The New Deduction for Pass-Through Income

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Owner of partnerships, S corporations, and sole proprietorships - as "pass-through entities" - pay tax at their individual rates. Prior to the new tax law, the highest rate was at 39.6 percent. That top rate was reduced to 37 percent for 2018 under the Tax Cuts and Jobs Act. The Act also allows owners of pass-through entities to take a deduction equal to 20 percent of the qualified income of their pass-through entities, subject to a number of limitations and qualifications. Thus, qualified pass-through income is subject to a top tax rate of 29.6 percent.


Under new Internal Revenue Code section 199A, individuals and other pass-through owners (except C corporations) may deduct up to 20 percent of domestic qualified business income from a partnership, S corporation, or sole proprietorship. This new deduction is not part of adjusted gross income (known as "above the line"), nor is it considered an itemized deduction ("below the line"). The IRS will have to devise a new line on the 2018 tax form to report this income. It is allowed whether or not a taxpayer claims the standard deduction. The deduction may not exceed a taxpayer's taxable income (reduced by net capital gain) for the tax year.


Ineligible Businesses

Certain specified businesses are not eligible for the pass-through deduction. This includes accounting, law, brokerage services, financial services, health, many investment-related professions, and companies where the reputation of an owner or employee is its principal asset. The Act contains rules to prevent owners in these businesses - particularly service providers like accountants, doctors, and lawyers - from converting their higher-rate compensation income into profits eligible for the new deduction.


Taxpayers in these ineligible businesses may still claim the deduction if their income is below certain levels. On a joint return with taxable income below $315,000, the deduction is allowed regardless of the type of business. It phased out above that and the deduction is fully eliminated above $415,000. For other than joint returns, the phaseout for ineligible businesses starts at $157,500 and the deduction is eliminated at $207,500.


Wage or Wage-Plus-Asset Limitation

The pass-through deduction is limited to a computation based on either the salaries the business pays, or a combination of its salaries and depreciable assets (like buildings). Using salaries alone, the limit is 50 percent of the W-2 wages the business pays. The pass-through deduction cannot exceed that amount. If the business pays little or no salaries, but has depreciable property (like many real estate companies), the wage-plus-asset limit may be used instead. Here, the pass-through deduction is limited to the combination of 25 percent of the business's W-2 wages, plus 2.5 percent of the original cost of its depreciable property.


This wage or wage-plus-asset limit is phased out for lower income taxpayers. The dollar amounts are the same as for ineligible businesses, discussed above. Thus, if taxable income on a joint return is below $315,000, the wage or wage-plus-asset limit does not come into play and the pass-through deduction may be claimed regardless of salary or assets.


If you have any questions on how the pass-through income deduction will affect your tax liability, please contact your LMC professional.



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