In December 2017, President Donald Trump signed the Tax Cuts and Jobs Act into law, ushering in the biggest changes to the tax code in more than 30 years.
Among the more significant changes made by the law is the creation of a new 20% deduction for certain pass-through business income. The deduction — sometimes referred to as the 199A deduction, after the section of the Internal Revenue Code in which it can be found — has the potential to reduce some clients’ taxable income by tens, if not hundreds of thousands of dollars.
Whenever there is a new tax law or regulation, it’s not uncommon for there to be confusion and/or different interpretations with respect to some of the provisions. Sometimes, in the rush to be “first to press,” there may even be some misinformation published by what are otherwise normally reliable sources. For whatever reason, however, there seems to be disproportional amounts of incorrect information being presented with respect to the new 20% pass-through deduction. So with that in mind, let’s cover some of the basics so you can be sure to relate the correct information to your clients.
The Deduction Applies to Most Corporate Structures
Depending upon the nature, size and type of business a client engages in — as well as other factors — they may choose to structure their small business in a number of ways. Common small-business structures include sole proprietorships, partnerships, limited liability companies and S corporations. Clients owning businesses structured in any of these ways may see benefits from the new 20% pass-through deduction.
That said, the precise benefit a client receives may vary depending upon the type of corporate structure they employ. For instance, clients may receive the deduction on all business income received from a sole proprietorship (net profits), but only on the profit distributions they receive from an S corporation (any salary earned from the S corporation is not eligible for the deduction).
Basic Mechanics of the Deduction
For most clients, the new 20% pass-through deduction will be applied to the lesser of their:
1) Eligible (qualified) business income
2) Taxable income (before application of the pass-through deduction), less any capital gains
Note: There are also certain adjustments that need to be made for so-called cooperative dividends. However, due to the fact that few clients have such dividends, their impact on the pass-through deduction is being disregarded here for simplicity purposes.
A quick look at a couple of examples should make the basic mechanics of the deduction much easier to understand:
Example 1: Jack, a single taxpayer, has a “regular” job where he earns a $100,000 salary as an employee. He also “moonlights” as a consultant and earns $50,000 of net profit via his Schedule C sole proprietorship. Now suppose that after accounting for deductions for self-employment taxes and the standard deduction, Jack’s taxable income is $133,500 (before application of the pass-through deduction).
Here, Jack’s business income of $50,000 is less than his taxable income of $133,500. As a result, the 20% pass-through deduction will be applied to Jack’s $50,000 of business income, resulting in a $10,000 ($50,000 x 20% = $10,000) deduction.
Example 2: Jill, a single taxpayer, is a real estate agent who earns $100,000 of net profit via her Schedule C sole proprietorship. This is Jill’s only source of income. After factoring in Jill’s deductions for self-employment taxes and the standard deduction, her taxable income is $73,000 (before application of the pass-through deduction).
Contrary to our first example, here, Jill’s taxable income of $73,000 is less than her eligible business income of $100,000. Therefore, Jill’s 20% pass-through deduction will be applied to her $73,000 of taxable income. This results in a $14,600 (73,000 x 20% = $14,600) deduction.
A New Category of Deduction: “Between the Lines”
One of the more interesting aspects of the 199A deduction is that it creates an entirely new type of deduction for clients.
Previously, deductions broadly fit into two categories on a client’s return. One category of deductions, above-the-line deductions, helped clients to lower their adjusted gross income (AGI) and was available to all filers, whether or not they itemized. The second category of deductions, below-the-line (itemized) deductions, was available only to clients who itemized deductions, and did not reduce AGI, but did help reduce taxable income.
The 20% pass-through deduction does not fit neatly into either of these categories. It is not an above-the-line deduction, because it does not help clients to reduce their AGI. Similarly, it is not a below-the-line deduction, because eligible clients may claim the deduction regardless of whether they itemize. As such, the pass-through deduction is truly in a category in and of itself, and one that has been dubbed by many an “in between the line” deduction.