Aside from corporate tax reductions, one of the most important aspects of the new Tax Cuts and Jobs Act beginning this year is the new 20% deduction for “pass-through” businesses – i.e. businesses that are not corporations. With the corporate tax rate being reduced to a flat 21%, the 20% deduction for other forms of businesses was designed to give a reduction to these businesses approximating the lower corporate tax rate. However, this 20% deduction, found in new Internal Revenue Code § 199A, is saddled with exclusions, phase-outs, technical issues, and uncertainties so that many well-meaning non-corporate business owners may not receive the benefit, at least in full, of this new deduction.
If applicable, the 20% deduction can be claimed by the owners of S corporations, partnerships, sole proprietorships, and even the beneficiaries of trusts. These are business entities that do not pay income tax at the business entity level (such as corporations), but where the profits and other income of the business go to or “pass-through” to the owners (or to the beneficiaries in the case of a trust).
The 20% pass-through deduction is not applicable generally to businesses that provide services, such as doctors, lawyers, accountants, athletes, stock brokers, and others (but architects and engineers can take it), except where the service provider has taxable income of less than $315,000 (married) or $157,500 (individual). The benefit to these service providers is phased out over these income thresholds (another $100,000 for married filers and $50,000 for individuals), so that where a married filer has over $415,000 in taxable income or an individual filer has over $217,500 in taxable income, the 20% deduction is lost. Thus, there is no benefit here to higher-paid service providers.
Understanding the “math” to the new 20% pass-through deduction is important. After all, the Internal Revenue Code is simply an attempt to convert mathematical terms to English.
For most pass-through business owners, the deduction is the lessor of (1) the “combined qualified business income” of the taxpayer, or (2) 20% of the excess of taxable income over the sum of any net capital gain. The term “combined qualified business income” is then defined as the lessor of (1) 20% of the business owner’s “qualified business income” (QBI) or (2) the greater of (A) 50% of the W-2 wages of the business allocable to the owner or (B) 25% of the W-2 wages of the business plus 2.5% of the unadjusted tax basis in property of the business allocable to the business owner. QBI is generally profit from the active income and expenses from the operation of the pass-through business, and does not include “passive income” such as interest, dividends, and even capital gains as well. QBI also does not include W-2 wages paid to the business owner himself. Thus, if a business owner pays himself a wage in addition to receiving the profits of the business, the amount of QBI, and the related deduction, may be larger.
Also, if a married business owner has joint taxable income of less than $315,000 or an individual business owner has taxable income of less than $157,500 (and with the benefit subject to phase-out – i.e. above $415,000 in taxable income for married filers and $217,500 for individuals), a business owner can potentially qualify simply on the basis of 20% of QBI and without the need to evaluate W-2 wages and property of the business.
The 20% pass-through deduction is taken on the business owner’s individual tax return (Form 1040), and not reported at the “pass-through” level – i.e. on the tax return of the S corporation, partnership, sole proprietorship, etc. This makes sense, as qualification for the deduction, and the specific amount, may depend on each owner’s individual taxable income level.
Brick and mortar businesses, services businesses (as limited to the above), and even real estate businesses may qualify for the new 20% deduction. Real estate businesses were added at the end of the Senate and House hearings on the new tax bill. Real estate may qualify, even if the real estate-related business has no employees. However, for real estate-related businesses there is much uncertainly about qualifying still, particularly if owners hold real estate in separate business entities (such as an LLC). It is still unknown whether real estate owners must apply all the tests for qualification at the single business entity level, or perhaps may be able to “aggregate” some or all of their real estate businesses to qualify. Moreover, simply holding real estate for “investment”, as compared to actively conducting a business with real estate, may not qualify for the new deduction.
Also, if a pass-through business has a loss in one year, as opposed to a profit, what then? The 20% deduction certainly does not apply when a business has a loss – it is based on net income or profit from the business – and the loss is then “carried over” and applied in following tax years to determine profit of the business for QBI purposes. Thus, if a business has a loss in year 1, but makes a profit in year 2, the loss from 1 year will be applied to the profit in year 2 and will reduce the amount of the 20% pass-deduction available to the business owner in year 2.
Much will be written now about new Section 199A and the 20% deduction for pass-through businesses. The IRS will be issuing regulations and offering other administrative guidance in the coming months (and years) about this new deduction. While Congress through this deduction may have intended to give pass-through business owners a tax rate equivalent to the new low 21% flat tax for corporations, because of all of the limitations, phase-outs, and other conditions for this deduction, it is expected that many businesses (and their owners) will simply not qualify or will not be able to claim the full benefit of the deduction. Non-corporate business owners must consult with their tax advisors to carefully plan in order to take full advantage of this new tax benefit.