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.
Application of the Deduction for Lower-Income Clients
A great deal of the coverage devoted to the new 199A deduction has focused on its complexity, and for good reason. It is clearly one of the more complicated provisions of the Tax Cuts and Jobs Act. There is, however, good news for many clients (and advisors). If a client’s income is low enough, the deduction is actually quite simple. And the even better news is that “low income” here really isn’t that low!
For single filers with taxable income below $157,500, and for joint filers with taxable income below $315,000, the only major wrinkle in the calculation of the 20% pass-through deduction is the aforementioned lesser-of-eligible-business-income-or taxable-income rule.
Note: Unlike most other thresholds in the tax code, which look at AGI (or modified AGI), the thresholds for the pass-through deduction are based on taxable income. This is actually more favorable for clients, particularly those clients with large itemized deductions who can substantially drive down their taxable income and potentially receive a larger pass-through deduction than if the threshold were keyed to AGI.
If a client’s taxable income is below their applicable threshold, then their chosen profession has no impact on their ability to claim the pass-through deduction. That means that, contrary to what many believe, a reasonable number of doctors, lawyers, accountants, performers, athletes and, yes, even financial advisors are eligible for the 20% pass-through deduction.
Furthermore, for these “low income” filers, there is no need to evaluate the amount of W-2 wages their business has paid, nor the amount of depreciable assets the business owns. They simply get the deduction at the lesser of 20% of their eligible business income, or taxable income less capital gains.
Application of the Deduction for High-Income Clients Engaged in a “Specialized Service Trade or Business”
For clients with taxable incomes above their applicable threshold, things begin to get more complicated and, in many cases, much less favorable. Nowhere is that more evident than for high earners with business income generated from a “specialized trade or business.”
For such clients, after a brief phase-out range ($157,500 – $207,500 for single filers, and $315,000 – $415,000 for joint filers), in which clients receive a deduction for a prorated amount of their business income, the 20% pass-through deduction is completely eliminated. Specialized trade or business income includes income stemming from performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any business where the principal asset of the business is the reputation or skill of one or more of its employees.
Bottom line: If your client is a single filer with more than $207,500 of taxable income, or a joint filer with more than $415,000 of taxable income AND their business income stems from one of the above professions, they get no 20% pass-through deduction — for any of their business income.
Application of the Deduction for High Income Clients NOT Engaged in a “Specialized Service Trade or Business”
For clients with high income who also have business income from an activity that is not specialized service trade or business, it gets even more complicated. Once a client’s income exceeds the same thresholds noted above, the 20% pass-through deduction is further limited. In such situations, the deduction available to a client may not exceed the greater of:
1) 50% of the W-2 wages paid by the business, or
2) 25% of the W-2 wages paid by the business, plus 2.5% of the unadjusted basis of depreciable property owned by the business
Example #3: Bob works as an executive with a large company and earns a W-2 salary of $500,000. In addition, he is the sole owner of an LLC that owns rental real estate. Bob reports net profit from the LLC of $300,000 and has total taxable income of $720,000 (before application of the pass-through deduction). The unadjusted basis of the LLC properties is $1,400,000, and the LLC pays W-2 wages to a property manager of $80,000.
Bob is well beyond the phase-out range, but since LLC is not a specialized service trade or business, he is not precluded from taking the 20% pass-through deduction. Rather, instead of simply applying the deduction to the lesser of eligible business income, or taxable income, less capital gains, we must now incorporate the third test noted above. As a result, Bob’s pass-through deduction will be $55,000, which is the lowest of the following amounts:
1) $60,000, which is 20% of Bob’s eligible business income of $300,000
2) $144,000, which is 20% of Bob’s taxable income of $720,000
3) The greater of:
- $40,000, which is 50% of the LLC’s W-2 wages of $80,000
- $55,000 which is 25% of the LLC’s W-2 wages of $80,000 plus 2.5% of the $1,400,000 unadjusted basis of the LLC property
This is by no means a complete analysis of the 199A deduction, and there will be much written in the coming weeks, months and years about how to maximize the deduction for clients. Armed with this information, though, you can begin to have discussions with your business-owning clients about how the deduction will affect them and what impact it will have on their overall plan.
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