The new income tax plan brings in a generous pass-through tax deduction for many small businesses in IRC Section 199A. If you have pass-through income, you may qualify for a deduction worth 20% of qualified business income.
The change came into effect in 2018, but it doesn’t affect your 2017 tax return. However, this new deduction could help to lower your 2018 quarterly payments. Moreover, it is on the books through the end of 2025. The specifics are a little tricky, but here’s an overview to help you understand the basics.
What Is Pass-Through Income?
The IRS and many states do not tax at the company level for many small business entities. Instead, the income passes to the owner of the company who pays personal income tax on those amounts. Businesses in this category include sole proprietorships, partnerships, s-corporations, and LLCs, and LLPs. Owners of these pass-through entities can capitalize on the new tax deduction along with trusts and estates that own an interest in a pass-through business.
Surprisingly, many people in this category are not traditional small business owners but independent professionals such as self-employed doctors, investors, consultants, and accountants. It also includes independent contractors and other types of businesses. For instance, if you’re a freelancer, you have pass-through income, if you own a small unincorporated grocery store, you also have pass-through income.
What Is the Pass-Through Tax Deduction?
As part of the new bill, the pass-through tax deduction is up 20% of qualifying business income. QBI is calculated per business, not per taxpayer. That refers to net income from a connected U.S. trade or business. Net income is business income minus expenses or profit, and it includes self-employment earnings from your business as well as money received from qualified rental properties, publicly traded partnerships, real estate investment trusts (REITs), and qualified cooperatives.
Under the new law, if you have qualified cooperative dividends, qualified REIT dividends or publicly traded partnership income, they get special treatment too. Note that for this deduction, QBI doesn’t include capital gains (short or long-term), dividend income, interest income, wages paid to s-corporation shareholders or that you earn as an employee, guaranteed payments to partners or LLC members, or money generated outside the United States.
For instance, if you have $100,000 in business revenue and $20,000 in business expenses, your QBI is $80,000, and you may be able to claim a 20% pass-through deduction worth up to $16,000. However, if you have a qualified business loss, then you get no deduction, but you can carry it forward to the next year. If next year the situation changes, then the loss offsets the QBI for the current year before calculating the pass-through deduction.
How Does Taxable Income Affect the Pass-Through Deduction?
The pass-through deduction can’t exceed 20% of your taxable income. Moreover, taxable income at certain levels can limit the deduction (as explained below) or eliminate it entirely for some businesses. To continue with the above example, imagine that the single taxpayer claimed the standard deduction of $12,000 for 2018. Based on $80,000 of QBI, that lowers their taxable income to $68,000. As a result, their pass-through deduction gets capped at 20% of $68,000 or $13,600.
Now, let’s say that individual is married filing jointly, and their spouse has a $40,000 of W-2 income. When added to the original taxpayers $80,000 in QBI, the couple brings in a total of $120,000. When they claim the standard couple deduction of $24,000, their taxable income becomes $96,000. As a result, the taxpayer can claim the full pass-through deduction of $16,000 because that is less than 20% of the couple’s taxable income.
What Are the Limits on the 20% Pass-Through Deduction?
The new law set limitations for certain types of pass-through businesses and taxpayers within specific income ranges. Specifically, a “specified service trade or business” or SSTB may not qualify at certain income levels. It includes people working in health, actuarial science, brokerage services, law, consulting, athletics, financial services, or any industry where the business is based on the skill of one or more of its owners or employees.
The tax code was written to prevent employees from becoming independent contractors and paying less tax on essentially wage income. However, the law does not include architects and engineers. Maybe because they help manufacture and build things? Because confusion still exists, the IRS will probably issue guidance regarding who qualifies for the pass-through deduction among other things in the bill. Some organizations have already asked the IRS for guidance such as the AICPA.
If your taxable income is over $207,500 (single, head of household or married filing separately) or over $415,000 (married filing jointly), you can’t claim the pass-through tax deduction at all if your business is an SSTB. However, if your business is not an SSTB and above the former thresholds, you can claim the deduction. However, calculating the pass-through deduction is not as easy.
If Your Taxable Income Is Above the Former Threshold
If your taxable income is over the respective $207,500 and $415,000 thresholds and you are not in one of the banned service industries, you can still claim the pass-through deduction but the calculation is different.
In this income range, you potentially can claim a deduction worth up to 20% of your pass-through income, but limited by the greater of the following two amounts:
- 50% of allocable W-2 wages paid by your business
- 25% of allocable W-2 wages plus 2.5% of a taxpayer’s allocable share of the unadjusted tax basis of the qualified business property immediately after acquisition (tangible property subject to depreciation)
Business property that qualifies does not include inventory but rather property you depreciate over time. It is property the business utilizes for the production of QBI.
An Example When Taxable Income Is Above the Former Threshold
To illustrate how that works, imagine someone is over the $207,500 (single, head of household or married filing separately) or $415,000 (married filing jointly) threshold but still in the qualifying range for the pass-through deduction. Take a married couple who file jointly and own a small pasta factory with $420,000 in pass-through income. The 20% pass-through deduction is worth $84,000, but the couple has to check the W2/property rule above.
To calculate the first number, let’s say they pay $100,000 to their four employees, and half that amount is $50,000. The couple has $500,000 in qualifying assets which includes a building and some pasta equipment, and 2.5% of that amount is $12,500. Therefore, the second number is 25% of their employee’s wages or $25,000 plus 2.5% of qualified business assets or $12,500. When added to $25,000, that becomes $37,500.
In this situation, the couple can claim a pass-through tax deduction of $50,000. That is the greater of the above two equations but less than the 20% they could claim if their income were under the $315,000 threshold.
Note, if the business has no W-2 employees or property, then no deduction exists. Any SSTB at or over the top threshold does not get a deduction.
If Taxable Income Is In Between Thresholds for Non-Specified Services
If your taxable income is between $157,500-$207,500 (single, head of household or married filing separately) or $315,000-$415,000 (married filing jointly), then calculating the deduction is done differently then above. In other words, the calculation for the deduction takes into account the 20% QBI rule as well as the W-2 and property rule discussed above. Since the W-2 and property rule phase in after $157,500 (single, HOH, MFS) or $315,000 (MFJ), then your deduction amount is impacted by the phase-in calculation percentage for the W-2 and property rules.
One equation to figure out the pass-through deduction for married filing jointly (MFJ) looks something like this:
[(20%*QBI) – [(20%*QBI) – (Greater of 50% of W2 Wages or 25% of W2 Wages + 2.5% of the unadjusted basis of property)]] * [(taxable Income – $315,000) / 100,000]
An Example for Non-Specified Service Providers Above the Initial Threshold Amount
Let’s take an example. Say a bakery, which is owned by a husband and wife, yields $350,000 a year in qualified business income. It has $10,000 in qualified business property and pays two employees a total of $90,000 a year. Since $350,000 is $35,000 over the $315,000 bottom income threshold, the phase-in calculation here is 35%. Next, we calculate two numbers with one assuming they are above $415,000 and the other below $315,000. Therefore, respectively, 50% of w-2 wages would be $45,000, and 20% of QBI would be $70,000. Next, we take the difference between the two numbers, which is $25,000, and multiply that by the phase-in percentage of 35%, which yields $8,750. Therefore, the $8,750 is subtracted from the QBI based deduction of $70,000, bringing the total pass-through deduction to $61,250.
If Taxable Income Is In Between Thresholds for Service Providers
If your taxable income is between $157,500-$207,500 (single, head of household or married filing separately) or between $315,000-$415,000 (married filing jointly) and you are a specified service provider, the pass-through deduction starts to phase out. Unlike non-service providers in this income range, at the top of the threshold ($207,500 single or $415,000 MFJ) no pass-through deduction exists.
It starts to phase out at one percent for every $1,000 over the $315,000 for married filing jointly (two percent for every $1,000 over the $157,500 threshold for single, head of household, or married filing separately). Here is what the equation may also look like for married filing jointly:
[1-((taxable income – $315,000) / 100,000))]*(Greater of 50% of W2 Wages or 25% of W2 Wages + 2.5% of the unadjusted basis of property)
For those filing single, it may look like this:
[1-((taxable income – $157,500) / 50,000))]*(Greater of 50% of W2 Wages or 25% of W2 Wages + 2.5% of the unadjusted basis of property)
An Example for Specified Service Providers Above the Initial Threshold Amount
For example, a married lawyer owns a law firm that yields $345,000 a year in qualified business income. The other spouse does not work. There is no depreciable business property, and the firm pays two employees a total of $75,000 a year. Since $345,000 is $30,000 over the $315,000 bottom income threshold, the phase-out calculation percentage here is 30%. Why? The threshold difference for Married Filing Jointly is 100,000 ($415,000 – $315,000) and $345,000 is $30,000 more than $315,000. Or simply, the phase-out percentage is equal to the difference between taxable income and the lower threshold amount divided by 100,000 (or 50,000 for single, HOH, or MFS). Therefore, 30% of the deduction disappears. But 30% of what? Well, you need to take the greater of:
- 50% of W-2 wages paid by your business
- 25% of W-2 wages plus 2.5% of a taxpayer’s allocable share of the unadjusted tax basis of qualified business property. It includes tangible property that you have not fully depreciated yet.
Therefore, the greater number here is 50% of w-2 wages, which equals $37,500. Since 30% is the phase-out percentage, 70% of the $37,500 (w-2 wages) is the pass-through deduction or $26,250.
If Your Taxable Income Is Below $157,500 (Single) or $315,000 (MFJ)?
If your taxable income is below $157,500 (single, head of household, married filing separately) or $315,000 (married filing jointly), then there are no limitations by trade or business type and calculating the pass-through deduction is simply multiplying QBI by 20% (QBI*20%). However, remember that the pass-through tax deduction cannot be greater than 20% of your total income.