By: Michael Cirangle
The Tax Cuts and Jobs Act (TCJA) is one of the most significant and business-friendly pieces of tax legislation in decades. The goal of reducing the effective tax rates for business owners seems to have been accomplished, but simplification of the new tax code has proved elusive. For privately-held businesses that are organized as pass-through entities, the most significant portion of TCJA, and certainly one of the most complex, is known as the “Pass-Through Deduction.” Understanding this new deduction should be a priority for business owners as it could bring significant tax savings to their bottom lines.
So why did Congress pass such a potentially advantageous deduction? The answer comes down to a simple case of majority: in the United States, most companies are pass-through entities. With the reduction of the corporate tax rate to a flat 21 percent, Congress needed to specifically address the tax rates of the pass-through entity owners. Typically, pass-through entities are not taxed at the entity level, but rather at their individual owner’s level. The top tax rate for individuals was only moderately reduced down to 37 percent from 39.6 percent, so action was necessary in order to level the playing field between C-Corporations and their pass-through counterparts. Out of this, the idea of the pass-through deduction was born, broadly providing for a 20 percent deduction from business income that moves to owners of pass-through entities including S-Corps, partnerships, LLC’s treated as partnerships and sole proprietorships.
While this deduction does apply to many businesses, there are exclusions. Specifically, any identified “specified service” trades or businesses, for which their owners exceed a certain income threshold based on their filing status, will not receive a benefit from this deduction. Businesses in the fields of health, law, accounting, actuarial service, performing arts, consulting, athletics, financial and brokerage services are specifically identified as “specified service” trades or businesses. In addition, trades or businesses in which the principal asset is the reputation or skill of one or more of its employees will also have trouble qualifying for this deduction.
As advisors, the last exclusion for businesses where their principal asset is the reputation or skill of their employees gives us significant pause. Neither the law nor the Treasury have defined its application. It can be broadly interpreted to include a larger number of businesses, many of which would not have otherwise been presumed to be a “service” trade or business. The Treasury has stated that they will be providing further guidance on the pass-through deduction toward the end of Q3 2018, but whether they address this specific definition is unknown. Until then, business owners should remain cautiously optimistic about whether this deduction will apply to them.
If your pass-through business is not a “specified service” trade or business, then the basic calculation of the deduction is 20 percent of what is called “qualified business income” (QBI) with certain limitations. The 20 percent deduction as calculated is limited to the greater of:
- 50 percent of “W-2 wages” of the business, or
- 25 percent of “W-2 wages” plus 2.5 percent of the unadjusted basis of qualified property
Additionally, the deduction that results from the above cannot exceed the taxable income of the individual (including spouses) from all sources.
Many of the terms used in the pass-through deduction rules have yet to be defined by the IRS and Treasury, causing further confusion. So while this article is intended to serve as a high-level overview of the pass-through deduction rules and applicability, not every individual nuance or scenario has been addressed. To be sure, I encourage ALL owners of pass-through entities to start looking at the potential impact this new deduction could have on their tax positions. Ellin & Tucker is here to help and only a phone call away.
MICHAEL G. CIRANGLE, CPA, a Principal in the Tax Department of Ellin & Tucker, brings a wealth of national and international tax planning and compliance expertise spanning more than a decade. His extensive experience and inside knowledge of privately owned companies enable him to provide the highest level of practical and technical tax compliance and consultation. He can be reached at email@example.com.