There is a significant new tax deduction taking effect in 2018 under the new tax law, the Tax Cuts and Jobs Act (the Act). It should provide a substantial tax benefit to individuals with “qualified business income” from a pass-through entity. Below are some key points to help you determine if you can take advantage of the new 20% Pass-Through Income Tax Deduction.
What types of income are considered "pass-through?"
Pass-through income includes (but is not necessarily limited to):
Income from a sole proprietorship
Income from an LLC or S-corporation
Income from rental properties (Including income passed through from REITs)
Any S-corporation, partnership, or trust that owns an interest in another pass-through business.
The deduction is generally equal to 20% of your “qualified business income” (QBI), defined as the net amount of items of income, gain, deduction, and loss with respect to your trade or business. The business must be conducted within the U.S. to qualify, and specified investment-related items are not included, e.g., capital gains or losses, dividends, and interest income (unless the interest is properly allocable to the business). Also, QBI does not include reasonable compensation received from an S corporation, or a guaranteed payment received from a partnership for services provided to a partnership's business as further explained in the following paragraph.
Income from performing services as an employee is not considered a trade or business for purposes of the 20% pass-through deduction. Therefore, no items of income, gain, loss from the trade or business of performing business as an employee constitute QBI. The income from the trade or business of performing services as an employee refers to all wages and other income earned in a capacity as an employee.
The deduction is taken “below the line.” In other words, it reduces your taxable income but not your adjusted gross income. However, it is available regardless of whether you itemize deductions or take the standard deduction. In general, the deduction cannot exceed 20% of the excess of your taxable income over net capital gain. If QBI is less than zero it is treated as a loss from a qualified business in the following year.
Can High Income Taxpayers Take Advantage of the Deduction?
The IRS has rules in place to deter high-income taxpayers from attempting to convert wages or other compensation for personal services into income eligible for the deduction. These rules involve “thresholds,” i.e. taxable income of over $157,500 ($315,000 for joint filers). If your taxable income is at least $50,000 above the threshold, i.e., it is at least $207,500 ($157,500 + $50,000), all of the net income from a “specified service trade or business” (see below for further explanation) is excluded from QBI. (Joint filers would use an amount $100,000 above the $315,000 threshold, in other words, $415,000.) For taxable incomes that are between the threshold amounts and the $207,500/$415,000 amounts, the exclusion from QBI of income from specified service trades or businesses is phased in.
Specified service trades or businesses are trades or businesses involving the performance of services in the following fields:
Health -- including doctors, pharmacists, nurses, dentist, and more.
Law -- specifically lawyers, paralegals, legal arbitrators, and mediators.
Performing arts -- However, broadcasters are generally excluded.
Financial services -- such as financial advisors, investment managers, and investment bankers.
Brokerage services -- This only has to do with securities. Real estate brokers, for example, are excluded.
Investing and investment management
Dealing in securities, partnership interests, or commodities
Any trade or business where the "principal asset ... is the reputation or skill of one or more of its employees or owners."
To help illustrate, a married taxpayer who operates a financial services business with $250,000 in total taxable income could still use the deduction. Above these thresholds, the deduction begins to phase out until a maximum taxable income of $415,000 (married) or $207,500 (all other filing statuses).
Additionally, for taxpayers with taxable income more than the above thresholds, there is a limitation on the amount of the deduction that is based either on wages paid or wages paid plus a capital element. Here's how it works: If your taxable income is at least $207,500 ($415,000 for joint filers), your deduction for QBI cannot exceed the greater of:
(1) 50% of your allocable share of the W-2 wages paid with respect to the qualified trade or business, or
(2) the sum of 25% of such wages plus 2.5% of the unadjusted basis immediately after acquisition of tangible depreciable property used in the business (including real estate).
Separately, there's another limitation. The pass-through deduction is also limited to the lesser of 20% of the qualified business income or 20% of the excess of taxable income over the taxpayer's net capital gain for the tax year.
Other limitations may apply in certain circumstances, particularly for taxpayers with qualified cooperative dividends, qualified real estate investment trust (REIT) dividends, or income from publicly traded partnerships.
What’s The Take-Away?
It’s important to point out that this is a summary of the high-level, key points. There's obviously a lot more in the IRS's 184-page guidance document. As you can likely surmise, the general takeaway is that this is a far more complicated deduction than it seems but it can have significant benefits to those who qualify.
If you have pass-through income, we recommend that you consult your tax professional at Restivo Monacelli well in advance of the April 15, 2019 tax deadline to determine if you qualify for the deduction. We can assist you with strategic planning moves to help maximize your federal income tax savings.