Tax Cuts and Jobs Act: Pass-Through Deduction
This month’s article details a rather complicated section of the Tax Cuts and Jobs Act, and we would like to break it down to its simplest form so you can rest easy knowing exactly how it relates to your business. Let’s discuss Section 199A of the law which covers the new 20% deduction for pass-through income from S Corporations, LLCs, partnerships, and sole proprietorships.
Right off the bat, if you receive pass-through income and your taxable income is less than $315,000, you automatically qualify to receive a special 20% deduction on the LESSER OF your qualified business income (QBI) or taxable income.
If this applies to you, you have all the information you need. That was easy, right?
Things get a bit more complicated as taxable income rises over $315,000, but here is an essential overview of the key aspects.
The first question you must answer is whether or not you qualify as a “specified service business.” As currently defined, this includes…
- Law firms
- Health care
- Financial services
- Consulting, and
- Brokerage services
Additionally, if your business is dependent on the reputation of you or your employees to generate revenue, you also fall under the “specified service business” category. It is important to note as well that architectural and engineering firms are exempt from consideration as specified service businesses.
From here, let’s break down the businesses into two subsections: Specified Service Businesses and Non-Specified Service Businesses, and discuss how the credit rules apply within each category.
Specified Service Businesses
As noted above, if you receive pass-through income and your taxable income is less than $315,000, you qualify for a 20% deduction on the lesser of your QBI or taxable income.
If your taxable income is anywhere between $315,000 and $415,000, you receive a partial deduction based upon a prorated calculation.
If your taxable income is greater than $415,000 you do not qualify for this special deduction.
Non-Specified Service Businesses
On the other side of the scale, if your business does not fall under the “specified services” net, there may be additional calculations you must make.
Again, as stated above, if you receive pass-through income and your taxable income is less than $315,000, you automatically qualify for a 20% deduction on the lesser of your QBI or taxable income.
Under the “non-specified service business” net, if your taxable income is between $315,000 and $415,000, you qualify for a deduction that is determined using a prorated calculation factoring in W-2 wages and qualified business property as discussed below.
If your taxable income is greater than $415,000, you must meet an additional standard related to W-2 wages paid to your employees and/or your qualified business property. In this scenario, you may deduct the LESSER OF
- 20% of your QBI or taxable income, or
- The greater of 50% of W-2 wages paid to employees or 25% of W-2 wages plus 2.5% of qualified business property
You may be thinking, wait…what? We know how you feel. To clear things up, let’s look at it again using an example.
Assume that your company has a QBI of $500,000 per year, taxable income of $420,000, the total amount of W-2 wages paid to employees is $150,000, and your qualified business property is equal to $1,000,000. This would mean…
- 20% of your QBI (20% x 500,000 = 100,000)
- 20% of your taxable income (20% x 420,000 = 84,000)
- 50% of W-2 wages paid to employees (50% x 150,000 = 75,000), and
- 25% of W-2 wages plus 2.5% of qualified business property
- (25% x 150,000 = 37,500)
- (2.5% x 1,000,000 = 25,000)
- Which, together, equals 62,500
The first step is to determine which is the lesser value between your anticipated QBI deduction and your taxable income deduction. In this case, it would be the taxable income deduction at $84,000.
Next, calculate which is the greater value between 50% of W-2 wages ($75,000) and 25% of W-2 wages plus 2.5% of qualified business property ($62,500). We can conclude here that the greater value is 50% of W-2 wages at $75,000.
Following so far?
Now that we know which two values to compare, the final step is to take the LESSER OF these two deduction values (taxable income of $84,000 and 50% of W-2 wages at $75,000). The smaller value here is $75,000, and therefore would be the final overall value your business could deduct.
Clear as mud, right? We understand that Section 199A is a complicated element of the new tax law and we would be delighted to discuss how it applies to you. We recommend contacting Shaw & Associates (or your own financial advisor if you use a different tax preparer) to determine the impact of this law on your business specifically and how to proceed. Please give us a call or schedule an appointment—following tax season please—and we will be happy to help!