The Tax Cuts and Jobs Act provides businesses with a variety of changes in tax reporting for tax year 2018. One such change in the latest tax reform is the 20% deduction for business income from pass-through entities.
The deduction starts in tax year 2018 and, as of now, ends after tax year 2025.
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 or businesses owned by a single taxpayer.
How does the income deduction work?
Here’s how the new qualified business income deduction works. Business owners can deduct 20% of the income they receive from their businesses if the taxable income they report on their personal returns does not exceed certain thresholds.
This 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. The thresholds for taxable income are $157,500 for people that file as single taxpayers and $315,000 for people filing joint returns. If taxable income does exceed the 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 deduction is phased out altogether when the thresholds are exceeded.
A couple 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 partnership and sold proprietorship, or income for purposes of the alternative minimum tax.
How would this translate 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. This could also be a good opportunity for taxpayers to invest additional capital into their businesses or hire more employees. Especially if the taxpayer bumps into the wage and capital limitations mentioned above
However, shareholders in S corporations and partners in partnership should be careful not to stop paying themselves wages or making guaranteed payments for services. If the IRS thinks that you are trying to underpay yourself to get a better qualified business income deduction, they can recharacterize your big profits distributions as wages and apply penalties and interest to the underreported income.
If the new tax reform for pass-through entities sounds complex…well, it kind of is. Until the IRS provides guidance on how this will look on your tax return (new forms, new language in the IRS publications) all we have to go on is the basic outline provided in the TCJA.