Most Business Owners Don't Fully Understand the New Pass-Through Deduction

The first year businesses have been operating under Tax Cuts and Jobs Act, passed in December 2017, is nearly over. Yet, there is still a lot of confusion and concerns over which businesses can qualify for the new 20% pass-through deduction and how it works. The deduction could mean substantial tax savings. With tax filing season just around the corner, now is the time to get your questions answered.

What exactly is a "pass-through business?"

A pass-through business is one that reports business income on the business owner’s personal tax return, including

• Sole proprietorships
• Partnerships
• S corporations
• Limited liability companies (LLCs)

However, to be eligible for the deduction, the income reported by a business must be “qualified business income.”

What exactly is "qualified business income?"

The 20% deduction applies to “qualified business income (QBI), which the new tax law defines as “the net amount of qualified items of income, gain, deduction and loss with respect to any trade or business.” In other words, your business’s net profit. QBI excludes certain types of income received by the business, including

• Interest income
• Income earned from outside the U.S.
• Capital gains or losses
• Dividends

What are the income limits?

Your total taxable income from all sources dictates how much if any of the 20% deduction is available to you. For 2018, if your total taxable income is at or below $157,500 ($315,000 for joint filers), then you are eligible for the deduction.

However, if your total taxable income is above those income limits, you will have to jump through several hoops to see if your business qualifies for all or a part of the deduction. At issue is the exact nature of your business and, this is where it gets complicated. If your business is considered under the tax law to be a “specified service or trade business” it may not qualify for a deduction.

What exactly is a "specified service or trade business?"

One of the qualification tests is determining if a business is a “specified service or trade business” (SSTB). Generally, SSTBs are restricted in their ability to use the pass-through deduction. If you are a high earning physician, dentist, attorney, consultant, professional athlete or actor, financial planner, among many other listed trades of businesses, won’t qualify for the deduction if their income in 2018 exceeds $207,500 ($415,000 for joint filers).

If your business is a SSTB and your QBI is between 157,500 and $207,500 ($315,000 and $415,000 for joint filers), it could qualify depending on the amount of wages paid to employees and the value of your business property. The higher those amounts, the higher your chances of qualifying for the deduction.

How exactly does the deduction work?

While the deduction can be as high as 20% of your taxable business income, it can’t add up to more than 20% of your total taxable income. To arrive at this, you need to first calculate your business income and expenses on Schedule C. Then, you calculate your adjusted gross income (AGI) on Form 1040. Finally, you calculate the pass-through deduction on Form 1040.

In addition, you don’t need to itemize to claim the deduction. If you use the standard deduction you can still take the pass-through deduction.

How do I know if I need professional tax help?

It’s important to note that the IRS is still figuring out the final rules governing this deduction, so it would be important to ensure you are current with the final regulations. It would be worth consulting with a tax professional who specializes in business taxes.

In addition, if your business might be considered a SSTB or your total taxable income exceeds the caps, you will want to consult with a tax professional about your options.