IRS Rules Complicate New Pass-Through Tax Deduction

December 10, 2018 by Cyndia Zwahlen

A new tax deduction that that is part 2017’s tax-reform bill may benefit owners of trucking companies, including owner-operators, and other businesses, if they’re not set up as corporations.

The deduction is part of the major changes made to the federal tax laws late last year. It could allow an owner to deduct up to 20 percent off business income tax, but it comes with limits and exclusions.

“People really have to be on their toes,” said Anthony J. Nitti, the Aspen, Colo.-based tax partner  at WithumSmith+Brown, an accounting, wealth management and consulting firm based in Princeton, NJ.

The new deduction is spelled out under Section 199A of the December 2017 Tax Cuts and Jobs Act. It is meant to match the large cut made to the federal tax rate for corporations under the act.

Here is an overview of how the new deduction works, based on advice from Nitti – who has written extensively on the topic – and information from the Internal Revenue Service.

The agency is still issuing guidance on how to use this deduction, so check with a qualified tax professional on how it might apply to your specific situation.

Who can take the new 20 percent deduction?

To take the deduction, taxpayers must have qualified business income that meets certain thresholds and is from:

  • Sole proprietorships
  • Partnerships
  • S corporations
  • Trusts and estates

The deduction also applies to taxpayers with two other types of income: real estate investment trust (REIT) dividends and publicly traded partnership income. Both must be calculated separately and cannot be included in qualified business income. (Publicly traded partnerships are generally limited by the IRS to energy-related businesses.)

What about LLCs, or limited liability companies?

Owners of limited liability companies also might qualify for the tax deduction on qualified business income, said Nitti, although the IRS doesn’t recognize an LLC as a separate type of business entity for federal income tax purposes.

Instead, an LLC with at least two members is classified by the IRS as a partnership, unless the LLC has filed the paperwork necessary to be treated as a corporation. (Remember, corporations don’t qualify for this tax deduction.)

A one-member LLC is treated as a sole proprietorship by the IRS for federal income tax purposes.

Since both partnerships and sole proprietorships qualify for the tax deduction, so do noncorporate LLCs.

What is qualified business income, anyway?

Qualified business income includes regular income from a U.S. trade or business, according to IRS rules.

It is the net amount of regular business income that results from tallying all income gains, deductions and losses for the business.

Employee wages, capital gains or losses, and certain interest and dividend income are excluded from qualified business income, according to the IRS. Wages paid to a shareholder or guaranteed payments to a partner also are excluded, Nitti said.

Dividends from REITS or income from publicly traded partnerships must be excluded, as noted above. Those amounts qualify separately for the tax deduction and can’t be part of a business’s income tally.

If a person has ownership in more than one business, the qualified business income, and the deduction, must be calculated separately for each business.

Are there thresholds for business income? 

Income thresholds also apply when figuring the deduction.

Married, filing jointly? The qualified taxable business income must be $315,000 or less to take the full 20 percent tax deduction with no restrictions.

For all other taxpayers, qualified taxable business income must be $157,500 or less to qualify for the deduction with no restrictions.

In either case, a taxpayer can deduct the lesser of:

  • Twenty percent of qualified business income, plus 20 percent of any qualified REIT dividends and qualified publicly traded partnership income, or
  • Twenty percent of the qualified business income minus net capital gains, if any.

A net capital gain is the amount by which total long-term capital gains and losses exceed short-term capital gains and losses. It’s a short-term gain or loss if the asset is owned for less than one year before being sold.

What if my business income is too high?

If taxable business income is over the IRS thresholds of $315,000 for a married taxpayer filing jointly and $157,500 for all other taxpayers, the deduction will be limited based on business type and wage and capital amounts, specifically:

  • Whether it is a service business
  • The W-2 wages paid by the business
  • The unadjusted cost basis of any qualified business property or asset immediately after it was acquired

W-2 wages do include the reasonable compensation that S corporations are required to pay their shareholders who provide significant services.

How is the deduction limited if my business income is too high?

If business income exceeds the IRS thresholds, the potential deduction will be limited to the greater of:

  • Half of the total W-2 wages paid by the business, or
  • One-quarter (25 percent) of W-2 wages plus 2.5% of the unadjusted cost basis of any qualified business property or asset immediately after acquisition.

These limits also are subject to a phase-in range, according to IRS rules. “These limitations are phased in for joint filers with taxable income between $315,000 and $415,000, and all other taxpayers with taxable income between $157,500 and $207,500,” the agency said. Once the taxable income exceeds those top levels, the full W-2 wage limits apply.

Do I need to change my business entity to qualify for the deduction?

That depends. The way the rules are written, a sole proprietorship has an advantage over a wholly owned S corporation when both business incomes fall below the IRS thresholds, even if both businesses have the same amount of business income.

That advantage switches to the S corporation if the business incomes – still the same amount for the S corporation and the sole proprietorship – are over the IRS thresholds.

This is a major inequity under Section 199A. It may lead higher-income sole proprietorships to consider converting to S corporations. Deadlines and limitations apply to converting, and a change in business entity can affect other types of taxes due, so it is vital to consult a qualified tax professional before making a change.

So service businesses don’t qualify for the deduction?

Service business owners do qualify for the deduction if the owner’s qualified business income is below the IRS thresholds of $315,000 for married taxpayers, filing jointly and $157,500 for all other taxpayers.

If taxable business income is over those levels, limits kick in for certain service businesses. And once a service business owner’s qualified income hits $415,000 for a married taxpayer, filing jointly, or $257,500 for all other taxpayers, no deduction is allowed.

Service trades or businesses affected are those in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services and financial brokerage services.

Also affected are service businesses involved in investing and investing management, or trading or dealing in securities, partnership interests or commodities.

I don’t itemize. Can I still take the deduction?

Yes, if the qualifications are met, the deduction is allowed whether the taxpayer chooses to use an itemized deduction or takes the standard deduction. And the deduction does not reduce adjusted gross income, or AGI. It is taken after AGI is calculated.

Will the deduction reduce my self-employment tax?

Sorry, no. Self-employment taxes are a type of payroll tax. This deduction only applies to income taxes.

My business runs on a fiscal year, not a calendar year. Is that a problem?

No. Although the deduction is effective as of Jan. 1, 2018, the rules say if the fiscal year for your pass-through entity bridges that date, you can still count your full fiscal year’s qualified business income and any W-2 employee wages and the property basis when calculating the deduction, according to Nitti.

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