IRS Issues Final Regulations on 20 Percent Deduction for Pass-Through Businesses

The IRS has issued final regulations on the new 20 percent deduction for pass-through business owners. The IRS has made a series of changes to make it simpler for businesses to determine if they can or can’t get the tax break. However, despite the final regulations the rules remain complex, especially for larger pass-through businesses.

The pass-through deduction was included in the last year’s tax overhaul to give a tax break to businesses whose owners pay the taxes on their personal tax returns — partnerships, limited liability companies, and S corporations.

All taxpayers who earn less than $157,500, or $315,000 for a married couple, can deduct 20 percent of the income they receive via pass-through businesses from their overall taxable income. If taxpayers earn above those amounts and aren’t service professionals — such as lawyers or accountants; they must meet certain tests to take the full deduction — the size of their deduction depends on how much they pay in employee wages or how much they’ve invested in capital like real estate. For service professionals, the break fully phases out if they earn more than $207,500 if they’re single, or $415,000 if they’re married.

The final regulations included a proposal clarifying that shareholders of mutual funds with real estate investment trust investments can get the deduction. Accordingly, individual REIT investors through mutual funds are eligible for the same 20 percent deduction as direct investors with respect to their qualified REIT dividends. The IRS is still considering whether publicly traded partnership investments held through a mutual fund will qualify for the deduction.

Real estate property owners can get the tax break if they — or someone they hire, such as a contractor — spend at least 250 hours a year on the business and keep records of their activities.

The rules make clear that companies can’t use a tax planning technique called “crack and pack” to avoid limits on the new tax break. Professional service providers had eyed the break to get around the income limits set for owners of pass-through businesses.

The strategy would have allowed them to split their firms into different entities to lower their tax bills. For example, a law firm could have put all of its secretarial staff into one entity and its lawyers into another to get the full deduction on the income tied to the administrative work.

But companies with some income that qualifies and some that doesn’t can still delineate those different activities, such as through separate accounting books, to get the deduction on the eligible income. For example, banking activities qualify for the deduction but wealth management advising doesn’t, so a bank with some investment advising can separate the bookkeeping for those two units and still get the deduction on the qualifying income.

The deduction is limited for employers who pay low wages or hire few workers. The rules make it easier for related pass-through businesses to maximize their deduction by allowing companies to combine at the entity level or at the owner level. For example, two related businesses — one with a lot of employees but little profit, and another with a lot of profit but few wages — could aggregate their payroll and income to get a bigger tax break.

The rules retain a provision meant to simplify record-keeping if companies only have a small amount of income from ineligible activities, such as health or law. If less than 10 percent of the income is from ineligible sources, the company can still get the full deduction on all its profits.

The final rules allow taxpayers to choose whether to use prior proposed regulations or the final regulations when preparing their returns. Ordinarily, final rules supersede earlier rules, but this time the Treasury Department made an exception because many taxpayers had already put their accountants to work for the filing season.

One thing the final rules didn’t clarify concerns taxpayers with multiple trades and businesses held within the same entity. For example, it’s not clear how much of a deduction would be available to an optometrist who sees patients, a service business subject to the cap, and also grinds lenses, a manufacturing business that is not.