The Least Understood Aspect of the New Tax Act (and Why It Matters!)

Much has been made of the new 20% tax deduction for S corporations and limited liability companies (LLCs) in the Tax Cuts and Jobs Act of 2017. The 21% tax rate given to C corporations has been a tremendous benefit to those structured in such a way. But what about “equality” for pass-through business entities, such as LLCs and S corporations? That is what the 20% exemption is designed to do — bring at least some degree of parity — allowing only 80% of certain pass-through income to be taxed at higher personal tax rates (equals a 20% rate reduction).

The goal of this article is to help you understand some of the details of this new tax provision, which is one of the most highly anticipated and least-understood aspect of the new law. A special “shout-out” to CPA Steve Throop, a senior tax partner at Hutchinson & Bloodgood, LLP, for bringing his keen eye and sharp pencil to “unstick the stuck” for us on several key points. Bringing clarity to confusing tax code provisions … “Imagine That™”!

Just Who or What is a “Pass-Through” Entity?

Internal Revenue Code Section 199A was created in the new federal tax law which went into effect this year. This section applies to owners of “pass-through” entities, such as S corporations, partnerships, limited liability companies (when taxed as a partnership), limited liability partnerships, sole proprietorships, and trusts and estates which own an interest in a flow-through business.

Good News! The 20% Deduction DOES Apply to Service Providers (With Some Exceptions)

The 20% tax deduction DOES apply to all businesses — including those who are “a specified service business,” which includes doctors, lawyers, accountants, actuaries, performing artists, consultants, athletes, stock brokers, and many others. For those whose taxable income is less than $315,000 (joint filers and $157,500 if filing as single), the benefit is 100%. If the service provider’s income exceeds the $315,000/$157,500 threshold, the deduction is proportionally reduced. Unfortunately, the deduction is lost entirely if the net taxable income exceeds $415,000 (joint filers) or $217,500 (single). Perhaps architects and engineers have better lobbyists, but for whatever reason, they are excluded from the designated service providers, even though they clearly provide services.

Another limiting factor is that wages are not qualified business income. S corporations are required to pay reasonable compensation for services. Therefore, only the excess earnings will be eligible for the deduction. Partnerships and LLCs also often pay “guaranteed payments” for services. Those amounts are also not eligible for the deduction. Therefore, you will have to first identify the actual business earnings passing through to your tax return.

Under Section 199A, the basic deduction is 20% of net “qualified business income” (QBI), or 20% of taxable income less capital gains, if that is less. That is designed so that the already preferential rate on capital gains is not further reduced.

The following table makes it easy to see whether you are entitled to the 20% deduction if you are a service provider:  

  Taxable income for all sources (incl. spouse)                                                                                      20% deduction

Less than $315,000 (joint filers)/$157,500

     Yes

Between $315,000-$415,000/$157,500-$217,500

     Partial deduction

More than $415,000/$217,500

     No

If You are Not a Service Provider, are You Entitled to the 20% Deduction?

If taxable income is less than $315,000 (if married)/$157,500 (if single), then the 20% deduction is available as noted above. If the taxpayer’s taxable income is greater than $315,000/$157,500, you need to do further calculations:

The Qualified Business Income deduction is limited to the LESSER of:

  • 20% of QBI (or 20% of taxable income less capital gains, if that is less)
  • 50% of the total W-2 wages paid by the business (W-2 limit calculation)
  • There is also an alternative limitation based on 25% of the W-2 wages paid plus 2.5% of unadjusted basis of certain business assets (depreciable asset limit calculation)

The following table makes it easier to see whether you are entitled to the 20% deduction if you are not a service provider:

  Taxable income for all sources (incl. spouse)                                                                            20% deduction

Less than $315,000 (joint filers)/$157,500

Yes

Between $315,000-$415,000/$157,500-$217,500

Partial deduction is compared to the W-2 limit and depreciable asset limit calculations phase in

More than $415,000/$217,500

The 20% deduction is compared to the full W-2 limit or depreciable asset limit calculations


Do You Need Help Navigating all the Particulars of Section 199A?

As with every new tax law provision, terms have very specific defined meanings, there are exceptions for various unusual situations not addressed above, and regulations are still needed to clarify some provisions. If you need help in determining how this section applies to your situation, please contact us and we’ll talk through your situation together.

Planning opportunities are available. For example, some business owners might benefit by taking more compensation for themselves to increase their business’s W-2 wage base. Also, larger benefit plan contributions, etc. might reduce total taxable income below a threshold. In addition, some business owners may want to run a comparison to determine whether they should keep their business as a pass-through entity or change to a C corporation to obtain the 21% federal tax rate. And remember, California tax law hasn’t changed to conform. While the tax code is a complex mismatch of assorted provisions, we can help simplify it to your particular situation … “Imagine That™”!

Image Credit: Zerbor/Shutterstock

 

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