Many families use pass-through entities such as partnerships, limited liability companies and S corporations for financial, estate or succession-planning purposes. If you own interests in any such entities, it is important to familiarize yourself with the new 20% “pass-through” deduction contained in the Tax Cuts and Jobs Act (TCJA). There may be opportunities to maximize the benefits of the deduction and reduce your tax burden.
Leveling the playing field
The new deduction, found in Section 199A of the tax code, is designed to level the playing field between pass-through entities and corporations, which now enjoy a dramatically reduced 21% income tax rate. By contrast, pass-through income is taxed at individual rates of up to 37%.
Eligible pass-through owners (as well as sole proprietors) may now deduct up to 20% of their allocable share of the entity’s qualified business income (QBI). Generally, QBI means net U.S. business income, excluding certain investment income such as capital gains, dividends and nonbusiness interest plus reasonable compensation or guaranteed payments received by shareholders or partners.
In a nutshell, the amount of your deduction is the lesser of:
- 20% of your share of QBI; or
- 20% of your taxable income (less net capital gains).
The deduction is taken against adjusted gross income. It is not an itemized deduction.
Limits for high-income earners
If your taxable income exceeds $157,500 ($315,000 for joint filers), your pass-through deduction may be reduced or eliminated. Once income exceeds this threshold, two limitations begin to kick in:
- The deduction becomes unavailable to “specified service businesses,” including health care providers, accounting, consulting, law and certain investment firms, and businesses whose principal asset is the reputation or skill of one or more of its employees. Architecture and engineering firms are not included in this group.
- The deduction is limited to the greater of 50% of your share of the entity’s W-2 wages, or 25% of your share of the entity’s W-2 wages, plus 2.5% of its unadjusted basis in qualified depreciable property.
Both limits are phased in beginning at the taxable income threshold and apply fully once income reaches $207,500 ($415,000 for joint filers).
If your taxable income exceeds the threshold, your pass-through deduction may be reduced or eliminated, either because the entity is engaged in a specified service business or because you have an insufficient share of W-2 wages or depreciable property to support a full deduction. Several planning opportunities exist to ensure you are taking full advantage of the deduction. These include, but are not limited to, income reduction strategies, ownership transfer strategies, filing status selection, employee versus independent contractor selection and entity structure selection. A comprehensive review of your individual and business circumstances is crucial to determine which planning opportunities may be right for you.
The deduction is complex
If you own interests in pass-through businesses, talk with your tax advisor. This deduction is complex and the IRS has issued nearly 200 pages of proposed regulations on the subject. Your advisor will help ensure that you take full advantage of this new area of the tax law.
Finally, keep in mind that the deduction is temporary. Unless Congress acts, it expires at the end of 2025.