This is the third in a series of posts aimed at analyzing the new tax laws that go into effect on January 1, 2018. There will still undoubtedly be numerous clarifications and corrections coming out over time as the IRS issues Regulations and Technical Corrections, so this is just a preliminary understanding. In this post, we will be looking at the details surrounding the new pass-through income deduction.
What is it?
The new tax plan includes a provision that allows owners of partnerships, S corporations and sole proprietorships to potentially deduct up to 20 percent of qualified business income. The deduction will be taken on the taxpayer’s Form 1040 for which the K-1 or sole proprietorship activity is recorded. This will effectively reduce the tax rate for the taxpayers that are able to take this deduction. This deduction reduces taxable income, not adjusted gross income and is available to both itemizers and non-itemizers. Trusts and estates are also eligible to claim this deduction.
What income qualifies?
The deduction only applies to qualified business income. Qualified business income (QBI) includes only the net amount of domestic qualified items of income, gain, deduction and loss that were included in taxable income for the current year. QBI does not include any amount paid by a partnership as a guaranteed payment or any amount that is treated as reasonable compensation of the taxpayer by an S corporation. Items that are not qualified include certain investment-related income, gain, deductions or loss. Essentially, this is income that is derived from the ordinary operations of the trade or business.
What type of activities qualify?
While partnerships, S Corporations, and sole proprietorships are what this deduction is aimed at, not all versions of these entities qualify for the deduction. Specified service businesses are only eligible for the deduction if the taxpayer’s taxable income does not exceed $315,000 for married filers, or $157,500 for single filers. The new tax bill defines specified service as any trade or business where the principal asset of such is the reputation or skill of one or more of its employees or owners.
Examples of these specified services include fields of:
- actuarial science
- performing arts
- financial services
- brokerage services
Are there any limitations?
There are two main limitations to the amount the deduction cannot exceed. The first is 50% of the W-2 wages paid with respect to the qualified trade or business. The second only applies if the first is not met. That is 25% of W-2 wages paid plus 2.5% of the unadjusted basis immediately after acquisition of all qualified property. For these purposes, qualified property means tangible property subject to depreciation for which the depreciable period has not ended before the close of the taxable year.
It is vital to stay up-to-date on how this new tax plan will impact your finances. At Malloy, Montague, Karnowski, Radosevich & Co., P.A. (MMKR), we strive to help all our clients create a solid strategy to protect their financial goals. If you are concerned about how this tax plan will affect your financial future, call our team today to schedule a consultation with one of our accountants.