Candice Horbacz
Washington D.C. – On April 15, 2026, Garrett Watson, Director of Policy Analysis at the Tax Foundation, delivered crucial testimony to the US House Small Business Committee, outlining the profound impact of the recently enacted 2025 reconciliation law on small businesses across the nation. His address not only detailed the significant tax policy shifts but also presented a forward-looking agenda for further reforms aimed at simplifying the tax code, bolstering investment incentives, and fostering sustained economic growth. The testimony underscores a pivotal moment in federal tax policy, as lawmakers moved to address the looming expiration of key provisions from the 2017 Tax Cuts and Jobs Act (TCJA) and introduce new measures designed to support the entrepreneurial backbone of the American economy.
The Pre-2025 Fiscal Cliff: Uncertainty Looms for Small Businesses
The period leading up to the end of 2025 was characterized by considerable apprehension within the business community, particularly among small and medium-sized enterprises (SMEs). The 2017 Tax Cuts and Jobs Act, a landmark legislative package, had introduced a suite of temporary tax changes for both businesses and individual taxpayers. As the scheduled expiration date for these provisions drew nearer, the prospect of a "fiscal cliff" created immense uncertainty, complicating long-term strategic planning for countless firms. Industry analyses had indicated that without legislative intervention, the expiration of TCJA provisions would have resulted in increased tax liabilities for approximately 62 percent of American taxpayers. This group disproportionately included small business owners and their employees, raising concerns that the impending changes could derail post-pandemic economic recovery and dampen investment.
Among the critical provisions slated for expiration that directly impacted small businesses were:
- Section 199A Deduction: This allowed eligible pass-through business owners to deduct up to 20 percent of their qualified business income (QBI), effectively lowering their marginal tax rates. Its removal would have significantly increased the tax burden on partnerships, S corporations, sole proprietorships, and real estate investment trusts (REITs).
- Lower Ordinary Income Tax Rates and Consolidated Brackets: The TCJA had reduced ordinary income tax rates and streamlined tax brackets. Their expiration would have seen the top ordinary income tax rate revert from 37 percent to 39.6 percent, impacting many high-earning small business owners.
- Bonus Depreciation Phase-Out: The TCJA temporarily allowed 100 percent bonus depreciation for short-lived investments (assets with a useful life of 20 years or less) from late 2017 to 2022. This crucial incentive, which permits immediate full deductions for investments, began phasing down by 20 percentage points each year after 2022 and was set to disappear entirely by 2027. Its removal would have penalized business investment, particularly for smaller firms that often lack the immediate cash flow to manage prolonged depreciation schedules.
- R&D Expense Amortization: Starting in 2022, research and development (R&D) costs, previously immediately deductible, became subject to amortization over five years (15 years for foreign R&D). This change was widely seen as a disincentive for innovation, increasing the cost of R&D for businesses of all sizes.
- Business Interest Expense Deduction Limitation: The TCJA had also introduced a limit on interest deductions, initially set at 30 percent of earnings before interest, taxes, depreciation, and amortization (EBITDA) from 2018-2021. From 2022 onwards, this limitation became stricter, based on earnings before interest and taxes (EBIT), excluding depreciation and amortization, thereby reducing the amount of deductible interest and impacting businesses relying on borrowed capital for growth.
The 2025 Reconciliation Law: A New Era of Tax Certainty
Against this backdrop of impending tax increases and uncertainty, the 2025 reconciliation law emerged as a significant legislative response, delivering the most extensive set of tax changes since the TCJA itself. This legislation aimed to provide stability and new incentives, particularly for small businesses.
Key Individual and Pass-Through Business Tax Changes:
The law made permanent several crucial individual income tax provisions that directly benefit pass-through businesses, which constitute the vast majority of small businesses in the U.S. (nearly 93 percent of pass-through firm employment is in firms with fewer than 500 employees).
- Permanent Section 199A Deduction: The 20 percent Section 199A deduction for qualified business income was made permanent, eliminating a major source of uncertainty for pass-through entities. Furthermore, the law expanded this deduction slightly by increasing the phase-in range for its limitations by $25,000 ($50,000 for joint filers) and introducing a new minimum deduction of $400 for material participants with $1,000 or more of QBI. This permanence ensures that small business owners continue to benefit from reduced marginal tax rates.
- Consolidated Ordinary Income Tax Rates: The TCJA’s consolidated set of ordinary income tax brackets and lower rates were also made permanent. This avoids the reversion to higher rates and ensures a more predictable income tax environment for small business owners whose business income is typically taxed at individual rates.
- Effective Tax Rate Reductions: Analysis by the American Enterprise Institute, cited by the Tax Foundation, estimates that pass-through businesses now face a marginal effective tax rate of 12.6 percent and an average effective tax rate of 20.5 percent following the 2025 reconciliation law, signaling a substantial reduction in their overall tax burden.
While the law made permanent certain individual TCJA provisions like the limitations on State and Local Tax (SALT) deductions and the cap on itemized deductions, which indirectly impact business income, these increases are generally offset by other provisions, resulting in net tax reductions for most taxpayers.
Significant Business Tax Improvements:
The reconciliation law also brought about critical improvements to business taxation, primarily focusing on cost recovery and investment incentives.
- Restoration of 100% Bonus Depreciation: A cornerstone of the new law is the permanent restoration of 100 percent bonus depreciation for property placed in service after January 19, 2025. This move is hailed by economists as essential for long-term investment, as it eliminates the tax penalty arising from the time value of money and inflation, which erodes the real value of deductions taken over time. This provision disproportionately benefits small businesses, which are more sensitive to cash flow and the timing of deductions.
- R&D Expensing Permanence and Retroactivity: The law permanently restored immediate expensing for domestic R&D investment starting in 2025. Crucially, it also provided retroactive R&D expensing for the 2023 and 2024 tax years, addressing a significant concern for innovative firms that had faced amortization requirements. The Tax Foundation estimates that the permanence of bonus depreciation and R&D expensing combined will boost long-run economic output by 0.7 percent and add approximately 180,000 jobs, making it a powerful engine for economic growth.
- New Commercial Structures Deduction: A temporary 100 percent deduction for qualifying commercial structures associated with tangible production, including manufacturing, was introduced. This represents a significant improvement from the typical 39-year depreciation schedule for commercial structures, as immediate expensing allows businesses to recover a much higher percentage of their real costs. Small businesses in manufacturing and tangible production sectors are expected to be major beneficiaries, though its temporary nature (expiring in 2031) and limited scope somewhat temper its long-term growth potential.
- Expanded Section 179 Expensing: The law doubled the maximum Section 179 expensing amount from $1.25 million to $2.5 million (indexed annually for inflation), with a phase-down starting when the cost of qualifying property exceeds an inflation-adjusted $4 million. Section 179 covers some assets not eligible for bonus depreciation, and this expansion improves the tax treatment of those investments. Further reforms to the phase-out limits could remove disincentives for small businesses to grow beyond certain thresholds.
- EBITDA-Based Interest Deduction: The interest deduction limitation was permanently reverted to the more generous EBITDA-based calculation. This aligns U.S. tax policy with international norms and mitigates the negative impact of a tighter interest deduction, especially in a high-interest-rate environment.
Persistent Challenges and Future Reform Opportunities
Despite the significant strides made by the 2025 reconciliation law, Garrett Watson highlighted several areas where the U.S. tax code remains overly complex, inconsistent, and uncertain, continuing to pose challenges for small businesses.
Complexity and Compliance Burdens:
Tax complexity remains a formidable hurdle, with annual compliance costs for the U.S. economy estimated at $536 billion and 7.1 billion hours spent on IRS filing and reporting requirements. Businesses bear over 70 percent of this burden, with small businesses disproportionately affected due to their limited resources for professional tax services.
- New Reporting Requirements: The 2025 law introduced new deductions for tipped income and overtime, which, while beneficial, will necessitate additional reporting and complex tax rules starting in 2026. This adds another layer of administrative burden, particularly for small businesses less likely to employ dedicated payroll or tax compliance staff.
- Section 199A Complexity: Despite its permanence, the Section 199A deduction remains a significant source of complexity, costing an estimated $20 billion annually in compliance costs. This complexity largely stems from the wage and capital limits for higher-income earners, requiring intricate calculations and additional form filings that can take over 24 hours per filer to complete. Simplifying these limits and ensuring consistent application across different pass-through entities (like REITs and publicly traded partnerships) could significantly reduce this burden.
Expanding Full Expensing:
While bonus depreciation and R&D expensing are now permanent, opportunities remain to expand full expensing to other critical asset classes commonly used by small businesses, including structures, inventory, and intangible investments.
- Structures Expensing: The temporary deduction for manufacturing structures should ideally be made permanent and broadened to include all types of structures. This would eliminate the need for small businesses to segment their investments and would have a lasting positive economic impact, potentially even addressing housing shortages and affordability by incentivizing construction. Alternatively, implementing a neutral cost recovery system that adjusts depreciation deductions for inflation and the time value of money would also benefit investment.
The Undermining Force of Tariffs:
Even as the tax code improved, the economic benefits of the 2025 reconciliation law are threatened by an unstable and evolving tariff regime. In February 2026, the Supreme Court struck down the legal basis for tariffs imposed under the International Economic Emergency Powers Act (IEEPA). However, residual tariffs, particularly those initiated by President Trump, persist. These tariffs are projected to impose an average $600 tax increase per U.S. household in 2026 and reduce long-run U.S. GDP by 0.2 percent.
- Disproportionate Impact on Small Businesses: This economic damage disproportionately affects small businesses, many of which rely on imported inputs for their supply chains and lack the economies of scale or domestic production alternatives of larger corporations. Higher input costs can either be passed on to consumers, fueling inflation, or absorbed by the businesses, reducing profitability, wages, and investment capacity. The ongoing policy uncertainty surrounding tariffs further exacerbates the problem, leading businesses to delay or cancel crucial investment and hiring decisions.
- Offsetting Economic Gains: The Tax Foundation estimates that if the Section 232 tariffs remain in place long-term, they could offset nearly one-third of the long-run economic benefits of the 2025 reconciliation law, despite covering only about one-sixth of its cost. The complete repeal of these tariffs would remove a significant economic headwind, allowing small businesses to fully realize the benefits of the new tax legislation.
Addressing Policy Instability and Fundamental Reforms:
Beyond specific provisions, small businesses grapple with broader uncertainty regarding the long-term trajectory of tax policy, which has become increasingly partisan and subject to radical shifts with each new congressional term. This instability complicates long-term planning, even for provisions made permanent.
- R&D Tax Credit Access: Small businesses struggle to access incremental R&D tax credits. While intended to spur innovation, the complexity of claiming these credits has historically favored larger firms. A 2013 SBA study revealed that small businesses received only 3 percent of the $6.9 billion allocated to the R&D credit, compared to 9.2 percent of the $5.4 billion in R&D expensing benefits. Simplifying administrative burdens and eligibility requirements would level the playing field.
- Tax Treatment of Losses: The tax code currently penalizes businesses that incur upfront losses, a common scenario for startups and entrepreneurs. Net Operating Losses (NOLs) are typically carried forward, but their real value erodes over time due to inflation and the time value of money. An adjusted carry-forward deduction could mitigate this penalty. Similarly, capital losses, often incurred in risky ventures, are limited in their deductibility and also suffer from value erosion when carried forward. Reforming capital loss rules with appropriate guardrails could significantly boost outside investment in startups.
- International Pass-Through Comparison: The U.S. pass-through tax system is more complex than those in many OECD countries, such as the United Kingdom and Canada, which utilize simpler entity-level reporting rather than individualized systems.
- Broader Tax Reform – Corporate Integration: More fundamental reforms could involve replacing the current U.S. pass-through system with a simplified business tax system that taxes profits only when distributed to owners, similar to models implemented in Estonia and Latvia. Such systems, known as corporate integration, eliminate the double taxation of corporate income (at both the entity and individual levels), thereby neutralizing tax differences between pass-through and corporate business forms and simplifying crucial decision-making for small businesses.
Conclusion: A Foundation for Growth, But More Work Ahead
The 2025 reconciliation law has undeniably laid a more stable foundation for small businesses by making permanent key individual TCJA provisions and enhancing cost recovery mechanisms. These changes are crucial for encouraging long-term planning, investment, and hiring. However, the full potential of these reforms remains constrained by persistent complexities within the tax code, uneven treatment across various investment types, and the lingering specter of policy uncertainty, particularly from tariffs and shifting political priorities.
For small businesses to truly thrive, policymakers must continue to broaden and make permanent full expensing for all asset classes. Simultaneously, structural reforms are needed to reduce distortions in business taxation. A consistent and predictable policy environment, coupled with targeted improvements to loss treatment, R&D incentives, and a significant reduction in compliance burdens, would empower small business owners with the confidence needed to innovate, expand, and drive America’s economic engine forward. The journey towards a truly simple, fair, and growth-oriented tax system for small businesses continues.
