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A Closer Look at New Pass-Through Rules Under the TCJA

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A Closer Look at New Pass-Through Rules Under the TCJA

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Red Ring Binder with Inscription Tax Law on Background of Working Table with Office Supplies, Laptop, Reports. Toned Illustration. Business Concept on Blurred Background. 3d Render.-1One of the most important — and complicated — changes established by the new Tax Cuts and Jobs Act (TCJA) is Section 199A, which concerns the type of businesses known as "pass-through entities," also known as flow-through entities.

Basically, these businesses pass their profits on to their individual owners. That's how most small businesses work, including S corporations, partnerships and LLCs. (Sole proprietorships handle business income in a similar way using Form 1040 Schedule C and are also covered by the new rules.)

The good news is that if you own one of these businesses, you may get as much as a 20% reduction in taxes on business net income under the new rules. The calculations can be very complex, however. Several factors — including your level of income, your profession and the amount your business spends on wages and property acquired during the year — determine the actual deduction. Let's take a closer look.

Tax Reform Background
The TCJA, signed in December 2017, changed the corporate tax rate structure to a flat 21% rate from a progressive scale with a top rate of 35%. That meant many pass-through business structures would pay more than regular C corporations. To offset this, Congress gave pass-through owners the new 20% business income deduction.

But Congress also put in place special rules limiting the ability of "specified service trades or businesses (SSTBs)" to take the full deduction. The list includes health, law, consulting, athletics, financial services, accounting firms "or any trade or business where the principal asset is the reputation or skill of one or more of its employees or owners."

So if you own a business that uses a pass-through business structure, you now pay tax on those profits based on your individual tax rate in conjunction with other income.

How to Determine Your Deduction — Easy Cases
First, make a rough calculation of your expected qualified business income (QBI). Generally, that's your net income from all your business entities. QBI does not include reasonable compensation to a shareholder paid from an S corporation or guaranteed payments paid to a partner. QBI is figured separately for each business activity, not on a per-taxpayer basis. The net QBIs from all trades or businesses are then aggregated and are subject to further limitations.

  • Easy Case 1: If your taxable income is less than $157,500 as an individual filer, or $315,000 as a married couple filing jointly, you can take the 20% deduction from your QBI.
  • Easy Case 2: If your taxable income is greater than $207,500 as an individual filer, or $415,000 as a married couple filing jointly, and you are in one of the SSTBs mentioned above, you can't take the deduction.

How to Determine your Deduction — Hard Cases
If you don't fall into either of the cases listed above, figuring out your pass-through deduction is much more difficult. Let's say you're a small-business owner with taxable income of more than $157,500 as an individual filer ($315,000 for married filing jointly) but less than the phase-out of $207,500 as an individual filer ($415,000 married filing jointly).

After your taxable income passes the threshold amount of $157,500 as an individual filer, or $315,000 as a married couple filing jointly, special wage and capital limits that reduce your deduction start to apply. And after your taxable income passes the threshold amount plus the phase-out amount, the wage and capital limits are applied fully in reducing your deduction. Now, you'll still get a reduced deduction … unless you're in one of those SSTBs. In that case, your deduction is eliminated completely.

The formula for calculating the wage and capital limits is based on the greater of 50% of the W-2 wages paid by your business, or 25% of the W-2 wages, plus 2.5% of the unadjusted basis immediately after acquisition of qualified property.

Sound confusing? The calculation will be straightforward in some cases, but not all. And more changes are probably coming.

The Rules Are in Flux
Every tax reform bill is subject to technical amendments that clarify what is confusing or fix what's not working the way lawmakers intended. The TCJA will likely be no different. The pass-through rules are among the most complicated parts of the act, so many of the moving parts will likely change over the coming months.

If you own a pass-through business, you'll need help navigating the choppy waters of tax reform. We suggest you schedule a consultation with your tax advisor as early as possible.

Rick Punturo is co-founder and managing partner of Bernstein & Punturo, LLP. He is also the President of Punturo Financial Services, Inc.
Rick Punturo

Author:

Rick Punturo

Co-founder and managing partner of Bernstein & Punturo, LLP

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This website is created by Supporting Strategies to provide general bookkeeping and accounting information only. Supporting Strategies does not provide tax, legal or accounting advice, and the information contained herein is not intended to do so. As such, the information provided should not be used as a substitute for consultation with professional tax, legal, and accounting advisors, and you should consult with a tax, legal and accounting professional before engaging in any transaction.