Just passing through
Tax reform has reduced the tax burden for many pass-through businesses, but accountants need more guidance from the Internal Revenue Service.
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From the pages of In Business magazine.
The Tax Cut and Jobs Act is still trying to gain some traction in the court of public opinion, but there is little doubt among accountants that it brings tax benefits — significant benefits in many cases — to pass-through businesses. The degree of those benefits is subject to opinion because even though small business confidence has reached record highs, the law’s critics charge that “pass-throughs” do not benefit as much as businesses organized as C corporations.
With a so-called “pass-through” business — such entities comprise the majority of small businesses — corporate profits are taxed according to the owner’s personal tax rate, not the new and much lower 21% corporate rate. Since most small businesses are organized to have income passed through to an owner who then reports it as personal income, we asked local accountants to assess how they make out.
With related rules having been proposed and the period for public comment having passed, it’s now up to the Internal Revenue Service to issue the final rules at some point in the near future. Accounting professionals interviewed for this article cited vague areas of the proposed rules they would like to see clarified in the final regulations, but overall they believe most “pass-throughs” will benefit from the law — with a few notable exceptions.
The best news, according to our tax experts, is that effective this year, owners of pass-through entities will be able to shave 20% off their earnings before paying taxes on it. The TCJA’s 20% deduction is on qualified business income (QBI) from a partnership, S corporation, or sole proprietorship. QBI basically means the net amount of income, gain, deduction, and loss with respect to the trade or business, but does not include certain types of investment such as capital gains or losses, dividends, and interest income unless the interest can be properly allocated to the business.
If your taxable income is more than $157,500 for individual filers or $315,000 for married couples filing jointly, the deduction is subject to limitations. This gets into the weeds just a bit, but the deduction is limited to the greater of 50% of W-2 wages paid with respect to the business or 25% of W-2 wages paid plus 2.5% of the unadjusted basis, immediately after acquisition, of all qualified property.
Second, the deduction isn’t allowed for specified service trade or businesses once the owner’s income exceeds certain threshold amounts, which are indexed for inflation.
“For taxpayers who are under those limits, applying the new rules will not be nearly as complex, but if you’re over those limits, it may be complicated,” says Dennis Kleinheinz, a partner with Meicher CPAs. “There are more hoops to jump through if you are over those income limits, particularly if you’re a specified service trade or business. Then, you might not qualify at all for the 20% deduction.”
Service businesses are one limitation, but the primary limitation is that 50% of the wages paid by the business to employees, including the owners themselves, must exceed the 199A deduction. Gordon Meicher, managing partner of Meicher CPAs, provided an example. “Let’s say you’re a proprietor, a simple LLC with no employees listed on your return, and you sell widgets. We have a guy that sells six products and makes $500,000. He has no wages, so he won’t get a deduction because he’s over the $315,000 threshold. The $500,000 times 20% is $100,000, so he needs at least $200,000 in wages in order to take the new Section 199A deduction. He doesn’t have any employees, so he has no wages and that hurts him.
“We take the same business and we say, ‘You’re an S corp, so pay yourself $200,000 in wages.’ It worked out to be $160,000. The S corp then paid about $160,000 in wages, and 50% of that is $80,000.
“Under his corporate structure as an S corp, this individual therefore has $80,000 a year tax-free that otherwise he was paying taxes on.”
That’s exactly the kind of thing that happens, and such changes in the tax law are why it’s more important than ever for small businesses to have someone who understands the new rules and can help determine what levels of wages need to be paid and how to stay under the income limits.
Ironically, most of the people who report pass-through income are not in fact small-business owners in the conventional sense but are professionals like lawyers, doctors, and accountants, or simply wealthy investors. Yet many of these very pass-through owners — particularly service providers such as accountants, doctors, and attorneys — don’t qualify for the pass-through deduction. Examples of the specified service businesses are those in the fields of health, law, accounting, actuarial science, performance arts, investment or investment management, trading or dealing in securities, partnership interests or commodities, consulting, athletics, financial services, brokerage services, or where the principal asset is the reputation or skill of one or more of its employees or owners.
Note that engineers are not listed among these specified service businesses, and Meicher provided an example of how bad accounting advice can impact business people. “Just yesterday, I had an engineer come in and he says, “Aw, it’s so bad, this new tax law. I’m not going to get any benefit. I’m going to lose my state tax deduction. I’m going to lose my mortgage deduction. It’s terrible.’ I told him that engineers are exempt from the specified service trade or business rules. His accountant didn’t even know that,” Meicher states.
Moreover, qualified business income is domestic trade or business income within U.S. and Puerto Rico other than investment income (except income from publicly traded partnerships that’s eligible for inclusion), investment interest income (other than qualified real estate investment trust and corporate dividends), net capital gains, and foreign currency gains.
“You have to have qualified business income to be eligible for the 20% deduction of domestic qualified business income (QBI),” notes Jason Grosh, director-tax for BKD CPAs and Advisors, who referred to it as the “20% deduction” and notes that it’s set to expire after Dec. 31, 2025. “That means you must have income from a qualified domestic trade or business.”
Moreover, if taxable income is above the specified income thresholds, the 20% deduction starts to get phased out if you’re in a specified service trade or business. If you’re in one of these “SSTBs” and your taxable income is over the full phase outs of $207,500 for single and $415,000 for married and filing jointly, you’re not eligible for the 20% deduction for that SSTB, although non-SSTB income would still potentially qualify for the 20% deduction. The floor and ceiling of the phase out will be indexed for inflation.
This gets even further into the accounting weeds, but for taxpayers who are not in an SSTB, if their taxable income is greater than the full phase outs, the deduction will be limited to the lesser of 20% of QBI or the greater of 50% of W-2 wages paid with respect to that business, or 25% of W-2 wages paid plus 2.5% of unadjusted basis immediately after acquisition of qualified property.
In plain English, these can be significant limitations if you’re over the thresholds. If you’re a higher income individual and you want to get this deduction, it’s something to be cognizant of. “Given these limitations and taxable income thresholds, it becomes even more important for taxpayers to engage in year-end tax planning to manage their taxable income and ensure they receive the permanent tax benefit related to the 20% deduction,” Grosh advises.
To make it even more complicated, the proposed regulations provide an opportunity to aggregate certain trades or businesses together for purposes of Sec 199A. The benefits of making the election will need to be evaluated by taxpayers on a case-by-case basis.