One of the key components of the “Tax Cuts and Jobs Act of 2017” (“TCJA”) was the newly created deduction for owners of pass-through entities. This topic was briefly discussed in our blog titled “Overview of the Business Provisions in the New Tax Reform Act,” but the following is intended to dig deeper into the details of the text of the TCJA and unpack these complex provisions. It is worth noting that we expect the Treasury Department to issue numerous regulations detailing the interpretation and practical implementation of many of these concepts.
The cornerstone of the TCJA was decreasing the corporate tax rate to a flat 21 percent. However, this did not help the many small businesses structured as pass-through entities (i.e., limited liability companies (LLCs), partnerships and S-corporations). Since the income from pass-through entities is taxed on the individual returns of the owners, the TCJA created a hybrid solution – the 20 Percent Deduction. The 20 Percent Deduction is calculated based on the income from pass-through entities, but it is reported on the individual income tax return of the pass-through owner.
The deduction is calculated by taking 20 percent of qualified business income (QBI) from the pass-through. Thus, the first step is to determine: what is QBI? It is the taxable income, gain, deduction or loss attributable from conducting a trade or business. Investment-type income, such as dividends and interest, and the related losses and deductions are excluded. Also excluded are amounts reported as reasonable compensation to an S-corporation shareholder, guaranteed payments to a partner for his or her services, or any other amount paid to a partner for his or her services other than in his or her capacity as a partner.
In short, the 20 Percent Deduction is calculated on the business-portion of the pass-through owner’s distributive share, without respect to any wages or guaranteed payments received by the owner. The deduction is from adjusted gross income (AGI) and reduces the taxable income whether the taxpayer itemizes his or her deductions or uses the standard deduction. Thus, the 20 Percent Deduction will reduce taxable income, but it will not affect AGI (or any AGI-related calculations).
It should be noted that, in the event the combined QBI is a loss, the 20 percent rate is applied to the QBI and the deduction is carried forward to the subsequent year. This negative carryforward will then reduce the amount of the 20 Percent Deduction in the subsequent year, but not below zero.
The calculation gets a little more complicated when the pass-through owner’s taxable income exceeds $157,500 ($315,000 for married filing joint taxpayers). For years after 2018, the thresholds are indexed for inflation. For owners exceeding these thresholds, there is a second calculation required in computing the amount of the 20 Percent Deduction, based largely on the Form W-2 wages paid. There are two options available for computing this deduction, and owners may use the one yielding the greatest benefit. This limitation is determined by calculating (a) 50 percent of the W-2 wages, or (b) 25 percent of the W-2 wage, plus 2.5 percent of the unadjusted basis of qualified property. Qualified Property is defined as tangible property used in a trade or business for the production of QBI, and for which the depreciation period has not ended prior to the end of the tax year. Depreciation Period is defined by the greater of: (a) 10 years from the date placed in service, or (b) the last day of the last full year in which the applicable recovery period (i.e., the last full year of the depreciable life for income tax purposes under Section 168).
Limitations for Specified Service Trades or Businesses (SSTBs):
SSTB is defined as 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 one or more of its employees or owners. Specifically excluded from this definition are the fields of architecture and engineering.
For owners of SSTB pass-through entities, the 20 Percent Deduction is not allowed unless the owner’s taxable income is below the threshold applicable threshold. The limitation phases in $157,500 ($315,000 for married filing joint taxpayers) and is fully eliminated when taxable income reaches $207,500 ($415,000 for married filing joint taxpayers).
The 20 Percent Deduction is expected to provide a great benefit to many pass-through owners. While the TCJA dedicated 23 pages to this deduction, we anticipate the Treasury to issue significant guidance through regulations and publications interpreting and applying these provisions. As additional guidance becomes available, we will provide updates. In the meantime, please feel free to reach out to our professionals should you have specific questions on these provisions.