Qualified Business Income Deduction – Tax Reform for Pass-Through Entities

October 10, 2018 : Nick Blount

Editor’s Note: This article was originally published on March 8, 2018. 

 

The Tax Cuts and Jobs Act provides businesses with a variety of changes in tax reporting starting with tax year 2018. One such change in the latest tax reform is the 20% deduction for pass-through entities’ qualified business income.

The qualified business income deduction starts in tax year 2018 and, as of now, ends after tax year 2025.

Terms to Know for Tax Reform: Pass-Through Income and Pass-Through Entity

With tax reform, pass-through income is receiving increased attention. But, what is a pass-through entity? A pass-through entity is a business entity that passes through its income to the owners of the business. The owners then report the business income on their personal returns. Generally, pass-through entities include partnerships and S corporations, but the qualified business income deduction also applies to other unincorporated entities such as sole proprietorships and single-member LLCs.

How Does the Qualified Business Income Deduction Work?

Here’s how the new qualified business income deduction works. Business owners can deduct up to 20% of their qualified business income or, if lower, 20% of their taxable income net of any capital gain. This deduction is claimed on the business owner’s individual return.

Generally, qualified business income refers to the business’s profits. Qualified business income does not include salary or wages paid to the taxpayer either as W-2 wages from a S corporation or guaranteed payments from a partnership.

This basic formula applies if the taxable income business owners report on their individual returns does not exceed certain thresholds. The thresholds for taxable income are $157,500 for single filers and $315,000 for people filing joint returns. The numbers will be adjusted for inflation after 2018.

If taxable income does exceed these thresholds, the deduction factors in limitations relating to the wages the business pays to its employees and depreciable assets the business owns. And, for certain businesses that provide services such as law firms, accounting firms, and doctors’ offices, the limitations are steeper and the deduction is phased out altogether when taxable income reaches $207,500 ($415,000 for joint filers).

A couple of important things to keep in mind – the latest pass-through business tax reform reduces federal income tax but does not reduce self-employment taxes for income from partnerships and sole proprietorships, or income for purposes of the alternative minimum tax.

What Does Pass-Through Entity Tax Reform Mean Day-to-Day?

So, what does this mean in practical terms? It means that a taxpayer can adjust his or her estimated taxes to account for this reduction in taxable income. But, be careful because if you underestimate how much income you’ll earn in a year, the penalty for underpayment of estimated taxes can hurt.

If the new tax reform for pass-through entities sounds complex . . . well, it kind of is. This is a new deduction, but the good news is you can rely on us. We can help you understand your eligibility for it and how to calculate the deduction.

Questions About the Qualified Business Income Deduction for Your Business?

To learn more about your business might be affected by qualified business income deduction or by tax reform overall, speak to one of the Tax Pros, who specialize in business taxes. Learn more about our business tax and services.

 

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