Under pre-Act law, the net income of these pass-through businesses— sole proprietorships, partnerships, limited liability companies (LLCs), and S corporations—was not subject to an entity-level tax and was instead reported by the owners or shareholders on their individual income tax returns. Thus, the income was effectively subject to individual income tax rates. In other words, no special treatment applied to pass-through income recognized by business owners.
For tax years beginning in 2018, the Tax Cuts and Jobs Act of 2017 establishes a new deduction based on a noncorporate owner’s qualified business income (QBI). This new tax break is available to individuals, estates and trusts that own interests in pass-through business entities. The deduction generally equals 20% of QBI, subject to restrictions that can apply at higher income levels. Below is an analysis of how the new law may impact business owners as well as the key areas to consider.
Note: The following is subject to interpretation from the Internal Revenue Service. Be sure to consult your tax professional for your specific situation before planning policy changes.
New Deduction for Pass-through Income
New Law: For tax years after 2017 and before 2026, individuals would be allowed to deduct 20% of “qualified business income” from a partnership, S corporation, or sole proprietorships, as well as 20% of qualified real estate investment trust (REIT) dividends, qualified cooperative dividends, and qualified publicly traded partnership income. (Special rules would apply to specified agricultural or horticultural cooperatives.)
QBI is generally defined as the net amount of qualified items of income, gain, deduction and loss from any qualified business of the noncorporate owner. For this purpose, qualified items are income, gain, deduction and loss that are effectively connected with the conduct of a U.S. business. QBI doesn’t include certain investment items, reasonable compensation paid to an owner for services rendered to the business or any guaranteed payments to a partner or LLC member treated as a partner for services rendered to the partnership or LLC.
The QBI deduction isn’t allowed in calculating the noncorporate owner’s adjusted gross income (AGI), but it reduces taxable income. In effect, it’s treated the same as an allowable itemized deduction.
For each qualified trade or business, the taxpayer is allowed to deduct 20% of the qualified business income with respect to such trade or business. Generally, the deduction is limited to 50% of the W-2 wages paid with respect to the business. Alternatively, capital-intensive businesses may yield a higher benefit under a rule that takes into consideration 25% of wages paid plus a portion of the business’s basis in its tangible assets. However, if the taxpayer’s income is below the threshold amount, the deductible amount for each qualified trade or business is equal to 20% of the qualified business income with respect to each respective trade or business.
For these purposes, “qualified business income” would mean the net amount of qualified items of income, gain, deduction, and loss with respect to the qualified trade or business of the taxpayer. These items must be effectively connected with the conduct of a trade or business within the United States. They do not include specified investment-related income, deductions, or losses.”Qualified business income” would not include an S corporation shareholder’s reasonable compensation, guaranteed payments, or — to the extent provided in regulations — payments to a partner who is acting in a capacity other than his or her capacity as a partner.
W-2 / Qualified Property Limitations
For pass-through entities other than sole proprietorships, the QBI deduction generally can’t exceed the greater of the noncorporate owner’s share of:
- 50% of the amount of W-2 wages paid to employees by the qualified business during the tax year, or
- The sum of 25% of W-2 wages plus 2.5% of the cost of qualified property.
Qualified property is the depreciable tangible property (including real estate) owned by a qualified business as of year end and used by the business at any point during the tax year for the production of qualified business income, and for which the depreciable period has not ended before the close of the taxable year. The depreciable period is generally ten years from the date the asset was placed in service.
Service Business Limitations
The deduction is generally not available for service businesses. The service business limitation includes any trade or business such as those individuals practicing accounting, law, consulting, medicine / health care, athletics, financial services and brokerage services – with the notable exception of architects and engineers. “Specified service trades or businesses” are described as businesses where the principal asset of the business is the reputation or skill of one or more of its employees.
Exemptions for W-2 Wage and Service Business Limitations
Under an exception, the W-2 wage limitation does not apply until an individual owner’s taxable income exceeds $157,500 ($315,000 for joint filers). Above those income levels, the W-2 wage limitation is phased in over a $50,000 range ($100,000 range for joint filers).
Contact Us to Discuss Tax Changes, and Strategies
The TCJA is the largest overhaul of the tax code in more than 30 years, and we’ve covered only the highlights of the pass-through business rule changes and tax provisions here. If you have questions or would like guidance for tax planning, please contact us. Keep in mind, there are additional rules and limits that apply – so always consult your tax advisor before taking action.