Small-business owners and partners are scratching their heads over the Tax Cuts and Jobs Act and how the new 20 percent tax deduction for pass-through entities will work. Here’s some background.
A pass-through entity can be a partnership, S corporation, limited liability company or partnership, or sole proprietorship - most of the country’s small businesses. Owners and shareholders of these entities are taxed on earnings based on individual, not corporate, tax rates. Effectively, company earnings, losses and deductions pass through to the individual’s personal tax rates, which, in the past, were typically lower than corporate rates. The pass-through deduction was a nice tax break. But things have changed.
In 2017, the U.S. corporate tax rate was 35 percent, one of the highest in the industrialized world. The new bill decreases that rate to a flat 21 percent, which is lower than the top individual tax rate of 37 percent. Earners who fall into that top tax tier would be unwise to claim a pass-through deduction, because their individual rate is now higher than the corporate rate.
To even things out, Congress has enacted a new law allowing pass-through owners to deduct 20 percent of their qualified business income, or QBI (Qualified Business Income) from their personal income taxes, whether or not they itemize. Unlike the corporate tax cut, which is permanent, this pass-through deduction lasts only through 2025, unless Congress extends it.
A 20 percent pass-through deduction can be beneficial. For example, if you have $100,000 in pass-through income, you can reduce your income taxes by $4,800 if you’re in the 24 percent income tax bracket.
What is QBI?
QBI is the profit a pass-through business makes during a year.
- Rental income from a rental business
- Income from publicly traded partnerships
- Real estate investments trusts
- Qualified cooperatives
QBI does not include:
- Dividend or interest income
- S corporation shareholder wages
- Business income earned outside the United States
- Guaranteed payments to LLC members or partnership partners
- Capital gain or loss
In order to take advantage of the pass-through deduction, you must have net taxable income from your businesses. If you don’t make any profit, you can’t deduct 20 percent from nothing. The QBI from each business is calculated separately. If you have several businesses, and one or more loses money in a given year, you will deduct that loss from the QBI from the profitable businesses.
Whether you can take advantage of all, some or none of the passthrough tax deduction depends on how much money you earn and how you earn it. For instance, if your taxable income falls below $315,000 if married filing jointly or $157,500 if single, you can take full advantage of the pass-through deduction. But if your taxable income is more than $315,000/$157,500, taking the deduction will depend on your total income and the kind of work you do. If you perform a personal service, such as doctor or consultant, you’ll lose the deduction at certain income levels.
The new pass-through deduction can be a nice tax break for those who qualify. Contact your RINA representative if you have any questions.