The New 20% Deduction on Pass-Through income, What is It? And does it affect you?

There are many intricacies of the new Tax Act that will be discussed and analyzed over the coming weeks and months.  While some of the changes will allow for a tax reduction for "pass-through" entities, the complexities of the tax bill should be discussed with your tax advisor to make sure you understand how it affects you before you make any significant financial or employment changes.  For now, here are some of the guidelines that you should be aware of for the 20 percent deduction on pass-through businesses:

First, pass-throughs include sole proprietorships, partnerships, limited liability companies and S-corporations.  As long as the income of the business flows from the business and is reported on the taxpayer's individual income tax return, you are likely a pass-through entity. 

Second, if your taxable income is under $315,000 (for a married-filing-joint return), or $157,500 for a single person, beginning January 1, 2018, you may qualify to reduce your net domestic “qualified business income” with a 20% deduction. 

For purposes of this article, “qualified business income” means ordinary operating income of a trade or business, but would generally exclude capital gains/losses from trading businesses.  “Net” means qualified domestic business income less allowable deductions.

Your qualified business income may be active or passive, so it may include real estate activities.  Further, under the passive income category, dividends from REITs (Real Estate Investment Trusts) or qualified publicly traded partnerships (but not including capital gains or capital dividends) would qualify.

The 20% deduction will be taken AFTER arriving at adjusted gross income, but before arriving at taxable income.  But keep in mind that net qualified business income would still be subject to Self-Employment taxes and/or Net Investment Taxes, as applicable, before the deduction.

With that said, here is an example:

Rose is a single independent consultant who earns $100,000 a year after expenses.  Since Rose is a sole proprietor, she takes the money from her business as income rather than a salary.  This is what is known as "pass-through" income and it is taxed at personal income rates and is also subject to self-employment taxes.

If Rose takes the standard deduction of $12,000, her taxable income would be $88,000 ($100,000 - $12,000). She, therefore, qualifies to take the business deduction. She would then deduct 20% of her pass-through business income $100,000 x 20% = $20,000.  Her new taxable income would be $68,000 ($100,000 - $12,000 - $20,000).

Phase out rules for the deduction will apply to taxpayers with income between $315,000 and $415,000 for a joint return, and between $157,500 and $207,500 for a single person.

Finally, For taxpayers over these limits, income from service businesses will be strictly limited as to what will be considered qualified business income.  Most service business, other than engineering or architectural services, fall under the definition of being a “specified service trade or business.” If you fall under this definition, you do not qualify for the deduction if your taxable income is in excess of the limits.

The pass-through tax rules are new and can be complex, it is advisable to consult with your tax advisor to ensure that you are planning accordingly with the new tax law in mind.

If you have any questions related to how you and your business might plan ahead for tax efficiencies under the new tax laws, please feel free to contact Glick and Trostin, LLC at 312-346-8258.

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