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 starting in 2018. 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. Let’s dive into the details and see how this effects your business.
Pass-through Income Deduction
Non-corporate taxpayers may deduct up to 20 percent of domestic qualified business income from a partnership, S corporation, or sole proprietorship (Code Sec. 199A deduction). A similar deduction is allowed for specified agricultural or horticultural cooperatives. Unfortunately there are limitations if you cross over the income thresholds for single filers with taxable income above $157,500 or for joint filers with taxable income above $315,000. Those limitations include a calculation of your deduction that may not exceed the greater of: 50% of the W-2 wages paid by the business or 25% of the W-2 wages paid by the business plus 2.5% of the unadjusted basis of depreciable property owned by the business. In addition, the deduction is not allowed for specialized trade or business income which includes income stemming from performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any business where the principal asset of the business is the reputation or skill of one or more of its employees. The deduction applies to tax years from 2018 through 2025.
For individual taxpayers, the Code Sec. 199A deduction is not allowed in determining adjusted gross income. Further, it is not an itemized deduction, but it is available to individuals who itemize deductions and to those who claim the standard deduction. However, the deduction amount cannot be more than the taxpayer’s taxable income (reduced by net capital gain) for the tax year.
The Code Sec. 199A deduction is similar to the domestic production activities deduction under Code Sec. 199, in that both allow taxpayers to deduct a portion of their “taxable income” if it is less than a portion of their relevant business income. Also, neither deduction can be claimed if the taxpayer has no relevant business income. It is anticipated that the IRS will provide a new worksheet or form for calculating the Code Sec. 199A deduction, similar to Form 8903, Domestic Production Activities Deduction.
Example : Bob works as an executive with a large company and earns a W-2 salary of $500,000. In addition, he is the sole owner of an LLC that owns rental real estate. Bob reports net profit from the LLC of $300,000 and has total taxable income of $720,000 (before application of the pass-through deduction). The unadjusted basis of the LLC properties is $1,400,000, and the LLC pays W-2 wages to a property manager of $80,000.
Bob is well beyond the phase-out range, but since LLC is not a specialized service trade or business, he is not precluded from taking the 20% pass-through deduction. Rather, instead of simply applying the deduction to the lesser of eligible business income, or taxable income, less capital gains, we must now incorporate the third test noted above. As a result, Bob’s pass-through deduction will be $55,000, which is the lowest of the following amounts:
1) $60,000, which is 20% of Bob’s eligible business income of $300,000
2) $144,000, which is 20% of Bob’s taxable income of $720,000
3) The greater of:
- $40,000, which is 50% of the LLC’s W-2 wages of $80,000
- $55,000 which is 25% of the LLC’s W-2 wages of $80,000 plus 2.5% of the $1,400,000 unadjusted basis of the LLC property
Limit on Excess Business Losses for Non-corporate Taxpayers
Under the Tax Cuts and Jobs Act, excess business losses of non-corporate taxpayers are not allowed for tax years beginning after December 31, 2017, and before January 1, 2026. Any excess business loss that is disallowed is treated as part of the taxpayer’s net operating loss (NOL) carryover to the following tax year.
Non-corporate taxpayers must apply this rule for excess business losses after applying the passive activity loss rules. For partnerships and S corporations, the limit on excess business losses is applied at the partner or shareholder level.
Comment: For losses arising in tax years beginning after December 31, 2017, an NOL may generally only reduce 80 percent of taxable income in a carryback or carryforward tax year.
An “excess business loss” is the excess, if any, of
(1) the taxpayer’s aggregate deductions for the tax year from the taxpayer’s trades or businesses, determined without regard to whether or not such deductions are disallowed for such tax year under the excess business loss limitation; over
(2) the sum of
(a) the taxpayer’s aggregate gross income or gain for the tax year from such trades or businesses, plus
(b) $250,000, adjusted for inflation (200 percent of the $250,000 amount in the case of a joint return).
The $250,000 amount is adjusted for inflation for tax years beginning after December 31, 2018.
If you are curious as to how the pass-through income deduction will impact your taxes, please contact your L&B professional at (858) 558-9200.