Emerging Tax and Regulations Alert- Pass-through provisions of the TCJA
The pass-through provisions of the TCJA: The devil is in the details
The Tax Cuts and Jobs Act (TCJA) has been touted for cutting the corporate tax rate, but the law also contains some valuable goodies for smaller businesses that operate as pass-through entities, including partnerships, limited liability companies, S corporations and sole proprietorships. These businesses stand to see their tax liabilities fall significantly, but determining just how much they will benefit can be complicated.
Pass-through tax cuts
The owners and shareholders of pass-through entities pay taxes on their net income at individual ordinary income tax rates, which had reached as high as 39.6% under prior law. The TCJA reduced individual tax rates, though, with the highest rate now at 37%. It also raised the thresholds for individual tax brackets, and the top rate doesn’t take effect until taxable income exceeds $500,000 for single filers and $600,000 for married couples filing jointly.
Moreover, the TCJA added a generous new business deduction for pass-through businesses that will slash taxable income. The qualified business income (QBI) deduction generally allows taxpayers to deduct 20% of QBI received. QBI is the net amount of income, gains, deductions and losses, exclusive of reasonable compensation, certain investment items and payments to partners for services rendered. The calculation is performed for each qualified business and aggregated. (If the net amount is below zero, it’s treated as a loss for the following year, thereby reducing that year’s QBI deduction.)
Once taxable income — not QBI — exceeds $157,500 for single filers or $315,000 for married couples filing jointly, a wage limit begins to phase in, under which taxpayers can deduct only the lesser of 20% of QBI or 50% of their allocable share of W-2 wages paid by the business. The wage limit is intended to deter high-income taxpayers from converting wages or other compensation for personal services to QBI that qualifies for the deduction.
Alternatively, taxpayers can deduct the lesser of 20% of QBI or 25% of wages plus 2.5% of their allocable share of the unadjusted basis of qualified business property (QBP) — essentially, the purchase price of tangible depreciable property held at the end of the tax year. This option makes it easier for capital-intensive firms with relatively low wages (for example, real estate, construction or manufacturing businesses) to take advantage of the deduction.
The wage limit phases in completely when taxable income exceeds $207,500 for single filers and $415,000 for joint filers. When it applies but isn’t yet fully phased in, the gross (without any wage limit) deduction is reduced by the same ratio of the difference between the amount of the gross deduction and the fully wage-limited deduction as the ratio of 1) the amount by which the taxable income exceeds the threshold to 2) $50,000 for single filers or $100,000 for married couples filing jointly.
The amount of the deduction may not exceed 20% of the taxable income less any net capital gains. So, for example, if the QBI for a married couple is $400,000 and their taxable income is $300,000, the deduction is limited to 20% of $300,000, or $60,000.
The QBI deduction is further limited for specified service trades or businesses (SSTBs). SSTBs include businesses involving law, financial, health care, brokerage and consulting services firms, as well as any business where the principal asset is the reputation or skill of one or more of its employees. The QBI deduction for SSTBs begins to phase out at $157,500 in taxable income for single filers and $315,000 for joint filers, phasing out completely at $207,500 and $415,000, respectively (the same thresholds by which the wage limit phases in).
The QBI deduction applies to taxable income and doesn’t come into play when computing adjusted gross income (AGI). It’s available to both itemizing and nonitemizing taxpayers.
Examples for non-SSTBs
The amount of the deduction for “qualified trades or businesses” depends largely on taxpayers’ taxable income — that is, their AGI less itemized deductions (excluding the QBI deduction). It’s most easily calculated when taxable income is under $157,500 for single filers and $315,000 for married joint filers so the wage limit doesn’t apply. For example, joint filers Bob and Mary have taxable income of $150,000, including $75,000 in QBI. They can deduct 20% of $75,000, or $15,000, from their taxable income.
Computing the deduction also is fairly straightforward when taxable income exceeds $207,500 for single filers or $415,000 for married joint filers. Let’s assume Bob and Mary have taxable income of $575,000, including $75,000 of Mary’s QBI. She pays $20,000 in wages and has $90,000 of QBP. The first option for the wage limit calculation in this situation is $10,000 (50% of $20,000), and the second option is $7,250 (25% of $20,000 + 2.5% of $90,000) — making the wage limit, and the deduction, $10,000.
What if Bob and Mary’s taxable income falls into the range between $315,000 and $415,000, where the wage limit is phasing in, with everything else remaining the same? If their taxable income is, say, $400,000, their deduction is partially capped by the wage limit. As in the immediately preceding example, the full wage limit is $10,000, but, with taxable income of $400,000, only 85% of the full limit applies:
($400,000 taxable income – $315,000 threshold)/$100,000 = 85%
To calculate the amount of their deduction, the couple must deduct 85% of the difference between the gross deduction of $15,000 and the $10,000 deduction if the full wage limit applied:
($15,000 – $10,000) × 85% = $4,250
That amount is deducted from the gross deduction for a final deduction of $10,750 ($15,000 – $4,250).
Example for SSTBs
When taxable income doesn’t exceed $157,500 for single filers or $315,000 for married couples filing jointly, SSTBs are treated in the same manner as qualified businesses (see first example above) when it comes to the QBI deduction. And, if the taxable income equals or exceeds $207,500 for single filers or $415,000 for married joint filers, SSTB owners receive no QBI deduction.
It’s when taxable income falls between those thresholds that things get trickier because the QBI, W-2 wages and QBP all gradually phase out on a prorated basis over this income range. The percentage that a taxpayer can take into account is 100% less the percentage equal to the ratio of 1) the amount by which taxable income exceeds the threshold amount to 2) $50,000 for single filers or $100,000 for joint filers:
1- (taxable income – applicable threshold)/$50,000 or $100,000 = applicable percentage
For example, let’s say Bob and Mary have joint taxable income of $400,000, and Mary has an SSTB with $75,000 in QBI. She pays $20,000 in wages and owns $90,000 in QBP. Only 15% of the QBI, or $11,250, qualifies for the deduction:
1- ($400,000 – $315,000)/$100,000 = 15% × $75,000 = $11,250
The gross deduction is 20% of $11,250, or $2,250. But, because only 15% of the QBI qualifies for the deduction, the couple can take account of only 15% of wages ($3,000) and QBP ($13,500) when calculating the wage limit. Fifty percent of wages for purposes of the limit, therefore, is $1,500, and 25% of wages plus 2.5% of QBP is $1,087.50 — setting the full wage limit at the greater amount of $1,500.
As for a non-SSTB, though, the wage limit phases in gradually over this income range. In this case, 85% of the limit applies:
($400,000 – $315,000)/$100,000 = 85%
The couple must reduce their QBI deduction by 85% of the difference between the gross deduction amount and the deduction amount if the full wage limit applied:
($2,250 – $1,500) × 85% = $637.50
As a result, their allowable deduction is $1,612.50 ($2,250 – $637.50).
It’s still early in the life cycle of the TCJA, and extensive regulations are expected in the near future. Among other things, the Treasury Department must draft regulations addressing the allocation of items and wages, along with reporting requirements, and the application of the QBI deduction to tiered entities. We’ll keep you abreast of important developments.