New deduction impacting pass-through entities in 2018

Disclaimer: The new rule on the pass-through deduction is complex, not exhaustive and will require guidance from Congress or the IRS for additional clarification, please contact your Lurie advisor to discuss your specific situation.

The recently passed tax act has changed the taxation of business income in many ways. For regular C-Corporations, the tax rate has been lowered from a maximum rate of 35% down to a flat rate of 21%. For businesses organized as a pass-through, the new act has created a complex set of new rules that may provide a deduction of up to 20% of the taxable income from that entity. The following provides an overview of the deduction for pass-through entities (LLCs, Partnerships, and S-Corporations) and is not intended to be an exhaustive analysis of the law.

The provisions of the law are split between two types of trade or business: specified service and qualified.

  • A specified service trade or business is defined as any trade or business involving the performance of services in the fields of health, law, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset is the reputation or skill of one or more of its employees or owners, or which involves the performance of services that consist of investment and investment management trading or dealing.
  • A qualified trade or business is defined as any business that does not meet the definition of a specified service trade or business, for example, a manufacturing company.

Below is how the deduction for these types of businesses is computed for pass-through entities.

Specified Service Trade or Business

Taxpayers who meet the definition of a specified service trade or business will be subject to one of the following three scenarios:

Scenario 1

Taxpayers with taxable income equal to or greater than $207,500 (twice that amount or $415,000 in the case of a joint return) will have the entire potential deduction phased out and will receive no benefit.

Scenario 2

Taxpayers with taxable income greater than $157,500 (twice that amount or $315,000 in the case of a joint return) but below $207,500 (twice that amount or $415,000 in the case of a joint return) will receive a limited deduction. The 20% deduction will be reduced by the percentage equal to the ratio of the excess of the taxable income of the taxpayer over the threshold amount divided by $50,000 ($100,000 in the case of a joint return).

Let’s break down this calculation with an example. If a single taxpayer has taxable income of $182,500 the maximum percentage that they could claim would be 10% of the specified service trade or business income.

Calculation:

$182,500 of taxable income – $157,500 threshold amount = $25,000

$25,000 / $50,000 = 50%

50% x 20% deduction = 10% maximum deduction

Scenario 3

Taxpayers with taxable income below $157,500 (twice that amount or $315,000 in the case of a joint return) will receive a deduction equal to 20% of the income from the specified service trade or business with no limitation based upon the wages or basis of the property.

 

Qualified Trade or Business

Taxpayers who meet the definition of qualified trade or business will be subject to one of the following three scenarios:

Scenario 1

Taxpayers with taxable income equal to or greater than $207,500 (twice that amount or $415,000 in the case of a joint return) will receive a deduction for the lesser of:

(a) 20% of the qualified trade or business income with respect to each business, or

(b) the greater of 50% of the W-2 wages with respect to the business or the sum of 25% of the W-2 wages and 2.5% of the unadjusted basis of all qualified property.

 

Here is an example for a married taxpayer with taxable income of $750,000, includes qualified trade or business income of $100,000 from a consulting business which the business also paid $10,000 of W-2 wages and owns qualified property of $300,000.

Taxpayer receives the lesser of:

= $100,000 of qualified trade or business income x 20% = $20,000

= 50% x $10,000 of W-2 Wages = $5,000, or

= 25% x $10,000 of W-2 Wages + 2.5% x $300,000 of Qualified Property = $10,000

Based on the above calculations, the taxpayer would receive a deduction of $10,000.

Scenario 2

Taxpayers with taxable income greater than $157,500 (twice that amount or $315,000 in the case of a joint return) but below $207,500 (twice that amount or $415,000 in the case of a joint return) the wage and property limitations will be phased in and potentially partially limit the 20% deduction.

Scenario 3

Taxpayers with taxable income below $157,500 (twice that amount or $315,000 in the case of a joint return) will receive a deduction equal to 20% of the income from the qualified trade or business with no limitation based upon the wages or basis of the property.

Conclusion

The deduction is a new category of deduction. It does not affect the taxpayer’s Adjusted Gross Income and it is available whether you itemized deductions or utilize the standard deduction. Therefore it does not affect any calculation that uses Adjusted Gross Income to determine the amount deducted such as medical expenses or charitable contributions.

Look to Lurie for future information on the Tax Cut & Jobs Act of 2018 (TCJA). To view our updates on TCJA you can check out our website at www.luriellp.com/news or follow us on social media @LurieLLP.

If you have any questions or would like additional information on how this change could affect you or your business please contact your Lurie advisor.

David Brauer, Partner

Tax Services

612.381.8838

 

 

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