The Tax Cuts and Jobs Act (TCJA) created a new 20% deduction for pass-through entities. Though the IRS has not fully interpreted the new rules—which won’t go into effect until the 2019 tax season—many of the implications are clear. This article’s companion piece examined what qualifies as a Pass-Through Entity (PTE).
This blog hopefully sheds some light on how PTEs will be impacted by the new law.
Why a Deduction for Pass-Through Entities?
Since their inception, pass-through entities have been a popular choice for entrepreneurs, especially after the 1986 Tax Reform Act (TRA). Better known as President Reagan’s second tax cut, the TRA was passed by Congress to simplify the tax code and adjust the federal tax brackets.
The TRA lowered individual rates from 50% to 28%, although later tax bills raised that rate and formed new tax brackets for high-income earners. Since the bottom corporate tax rate in 1986 was 34%, the TRA made pass-through entities an enticing structure for tax purposes.
Starting in 2018, the Tax Cuts and Jobs Act will lower the corporate tax rate to 21%, far below the current top individual rate of 37%. Had Congress stopped there, it would have effectively flip-flopped the PTE tax advantage. To maintain this balance, Congress adopted a 20% deduction for pass-through entities.
Qualified Business Income & Thresholds
The Tax Cuts and Jobs Act provides a 20% deduction on qualified business income (QBI) for all pass-through entities below specific thresholds. To understand how the deduction is applied, you must first understand how QBI is calculated and what the thresholds are.
- Qualified business income is all ordinary income minus deductions. It does not include:
- Wages earned as an employee
- Guaranteed payments (payments made to owners regardless of company profits)
- Short and long-term capital gains or losses
- Dividend and interest income
Imagine you were an S-corporation owner with total revenues of $100,000. If you paid yourself a reasonable wage of $40,000, then those wages would not count towards QBI.
Business owners are not eligible for the 20% deduction above certain thresholds: $157,500 for individuals, and $315,000 for couples filing jointly. The loss of the deduction, however, is phased-in over a particular range. That range is $50,000 above the threshold for individuals, and $100,000 above the threshold for couples filing jointly. Within the phase-in range, you still qualify for a deduction, but not the full 20%.
Limitations & Exceptions
If your taxable income is beneath the threshold, you’re in great shape. You can take the 20% deduction regardless of your business type, and you can take the deduction in full.
Above the threshold, however, the math gets tricky.
At this writing, the IRS has not released complete rules for implementing the calculations and deductions found in the TCJA. For this reason, we will limit examples and examine the broader implications.
Above the threshold, a number of limitations kick in, specifically:
- W2 Wage Limits
- Phase-In Ranges
- Disqualification for Specified Services & Trades
W-2 Wage Limitations
Once you’re above the threshold, W-2 wage limits kick in. The formula for calculating the deduction is as follows:
- The lesser of:
- 20% of QBI,
- The greater of:
- 50% of W2 wages, or
- 25% of W2 wages plus 2.5% of unadjusted basis of qualified property
This wage limitation is critical to ensuring that high-wage-earners cannot dodge taxes by transitioning from being employees with their current employer to PTE owners independently contracting for the same service.
The threshold is not an absolute line. Once you’re above it, the phase-in range applies:
- Individuals: $157,500 to $207,500
- Couples: $315,000 to $415,000
The phase-in limits the amount of deduction you can receive. It is progressive, so the higher your income—the closer it comes to the end of the range—the lower your deduction. If your income lands 60% of the way through the range, you lose 60% of the benefit.
At the end of the range, the deduction disappears entirely.
Specified Trades & Businesses
The TCJA disqualifies all specified service trades or businesses from receiving the new deduction, but this disqualification only occurs beyond the phase-in range. If you’re below the range, your business is still eligible.
A specified trade/business is a PTE in which the principal asset is the reputation or skill of one or more of its employees. The TCJA singles out the fields of health, law, accounting, consulting, and financial and brokerage services, but other fields apply.
The TCJA makes an exception to the specified trades and businesses in the form of qualified property. Qualified property (QP) is any tangible property utilized by your business to generate profit.
Many real estate companies generate income with few employees. Look again at the TCJA formula for calculating deductions above the threshold:
- The lesser of:
- 20% of QBI
- The greater of:
- 50% of W-2 wages, or
- 25% of W2 wages plus 2.5% of unadjusted basis of QP
Without the addition of qualified property, a real estate PTE with few employees—and thus little W-2 wages—would receive only a meager deduction.
Imagine two companies conducting exactly the same business and generating precisely the same income. Company A is an S-corporation. It’s owner, Barbara, pays herself $175,000 in W-2 wages. Company B is structured as a partnership. It’s owner, Amy, receives guaranteed payments in the same amount.
Both companies are subject to wage limitations and phase-in. But the formula is calculated upon W-2 wages and QBI, and when calculating QBI guaranteed payments are excluded. Thus, Barbara will qualify for a deduction, while Amy will not.
Same business. Same income. Different tax breaks.
It is unlikely Congress intended such a result, although it is not entirely surprising. New tax laws often require clarification from the IRS. As of now, the IRS has not announced when it will release guidance for every aspect for the TCJA, but disclosures can be found on the Department of Treasury website.