Plan for your 20 Percent Pass-Through Tax Deduction

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By Narender Singh

With the 20 percent pass-through deduction, noncorporate taxpayers may deduct up to 20 percent of domestic qualified business income (QBI) from a:

  • Partnership
  • S corporation
  • Sole proprietorship

There is a limitation based on wages paid, or on wages paid plus a capital element.

The deduction is not allowed for certain service trades or businesses, but some business owners in these trades may still qualify if their income is below a certain level. The deduction applies to tax years 2018 through 2025.

Which Businesses Qualify

The new pass-through tax law’s 20 percent deduction on qualified business income is subject to limitations, so it is not available to every entrepreneur.

In general, to qualify for the full deduction, your taxable income must be:

  • Below $157,500 if you’re single
  • Below $315,000 if you’re married and file jointly

How the Pass-Through Tax Deduction Works

The 20 percent deduction is considered a “between the lines” deduction. This means it doesn’t lower your adjusted gross income, and you don’t have to itemize on your taxes to take it.

Generally, if you qualify for the deduction, the 20 percent break will apply to the lesser of:

  • Your qualified business income
  • Your taxable income minus capital gains

For example, let’s look at a qualifying small business owner named Jennifer.

Jennifer is a joint filer with a Schedule C business. Her standard deduction is $24,000.

Her other business financials include:

Business Gross Income $130,000
Business Expenses $30,000
Net profit from business (QBI) $100,000
Spouse’s income $70,000
Above the line deductions for:

  • Deductible portion of self-employment tax
  • SEP IRA contribution
  • $7,500
  • $20,000

Jennifer’s taxable income before applying the pass-through deduction is $118,500.

In this case, her qualified business income of $100,000 is less than her taxable income of $118,500. The 20% pass-through benefit will apply to the qualified business income, and so Jennifer can claim a $20,000 deduction.

Jennifer and her spouse are in the 22 percent tax bracket, so they get to save about $4,400 in federal taxes.

Pass-Through Tax Savings and Planning Opportunities

Certain small business owners should consider doing some tax planning to optimize the 20 percent deduction.

There are some key savings opportunities that benefit some small business owners, including:

  1. Because of the phase-outs and threshold amounts, married taxpayers may want to compare married filing jointly versus married filing separately to see which status yields a higher deduction.
  2. It’s often advantageous to reduce W-2 wages to minimize self-employment taxes. However, it may be necessary to increase W-2 salaries to a certain level to optimize the 20 percent deduction. In some cases, converting a 1099 contractor to a W-2 employee could be beneficial.
  3. Small businesses qualifying for the 20 percent tax deduction could see their effective marginal tax rate reduced to 29.6 percent. Under the new law, the top income tax rate for C corporations is reduced to 21 percent. C corporations are taxed twice (once on the income and then on the returns to investors), so it may not make sense to convert an S corporation to a C corporation.

Consult with your Chugh, LLP tax professional today to maximize your pass-through deduction.