20% Pass-Through Deduction Available for Select Owners of LLCs, S Corporations, Partnerships and Sole Proprietorships Under New Tax Act
The Tax Cuts and Jobs Act (TCJA) creates a brand-new tax deduction for owners of pass-through entities, including partners in partnerships, shareholders in S corporations, members of limited liability companies (LLCs) and sole proprietors. However, this part of the tax code is so complex that even tax experts are challenged by it.
To begin, owners of pass-through entities are effectively taxed on earnings at individual tax rates similar to the way corporate owners are taxed on wages. Under the TCJA, tax rates for individuals are generally lowered over seven brackets, featuring a top tax rate of 37%. In contrast, C corporations will be taxed at a flat rate of 21%, which might be considerably lower than a business owner’s individual rate.
To balance things out, lawmakers have provided a deduction of up to 20% for pass-through entities on “qualified business income” (QBI), subject to certain limits and restrictions. QBI is generally defined as net income from your business without counting amounts in the nature of compensation (W-2 wages and guaranteed payments from LLCs and partnerships), in addition to excluding any investment income from the pass-through entity. Note that QBI is figured separately for each business activity rather than on a per-taxpayer basis.
But there are two main hurdles for claiming the full 20% deduction (referred to as “the deduction” throughout this article). The deduction may be reduced or even eliminated under a test for “specified service businesses” and a “wage and capital” limit.
Taxpayers who have income below the lower income threshold ($157,500 for single filers and $315,000 for joint filers) have no worries at all. They are entitled to the full deduction. However, individuals in certain service professions that are traditionally high-paid may not qualify for any deduction. The deduction for taxpayers in other businesses can vary widely. Business that qualify for the deduction means any trade or business other than 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. However, it does not include engineering or architecture. So if you don’t qualify for the deduction because you are a personal service business the trick would be to tax plan to get your income to be below the income threshold amounts above.
In addition, the deduction can’t exceed your taxable income for the year (reduced by net capital gain). If the net amount of your QBI is a loss, you can carry it forward to the next tax year.
The wage limits rules are designed to curb abuses, such as having business owners who do substantial work artificially reclassifying wages as QBI eligible for the deduction. Nevertheless, taxpayers may be tempted to establish themselves as independent contractors, further increasing the number of conflicts with the IRS on this issue. Independent contractor status has already been a point of contention in recent years.
The wage limit component discussed above presents issues for independent contractors, sole proprietorships and single-member LLCs that are above the income thresholds of $157,500 for single filers and $315,000 for joint filers and that have no W-2 wages in that it eliminates the availability of the deduction altogether. One of the solutions to this would be to shift to an S corporation and re-characterize some of your compensation as W-2 wages.
The 2.5% of the capital limit component discussed above presents a lucrative tax break for some, including wealthy owners of commercial property. This opens the deduction up to commercial property businesses, where there aren’t a lot of workers, but there is a lot of valuable property around. As discussed above, the pass-through caps can be eligible for the 20-percent deduction based on a formula: 50 percent of employee wages paid; or 25 percent of wages plus 2.5 percent of the value of a qualified property at purchase, whichever is greater. The idea is for these entities to use the sum of the ‘2.5 percent rule’ plus 25 percent of wages to get the full 20-percent deduction.
In addition, the deduction is:
Done on a separate entity basis and not in the aggregate
Allowed for both regular and alternative minimum tax purposes
Allowed whether a taxpayer is an active or passive owner in the business
Eliminated beginning after December 31, 2025
Available to both non-itemizers and itemizers.
With the C corporation tax rate lowered to 21% some lawmakers had predicted that the steep corporate tax cut would cause pass-through entities to convert to C corporations to take advantage of the lower rate.
That’s unlikely to come to pass, as S corporations, limited liability companies, and partnerships would likely continue to be advantageous structures for most businesses, despite the proposal to drop the corporate rate to 21 percent from 35 percent. C corporations would face a lower rate under the tax plan, but C corporations face a second level of tax on the dividends distributed to investors. Pass-through status has become the entity of choice in recent decades because of the single layer of tax and a more malleable structure for distributing cash and assets.
These are just the basics on this complex new deduction. It is expected that the IRS will soon issue guidance for pass-through entities, especially regarding rules for re-characterization of wages. As the year unfolds, we will highlight strategies for maximizing the deduction under IRS-prescribed guidelines.