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Tax Cuts and Jobs Act: Impact on Pass-Through Entities
Jan 30, 2018
By Charles R. Kennedy, CPA, MBA
Director of Tax Services
Most small businesses in the U.S. are “pass-through” entities, so the changes in the recently-enacted Tax Cuts and Jobs Act that affect them will have broad effect across the country. Among the most significant effects may be changes to the tax planning strategies that business owners have relied on for more than 30 years.
Pass-through entities include S Corporations, limited liability companies, partnerships of all kinds (i.e. general, limited, limited liability partnerships), and sole proprietorships. The profits or losses from these businesses “pass-through” or “flow-through” to their owners and are reported on the owners’ personal income tax returns.
Before discussing the impact of the TCJA on these businesses, it is important to understand a new term that the TCJA introduces – “qualified business income,” or QBI.
How is QBI calculated?
Qualified business income is ordinary income, but does not include:
- Capital gains/losses
- Dividends and interest
- Annuity payments
- Foreign currency gains/losses
- Reasonable compensation paid to the business owner
- Guaranteed payments to a partner for services rendered
The biggest change for pass-through entities in the TCJA will be a significant deduction from QBI. The deduction can be limited, and is the lesser of:
- 20% of the qualified business income from the taxpayer’s trade or business,
- OR the greater of:
- 50% of the total W-2 wages of the business paid to all employees, or
- 25% of the W-2 wages, plus 2.5% of the original acquisition cost of the business’ real property.
In the example below, the figure in green represents the deduction for each company.
It is important to note that, under the TCJA, this deduction for pass-through entities is temporary – it only lasts from 2018 through the 2025 tax year.
While a deduction of this size is good news for business owners, there are some caveats.
Special rules for ‘Specified Service Businesses’
Owners of pass-through businesses in specific industries are subject to special limitations on the 20% deduction in the form of a phaseout.
The industries include:
- Financial Services
- Actuarial Science
- Brokerage Services
- Performing Arts
Generally, for taxpayers who own these types of businesses the deduction starts to phase out at incomes of $157,500 (for single filers) or $315,000 (for joint filers), and disappears entirely for taxpayers with more than $207,000 (for single filers) or $415,000 (joint filers) in income.
For non-Specified Service Businesses that are under the income thresholds, the wage limitation does not apply.
Other notable issues
- If a taxpayer’s QBI is a loss, the loss is carried over to the next year. Any deduction allowed for the next year is reduced by 20% of the carryover QBI loss.
- The 20% deduction does apply to rental real estate.
- The 20% deduction limitations are based on taxable income, not adjusted gross income.
- The provisions of this section of the TCJA apply to estates and trusts, as well as agricultural and horticultural cooperatives.
Changes in tax planning strategy
The treatment of pass-through entities is one of many areas where the TCJA promises to fundamentally change the approach to tax planning for many business owners. Certain tax planning strategies for businesses that have been common for the past 30 years will be revisited and, in many cases, found to be counterproductive under the TCJA.
- S Corporations that have historically paid bonuses to shareholders in order to withhold taxes to cover the corporation’s profits, which flow through to the owners’ individual tax returns, may want to reconsider this strategy. Taking excess salary reduces the S Corporation profit, and under the TCJA this will have the effect of reducing the value of the 20% deduction described above. To maximize that deduction, owners of some S Corporations may want to minimize their own salaries and bonuses. However, reasonable compensation rules still apply.
- Sole proprietors and owners of partnerships in the specified industries with income phaseout rules, particularly those with no employees, may want to consider changing their entity structure to an S Corporation in order to maximize the value of the pass-through deduction.
- Some businesses in the specified industries, especially those just over the income phaseout rules, may find it advantageous to change their strategy with regard to Sec. 179 and bonus depreciation in order to impact their QBI and capture the pass-through deduction.
The TCJA’s treatment of pass-through entities is complicated, and regulations aimed at clarifying it undoubtedly will be issued by the IRS. In the meantime, if you have questions about how you can prepare your business for these changes, contact Charles R. Kennedy, CPA, MBA, at 617-696-8900.
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