The new tax law has been touted for cutting the corporate tax rate, but the law also contains some valuable benefits for businesses that operate as pass-through entities or PTE. Pass-through entities include partnerships, limited liability companies, S corporations and sole proprietorships. The potential benefits for owners of PTE are significant, but determining just how much they will benefit can be complicated.
Pass-Through Tax Cuts
The owners and shareholders of pass-through entities pay taxes on their net income at individual ordinary income tax rates, which had reached as high as 39.6% under prior law. The new highest rate is now at 37%. The law also raised the thresholds for individual tax brackets, so that the top rate does not take effect until taxable income exceeds $500,000 for single filers and $600,000 for married couples filing jointly.
Moreover, the law added a generous new business deduction for pass-through businesses. The qualified business income (QBI) deduction generally allows taxpayers to deduct up to 20% of QBI received.
QBI is the net amount of income, gains, deductions and losses from a pass-through entity, but does not include reasonable compensation, certain investment items, and payments to partners for services rendered. If the owner’s taxable income is over a threshold amounts ($157,500 for single filers and $315,000 for joint returns), certain limitations apply. The thresholds are indexed for inflation.
Calculation of the deduction – and limitations – is performed for each qualified business separately and then the amounts are aggregated. If the aggregate amount is less than zero, it reduces the aggregate amount in the following year.
The aggregate amount in any year cannot exceed 20% of the taxpayers taxable income reduced for capital gains and certain income from cooperatives and real estate investment trusts.
Over the Threshold
Once taxable income — not QBI — exceeds $157,500 for single filers or $315,000 for married couples filing jointly, a wage limit begins to phase in. The wage limit phases in completely when taxable income exceeds $207,500 for single filers and $415,000 for joint filers.
Owners can apply one of two limits based on wages and depreciable property. Both limits are applied to each qualified business separately.
The first limits the QBI deduction to 50% of the owner’s allocable share of W-2 wages paid by the business. The second limits the deduction to the owner’s share of 25% of wages plus 2.5% of the unadjusted basis of qualified business property (QBP). Essentially, the “unadjusted cost basis” is the purchase price of tangible depreciable property held.
In addition, when taxable income is over the threshold, specified service trades or businesses (SSTB) cannot take the deduction. The exclusion of these service businesses is also phased in up to taxable income of $207,500 for single filers and $415,000 for joint filers.
SSTB include businesses in the fields of law, financial, health care, brokerage and consulting services firms, as well as any business where the principal asset is the reputation or skill of one or more of its employees. Providing a clearer definition of SSTB has been cited as a very high priority for the IRS regulation writers.
The QBI deduction reduces taxable income regardless of whether the taxpayer itemizes deductions. However, it does not reduce adjusted gross income (AGI) or amounts subject to self-employment taxes or net investment income tax.
Examples for Non-SSTB
The amount of the deduction for qualified trades or businesses depends largely on taxpayers’ taxable income before the QBI deduction — that is, their AGI less itemized deductions. It’s most easily calculated when taxable income is under the thresholds so the wage limit doesn’t apply.
For example, joint filers Bob and Mary have taxable income of $150,000, including $75,000 in QBI. They can deduct 20% of $75,000, or $15,000, from their taxable income.
Computing the deduction also is fairly straightforward when taxable income exceeds $207,500 for single filers or $415,000 for married joint filers. Let’s assume Bob and Mary have taxable income of $575,000, including $75,000 of Mary’s QBI. She pays $20,000 in wages and has $90,000 of QBP. The first option for the wage limit calculation in this situation is $10,000 (50% of $20,000), and the second option is $7,250 (25% of $20,000 + 2.5% of $90,000). The $10,000 limit is higher so the QBI deduction is $10,000.
What if Bob and Mary’s taxable income falls into the range between $315,000 and $415,000, where the wage limit is phasing in, with everything else remaining the same? If their taxable income is, say, $400,000, their deduction is partially capped by the wage limit. As in the immediately preceding example, the full wage limit is $10,000, but, with taxable income of $400,000, only 85% of the full limit applies:
($400,000 taxable income – $315,000 threshold)/$100,000 = 85%
To calculate the amount of their deduction, the couple must deduct 85% of the difference between the gross deduction of $15,000 and the $10,000 deduction if the full wage limit applied:
($15,000 – $10,000) × 85% = $4,250
That amount is deducted from the gross deduction of $15,000 for a final deduction of $10,750.
Example for SSTB
Below the thresholds, SSTBs are treated in the same manner as qualified businesses (see first example above). If the taxable income equals or exceeds $207,500 for single filers or $415,000 for married joint filers, SSTB owners receive no QBI deduction.
It’s when taxable income falls between those thresholds that things get trickier because the QBI, W-2 wages and QBP all gradually phase out on a prorated basis over this income range. The percentage that a taxpayer can take into account is 100% less the percentage equal to the ratio of 1) the amount by which taxable income exceeds the threshold amount to 2) $50,000 for single filers or $100,000 for joint filers:
1- (taxable income – applicable threshold)/$50,000 or $100,000 = applicable percentage
For example, let’s say Bob and Mary have joint taxable income of $400,000, and Mary has an SSTB with $75,000 in QBI. She pays $20,000 in wages and owns $90,000 in QBP. Only 15% of the QBI, or $11,250, qualifies for the deduction because of the SSTB limit phase in:
1- ($400,000 – $315,000)/$100,000 = 15% × $75,000 = $11,250
The gross deduction is 20% of $11,250, or $2,250. Also because of the SSTB limit, the couple can take account of only 15% of wages ($3,000) and QBP ($13,500) when calculating the wage limit. Fifty percent of wages for purposes of the limit, therefore, is $1,500, and 25% of wages plus 2.5% of QBP is $1,087.50 — setting the full deduction at the greater amount of $1,500.
As for a non-SSTB, though, the wage limit phases in gradually over this income range. In this case, 85% of the limit applies:
($400,000 – $315,000)/$100,000 = 85%
The couple must reduce their QBI deduction by 85% of the difference between the gross deduction amount and the deduction amount if the full wage limit applied:
($2,250 – $1,500) × 85% = $637.50
As a result, their allowable deduction is $1,612.50 ($2,250 – $637.50).
Future Guidance Promised
The new law is very early in the lifecycle of guidance for such complex legislation. Extensive regulations from the Treasury Department are expected in the near future. Among other things, Treasury must draft regulations addressing the allocation of items and wages, reporting requirements, and the application of the QBI deduction to tiered entities. Look for future alerts on important developments.
Still Have Questions?
For more information on the Tax Cuts and Jobs Act, contact Thomas R. Vance or your ORBA advisor at 312.670.7444.