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This article was fact-checked by our editors and CPA Janet Murphy, senior product specialist with Credit Karma Tax®.
At the first IRS Forum of 2018, a presenter leading a session on business taxes encouraged a roomful of tax professionals to practice what he called the “pass-through deduction exercise.”
The professionals, he said, would need the practice for when business clients ask how the deduction created by the Tax Cuts and Jobs Act might affect their 2018 taxes. The move: Lift both shoulders to your ears … and relax.
His point, of course, was that the new pass-through deduction can be very confusing — for both small-business owners and the tax professionals who work with them.
- Introducing the pass-through deduction
- What is a pass-through business?
- How does the pass-through deduction work?
- Calculating the pass-through deduction
Introducing the pass-through deduction
The Tax Cuts and Jobs Act granted a potentially valuable tax break to owners of pass-through businesses. But calculating the pass-through deduction is no easy task.
Small-business owners, freelancers, side hustlers and gig economy workers have been following news about tax reform since the measure was signed into law late last year, and for good reason. The law created a potentially generous new tax break, Section 199A, also known as the pass-through deduction.
The new law gives a 20% deduction to pass-through businesses. Pass-through income is reported and taxed on the business owner’s personal returns rather as an entity at corporate tax rates. But there are a few categories of high-earners who could be excluded.
Let’s take a look at what the pass-through deduction is, who qualifies and how it’s calculated.
What is a pass-through business?
A pass-through business has a business structure that allows income to be taxed like an individual, at an individual marginal tax rate. Pass-throughs can include sole proprietorships, partnerships, S corporations and some LLCs. Businesses like C corporations, on the other hand, pay federal income tax at the corporate level.
About 95% of businesses in the U.S., including freelancers, gig workers and independent contractors, are pass-through businesses. And the majority of business income generated in the U.S., and more than half of all employment, comes from pass-through entities.
It’s that prevalence that led Congress to create the pass-through deduction.
Tax reform slashed the corporate tax rate to 21%. It also lowered individual income tax rates (which also apply to pass-through business income). But only people in the lowest two income tax brackets have tax rates lower than the corporate rate. Other individual rates range from 22% to 37%.
In early drafts of the legislation, C corporations appeared to be getting the deepest tax cuts via a reduction in their tax rate. Representatives for small-business owners expressed concern over the disparity, and the pass-through deduction was born.
How does the pass-through deduction work?
Simply stated, Section 199A allows owners of pass-through businesses to deduct up to 20% of the qualified income earned by the business.
That sounds simple enough, but the law is rife with limitations, exceptions, phase-ins and phase-outs, and poorly defined terms. As a result, more than six months after its enactment, there is still significant controversy over who will benefit from the deduction and by how much. The IRS issued proposed regulations addressing the deduction in August of 2018, but until final regulations are issued, many tax professionals are giving their clients big disclaimers along with any tax advice that includes Section 199A.
For now, we’ll consider how the pass-through deduction is supposed to work.
First, the law sets a taxable income threshold. Generally single filers making less than $157,500 and joint filers making less than $315,000 in total taxable income are eligible for the full 20% deduction on their pass-through income. Note that total taxable income refers to all the taxpayer’s taxable income, minus deductions (except the pass-through deduction). This is essentially the taxpayer’s adjusted gross income and may include wages from other jobs, interest and dividends, capital gains, rental income and more.
Next, for individuals making between $157,500 and $207,500 or couples making between $315,000 and $415,000, the available deduction depends on whether their business is considered a “specified service trade or business.”
A specified service generally includes any business involved in the performance of services, other than engineering or architecture, where the principal asset of the business is the reputation or skill of its employees or owners. That’s a broad definition, but it includes law firms, medical practices, consulting firms, professional athletes, accountants, financial advisers, performers, investment managers and more. The proposed regulations include several pages addressing what constitutes a specified service trade or business, so dig in if you’re concerned about whether or not your business will qualify.
If the taxpayer’s business does not fall into this category, the taxpayer is eligible for the full 20% deduction — provided the taxpayer isn’t subject to phased-in limitations on wages or capital gains. Specified-service businesses are only eligible for a partial benefit, as the amount of business income eligible for the deduction phases out. We’ll delve into those calculations later.
Finally, those specified-service businesses are subject to a taxable income ceiling, after which they receive no deduction at all. For single taxpayers, that ceiling starts at $207,500. For couples filing jointly, it starts at $415,000.
Businesses that are not specified-service businesses may still get a deduction, but it will be limited based on the amount of wages their business pays and any capital gains.
Calculating the pass-through deduction
To calculate the deduction, the taxpayer must first calculate qualified business income, or QBI, for each pass-through business. This is generally the business’s net income. If the taxpayer’s total taxable income is less than $157,500 ($315,000 if married filing jointly), then the taxpayer can simply deduct 20% of the combined QBI, which is the total QBI calculated for each qualifying business. But calculating the deduction for taxpayers who make more than that gets more complicated.
For specified-service businesses, the deduction is phased out on a pro rata basis until individual income exceeds $207,500 ($415,000 for married filing jointly), at which point there’s no deduction at all.
The deduction for all businesses may also be limited based on the amount of W-2 wages paid to employees and the value of depreciable assets the business owns. The deduction is partially limited by the greater of 50% of the wages paid to employees, or 25% of wages plus 2.5% of the unadjusted basis of the business’s qualified property (i.e., machinery and equipment, real estate and any other depreciable property that hasn’t reached the end of its depreciation period).
To complicate things further, the wage limit is gradually applied over the income range. So if only 55% of the taxpayer’s QBI qualifies for the pass-through deduction, then the taxpayer can only include 55% of wages or property in the respective calculation. A business owner must compare these calculations to 20% of QBI and deduct the smaller amount.
The pass-through deduction can provide a generous tax break for small businesses that are able to claim it. But calculating the deduction is no easy task.
Additional guidance from the IRS should clear up some of the confusion. Until then, it’s a good idea to get a general understanding of how the rule could apply to your situation.
A senior product specialist with Credit Karma Tax®, Janet Murphy is a CPA with more than a decade in the tax industry. She’s worked as a tax analyst, tax product development manager and tax accountant. She has accounting degrees and certifications from Clemson University and the U.S. Career Institute. You can find her on LinkedIn.