In December 2017, President Trump signed The Tax Cuts and Jobs Act (TCJA) into law. This law was the first significant tax code reform since President Reagan’s Tax Reform Act of 1986.
A major element of the TCJA is the pass through deduction for small business owners. Qualifying business owners may deduct up to 20% of their net business income.
The Tax Cuts and Jobs Act took effect in Tax Year 2018 and continues through the end of 2025. Let’s look at this legislation as a whole to help understand how it benefits your small business.
Key Provisions of the TCJA
The Tax Cuts and Jobs Act, as a whole, simplifies individual income tax for households. Approximately 28.5 million households will benefit more from the new standard deduction rules.
Summarized below are the key provisions of the TCJA.
Expanded Standard Deduction
The TCJA increased the standard deduction from $6500 to $12,000 for individuals. For married couples filing jointly, the standard deduction grew to $24,000 from $13,000.
Increased Child Tax Credit
The new law raises this credit to $2000, from $1000 per child. It also raises the phase-out level from $110,000 to $400,000 for joint filers.
Itemized Deduction Changes
With the higher standard deduction comes changes to two other deductions.
First is the mortgage interest deduction. Tax itemizers may now deduct mortgage interest on only $750,000 of debt versus the previous $1,000,000.
Also, the law suspends interest deductions on home equity loans and lines of credit. Now it can only be taken when using the proceeds for buying, building or improving the home securing the loan.
Second is state and local income taxes paid (SALT). In prior years, individuals could deduct sales tax paid or state income tax paid. They could also deduct state and local property taxes.
Under the TCJA, the deduction limit is $10,000 for state and local property, income and sales tax combined.
Alternative Minimum Tax Reform
The new tax law reduces the number of people filing the AMT tax form with even fewer having AMT liability. Filings are expected to drop from 10 million to 1 million.
Addition of the Pass Through Deduction
A major addition to the Internal Revenue Code is the pass through deduction. It allows owners of pass through businesses to deduct up to 20% of their qualified business income.
The deduction doesn’t apply to self-employed businesses organized as C Corporations. The result levels the unbalanced playing field created when the TCJA reduced the maximum corporate tax rate to 21%.
All these reforms are exciting news for taxpayers. But the pass-through deduction gives professionals, freelancers, and small business owners, even more, to be excited about.
How to Qualify for the Pass Through Deduction
The TCJA says you must meet three criteria to qualify for the pass-through deduction. You must be a pass through business and have both qualified business income taxable income.
Pass Through Business
The first is being a pass-through business. A pass-through business is any business owned and operated by a pass-through business entity.
So what’s a pass through business entity?
Any business that’s one of the following:
- Sole Proprietorship
- S Corporation
- Limited Liability Corporation
- Limited Liability Partnership
What makes these businesses pass through entities is they don’t pay taxes themselves. Their profits, or losses, pass through to the owners. The owners include the income on their individual income tax returns.
Qualified Business Income
The next criterion is having qualified business income. This is net income from your pass through business. Subtract business expenses from business income and QBI is what’s left.
A few types of business income aren’t part of QBI. These are:
- Short-term capital gain/loss
- Long-term Capital gain/loss
- Dividend income
- Interest income
- Guaranteed payments to partners in partnerships or LLC members
- Business income earned outside the United States
Finally, you must have taxable income to qualify. This is total taxable income from all sources, minus all deductions. If your taxable income is zero, there is no deduction.
In addition, the pass through deduction can never be more than 20% of your taxable income.
There are income parameters when determining eligibility for the pass-through deduction. If your taxable income is below $315,000, for married filing jointly, or $157,500, for single filers, the pass-through deduction is equal to 20% of QBI.
But when taxable income is higher than $315,000 (married) or $157,500 (single) and you own a “specified service business,” the pass-through deduction starts to phase out.
Pass Through Deduction Limits
To understand the phase-out, let’s look at the IRS list of specified service businesses.
- Health (doctors, dentists, nurses, pharmacists, and others)
- Law (attorneys, paralegals, arbitrators, and mediators)
- Actuarial science
- Performing arts
- Financial services
- Brokerage services
- Investing and investment management, or
- Trading and dealing in securities or commodities.
For example, a married, self-employed CPA with $275,000 in total taxable income can still take the pass through deduction.
But a self-employed attorney with $325,000 in total taxable income, married filing jointly, only receives a partial deduction. Once taxable income rises over $415,000, the deduction is completely phased out.
For single filers, the deduction phases out completely at $207,500.
There are other limitations for taxpayers with more than $315,000 (married filing jointly) or $157,500 (single) of taxable income.
The deduction is limited to the greater number of these two options:
- 50% of W-2 wages from the qualified trade or business
- The sum of 25% of W-2 wages from the trade or business plus 2.5% of the unadjusted basis right after the acquisition of all qualified property.
Also, the deduction is limited to the lesser of 20% of QBI or 20% of excess taxable income over the taxpayer’s net capital gains for the tax year in question.
Bottom line is the pass-through deduction is not without complications. This is especially true once taxable income exceeds the $315,000 / $157,500 limits. The IRS published a 184-page guidance document on this deduction for a reason.
Take Advantage of Tax Reform
Perhaps the best thing about the pass through deduction is it’s available whether or not you itemize deductions. It’s a deduction independent contractors, service professionals, and small business owners can benefit from.
It’s complicated at higher income levels but relatively straightforward at lower levels. It’s also brand new for 2018 so it will probably take years before we completely understand its impact.