199A may not be the most efficient way to promote economic growth. They suggest that prioritizing more neutral and directly pro-growth policies like immediate expensing for capital investments and research and development would be a more strategic use of revenue.
Navigating These Changes: What Pass-Through Businesses Should Do
The proposed Section 199A Deduction Changes, while aiming to simplify in some areas, still present complexities that pass-through businesses need to understand. The potential increase in the deduction rate could be a significant benefit, but the revised limitation rules will require careful consideration, especially for businesses operating above the income thresholds. It’s crucial for business owners and tax professionals to analyze how these changes would specifically impact their situations.
Staying informed about the progress of this tax legislation is paramount. If these changes are enacted, businesses will need to adjust their tax planning strategies accordingly. Understanding the interplay between the increased deduction rate and the new two-step limitation process will be essential for maximizing tax benefits and ensuring compliance.
We can help
Navigating the intricacies of tax legislation, especially significant changes like these Section 199A Deduction Changes, can be challenging. At [Your Company Name], we offer comprehensive tax planning and consulting services to help pass-through businesses understand their obligations and opportunities. We can assist you in:
- Analyzing the potential impact of these proposed changes on your specific business.
- Developing tax-efficient strategies to maximize the benefits of the Section 199A deduction under the new rules.
- Ensuring compliance with all relevant tax regulations.
- Staying up-to-date on the latest legislative developments.
Contact us today for a consultation and let our experienced tax professionals guide you through these complex Section 199A Deduction Changes. Visit our [Your Company’s Tax Planning Page] to learn more about our services.
Conclusion: The Future of the Pass-Through Deduction
The House-passed tax bill proposes significant Section 199A Deduction Changes that would make this key tax break for pass-through businesses permanent and, in many cases, more generous. The increased deduction rate and the revised limitation rules represent a substantial shift in the tax landscape for noncorporate entities. While the aim may be to provide continued tax relief and potentially stimulate economic activity, the complexities of the new two-step limitation process and the significant revenue cost warrant careful consideration. Understanding these proposed changes is crucial for pass-through businesses to effectively plan for the future.
Final Thoughts & Call to Action
The potential Section 199A Deduction Changes highlight the ever-evolving nature of tax law. Staying informed and seeking professional guidance are essential for businesses to navigate these complexities successfully. Don’t wait until the last minute to understand how these proposed changes could affect your bottom line.
Visit TRP today to access our resources on tax reform and learn how our expert team can help your pass-through business navigate the potential Section 199A Deduction Changes and optimize your tax strategy for long-term success. Your proactive approach to understanding these changes will be key to your business’s financial well-being.