All About the Pass-Through Tax Deduction

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There is a lot of confusion about how the 20% pass-through deduction works, as launched by The Tax Cuts and Jobs Act. Which specific business owners qualify for the deduction, and how does the computation work? Here are the answers to these questions.

By: Baljeet Singh

The Tax Cuts and Jobs Act launched a new deduction of up to 20% on the business income of pass-through entities, effective 2018. This new deduction can greatly reduce the tax on pass-through incomes, bringing it closer to or lower than the new 21% tax rate of the C corporations.

It is important to review the rules listed below to evaluate whether the deduction would apply for a specific taxpayer, and how the computation of deduction works.

Basic Qualifications to Claim the Deduction

The following are the basic requirements to qualify for the tax deduction.

  1. You must be an owner of a pass-through business from a tax perspective. This includes sole proprietorships, entities being taxed as partnerships (filing form 1065), and S- corporations (filing form 1120-S), regardless of how they were set up.
  2. You should have a “Qualified Business Income (QBI)”. The QBI of a qualified trade or business carried on by a taxpayer for a tax year is the net amount of the business’s qualified items of income, gain, deduction, and loss. QBI is qualified to the extent that it is effectively connected with the conduct of a trade or business within the United States, and it is included or allowed in determining taxable income for the tax year.

Qualified items of income, gain, deduction, or loss and qualified business income do not include:

  • items of short-term capital gain or loss, or long-term capital gain or loss;
  • dividends, income equivalent to a dividend, or payments in lieu of dividends;
  • interest income which is not properly allocable to a trade or business;
  • the excess of gain over loss from commodities transactions, other than those entered into in the normal course of the trade or business or with respect to stock in trade or property held primarily for sale to customers in the ordinary course of the trade or business, property used in the trade or business, or supplies regularly used or consumed in the trade or business;
  • the excess of foreign currency gains over foreign currency losses from Internal Revenue Code Sec. 988 transactions, other than transactions directly related to the business needs of the business activity;
  • net income from notional principal contracts, other than clearly identified hedging transactions that are treated as ordinary (i.e., not treated as capital assets);
  • amounts from an annuity not received in connection with the trade or business; or
  • items of deduction or loss properly allocable to an amount described in the above bullet points.
  • reasonable compensation paid to the taxpayer by the business for services rendered;
  • guaranteed payments to a partner for services rendered;
  • payments described in Internal Revenue Code Sec. 707(a) to a partner for services rendered (to the extent provided in regulations);
  • qualified REIT (Real Estate Investment Trusts) dividends;
  • qualified cooperative dividends; or
  • qualified publicly traded partnership income.
  1. You must have taxable income for the year to qualify for the pass-through deduction.

How the Deduction Works Once You Meet the Basic Qualification Criteria

Once you meet the basic qualifications as discussed above, divide your business in to one of the following categories to understand how the deduction works:

  1. Businesses providing specified personal services: These involve the performance of services in the fields of accounting, actuarial science, athletics, brokerage services, consulting, financial services, health, law, or the performing arts; OR the performance of services consisting of investing and investment management, trading, or dealing in securities, partnership interests, or commodities; OR whose principal asset is the reputation or skill of one or more of its employees or owners.
  2. All other businesses.

Passthrough Deduction for Owners of Personal Services Businesses

  1. Taxpayers filing as “Single” who make less than $157,500 or taxpayers filing as “Married Filing Joint” who make less than $315,000 in total taxable income, may take the full 20 percent deduction on their pass-through income.
  2. Taxpayers filing as “Single” who make more than $207,500 or taxpayers filing as “Married Filing Joint” making more than $415,000 are not allowed any deduction at all.
  3. Taxpayers with incomes between the above thresholds are only eligible for a partial deduction, and the amount of business income eligible for the deduction phases out for personal service firms. This is the two steps process:
    1. There is a limit that phases in over the taxable income range between $157,500 and $207,500 for taxpayers filing as “Single” and between $315,000 and $415,000 for joint filers. The 20% of qualified business income deduction may be limited by the greater of either 50 percent of the wages the business pays its employees OR 25 percent of wages plus 2.5 percent of the basis of the business’ qualified property that is compared with the 20 percent deduction and the taxpayer may deduct only the smaller amount. If the business has no employees or qualified business property, the taxpayer gets no deduction.
    2. After applying the above limitation and arriving at the passthrough deduction, if the business has employees or property, the passthrough deduction is gradually phased out up to 207,500 of qualified business income for taxpayers filing as ‘Single’ and $415,000 of the qualified business income for joint filers. The deduction is phased-out by 1% for every $1,000 of taxpayer’s income exceeds the $315,000 threshold. There is no deduction when the taxpayer’s income reaches $415,000. In case of taxpayer filing as “Single”, the deduction is reduced by 2% for every $1,000 of taxpayer’s income exceeding the $157,500 threshold and gets no deduction when the income reaches $207,500.

Passthrough Deduction for Owners of All Other Businesses

  1. Taxpayers filing as “Single” who make less than $157,500 or taxpayers filing as “Married Filing Joint” who make less than $315,000 in total taxable income, may take the full 20 percent deduction on their pass-through income.
  2. Taxpayers filing as “Single” who make more than $207,500 or taxpayers filing as “Married Filing Joint” who make more than $415,000 may get a deduction in respect of non- personal service business, but it will be limited or eliminated based on the amount of wages their business pays and the property it owns. The 20% of qualified business income deduction may be limited by the greater of either 50 percent of the wages the business pays its employees OR 25 percent of wages plus 2.5 percent of the basis of the business’ qualified property that is compared with the 20 percent deduction and the taxpayer may deduct only the smaller amount. If the business has no employees or qualified business property, the taxpayer gets no deduction.
  3. Taxpayers with incomes between the above thresholds are only eligible for a partial deduction. If your taxable income is $315,000 to $415,000 if you’re married filing jointly, or 157,500 to $207,500 if you’re single, the W2 wages/property limitation referred to in the prior paragraph is phased in—however, only part (proportion) of the deduction is subject to the limit based on wages/property limit referred to in earlier paragraph in a way that at the top of income the range ($415,000 for marrieds, $207,500 for singles), the entire deduction is subject to the W2 wages/business property limit. If the business has no employees or qualified business property, the taxpayer gets no deduction.

A careful consideration of the above factors, coupled with effective tax planning, can help taxpayers to claim major tax deductions and save thousands of dollars. Every business should have their tax advisor evaluate their specific situation before reaching any conclusion.