IRS aims to clear up confusion around the pass-through deduction

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Tax reform created a potentially valuable new deduction for businesses — the qualified business income deduction.

But then it left everyone wondering exactly how the so-called “pass-through deduction” would work.

The deduction created by the Tax Cuts and Jobs Act of 2017 aimed at allowing owners of sole proprietorships, partnerships and S corporations (and some trusts or estates) to deduct up to 20% of their qualified business income on their federal income tax returns. But the act didn’t make it clear exactly how the new deduction would work.

On Jan. 18, 2019, just 10 days before it was set to begin accepting individual income tax returns for the 2018 tax year, the IRS addressed this uncertainty. The agency finalized a set of regulations it had proposed in August 2018 and proposed additional regulations to address more-obscure aspects of the deduction.

The regulations could help many small-business owners with business income that passes through to their individual income tax returns take advantage of the deduction.

Want to know more?

What’s the background?

Tax reform cut the corporate tax rate to just 21%. But that reduction doesn’t help pass-through business owners, whose business income gets taxed at individual rates (currently 10% to 37%) since it’s reported on their individual tax returns. Only earners who fall into the lowest two individual income tax brackets are subject to rates lower than the corporate tax rate.

“The qualified business income deduction was intended to help small businesses reap their share of the benefits of tax reform,” says Christina Taylor, senior manager of tax operations for Credit Karma Tax®. “If they qualify for the deduction, certain pass-through business owners could be able to take a deduction on their individual income tax returns for up to 20% of their qualified business income.”

Why does this matter?

According to a 2017 Brookings Institute report, the majority of businesses in the U.S. — about 95% — are pass-through businesses, including freelancers, gig-workers, independent contractors, S corporations and partnerships. Pass-through entities account for the majority of business income generated in the U.S. and more than half of all employment, according to a 2017 report from the Tax Foundation.

Still, not all pass-through business owners will be eligible for the deduction. Higher earners face limitations on whether they can qualify, including factors like type of trade or business that’s eligible for the deduction, taxable income, the amount of W-2 wages paid by the business and other restrictions.

But these limitations don’t apply for single filers whose taxable income is $157,500 or less and for married couples filing jointly with taxable income of $315,000 or less. They could be eligible for the full deduction of 20%.

How could this impact you?

If you’re a self-employed small-business owner — a freelancer, gig-worker, independent contractor or other type of small business — and your total taxable income is lower than the thresholds for your filing status, the qualified business income deduction could basically shelter up to 20% of your qualifying business earnings from being taxed.

And the finalized and proposed IRS regulations could make it easier for tax professionals, tax-software vendors, and online tax-preparation and -filing services to help eligible small-business owners claim this valuable deduction.