Complicated new rules for business owners
The new Tax Cuts and Jobs Act (TCJA) creates a brand-new deduction for pass-through entities, designed to provide a balance to corporations benefiting from tax rate cuts. But the deduction is not nearly as simple as the new flat 21% rate for corporations authorized by the TCJA. Although many tax experts are still grappling with the rules, here are the basics of what we know so far.
The deduction, which takes effect in 2018, is available to pass-through entities such as partnerships, S corporations and limited liability companies (LLCs), as well as sole proprietors. It can be as high as 20% of business income received.
However, deductions are reduced or eliminated for certain taxpayers, depending on the amount of qualified business income (QBI) and the nature of the business activity and, in some cases, wages paid to employees, and business property. QBI is generally defined as your net income from the business without including amounts in the nature of compensation.
For starters, pass-through entities are divided between those that provide personal services and those that do not. The personal service group includes attorneys, physicians, consultants, athletes, financial advisers, accountants, stockbrokers and others who typically offer services to the public; however, engineers and architects are specifically excluded. Then, the following rules apply:
- If you have income lower than $157,500 as a single filer or $315,000 as a joint filer, you are entitled to the full 20% deduction of QBI—no questions asked. It does not matter whether you are a personal service owner.
- If your income exceeds $207,500 as a single filer or $415,000 as a joint filer, you receive no deduction if you are a personal service owner. For other owners above these thresholds, your deduction is limited and possibly eliminated.
- If your income falls between the thresholds stated above, your deduction is reduced, regardless of whether you are a personal service owner.
For instance, assuming you are a personal service owner who files a joint return, the amount of your QBI is phased out on a pro rata basis until it disappears completely when total taxable income exceeds $415,000. For other pass-through owners above the upper threshold, the deduction is limited by the greater of either (1) 50% of the wages the business pays its employees or (2) 25% of wages plus 2.5% of the basis of the qualified property owned by the business. After comparing this limited deduction to the maximum 20% deduction of QBI, you are entitled to deduct the smaller of the two.
Suffice it to say, calculations involving the new deduction for pass-through entities will often be exceedingly complex. As of this writing, the IRS has not yet weighed in on the issue, although it is expected to provide some much-needed guidance before the end of the year.
Should business owners shift to a pass-through entity form to benefit from this new deduction? This is a decision that involves an analysis of many factors in addition to this tax break. Obtain expert advice for your particular situation before you proceed further.