Affectionately being referred to as the Pass-Through Deduction, the new tax law will allow partnerships, LLCs, S corporations and sole proprietorships (in other words, pass-throughs) to deduct up to 20% of their Qualified Business Income under revised provisions of IRC § 199A.
How is the Pass-Through Deduction Calculated?
The Pass-Through Deduction usually will be whichever is smaller between 20% of the household’s Qualified Business Income or 20% of the household’s taxable ordinary income. For example, assume a self-employed plumber has $50,000 of Qualified Business Income in 2018, with no other sources of income. If the plumber is a single filer he may claim a $12,000 standard deduction, resulting in $38,000 in taxable income. Therefore, 20% of the plumber’s Qualified Business Income is $10,000 ($50,000 x 20%), while 20% of his taxable income is $7,600 ($38,000 x 20%). The plumber may claim a $7,600 Pass-Through Deduction, the smaller of the two amounts.
What is Qualified Business Income?
In general, Qualified Business Income is net income that is received from a Qualified Trade or Business. However, there are some exclusions, the most common of which are capital gains, dividend and interest income. Additionally, any guaranteed payments or “reasonable compensation” paid to owners must be excluded.
What is a Qualified Trade or Business?
In general, a Qualified Trade or Business is any trade or business that is not a “Specified Service Trade or Business” or the trade or business of performing services as an employee.
The IRS Defines a Specified Service Trade or Business as:
- any trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of 1 or more of its employees or owners,
- any banking, insurance, financing, leasing, investing, or similar business,
- any farming business (including the business of raising or harvesting trees),
- any business involving the production or extraction of products of a character with respect to which a deduction is allowable under section 613 or 613A,
- any business of operating a hotel, motel, restaurant, or similar business, and
- any business which involves the performance of services that consist of investing and investment management, trading, or dealing in securities, partnership interests, or commodities.
Income Based Exception for Specified Service Trade or Business Owners
An income-based exception exists for owners of a Specified Service Trade or Business which will allow them to take the Pass-Through Deduction as long as their income is below a certain amount. For 2018, that amount is $207,500 (or $415,000, for MFJ) to be eligible for a partial deduction and $157,500 (or $315,000, for MFJ) to be eligible for the full deduction. Therefore, even if a taxpayer owns a Specified Service Trade or Business if her income is below $157,500 (or $315,000, for MFJ) for the year she may still take the full 20% pass-through deduction. While, if her income is greater than $157,500 (or $315,000, for MFJ) but below $207,500 (or $415,000, for MFJ), she may take a partial deduction.
Phase Out Provisions and other Requirements for Certain Taxpayers
The New Pass-Through Deduction is very complex. While we have discussed the basics here, the new law contains numerous nuances. For example, for taxpayers who have income greater than $207,500 (or $415,000 for MFJ) the deduction must be calculated in a different manner. It is advised that you speak with a tax professional to determine your specific eligibility for the new Pass-Through Deduction.