The 20% Pass-Through Deduction: The $415 Billion Tax Deduction
One of many provisions in the Tax Cuts and Jobs Act (TCJA) is the provision that allows certain taxpayers a 20 percent deduction for qualified business income of pass-through entities.
The Joint Committee on Taxation estimates that the pass-through deduction, which will expire at the end of 2025, will cut approximately $415 billion in federal tax revenue. That is a conservative estimate due to the potential for gamesmanship relating to the deduction. The Senate Committee on Finance predicted the deduction will total $40.2 billion in 2018, and that $17.8 billion of the total (44%) will be claimed by taxpayers making over $1,000,000.
Now that I hopefully have your attention, I will define some key terms of the provision, describe the challenge the Treasury has in drafting the regulations, and try and point you all in a direction to maximize your deduction.
First, let’s look at some definitions. The law defines a qualified trade or business as any business other than (1) a specified trade or business or (2) the business of performing services as an employee. The specific trade or business exclusion is aimed at service industries. The employee exclusion will prevent a W-2 employee from becoming a pass-through entity.
Specified Trade or Business
The new category of specified trade or business is a listing of businesses that cannot take advantage of the deduction. These businesses involve performing services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, investing and investment management, trading or dealing in securities, or where the principal asset of the business is the reputation or skill of one or more employees or owner.
Even though specified trade or businesses are excluded from the deduction, the law provides an exception to the owner if the owners’ taxable income is below certain threshold amounts. These amounts are $315,000 for (Married Filing Jointly) and $157,000 for individuals, with phaseouts for income up to $415,000 for MFJ and $207,500 for individuals. The following chart shows how this works.
Therefore, a business does not want to be classified as a specific trade or business. The regulations have not been drafted—certain industry groups are lobbying to have their classifications removed from the specific trade or business classifications, just as engineers and architects were deleted from the original law.
Qualified Business Income
We will now define what is qualified business income. These items include income gain, deductions and losses with respect to any qualified business of the taxpayer. It is limited to U.S. sourced income. With items that are not included as qualified business income. The items below are not included:
- Reasonable compensation paid to the taxpayer by the qualified business for services rendered;
- Guaranteed payments paid to a partner for services rendered;
- Passive-type income such as capital gains, dividend income, interest income, and certain investment income; and
- Qualified REIT dividends, qualified cooperative dividends, qualified publicly traded partnership income.
Once we have quantified the qualified business income, we have to apply certain limiting criteria. These criteria do not apply if taxable income is under $157,500 (individual) or $315,000 (Married Filing Jointly)—the specific trade or business thresholds. Whether you are a qualifying business or a specific trade or business, you have the same magic thresholds.
The limiting criteria for the 20% deduction are the lesser of:
- 20% of the qualified business income of the pass-through entity
- The greater of
o 50% of the allocable W-2 wages or
o 25% of the allocable W-2 wages plus 2.5% of the unadjusted basis of all qualified real and tangible property on hand at year end (excluding land) used in the business.
The above computation cannot exceed 20% of the excess of taxable income over net capital gains.
Pass-through entities that have large W-2 wages or large amounts of fixed assets can have a tremendous benefit from the deduction.
Working with Your CPA
For those businesses that qualify for the pass-through deduction, owners should tweak their operations to maximize the deduction, by reviewing review of the items that are deductions for qualified business income to see if reclassifying salaries to owners or fixed payments to partners would benefit their operation. There is NO cap on the amount of tax deduction.
For those businesses that are categorized as specified trades or businesses, contact your lobbying organization to see how you can be included in businesses qualifying for the deductions.
However, if after the regulations are drafted you are still in the specified trades or businesses category, then there are certain things you may do. First, if your business has enough scale, reorganize your business into several smaller businesses, such as administrative or property management, to have a qualifying business for the deduction.
If your business is a smaller scale operation, figure out ideas to get below the $315,000 (MFJ) or $157,500 (individual) thresholds. You can accomplish this by establishing and funding retirement plans or by making charitable contributions. Speaking of the latter, there is no better way to leverage your contributions than with an investment in a conservation partnership. It works great, too, for those who already qualify for the deduction.
Of course, check with your CPA on how best to move ahead with any of these strategies. We will be working with CPAs around the nation to better understand the new law, and how to help clients navigate the evolving regulations. As we learn, I will continue to keep you informed. If you have questions, or further insights to share, please reach out to me.
Don Deans CPA / PFS