By now, most of you with businesses have heard about the new 21% income tax rate for corporations, but that rate is only for C-corporations. While there are tens of thousands of C-corporations in existence, the majority of small businesses are organized as sole proprietorships, partnerships, LLCs, or S-corporations. All of these entities are known as ‘pass-through’ entities. And, while pass-through entities were not left out of the new tax act, the benefits are much different and more complex than those of C-corporations.
Contrary to many of the articles out there, pass-through entities are not taxed at a 20% tax rate; rather, qualifying pass-throughs will receive a deduction equal to 20% of their pass-through income (subject to a number of provisions). In this Part 1 article we will attempt to make clear the new law as it relates to pass-through entities, but please bear with us – this particular provision of the new law is already being called one of the more complex additions to an already complex tax code. In Part 2 we will look at some 'real world' examples of these new provisions.
Pass-through Entities Defined
Businesses whose income is not taxed at the entity level, but rather “passed through” to the individual owners and taxed at their tax rates, are known as pass-through entities (“PTEs”). PTEs have enjoyed great popularity over C-corporations primarily because of the 1) lack of double taxation, and 2) latitude in how monies are passed out to owners. While the double taxation issue is important and has garnered most of the press, most business owners will admit that the freedom, flexibility, and control over how cash is paid or distributed is of equal importance.
New Terms Defined
Many of the terms we’ve included here are directly from the content of the new law, and play an important role in how a PTE’s income is calculated. That said, we will do our best to explain each new term, so here we go:
Threshold Amount
This is important! If the taxable income from all sources on your individual tax return is UNDER the Threshold Amount, regardless your profession or business industry, you qualify for the 20% deduction, period. The “threshold amount” then is defined as the income ceiling under which a taxpayer qualifies for the 20% PTE deduction. That threshold is $157,500 for single taxpayers and $315,000 for married taxpayers filing jointly, and please note that for this threshold, income has been defined as taxable income. Taxable income is basically your income adjusted for all deductions and losses.
- If you are a “specified service trade or business” (see below), anything in excess of these amounts causes a phase-out of the 20% deduction. The deduction is completely phased out at $207,500 (single filers) or $415,000 (married filing joint filers). If your income falls between the ceiling and phase-out range, then you have to use a formula called the “applicable percentage rate” to calculate your PTE deduction, but understand that for every dollar you are over the Threshold Amount, you will lose a portion of the PTE deduction. (The “applicable percentage rate” will be explained at a later date.)
- If you are NOT a “specified service trade or business” AND you are above the Threshold Amount, any PTE deduction is subject to the CQBI provision (see below).
Qualified Business Income (QBI)
QBI is basically defined as the net income from your business not including salary paid to S-corporation owners or guaranteed payments to partners/members of partnerships/LLCs. If you own multiple businesses, QBI is calculated separately for each one (no combining profitable entities with loss entities).
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Specified Service Trade or Business (SSTB)
An SSTB is any business involving the performance of services of an individual or individuals. The professions defined within are: health, law, consulting, athletics, financial services, brokerage services, or "any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners." The two very fortunate professions specifically EXCLUDED from this definition are engineering and architecture.
Combined Qualified Business Income (CQBI)
OK, pay attention to this one – QCBI is defined as:
The lesser of:
- 20% of the taxpayer's QBI
OR
The greater of:
- 50% of the W-2 wages with respect to the business,
OR
- 25% of the W-2 wages with respect to the business plus 2.5% of the unadjusted basis of all qualified property (see below).
Qualified Property (QP)
QP includes those tangible assets you depreciate AND use to produce income in your business. The word tangible is key – if you can’t touch it, it doesn’t qualify as QP (in other words, an insurance agent’s customer list or a lawyer’s client base would not be considered tangible even though income is generated from those intangible assets).
The New Law for PTEs
Beginning January 1, 2018, a new section has been added to the Internal Revenue Code defining possible tax benefits to PTEs. We have provided you with the law as written (if for no other reason than to express our incredulity at the complexity of this new law) and then a plain English explanation (that will hopefully give our readers a Cliff Notes version of the arcane language in the new law).
New Law:
The Act adds a new section in the Internal Revenue Code, Sec. 199A, Qualified Business Income, under which a non-corporate taxpayer, including a trust or estate, who has qualified business income from a partnership, S corporation, or sole proprietorship is allowed to deduct:
(1) the lesser of: (a) the “combined qualified business income amount” of the taxpayer, or (b) 20% of the excess, if any, of the taxable income of the taxpayer for the tax year over the sum of net capital gain and the aggregate amount of the qualified cooperative dividends of the taxpayer for the tax year; plus
(2) the lesser of: (i) 20% of the aggregate amount of the qualified cooperative dividends of the taxpayer for the tax year, or (ii) taxable income (reduced by the net capital gain) of the taxpayer for the tax year.
Thresholds and exclusions:
The deduction does not apply to specified service businesses (i.e., trades or businesses described in IRC 1202(e)(3)(A), but excluding engineering and architecture; and trades or businesses that involve the performance of services that consist of investment-type activities). However, the service business limitation begins phasing out in the case of a taxpayer whose taxable income exceeds $315,000 for married individuals filing jointly ($157,500 for other individuals), both indexed for inflation after 2018. The benefit of the deduction for service businesses is phased out over the next $100,000 of taxable income for joint filers ($50,000 for other individuals). The deduction also does not apply to the trade or business of being an employee.
My Interpretation:
It is clear that the first step in determining your PTE deduction, if any, is where you fall in the Threshold Amount. So –
(1) If the income on your individual tax return is below the Threshold Amount, you qualify for the full 20% PTE deduction. Generally then, the calculation of your deduction is:
- PTE deduction equals the QBI of your business multiplied by 20%.
But, if your income is above the Threshold Amount, the next step in the calculation is to determine if your business is subject to the definition of an SSTB.
(2) If your business does NOT fall under the definition of an SSTB, then the calculation, generally, of your PTE deduction is:
Your PTE deduction is calculated under the CQBI definition (as defined above, but repeated here).
- The lesser of 20% of your QBI
OR
- The greater of (a) 50% of the W-2 wages with respect to the business,
OR
- 25% of the W-2 wages with respect to the business plus 2.5% of the unadjusted basis of all qualified property.
(3) If your business DOES fall under the definition of an SSTB, then the calculation, generally, of your PTE deduction is:
- You will receive a decreasing PTE deduction until your income hits the phase-out amounts of $207,500 (single filers) or $415,000 (married filing joint filers) at which point, your PTE deduction is $0.
In Part 2 of this article we will look at examples of how the PTE deduction will be calculated in four situations where a taxpayer's income is either above or within the Threshold Amount.
About the Author:
Rob Shaff is a partner in the accounting firm of Colton & Associates, PC which is based in Oklahoma City. Rob serves as the contributing tax author for Insightful Accountant.
DISCLAIMER:
This article is for informational purposes only and does not constitute tax or legal advice. If you want tax or legal advice, please contact a qualified tax professional or attorney.