The Tax Cuts and Jobs Act (HR 1, “TCJA”) established a brand new tax deduction for owners of pass-through businesses. Pass-through owners who qualify can deduct up to 20% of their net business income from their income taxes, reducing their effective income tax rate by 20%. This deduction begins for 2018 and is scheduled to last through 2025—that is, it will end on January 1, 2026 unless extended by Congress.
This deduction can really add up. For example, if you have $100,000 in pass-through income, you could qualify to deduct $20,000, reducing your income taxes by a whopping $4,800 if you’re in the 24% income tax bracket. Clearly, all small business owners need to understand this complex deduction. Here are the requirements to take it.
You Must Have a Pass-Through Business
You have to have a pass-through business to qualify for this deduction. A pass-through business is any business that is owned and operated through a pass-through business entity. This includes any business that is a:
- a sole proprietorship (a one-owner business in which the owner personally owns all the business assets)
- a partnership
- an S corporation
- a limited liability company (LLC), or
- a limited liability partnership (LLP).
For tax purposes, what distinguishes these types of businesses is that they pay no taxes themselves. Instead, the profits (or losses) from such businesses are passed through the business and the owners pay tax on the money on their individual tax returns at their individual tax rates. The vast majority of smaller businesses are pass-through entities. Indeed, over 86% of businesses without employees are sole proprietorships.
Regular “C” corporations do not qualify for this deduction; however, starting in 2018 they do qualify for a low 21% corporate tax rate.
You Must Have Qualified Business Income
Individuals who earn income through pass-through businesses may qualify to deduct from their income tax an amount equal to up to 20% of their “qualified business income” (“QBI”) from each pass-through business they own. (New IRC Sec. 199A.) QBI is the net income (profit) your pass-through business earns during the year. You determine this by subtracting all your regular business deductions from your total business income. QBI includes rental income so long as your rental activity qualifies as a business (as most do). It also includes income from publicly traded partnerships, real estate investment trusts (REITs), and qualified cooperatives.
QBI does not include:
- short-term or long-term capital gain or loss—for example, a landlord would not include capital gain earned from selling a rental property
- dividend income
- interest income
- wages paid to S corporation shareholders
- guaranteed payments to partners in partnerships or LLC members, or
- business income earned outside the United States.
QBI is determined separately for each separate business you own. If one or more of your businesses lose money, you deduct the loss from the QBI from your profitable businesses. If you have a qualified business loss—that is, your net QBI is zero or less–you get no pass-through deduction for the year. Any loss is carried forward to the next year and is deducted against your QBI for that year. This serves as a penalty for having a money-losing business.
Example: During 2018, George earned $20,000 in QBI from his bitcoin mining business and had a $50,000 loss from his bakery business. He had a $30,000 qualified business loss, so he gets no pass-through deduction for 2018. The $30,000 loss must be carried forward and deducted from his QBI for 2019.
You Must Have Taxable Income
To determine your pass-through deduction, you must first figure your total taxable income for the year (not counting the pass-through deduction). This is your total taxable income from all sources (business, investment, and job income) minus deductions, including the standard deduction ($12,000 for singles and $24,000 for marrieds filing jointly in 2018). You must have positive taxable income to take the pass-through deduction.
Moreover, the deduction can never exceed 20% of your taxable income.
Example: Larry, a single taxpayer, runs a consulting business which earned $100,000 in profit this year. He had no other income and takes the standard deduction ($12,000). His taxable income is $88,000 ($100,000 income – $12,000 standard deduction = $88,000). His pass-through deduction cannot exceed $17,600 (20% x $88,000 = $17,600). Thus, although Larry had $100,000 in QBI, his deduction is limited to $17,600, not 20% of $100,000 = $20,000.
20% Deduction for Taxable Income Below $315,000 ($157,500 for Singles)
If your taxable income is below $315,000 if married filing jointly, or $157,500 if single, your pass-through deduction is equal to 20% of your qualified business income (QBI). This is the maximum possible pass-through deduction.
Example: Tom is single and operates his public relations business as a sole proprietorship. His business earns $100,000 in qualified business income during the year. His total taxable income for the year is $120,000. His pass-through deduction is 20% x $100,000 QBI = $20,000. He may deduct $20,000 from his income taxes.
If your taxable income is within the $315,000/$157,500 thresholds, that’s all there is to the pass-through deduction. You can stop reading.
Deduction for Income Above $315,000 ($157,500 for Singles)
If your taxable income exceeds $315,000 if married, or $157,500 if single, calculating your deduction is much more complicated and depends on your total income and the type of work you do. First of all, you need to determine whether your business falls within one of the following service provider categories:
- health (doctors, dentists, and other health fields)
- actuarial science
- performing arts
- financial services
- brokerage services
- investing and investment management, or
- trading and dealing in securities or commodities.
There is a final catchall category that includes any business where the principal asset is the reputation or skill of one or more of its owners or employees. This likely includes many individuals who provide services not listed above. However, all the details have yet to be worked out by the IRS. Architecture and engineering services are expressly not included in the list of personal services.
Pass-through owners who provide personal services are not favored under the pass-through deduction. Indeed, they lose the deduction entirely at certain income levels. There are no such limitations on pass-through owners who don’t provide personal services. Presumably, Congress figured that nonservice providers who sell goods or make things are better for the economy and deserve more tax benefits than service providers.
Deduction for Non-Service Providers (Income Over $315,000/$157,500)
If your business is not included in the list of service providers, and your taxable income is over the $315,000/$157,500 thresholds, how you figure your deduction depends on your taxable income.
Taxable Income Above $415,000 ($207,500 for Singles)
If you’re a non-service provider and your taxable income is over $415,000 if married filing jointly, or $207,500 if single, your maximum possible pass-through deduction is 20% of your QBI, just like at the lower income levels. However, when your income is this high a W2 wage/business property limitation takes effect. Your deduction is limited to the greater of:
- 50% of your share W-2 employee wages paid by the business, or
- 25% of W-2 wages PLUS 2.5% of the acquisition cost of your depreciable business property.
Thus, if you have neither employees nor depreciable property, you get no deduction. This is intended to encourage pass-through owners to hire employees and/or buy property for their business.
The business property must be depreciable long-term property used in the production of income—for example, the real property or equipment used in the business (not inventory). The cost is its unadjusted basis—the original acquisition cost, minus cost of land, if any. The 2.5% deduction can be taken during the entire deprecation period for the property; however, it can be no shorter than 10 years.
Example: Hal and Wanda are married and file jointly. Their taxable income this year is $500,000, including $400,000 in QBI they earned from their bar business they own through an LLC. They employed four bartenders during the year to whom they paid $150,000 in W2 wages. They own their bar building. They bought it four years ago for $600,000 and the land is worth $100,000, so its unadjusted acquisition basis is $500,000. Their maximum possible pass-through deduction is 20% of their $400,000 QBI, which equals $80,000. However, since their taxable income was over $415,000, their pass-through deduction is limited to the greater of (1) 50% of the W2 wages they paid their employees, or (2) 25% of W2 wages plus 2.5% of their bar building’s $500,000 basis. (1) is $75,000 (50% x $150,000 = $75,000; (2) is $50,000 (2.5% x $500,000) + (25% x $150,000) = $50,000. (1) is greater so their pass-through deduction is $75,000.
Many owners of pass-through businesses, especially landlords, have no employees, thus the 25% plus 2.5% deduction is of most benefit to them.
Example: Alice, a single taxpayer, owns a 5-unit apartment building. She earned $250,000 in total taxable income during 2018, well over the $207,500 threshold for singles. She has no employees in her rental business. Thus, her pass-through deduction is limited to 2.5% of the unadjusted basis of the long-term property she uses in her rental business. This consists of her building, which she purchased five years ago. Her unadjusted basis in the building (purchase price minus value of the land) is $500,000. Her pass-through deduction is 2.5% x $500,000 = $12,500.
Taxable Income $315,000 to $415,000 (157,500 to $207,500 for Singles)
If your taxable income is $315,000 to $415,000 if you’re married filing jointly, or 157,500 to $207,500 if you’re single, the W2 wages/property limitation is phased in—that is, only part of your deduction is subject to the limit and the rest is based on 20% of your QBI. The phase-in range is $100,000 for marrieds, and $50,000 for singles. At the top of income the range ($415,000 for marrieds, $207,500 for singles), your entire deduction is subject to the W2 wages/business property limit: If you have no W2 wages or business property, you get no deduction.
To calculate the phase-in, first determine what the amount of your deduction would be if the W2 wages/property limit didn’t apply at all—this is 20% x your QBI. Next, calculate your deduction as if the W2 wages/property limit applied in full. Your phase-in amount is based on the difference between these two calculations multiplied by your phase-in percentage.
Example: Sid and Nancy are married and operate a bike rental business as an LLC. Their QBI this year is $345,000, and the business pays $100,000 in W-2 wages and owns no property. Their phase-in percentage is 30% because their $345,000 QBI is $30,000 over the $315,000 limit. Their deduction if the W2 wages/property limit didn’t apply would be 20% of their $345,000 QBI, which equals $69,000. Their full deduction based on W2 wages is $50,000 (50% of $100,000 W2 wages = $50,000). The difference between the two is $19,000. This amount is multiplied by the 30% phase-in percentage to determine the phase-in amount, which is $5,700 (30% x $19,000 = $5,700). The phase-in amount is subtracted from the $69,000 deduction based on QBI, resulting in a deduction of $63,300 ($69,000 + $5,700 = $63,300). Had their QBI been $415,000, their phase-in percentage would have been 100% and their total deduction limited to 50% of their W2 wages, or $50,000 ($69,000 – $19,000 = $50,000).
Deduction for Service Business Owners (Income Over $315,000/$157,500)
If your business involves providing personal services, and your taxable income is over the $315,000/$157,500 thresholds, your pass-through deduction is gradually phased out up to $415,000/$207,500 of QBI. At the top of the income range you get no deduction at all. That is, if your total income is $415,000 if you’re married, or $207,500 if you’re single, you get no deduction. This was intended to prevent highly compensated employees who provide personal services—lawyers, for example–from having their employers reclassify them as independent contractors so they could benefit from the pass-through deduction. There is no such phase-out of the entire deduction for nonservice providers.
To calculate your deduction, you start by using the same formula as for non-service providers discussed above. Your maximum possible deduction is 20% of your QBI. However, your deduction may not exceed the greater of
- 50% of your share W-2 employee wages paid by the business, or
- 25% W-2 wages PLUS 2.5% of the acquisition cost of depreciable property used in the business.
Thus, if you have no employees or depreciable business property, you get no deduction.
Next, you calculate the phase-out of the deduction. If you have employees or property, your deduction is phased-out by 1% for every $1,000 your income exceeds the $315,000 threshold. When your income reaches $415,000 you get no deduction. If you’re single, your deduction is reduced by 2% for every $1,000 your income exceeds the $157,500 threshold and you get no deduction if your income reaches $207,500.
Example: Mark is married and files jointly. He earned $345,000 in taxable income this year. His sole proprietorship consulting business earned $345,000 and paid $100,000 to employees. Consulting is one of service provider categories, so his pass-through deduction is subject to the phase-out. His $345,000 taxable income is $30,000, or 30%, over the $315,000 threshold. Before the phase-out, his deduction is limited to 50% of the W2 wages he paid, which was $50,000 (50% x $100,000 W2 wages = $50,000). Since, his phase-out percentage is 30%, he gets 70% of the full dedudtion, or $35,000 (70% x $50,000 = $35,000).
Taking the Deduction
The pass-through deduction is a personal deduction you may take on your Form 1040 whether or not you itemize. There will likely be a line to list it on the second page of our Form 1040. It is not an “above the line” deduction on the first page of Form 1040 that reduces your adjusted gross income (AGI). Moreover, the deduction only reduces income taxes, not Social Security or Medicare taxes.