Pass-through taxation has been one of the most contentious and confusing parts of the debate surrounding the Republican tax bill.ese businesses — sole proprietorships, partnerships, limited liability companies (LLCs) and S corporations — are not themselves subject to federal taxation the way traditional corporations are. Instead, the income earned from these operations is passed through on the owner's personal income tax filing.
As I and many, many other media outlets and bloggers have noted, the final version of H.R. 1, the Tax Cuts and Jobs Act, that House and Senate conferees approved Dec. 15 basically followed the Senate's taxing methodology .
Rather than setting a specific tax rate as the House suggested, the conference committee members opted for the deduction proposed by the Senate. But the Upper Chamber's original 23 percent deduction for pass-through income was reduced to 20 percent.
So how would this work? Rather that reinvent the wheel, I'm giving a delayed Monday Shout Out (since my weekend focus on the tax bill prevented a regular Saturday or Sunday virtual high five to another tax piece) to Alistair M. Nevius with the Journal of Accountancy.
In his review of the tax bill, Nevius provides a good section on the pass-through income deduction:
For tax years after 2017 and before 2026, individuals would be allowed to deduct 20% of "qualified business income" from a partnership, S corporation, or sole proprietorships, as well as 20% of qualified real estate investment trust (REIT) dividends, qualified cooperative dividends, and qualified publicly traded partnership income. (Special rules would apply to specified agricultural or horticultural cooperatives.)
A limitation on the deduction would be phased in based on W-2 wages above a threshold amount of taxable income. The deduction would also be disallowed for specified service trades or businesses with income above a threshold.
For these purposes, "qualified business income" would mean the net amount of qualified items of income, gain, deduction, and loss with respect to the qualified trade or business of the taxpayer. These items must be effectively connected with the conduct of a trade or business within the United States. They do not include specified investment-related income, deductions, or losses.
"Qualified business income" would not include an S corporation shareholder’s reasonable compensation, guaranteed payments, or — to the extent provided in regulations — payments to a partner who is acting in a capacity other than his or her capacity as a partner.
"Specified service trades or businesses" include any trade or business in the fields of accounting, health, law, consulting, athletics, financial services, brokerage services, or any business where the principal asset of the business is the reputation or skill of one or more of its employees.
The exclusion from the definition of a qualified business for specified service trades or businesses phases in for a taxpayer with taxable income in excess of $157,500 or $315,000 in the case of a joint return.
For each qualified trade or business, the taxpayer is allowed to deduct 20% of the qualified business income with respect to such trade or business. Generally, the deduction is limited to 50% of the W-2 wages paid with respect to the business. Alternatively, capital-intensive businesses may yield a higher benefit under a rule that takes into consideration 25% of wages paid plus a portion of the business’s basis in its tangible assets. However, if the taxpayer’s income is below the threshold amount, the deductible amount for each qualified trade or business is equal to 20% of the qualified business income with respect to each respective trade or business.
See, I told you he did the heavy lifting! The shouting out definitely was worth the wait.
Right now, it's looking like both the House and Senate have the votes to approve the bill.
Both bodies are looking at votes on H.R. 1 on Wednesday, Dec. 20 Tuesday, Dec 19. That should allow them to get the bill to the White House for Donald J. Trump's signature by the end of this week.
You can read about other Tax Cuts and Jobs Act provisions in my two-part series on the bill: Part 1 (which has a tax rates/income brackets table) and Part 2.
Jack
Check the Taxmode app out – it has the 2018 TCNJ computations already implemented. I use it on iPhone, it is also available for Android.
rk
Will the tax value of that 20% deduction be calculated at your top marginal rate(s), or a lower rate? How do contributions to a solo-401k affect the calculation (and for a very small business, what if all/most of the net is contributed to that retirement fund?).
Whelan Tax
This is great explaining how taxes on pass-through businesses would work under the gop tax plan.
Sandy Botkin
I am confused how the deduction applies to sole proprietors who earn over $315,000 and are married and are not in a specified service business. QBI is 400K and also for 500K, how much is the deduction for a sole proprietor with no salaries and very little capital equipment ( just to make it easier to understand) ?
Sid Johnson
It seems the lawmakers left a little to be desired on the target of the 20%. Clearly, the deduction will be taken below the AGI line and before individual tax is calculated. Self-employment tax is added after the individual tax is calculated.
But what about above-the-line deductions arising from self-employment, such as health insurance, SEP contributions, and the deduction for self-employment tax? These deductions reduce pass-through income already. Will the 20% deduction target be pass-through income or p-t income less these above-the-line deductions? Thanks!
mark
What happens with a pass-through entity that has an Oct 31 2017 fiscal year-end?
Is the deduction applied to the owner as part of 2018 taxes or does it not apply since the pass-through entity has a fiscal year-end start before Dec 31 2017?
Lance
Question for the experts.
I run a medical practice with 2 part. One I see patients. Two I provide medical consulting services to an insurance company. Combined my income is greater than the 315K phase out for service trades.
Can I split my two businesses apart and obtain the 20% deduction if each is under 315K? Or are they too similar and would be considered the same “trade”.
Thanks.
JK
So if a realtor with a w2 income of $80,000 with deductible expenses of $18,000 (advertising expenses, mileage etc) so that $72,000 is passed through and added as personal income — does he take the 20% business deduction on $72,000? Are most deductions other than entertainment still on new tax bill?
Jeff
If I am an actor & create an LLC that all of my income flows into, effectively creating a sole proprietorship, would I be eligible to take this deduction? What if I’m a financial consultant? Essentially my question is what is the EXACT definition of who can or cannot take advantage of this deduction? Thx!
Jane
I just read an article that said that the pass-through business deduction is not applied until taxable income has been calculated using all other deductions, and is then limited to 20% of that portion of the calculated taxable income that is not attributable to capital gains. Example: say I have business income of $25,000, and therefore a potential pass-through business deduction of $5,000. If my taxable income minus capital gains is less than $25,000 (and it may well be since I have big medical expenses), I don’t get to take the whole deduction. I see nothing in the article or comments above that says that, and I see lots of articles elsewhere that don’t mention it. Can you clarify?
Steven M Kaplan, CPA
The Qualified Business Income deduction is taken AFTER computing adjusted gross income (AGI) on the tax return, so you would pay SE tax on the full profit.
The deduction is only used to reduce taxable income, not SE income.
Additionally, the deduction is available to both non-itemizers and itemizers.
Matthew
@Todd Pratt From the conference report: “The conference agreement clarifies that the 20-percent deduction is not allowed in computing adjusted gross income, and instead is allowed as a deduction reducing taxable income. Thus, for example, the provision does not affect limitations based on adjusted gross income. Similarly the conference agreement clarifies that the deduction is available to both nonitemizers and itemizers.”
So, will not change AGI, but will not have to itemize to use this. Which must mean a new line on the 1040.
Scott
Scenario:
1) Small, capital-intensive online retail business (capital is the inventory).
2) Owner/manager pays industry average salary of $50k.
3)Business earns $150k profit after all expenses/wages to employees (who do most of the actual work). 4) 48k is paid out to owner/manager in distributions ($4k/month, not guaranteed). Most goes to pay estimated quarterly taxes. All $150k passes through to personal tax return.
Is the 20% pass through deduction applied to the the entire profit ($150k, so $30k deduction), or just 20% on W-2 wages to the owner/manager?
Mason
I do part-time consulting, with a family W-2 income from our primary jobs of $225K and consulting income of $50K. My consulting service is as a sole proprietor and would apparently be a “specified service trades or businesses” because the principal asset of the business is my reputation/skill. Would I be able to take the 20% deduction on the $50K consulting work?
Todd Pratt
Can anyone tell me if the 20% deduction is an above the line deduction or will I need to itemize?
Jason
Do you know if you pay self employment tax (15%) on income before or after the 20% deduction?
Kevin
@ Jeremy – The threshold would be on the $200K in profit. Its the net of income and allowable business deductions.
Kay Bell
Thanks, Vit, for your detailed example of what a mess this is and will be. I applaud your work and glad I just write about it! Kay
Vit Gulbis
A dental practice is a wonderful hypothetical for the passthrough changes because it raises so many questions. On the first pass, I suspect that a dental practice will not be able to take advantage of the deductions since it is likely a “specified service, trade or business” (in my view it falls within medical). But maybe there is an opportunity to restructure the business. For example, what if the dentist restructures his practice into the following components (i) an equipment leasing company organized as a passthrough (which leases his dental equipment to the practice), (ii) a dental appliance manufacturing/distribution company organized as a passthrough (which makes, or buys and resells, items such as crowns, bridges, fixtures, etc), and (iii) a real estate rental company, which owns the office and leases it to the practice. All of these other entities would have businesses eligible for the passthrough deductions, and the dentist could bleed the profits from his overall practice into these related entities and away from the entity which provides professional dental services. As a tax lawyer, I think I I will have a lot on my plate next year as healthcare professionals, among others, restructure their practices.
This is not tax simplification. There will need to be pages upon pages of additional regulations and guidance.
Jeremy
How will a dentist’s taxes be affected as a LLC? If the practice profits run through the dentist’s personal tax returns of close to a million dollars, will the dentist see any tax relief? The overhead/expenses account for 80% of the profits claimed. The actual take home income of the dentist would be $200,000. Is the threshold for earnings related to the overall profit of the business, 1 million, or the take home profit of the dentist, $200,000.
Eric
will I have to itemize to take the 20% deduction?
Lmaris
If your postcard is the size of Montana, sure it will fit.
Kay Bell
Oh, Nick, you are such a [post]card!
Nick
Will I be able to do this on a postcard?