Tax Reform Brings Favorable but Complicated Treatment of Pass-Through Business Income by Thomas L. Smitha, JD, CPA
Posted on January 21, 2018
While the Tax Cuts and Jobs Act (TCJA) reduces the corporate tax rate significantly from 35 percent to a flat 21 percent, the tax rate on income earned by many pass-through entities organized as LLCs, partnerships, S corporations, or sole proprietorships is also reduced albeit in a more complicated manner. According to the Brookings Institute, approximately 95 percent of small businesses are organized as pass-through entities, so the impact of the new pass-through tax rate reduction is important.
Under the TCJA, for tax years beginning on Jan. 1, 2018, and before Jan. 1, 2026, owners of qualifying pass-through entities may, subject to certain limitations, deduct at the individual owner level, up to 20 percent of the U.S.-source qualified business income (QBI) that passes from their businesses through to their personal income tax returns. QBI is a new tax term defined as ordinary passive or active income earned from a trade or business less ordinary deductions. QBI also includes qualified dividends received from REITs, qualified cooperative dividends, qualified income from publicly traded partnerships, and income generated from rental property or from trusts and estates with interests in qualifying pass-through entities. Excluded from the QBI deduction is foreign income, investment income, and wages that owners/partners earn as employees of those businesses.
When individual taxpayers qualify to claim the full 20 percent deduction on QBI, the remaining pass-through income they report on their individual income tax returns will be subject to a top effective tax rate of 29.6 percent. This cap is based on the TCJA’s new top individual income tax rate of 37 percent applied to 80 percent of an entity’s QBI. While this is quite an improvement from the top rate of 39.6 percent that was in effect prior to the TCJA, the new reduced rate for pass-through income is subject to a myriad of complex calculations and phase-out rules that taxpayers must plan for carefully.
Limitations Based on Income and Wage Thresholds
To qualify for the full 20 percent QBI deduction, business owners’ total taxable income (before the QBI deduction) must be at or below $157,500 for individual taxpayers or $315,000 for married taxpayers filing joint returns. When a business owner’s taxable income exceeds these thresholds and the pass-through entity is not a specified service business, the QBI deduction will be limited, based on the business’s W-2 wages and capital investments.
More specifically, the QBI deduction for individuals with taxable incomes above these thresholds is limited to:
- The lesser of 20 percent of QBI, or
- The greater of:
- 50 percent of the business’s W-2 wages; or
- 25% percent of W-2 wages plus an additional 2.5 percent of the unadjusted basis (purchase price) of qualifying tangible depreciable property that generates trade or business income, including buildings, furniture, fixtures and equipment.
With this in mind, owners of pass-through businesses that pay large sums of employee W-2 wages may be able to take a larger QBI deduction than owners of businesses that pay less wages or have fewer W-2 employees. The same is true for owners of businesses with significant investment in tangible assets, such as real estate and equipment, who may be in a better position to maximize their QBI deduction than entities that are not as capital intensive.
As a result of these new rules, qualifying pass-through businesses should plan and project their future taxable incomes at both the entity and individual owner levels while considering the pros and cons of their entity choice. In some instances, it may make sense for a pass-through business to convert to a C corporation and take advantage of the new 21 percent corporate tax rate. Alternatively, business owners may maximize their QBI deductions when they increase their capital investments and buy depreciable property that they previously leased, or when they hire more employees to increase their W-2 wage base, rather than relying on independent contractors.
Treatment of Professional Service Businesses
The law limits the preferential treatment of pass-through business income when it is earned through 1) a “specified service trade or business” in which the principal business assets are the skills and/or reputation of one or more of the owners or employees, or 2) the trade or business of performing services as an employee. More specifically, the law references businesses that involve the delivery of services in the fields of medical care (i.e., physicians, dentists, nurses), legal counsel, accounting and tax counsel, actuarial sciences, performing arts, consulting, athletics, financial services, and financial brokerage services. Due to some last-minute law changes, architectural and engineering services were eliminated from the “specified service trade or business” treatment.
In general, the full 20 percent QBI deduction is available when an owner’s taxable income, including specified service business income but excluding the QBI deduction, is less than $157,500 for individuals or less than $315,000 for married couples filing joint tax returns. When the owner’s taxable income exceeds these ceilings, the 20 percent deduction is gradually phased out, and the owner may receive a reduced QBI deduction. Once taxable income reaches $207,000 for single filers, or $415,000 for joint filers, the QBI deduction for specified service business pass-through income is fully phased out, and the business owner receives no QBI deduction for that pass-through business. To the extent the QBI deduction is limited or eliminated, pass-through business owners will be taxed at their individual rates on their pass-through income, which the TCJA maxes out at 37 percent for individual taxpayers with taxable income of $500,000 or more, or $600,000 or more for married couples filing jointly.
As a result of these specified service businesses restrictions, medical and dental practices, law firms, accounting firms, and other entities whose services include “consulting” or whose primary assets are the skills and reputation of one or more owners or employees, should carefully consider their current structures and project future tax liabilities and potential savings they may yield by restructuring as C corporations. For some entities, such as those that reinvest profits back into the businesses rather than paying dividends to their owners, a timely conversion to a C corporation may allow them to take advantage of the preferable 21 percent tax rate on corporate profits.
Alternatively, specified service business owners may consider separating out each income-generating aspect of their business operations under different structures. For example, a doctor may form a separate legal entity to hold his or her ownership of an office building or surgical center. This will effectively remove revenue generated from real estate assets from the physician’s service income and keep service income below the legislative limits. In addition, owners of specified service business who file joint tax returns with their spouses may instead consider whether electing married filing separately status might increase their QBI deduction.
The new flow-through deduction rules and QBI calculations incorporate other less common income and loss sources, such as the carryover of qualified business losses, income from qualified REIT dividends, publicly traded partnerships income and losses, and capital gains. While not addressed in this article, taxpayers with flow-through businesses should comprehensively address all QBI factors to ensure an accurate QBI deduction.
Unlike many of the business-related provisions contained in the Tax Cuts and Jobs Act, the deduction of pass-through business income is temporary. Moreover, the future political climate, including the 2020 elections, may shift the power in Washington, D.C., away from the Republicans and result in a repeal of all or some parts of the TCJA before the Dec. 31, 2025 expiration date.
In light of these facts and the complexity of interpreting the QBI rules for pass-through businesses, it is critical that entrepreneurs meet with their accountants and tax advisors during the first half of 2018 to properly plan for these new laws and optimize their tax savings without incurring undue risks or derailing their business and financial goals. The best course of action will depend on each taxpayer’s unique facts and circumstances.
About the Author: Thomas L. Smitha, JD, CPA, is an associate director of Tax Services with Berkowitz Pollack Brant, where he provides accounting and consulting services, as well as tax planning and tax structuring counsel to private and publicly held companies. He can be reached at the CPA firm’s Miami office at (305) 379-7000 or via email at firstname.lastname@example.org.