How Does the Small Business 20% Pass-Through Deduction Work?

Small Businesses and the Pass-Through DeductionOne of the most significant changes made to the tax code through tax reform was a major reduction in the corporate tax rate, from 35% to 21%. Understanding that this only directly benefited C Corporations, legislators included a new deduction to give a like tax break to smaller businesses. This brand-new deduction for ‘pass through’ entities allows for a 20% deduction on income that flows through to business owners, with some limitations.

Pass through entities include sole proprietorships, partnerships, LLCs, and S-Corps and are named as such because income generated by the business is ‘passed through’ to the owner(s) and is then taxed at the owner’s marginal tax rate, rather than having the income taxed to the business itself as is the case with C Corporations.

At this point, as a small business owner, you are probably assuming you will be able to claim a deduction on all income that flows through to you on your 2018 tax return. In some instances that will be the case, but a number of restrictions and limitations do apply.

Pass-Through Restrictions

First, for income to qualify for the 20% deduction, it must be deemed Qualified Business Income (QBI), which varies by business type.

S-Corps: excluded from QBI will be all ‘reasonable compensation’ paid to owner-employees of an S Corp. A natural reaction to this would be to reduce W2 wages to increase pass through income, but IRS rules state owner’s must pay themselves a ‘reasonable salary’ – which in the past has been defined as ‘the salary that would be paid to a replacement employee to fill their role’.

Partnerships and LLCs: guaranteed payments to owners will not be eligible for the pass-through deduction. Owners are not paid W2 wages, but rather take a ‘draw’. As such, partnerships do not have the ‘reasonable compensation’ requirement like S-Corps. At this point, given owners are not required to take guaranteed payments, it appears all income which flows through to owners of a partnership will be eligible for the deduction, but we expect further IRS clarification to be issued.

Sole Proprietorships: no ‘reasonable compensation’ requirement is placed on sole proprietors, so early analysis of the deduction as applied to sole proprietorships leads us to believe all income passed through to the owner will be eligible for the 20% deduction.

Income Limitations

Income limitations are applied differently to pass through entities depending on whether they are defined as ‘service businesses’, including health, law, accounting, and financial services, or not. Interestingly, businesses that provide engineering or architectural services are considered to be non-service businesses for the purpose of applying this rule.

Service Business

Eligibility for the 20% pass through deduction is based on the taxpayer’s taxable income, which if too high, will result in a complete phase-out of the deduction. Individuals whose taxable income surpasses $157,500 and couples who file married filing jointly with a taxable income greater than $315,000 will be subject to the phaseout. If taxable income surpasses $207,500 for individuals and $415,000 for those married filing jointly, the 20% pass through deduction is completely lost.

Non-Service Business

If an owner’s taxable income falls below the phaseout ranges referenced above, then they are eligible to take the full deduction. If taxable income exceeds this threshold, however, their deduction is limited to the lesser of 20% of its business income or 50% of the total wages paid by the business to its employees.

The inclusion of this new deduction into the tax code has created a significant tax savings opportunity for small business owners. With so many caveats, we recommend working with a tax professional to conduct a comprehensive tax plan to gain a better understanding of your eligibility and to make sure you are taking full advantage of the deduction.

*We continue to wait on further clarification on many important details of the new 20% pass through deduction and will provide updates to this article when available

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