The Tax Cut and Job Act of 2017, which took effect on Jan. 1, 2018, made a number of significant changes in the wonderful world of tax law. Among the exciting new changes set forth in the new regime is a brand new income tax deduction for tax-savvy business owners who own their interests in pass-through entities (i.e., partnerships, LLCs, S-corporations and sole proprietorships).
A short and sweet explanation of the not-so-short-and-sweet new law: Any taxpayer that owns an interest in a pass-through entity may qualify for up to a 20 percent income tax deduction on the income of that business.
Simple, right? In some cases, yes. In others, a resounding no. The applicable Code section (I.R.C. § 199A) treats different taxpayers differently with respect to this deduction. Whether the deduction applies at all and to what extent it applies depends on a variety of factors including the total income of the taxpayer, type of business in which the taxpayer is engaged, wages paid by the taxpayer’s business and property owned by the taxpayer’s business.
If you are a single, business-owning taxpayer with total income less than $157,500 or a joint filer making less than $315,000, you may take the full 20 percent deduction on income earned through the pass-through entity. For taxpayers at this income level, the deduction applies to you, regardless of the type of business in which you are engaged and irrespective of the wages your business pays to its employees or the property owned by the business.
On the other hand, if you are a single business-owning taxpayer with total income in excess of $207,500 or a joint filer making more than $415,000, whether and to what extent the deduction will apply to you will depend on the type of your business, the amount of wages your business pays to employees and the property your business owns. As a preliminary matter, if the pass-through business is engaged in what the Code defines as a “specified service” business, no deduction is available. The definition of specified service businesses generally includes businesses that perform services in the fields of health, law, accounting, financial or brokerage services, as well as professional artists and athletes. This definition means that taxpayers at this income level who own medical practices, law firms, consulting firms, etc., are out of luck when it comes to this deduction. For taxpayers at this income level that are in other, non-specified service businesses, the deduction will be reduced, and may be eliminated, based on the wages the business pays to its employees and the property it owns. The calculation related to the phase out for taxpayers at this level is quite complex. Suffice it to say – if you are a taxpayer at this income level with an interest in a pass-through entity that is not a specified service business, a discussion with your CPA or tax attorney is in order.
And finally, for the income “tweeners,” that is—the single business-owning taxpayers with total income between $157,500 and $207,500 or joint filers with income between $315,000 and $415,000—your pass-through business may be entitled to an income tax deduction, thanks to the TCJA, but you will not receive the full 20 percent deduction, thanks to the phase-in quality of the limit to the deduction which is triggered when the taxpayer’s total income reaches $157,500 ($207,500 for joint filers). Again, the complexity of the deduction in light of this phase-in limit precludes a discussion in this brief article of how the phase-in limit is calculated.
A couple of caveats of the new law should also be noted:
- An owner of a pass-through entity must take into account only his or her interest (i.e., allocable share of the income, gain, deduction and loss) in determining the “qualified business income” against which the deduction may apply.
- The deduction only applies to owners of these pass-through businesses, not employees, meaning that an employee cannot take the deduction against his or her wage income.
- The deduction only applies to “qualified business income” which does not include certain investment-related income (i.e., capital gains, dividend income, interest income, etc.).
Taxpayers can claim the deduction for the first time on a 2018 federal income tax return, which, of course, is due to be filed in 2019. Unless repealed or modified, this deduction will be available until January 1, 2026. If you believe you might be entitled to this deduction, you should consult with a tax professional.
J. Scot Kirkpatrick is a shareholder in the Atlanta office of Chamberlain Hrdlicka and leads the firm’s Trusts and Estates Practice. He counsels clients in a variety of tax and estate matters including planning for business owners, high net worth individuals and their families.
J. Thompson Turner is an associate in the Atlanta office of Chamberlain Hrdlicka and a member of the firm’s Trusts and Estates Practice. He focuses his practice on all aspects of sophisticated estate and wealth transfer planning and estate and trust administration.