by Wayne Lenell, CPA, Ph.D.
The Pass-through Deduction for Higher Income Taxpayers (For taxpayers exceeding taxable income levels of $157,500 Single and $315,000 Married Filing Jointly)
While the Tax Cuts and Jobs Act of 2017 created a new deduction for business owners of “pass-through” entities including: sole proprietorships, farms and ranches, partnerships, Subchapter S corporations, and rental properties, the new law is anything but simple, especially for higher income taxpayers. As such, this article is not meant to provide specific tax advice, but rather an overview of this provision of the Tax Cuts and Jobs Act. The law defines higher income taxpayers as those with incomes exceeding $157,500 if filing single and $315,000 if married filing jointly.
If your income falls above the aforementioned limits, the first step is to determine whether the pass-through income was derived from a “specified service trade or business.” Congress targeted certain types of taxpayers and limited the deduction for them. The specified service trade or business categories include the following:
Consulting. [Luckily, the IRS defined consulting as “the provision of professional advice and counsel to clients to assist the client in achieving goals and solving problems.” For example, if an engineer recommends a solution to a client, that service constitutes consulting. If, however, the engineer designs the solution, that service is not consulting. Further, consulting does not include services that are imbedded in, or ancillary to, the sales of goods if services are not separately billed. Finally, the IRS allows a business to have up to 10% of its revenues be that of consulting without the company being classified as a consulting company.]
Trade or business where the principal asset is the personal reputation or skill of one or more of its employees. [At first, this category seems to be a catch-all for all other types of business until the IRS issued its regulations and narrowly defined this category. It applies to those who receive income for endorsing products or services, or income from the use of an individual’s image, name, voice, etc.]
If a pass-through entity is a specified service trade or business, the taxpayer owning that business may qualify for a deduction, but there are additional limits if the taxpayer’s income is above the $157,500/$315,000 threshold. As the taxpayer’s income exceeds the threshold, the 20% deduction is ratably reduced over the next $50,000 (for single) or $100,000 (for married filing jointly). Thus, a taxpayer filing married filing jointly would receive none of the 20% deduction if their taxable income was above $415,000 and a partial deduction if their taxable income was between $315,000 and $415,000.
If a pass-through entity is not a specified service trade or business, there is a different, and more complicated, upper limit. The steps are as follows:
Compute the 20% of pass-through income.
Compute the larger of:
50% of wages paid with respect to that trade or business, or
25% of wages paid plus 2.5% of the unadjusted basis immediately after purchase (i.e., the original purchase price) of qualified property.
Take the lower of 1 or 2.
Take the lower of 3 or taxable income before applying the 20% deduction.
Qualified property means depreciable property (so not land) acquired during the latter of 10 years or the recovery period. This usually means all equipment and vehicles purchased within the last 10 years (even if the asset is fully depreciated) plus buildings that have yet to be fully depreciated.
A farmer has a profit in 2018 of $600,000. He is self-employed and has paid no wages. He has the following property and equipment:
Farm buildings $200,000 (not fully depreciated)
Equipment more than 10 years old $100,000
Equipment less than 10 years old $150,000
His “qualified” property consists of the farm buildings of $200,000 and equipment less than 10 years old of $150,000.
20% of $600,000 profit = $120,000
Wages = 0.
Wages of 0 + 2.5% of $350,000 = $8,750 (3 is higher than 2 so 3 applies).
Taxable income (most likely much higher than $8,750)
20% deduction limited to the lower of 1 or 3. Therefore, the deduction is $8,750.
Assume the same facts except that, instead, the farm was an LLC and the farmer elected Subchapter S tax status. This requires that he pays himself a “reasonable” salary which the farmer concludes would be $100,000 annually. This lowers his farm profit by $100,000 down to $500,000.
$20% of $500,000 profit = $100,000
Wages = $100,000 x 50% = $50,000 (2 is the higher of 2 or 3 so 2 applies)
Wages = $100,000 x 25% + 2.5% of $350,000 = $33,750.
Taxable income (most likely much higher than $50,000)
20% deduction limited to the lower of 1 or 2. Therefore, the deduction is $50,000.
In this example, the Subchapter S status resulted in the taxpayer benefitting from a deduction of $50,000 rather than $8,750 had the farmer been self-employed.
Some taxpayers have more than one pass-through entity. There are two methods available to taxpayers with multiple pass-through entities. The default method is to simply add together the profits and losses of all qualifying pass-through entities and compute the 20% deduction.
Taxpayers also have the option of aggregating their pass-through entities which means that the wages of all qualifying entities are totaled and the qualifying property of all qualifying properties are totaled and then the computations are made. This method can be advantageous if a taxpayer has an entity that has large wages and another entity has a large amount of qualified property. Once elected, however, the taxpayer must aggregate those entities going forward.
To qualify to aggregate entities, the entities must have at least 50% of the same owners (applying the rules of attribution) and must pass any two of the following three requirements:
The entities must be of the same product or service or customarily be offered together
The entities must share facilities, personnel, or other significant resources
The entities must operate in coordination of, or in reliance, upon one another
Though complex, and perhaps unnecessarily so, the 20% deduction for pass-through entities can result in a significant deduction for taxpayers beginning with the year 2018. If you have questions about how this applies to your business, give us call, and we can walk through the facts of your situation.
photo by Charles Deluvio 🇵🇭🇨🇦 on Unsplash