The 2017 tax overhaul, among other things, provides for a new business tax break called the pass-through deduction. Unlike the new reduction in the corporate income tax rate that has affected the tax planning of many C corporations, this tax break will affect a different set of entities, including S corporations, limited liability companies, partnerships and even sole proprietors. If you are involved in one of these businesses, you may well benefit from the new deduction discussed here.
The pass-through deduction allows qualified businesses and taxpayers to take a deduction of twenty percent of pass-through income. This reduces the effective income tax rate and lowers the tax burden on taxpayers owning such businesses. The pass-through deduction may be taken from the combined income from all of a taxpayer’s qualified businesses and is separate from and taken in addition to the standard deduction taken by the taxpayer. This makes the deduction even more impactful for many taxpayers.
However, not all non-corporate business entities will be able to make full use of the pass through deduction. Businesses that provide services such as law, accounting, financial and brokerage services, investment management, performing arts, health and medical services, among other similar types of business, likely will be subject to a limitation on the deduction. In practice, the deduction will be phased out at higher income levels for these businesses. The law also provides that businesses in which the principal asset of the firm is the reputation or skill of one or more owners or employees is considered a service business subject to the limitations on the pass-through deduction.
The limitations on the deduction for non-qualified businesses are significant. The deduction begins to be phased out at where taxable income from all sources reaches $157,500 for single taxpayers and $315,000 for married taxpayers filing jointly. The deduction is phased out entirely when income reaches $207,500 for single taxpayers and $415,000 for married taxpayers filing jointly. As you may imagine, this is not necessarily a high bar given that many service providers earn substantially more. Again, this limitation does NOT apply to businesses that are not the described non-qualified service providers but instead are manufacturing or other non-service businesses.
In addition to the above described limitation, there is a second limitation on the deduction which is based on the W-2 wages and capital of a qualified business. This limitation provides that the deduction cannot exceed half (50%) of the total W-2 wages paid by the business. A separate test combines one-fourth (25%) of the W-2 wages plus 2.5% of the capital of the business (the unadjusted basis of all qualified property of the business). The limitation under this part of the law is equal to the greater of the two calculations and is designed to allow some benefit to qualified businesses that are not significant wage payers.
What does this all mean? If you are operating one or more pass-through businesses, and particularly where those businesses are not considered service businesses, you will receive a very substantial deduction from your taxable income, perhaps amounting to tens of thousands of dollars. This can be a strong incentive to structure a business to qualify under the new tax law for this particular deduction.
However, given the uncertainty in the details of the law and its application – such as how particular businesses may be classified – the deduction may not be available to persons and businesses that may be expecting to take advantage of this tax break. Case in point: a business whose owner relies on reputation as a selling point for services may be found unqualified under the letter of the law because of the personal nature of that aspect of the business.
The fairness of a determination whether a specific business is entitled to the deduction without limitation may well become an issue going forward. Although the IRS is tasked with creating guidelines for businesses to follow, they may not be issued in time for businesses to make a reasonable decision about what they might expect. The uncertainty whether a particular business is so entitled may well lead to litigation against the IRS to attempt to invoke the tax advantages of the pass-through deduction. Business persons would do well to consult with their tax professionals in order to have an idea whether and to what extent this deduction will apply to them.
Finally, note that this deduction, like many other aspects of the recent tax overhaul, will expire in 2025 unless Congress takes further action. If you do qualify for this deduction, enjoy it while you can!
George Chamberlin & Mentor RIA Consulting © 2018