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New Deduction for Pass-Through Income

Below is one of the more important elements of the new tax law that have an impact on partnerships, S corporations, and pass-through income. In general, they are effective starting in 2018:

New deduction for pass-through income. The new law provides a 20% deduction for “qualified business income (QBI),” defined as income from a trade or business conducted within the U.S. by a partnership, S corporation, or sole proprietorship.

  • Investment items (capital gains or losses, dividends, and interest income), reasonable compensation paid by an S corporation, and guaranteed payments from a partnership are excluded.
  • The deduction reduces taxable income but not adjusted gross income. It is available regardless of whether you itemize deductions or take the standard deduction.
  • For taxpayers with taxable income above $157,500 ($315,000 for joint filers),
    • a limitation based on W-2 wages paid by the business and the basis of acquired depreciable tangible, property used in the business is phased in, and 
    • the deduction is phased out for income from certain service related trades or businesses, such as health, law, consulting, athletics, financial or brokerage services, or where the principal asset is the reputation or skill of one or more employees or owners.

Here's how the limitation works (1):

  • If your taxable income is at least $50,000 above the threshold, i.e., $207,500 ($157,500 + $50,000), your deduction for QBI cannot exceed the greater of (1) 50% of taxpayer's allocable share of the W-2 wages paid with respect to the qualified trade or business, or (2) the sum of 25% of such wages plus 2.5% of the unadjusted basis immediately after acquisition of tangible depreciable property used in the business (including real estate). So if your QBI were $100,000, leading to a deduction of $20,000 (20% of $100,000), but the greater of (1) or (2) above were only $16,000, your deduction would be limited to $16,000, i.e., it would be reduced by $4,000.
  • If your taxable income were between $157,500 and $207,500, you would only incur a percentage of the $4,000 reduction, with the percentage worked out via a fractional percentage of the phase-out range. (For joint filers, the same operations would  apply using the $315,000 threshold, and a $100,000 phase-out range.)

Here's how the specified service phase-out works (2):

  • If your taxable income is at least $50,000 above the threshold, i.e., $207,500 ($157,500 + $50,000), all of the net income from the specified service trade or business is excluded from QBI. (Joint filers would use an amount $100,000 above the $315,000 threshold, viz., $415,000.)
  • If your taxable income is between $157,500 and $207,500, you would exclude only that percentage of income derived from a fraction the numerator of which is the excess of taxable income over $157,500 and the denominator of which is $50,000.
  • If taxable income is $167,500 ($10,000 above $157,500), only 20% of the specified service income would be excluded from QBI ($10,000/$50,000). (For joint filers, the same operation would apply using the $315,000 threshold, and a $100,000 phase-out range.)

Obviously, the complexities surrounding this substantial new deduction can be formidable, especially if your taxable income exceeds the threshold discussed above.

If you wish to work through the mechanics of the deduction with us, with particular attention to the impact it can have on your specific situation, please give us a call.