By: Bruce Ruotsala, CPA, Senior Staff Accountant
Probably the most anticipated, and misunderstood, provision of the Tax Cuts and Jobs Act (TCJA) is the business pass-through deduction. The purpose is to provide some parity between the newly lowered corporate tax rates and the tax rates paid by pass-through entities. (Pass-through businesses pay tax on all earnings at individual tax rates, which can be much higher than the marginal corporate tax rate).
Currently, owners of partnerships, S corporations, and sole proprietorships – as “pass-through” entities – pay tax at the individual rates, with the highest rate at 39.6 percent. The highest rate is reduced to 37 percent under the Tax Cuts and Jobs Act. The Act also allows a temporary deduction in an amount equal to 20 percent of qualified income of pass-through entities, subject to a number of limitations and qualifications. Conversely, the Tax Cuts and Jobs Act limits the deduction for excess business losses from pass-through entities.
Pass-through Income Deduction
Noncorporate taxpayers may deduct up to 20 percent of domestic qualified business income from a partnership, S corporation, or sole proprietorship (Code Sec. 199A deduction). This deduction is essentially a replacement for a previous deduction, the Domestic Production Activities Deductions (Former DPAD Sec 199), which had only been available to certain manufacturing and building activities. A limitation based on wages paid, or on wages paid plus a capital element, is phased in for taxpayers with taxable income above a threshold amount. The deduction is not allowed for certain service trades or businesses, but this disallowance is phased in for lower income taxpayers.
Effective for tax years beginning after December 31, 2017 and before January 1, 2026, a taxpayer other than a corporation is entitled to a deduction equal to 20% of the taxpayer’s “qualified business income” earned in a “qualified trade or business.” The deduction is limited, however, to the greater of:
- 50% of the W-2 wages with respect to the qualified trade or business, or
- The sum of 25% of the W-2 wages with respect to the qualified trade or business, plus 2.5% of the unadjusted basis immediately after acquisition of all qualified property.
Thankfully, the W-2 and qualified property-based limitations do not apply when the taxpayer claiming the deduction has taxable income for the year of less than $315,000 (if married filing jointly, $157,500 for all other taxpayers. Taxpayers under these threshold amounts simply claim the 20% deduction without limitation.
Caution. The Tax Cuts and Jobs Act provides rules that would prevent pass-through owners—particularly service providers such as accountants, doctors, lawyers, etc.—from converting their compensation income taxed at higher rates into profits taxed at the lower rate.
Limit on Excess Business Losses for Noncorporate Taxpayers
Under the Tax Cuts and Jobs Act, noncorporate taxpayers are only allowed to deduct $250,000 of business losses against other income. The remainder has to be carried forward as a Net Operating Loss (NOL).
Example: For 2018, Ned Brown has $1,000,000 of gross income and $1,400,000 of deductions from a retail business that is not a passive activity. His excess business loss is $150,000 ($1,400,000 – 1,000,000 – $250,000). Brown must treat his excess business loss of $150,000 as an NOL carryover to 2019.
The result of this provision is that an individual taxpayer is limited to offsetting a maximum of $250,000 of business loss against other income for the tax year. In the example, if Ned Brown reported wages of $400,000 (and no other income) in 2018, his adjusted gross income would be $150,000. Under present law, all of the $400,000 of losses can be used to offset wage income to arrive at adjusted gross income of $0.
While the pass-through income deduction is likely one of the most substantial changes for small business taxpayers, there are several other changes to be aware of as well:
- Changes to personal exemption and standard deduction: The personal exemption has been eliminated, but conversely the standard deduction has been nearly doubled to $12,000 for single and $24,000 for married taxpayers. In order to relieve the burden of the elimination of personal exemptions for taxpayers with children, the child tax credit has been increased to $2,000 per child.
- Withholding: The IRS has updated withholding tables in an effort to put more money into people’s paychecks by reducing tax withholding. However, this adjustment may or may not be accurate depending on your individual tax situation. Due to all of the tax changes taking effect, it is recommended to use the IRS.gov withholding calculator to see if your withholding will be appropriate. This is probably one of the areas that will most likely cause surprise tax bills come tax season.
- Itemizing: Although the changes in the standard deduction will greatly reduce the number of taxpayers who will itemize, the Schedule A can still be an important tax break for certain taxpayers. However, with the State and Local Income Tax and property tax deduction now capped at $10,000, it will be more difficult to itemize.
- Home Loan Interest: Home equity interest will still be deductible, but only if it is used to buy, build, or substantially improve the taxpayer’s home that secures the loan. The total deductible residential debt has been decreased from $1,000,000 to $750,000 for a MFJ taxpayer.
If you have any questions on how the pass-through income deduction or the individual tax changes of the TCJA affects your tax liability, please reach out.