What the New 20% Pass-Through Deduction Means for Business Owners
It is essential for business owners to be familiar with their landscape, reap all available tax benefits, and stay up-to-date with developments in the business world. The 20% deduction for pass-through businesses, outlined in IRC Section 199A, was introduced in the 2017 Tax Cuts and Jobs Act. It is the subject of wide discussion (and some confusion) by business owners and informed citizens. An overview of the deduction and its terms sheds light on the deduction and what it means for U.S. business owners.
The 20% Pass-Through Tax Deduction applies to pass-through (or flow-through) entities. This include sole proprietors, partnerships, S corporations, and LLCs.
Pass-through entities are not subject to corporate income tax. As opposed to C corporations, which are taxed doubly, pass-through entities are only taxed once on their profits.
Profits made by pass-through entities are taxed on an individual basis (the income of owners is taxed). The deduction applies to the owner’s tax return.
The 20% Pass-Through Tax Deduction applies to Qualified Business Income (QBI). There are several restrictions to Qualified Business Income.
Capital gains and capital losses, dividends, and interest income are not included in the definition of Qualified Business Income, and are excluded from the 20% pass-through deduction. Services performed by employees of a trade or business are also inapplicable.
Income generated by a specified service trade or business (SSTB) is excluded from the deduction, but only if the business income exceeds a certain amount. Specified service trades or businesses include any business or trade where the service provided is dependent on the skill or expertise of one or more of its employees. As such, trades and businesses in the industries of law, performing arts, investing, and medical services, among others, do not qualify for the deduction with respect to high-earning businesses. IRS.gov states that “This exception only applies if a taxpayer’s taxable income exceeds $315,000 for a married couple filing a joint return, or $157,500 for all other taxpayers.”
Who is eligible for the 20% pass-through deduction?
- For trades or businesses that fall under the taxable income limitation listed above ($315,000 for jointly filed returns and $157,000 for all others), the following options are calculated and the lesser of the options will be deducted:
- The taxpayer receives a 20% deduction of Qualified Business Income. In addition, the taxpayer also receives a 20% deduction on qualified real estate investment trust dividends and money earned publicly traded partnerships.
- The taxpayer receives a 20% deduction on taxable income after subtracting net capital gains.
- For trades or business with taxable income that is higher than $157,000 for single filings or $315,000 for married joint filings but lower than $207,500 (single) or $415,000 (married), the deduction depends on whether the business is a specified service trade or business (SSTB) or not, and is calculated as follows:
- SSTB: The deduction is phased out as income increases. This means that they do not receive the full 20% deduction, but still receive a partial deduction for their specified service trade or business. As the SSTB income reaches the cap of $207,500 for singles and $415,000 for married couples, the deduction becomes 0%.
- Non-SSTB: The business may still qualify for the 20% deduction, with limitations. See the deduction calculation for the next-highest income bracket.
- For pass-through trades or businesses that exceed $207,500, or $415,000 for married joint filings, the 20% deduction does not automatically apply. In addition, the specified service restriction applies to this income bracket. All specific service trades or business are excluded from the deduction in this bracket. For non-SSTB pass-throughs, the deduction is calculated by comparing the following options and determining the smallest amount. The option resulting in the smallest amount is the applicable deduction for this bracket:
- 20% deduction on Qualified Business Income; or
- The greater of the following:
a) 50% deduction of total employee wages
b) 25% deduction of total employee wages in addition to 2.5% deduction of the cost basis of the business’ qualified property.
Business owners can agree that it is crucial to understand and make the most of tax breaks, laws, and regulations. Navigating business and tax matters can be a complicated process, but it doesn’t have to be. Having the assistance of a business professional can calm uncertainty, build confidence, and fortify your business endeavor. Contact us at the Law Offices of Elsa W. Smith, LLC to schedule your business consultation today.