Just before year-end in 2017, President Trump signed into law the Tax Cuts and Jobs Act, Public Law 115-97, with massive tax cuts of $1.5 trillion over the next decade. The changes affect all individuals and every type of business with most taxpayers seeing a reduction in their taxes, although some individuals and entities could be hit with tax increases down the road.
The complex legislation, which took effect on January 1, 2018, is designed to be a 10-year plan. The corporate rate reduction to 21% is permanent, while the deduction for passthrough income and the individual rate reductions expire after 2025. The complex interplay between the individual tax rates and the new tax scheme for passthrough entities is one of the stand-outs of the law. Passthroughs have a new set of rules to navigate.
Here’s a primer on the how the tax reduction works for passthroughs, such as partnerships, limited liability companies (LLCs), and S Corporations.
Deduction Yields 29.6% Top Rate
Ultimately, Congress followed the Senate’s plan for passthrough businesses, allowing a 20% deduction for profits that flow through to owners. The House plan would have established a 25% top tax rate for passthrough profits instead of using a deduction to reduce the tax on these entities. The deduction is contained in new Code Section 199A, not to be confused with the Section 199 domestic production deduction, which was repealed by the new tax law.
Example: A taxpayer owns a small business that generates $100,000 in passthrough income. The taxpayer would get a $20,000 deduction against this income, leaving $80,000 of income taxed at individual tax rates.
To understand the new deduction, it is important to remember that sole proprietorships, partnerships, LLCs, and S corporations do not pay tax at the entity-level. Instead, the income earned from these businesses is passed through and reported on the owners’ personal income tax returns. As a result, passthrough income can be taxed at the highest individual rate, which was 39.6% before the Tax Cuts and Jobs Act was passed.
The new tax law reduces the top individual rate to 37% and allows a 20% deduction for passthrough income. The combination of these two tax provisions results in a top 29.6% tax rate for passthrough income (i.e., the new 37% top rate x the 20% deduction = 29.6%).
Anti-Abuse Rules Target Professional Services
Because the deduction makes the rate on passthrough income lower than individual tax rates, there is an incentive for people to find ways to classify their earnings as passthrough business income. To prevent this practice, Congress included in the new law complex anti-abuse rules that limit the availability of the 20% deduction based on income level, the type of business, the amount of wages paid out, and the amount of depreciable property held by the business.
The first limit to consider is the income limit. For professional service firms, such as law firms, CPA firms, and investment firms, the full deduction is not allowed unless the owners’ taxable income is less than $157,500 for single filers and $315,000 for joint filers. If a taxpayer is above these income levels, the deduction is reduced as income rises and is completely lost when a taxpayer gets to $207,500 in taxable income for single filers and $415,000 for joint filers. When a taxpayer hits these upper limits, the taxpayer must treat passthrough income the same as under the old rules, with income flowing through and being fully taxed at individual rates with no deduction.
Professional firms affected by this rule include those where the “principal asset of the business” is the “reputation or skill” of their employees or owners. Medical practices, law firms, accounting and financial services firms are included as well as firms that offer professional services in the areas of consulting, athletics, brokerage services, investment management services and dealing in securities, partnership interests, or commodities.
Interestingly, the final bill excluded engineering firms and architectural firms from the professional service limitations. These firms are not subject to the strict income limitations.
Qualified Business Income Includes Rental Real Estate
A second requirement is that the passthrough deduction only be applied against “qualified business income”, defined as net income from the business (ordinary income less ordinary deductions, or the operating income of the business). Income from rental property reported on Schedule E qualifies for the deduction as do REIT dividends, cooperative dividends and publicly traded partnership income of the taxpayer.
Qualified business income does not include compensation paid to owners, including “reasonable compensation” paid to S Corporation owners, a partner’s guaranteed payments for services, or any amount paid to a partner for services outside the role of partner.
Example: A partner who has partnership profits of $150,000 plus receives a guaranteed payment of $50,000 may only take the deduction on the $150,000, not the full $200,000 in income that the partner is getting from the business.
Qualified business income also does not include investment-type income, such as capital gain or loss, dividend income or interest income. Finally, taxpayers cannot take the deduction against foreign earnings—income that is not “effectively connected with the conduct of a U.S. trade or business.”
Once you determine the amount of qualified business income, the deduction is calculated as the lesser of:
1) the “combined qualified business income” of the taxpayer;
2) 20% of taxable income over net capital gain.
Example: If a taxpayer has taxable income of $100,000 which includes $30,000 of net capital gains, the deduction would be limited to 20% of $70,000 ($100,000 – $30,000), or $14,000.
Combined business income takes into account both income and losses from passthrough investments. In other words, if a taxpayer has losses from one passthrough business that exceed the income from another passthrough, the taxpayer’s deduction would be $0. In short, taxpayers must aggregate their qualified business income and, if they have a loss overall, they will get no passthrough deduction.
Wage Cap and Depreciable Property
For taxpayers who are not in the professional services business, two other limitations come into play once those taxpayers reach the $157,500/$315,000 thresholds. The deduction allowed is the lesser of 20% of qualified business income or 50% of the W-2 wages paid by the flow-through entity.
Taxpayers who hold depreciable business assets have another option for increasing their passthrough deduction. Those taxpayers can use an alternative measure to compute their allowable deduction, the cost of depreciable property used in the business.
For capital-intensive businesses, the taxpayer’s deduction can be computed as the higher of:
1) 50% of the W-2 wages paid by the business
2) 25% of wages paid plus 2.5% of the cost of tangible depreciable property held by the business.
Where there is more than one owner, the taxpayer’s deduction is calculated based on the taxpayer’s allocable share of the W-2 wages and depreciable property cost. The “cost of depreciable property” is the unadjusted basis of assets used in the business. The good news is that the unadjusted basis can be used even if a taxpayer has written off the assets in full immediately under the new expensing provisions.
Example: A taxpayer has $1,000,000 of qualified business income and a potential $200,000 passthrough deduction. If the business’s wages equal $140,000 and the business holds $1.5 million in depreciable property, the deduction limitation would be calculated as:
1) $70,000 (50% of $140,000 in W-2 wages)
2) $35,000 (25% of wages) plus $37,500 (2.5% of $1.5 million) equals $72,500.
The taxpayer would deduct the higher amount of $72,500.
Note that these limitations are computed on a business-by-business basis, so you cannot use W-2 wages from one business to compute the deduction for a different business.
The new tax law starts out with a new 20% deduction for passthrough income, but the deduction will apply very differently depending on the type of business the passthrough is in.
The most restrictive rules apply to professional services businesses. The passthrough deduction is restricted or completely eliminated for high-income sole proprietors, S Corporations, LLCs, and partnerships that involve practice in the professional services industry. Engineers and architects, however, are not affected by these limitations.
For other firms, the full 20% passthrough deduction may not be available if the business does not have many W-2 employees because of the W-2 wage limitation. Passthroughs in capital intensive industries like real estate, however, can avoid the W-2 wage restriction if they have valuable depreciable assets held in the business.
The new rules present planning opportunities around the concept of “qualified business income.” Business owners will have to strategize to find ways to get their passthrough income classified as “qualified business income.” For example, S Corporation owners may try to reduce their W-2 wages and take more company income out as profits, but they still must adhere to a “reasonable compensation” standard. Partners can voluntarily limit their guaranteed payments. The ability to make these kinds of changes will become more clear as IRS releases regulations and rulings interpreting the new law.
Other Important Points
- The 20% passthrough deduction is a below-the-line deduction but is not treated as an itemized deduction. That means taxpayers can take it even if they do not itemize, which is good for small businesses.
- The deduction will not lower a taxpayer’s AGI, which is unfavorable because many restrictions and phase-outs in the tax Code key off the AGI figure. Lower AGIs are more beneficial to taxpayers.
- The 3.8% net investment income tax still applies to passthrough income for taxpayers who hold passive interests.
Considering the complexity and number of what-ifs regarding the new law, it is important to consult your tax advisor at Frazier & Deeter to help you take advantage of planning opportunities presented by the new 20% passthrough deduction.
Lucia Nasuti Smeal is a guest blogger on tax topics for Frazier & Deeter. Smeal is an attorney, a tax professor with Georgia State University’s J. Mack Robinson College of Business, and former editor of Tax Notes Today, published by Tax Analysts. Smeal also worked as a legislative analyst for the Congressional Research Service and is a former member of the U.S. House Periodical Press Corps. She is a frequent speaker on current tax developments.