Senator Ron Wyden (D-OR) recently rolled out a plan to overhaul the pass-through deduction instituted in the 2017 Tax Cuts and Jobs Act (TCJA). While the deduction, known as Section 199A, is not without its flaws, Wyden’s “solution” would undermine much of the rationale that led to the deduction being passed into law in the first place. Even more bizarrely, it seems to work at cross purposes with Democrats’ efforts to reduce the use of the “independent contractor” employment designation.
The 199A deduction allows taxpayers with “pass-through” business income to claim a deduction on their individual income tax returns. For taxpayers making under $163,300 (or $326,600 for married filers), the deduction is relatively simple to calculate: taxpayers are eligible to claim 20 percent of the lower of either qualified business income or ordinary taxable income. Over those limits, more complex anti-abuse rules exclude certain service occupations and businesses that fail to engage in legitimate economic activities.
Though these rules that come into effect over the $163,300/$326,600 thresholds are complicated, what’s relevant is the goal behind this construction: ensuring that taxpayers claiming the pass-through deduction are legitimately business owners, not taxpayers trying to take advantage of the deduction by shifting some income around.
Wyden’s reforms, on the other hand, would undermine this goal. By eliminating the exception for workers in service industries, his version would encourage employees at law firms and accounting businesses making six figures to request that their employers reclassify them as independent contractors in order to receive a hefty deduction.
Ironically, Democrats have been pushing recently to cut down on independent contractor employment statuses. California garnered national attention by instituting a new employment test that effectively prohibited Uber and Lyft from classifying their drivers as independent contractors, a change that threatens the flexibility that makes ridesharing driving attractive to many part-time drivers. But that same law also affected other industries that benefit from the independent contractor relationship, like freelance writing and trucking.
More recently, Congressional Democrats have been pushing the Protecting the Right to Organize (PRO) Act. The PRO Act would effectively subjectthe entire country to California’s ill-advised classification rules, leaving many freelance workers without jobs. To push low-income workers out of their independent contractor roles “for their own good,” only to turn around and encourage wealthy professionals to become independent contractors in order to receive a deduction intended to help small businesses is the epitome of awful policymaking.
Wyden’s Section 199A reform would also undermine the central reasoning behind the deduction’s existence in the first place. Section 199A was written into law in order to help small- to medium-sized businesses achieve tax parity with larger C-corporations who received a lower corporate income tax rate in the TCJA.
Wyden, however, would phase out the deduction starting at $400,000. It’s probably not a coincidence that that is the income level at which President Biden has promised not to raise taxes, but that’s an arbitrary factor in the construction of tax policy.
So not only would Wyden’s proposal reduce competitiveness for certain pass-through firms, but it would also make the 199A deduction even more prone to abuse than it currently is. Any serious effort to reform Section 199A should focus on improving administration while ensuring that the tax code does not favor certain sizes of businesses over others.