The Tax Act's New Pass-Through Deduction: Critical Thoughts
Gibbons Corporate & Finance News - Legislative Tax Alert
January 3, 2018
One of the more intricate provisions of the new Tax Act is the 20% pass-through deduction for qualified business income, effective January 1, 2018. This article provides a summary of how this new deduction operates, with a focus on the implications of the deduction’s structure.
Pass-through Deduction – Overview
Currently, the tax rates that apply to pass-through income, i.e., income allocated by partnerships or S corporations to their partners or shareholders, as well as income earned by sole proprietors, are the marginal rates that apply to such partners or shareholders as individuals.
Without changing the general taxation of pass-through income, the new Tax Act allows individual partners, S corporation shareholders, and sole proprietors to deduct up to 20% of qualified business income (generally all domestic business income other than investment income) against taxable income. With a new maximum marginal individual rate of 37%, taxpayers with pass-through income that fully qualifies for the 20% deduction would be taxed on such income at a rate of no more than 29.6% (37% x (100% – 20%)).
Critically, the 20% deduction is subject to overlapping limitations as a taxpayer’s taxable income exceeds certain “threshold amounts”: $315,000 for married couples filing joint returns, and $157,500 for individuals.
Limitation on Specified Service Businesses
First, the 20% deduction will either be limited or completely phased out for specified service trades or businesses as a taxpayer’s income exceeds the threshold amounts, such that a joint return filer with taxable income in excess of $415,000 ($100,000 over the joint threshold amount), and a single return filer with taxable income in excess of $207,500 ($50,000 over the single threshold amount), would obtain no benefit from the 20% pass-through deduction.
The category of specified service trades or businesses is defined broadly, and includes any trade or business involving the performance of services in the fields of:
- actuarial science
- performing arts
- financial services
- brokerage services
- any trade or business in which the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners
- any trade or business which involves the performance of services that consist of investing and investment management, trading, or dealing in securities, partnership interests, or commodities
Limitation Based on Wages or Capital of Qualified Business
Second, again for taxpayers whose taxable income exceeds the threshold amounts, the 20% deduction would generally be limited to the greater of:
(a) the taxpayer’s allocable share of 50% of the W-2 wages paid with respect to the qualified trade or business, or
(b) the sum of 25% of the taxpayer’s allocable share of the W-2 wages paid with respect to the qualified trade or business, plus 2.5% of the unadjusted basis, immediately after acquisition, of all qualified property. Generally, qualified property is tangible, depreciable property for which the depreciable period has not ended and which is used in the qualified trade or business.
The ability to include 2.5% of the unadjusted basis of qualified property in calculating the second alternative test in subpart (b) above should allow more capital intensive businesses, such as commercial rental real estate trades or businesses, to use the 20% pass-through deduction, even though such businesses do not have a large employee payroll, and despite the income levels of the ultimate individual taxpayer.
Note that for taxpayers who earn somewhat more than the threshold amounts (for joint return filers, over $315,000, but not in excess of $415,000, and for single return filers, over $157,500, but not in excess of $207,500), the exemption from the limitations based on W-2 wages or depreciable capital is phased out as taxable income reaches those higher amounts. But unlike the limitation on specified service businesses, which entirely prevents use of the 20% pass-through deduction as taxable income exceeds those amounts in excess of the threshold amounts, although the limitation based on a qualified businesses wages or depreciable capital is triggered at those same amounts, with adequate amounts of W-2 wages or depreciable capital, a taxpayer engaged in a business other than a specified service business may still be able to use the maximum pass-through deduction.
Implications of Fundamental Structure of New Pass-through Deduction
The application of the new 20% pass-through deduction for those taxpayers with taxable income below the threshold amounts is fairly simple – they will be entitled to a deduction equal to 20% of their combined qualified business income (including income from a specified service trade or business). I.e., the qualified business income of multiple businesses is aggregated with respect to the particular taxpayer/owner and the 20% deduction is allowed against the total net qualified business income.
For joint return taxpayers earning income from a specified service trade or business with taxable income of more than $100,000 above the threshold amounts ($50,000 above for single return filers), the result is also simple: no portion of the pass-through deduction is available.
For those taxpayers with qualified business income not from a specified service trade or business and with taxable income meaningfully above the threshold levels, to participate fully in the 20% deduction, either (i) their allocable share of W-2 wages paid by the qualified trade or business (allocated in the same manner as the partner’s or shareholder’s allocable share of wage expense) must be an amount that is at least two times 20% of their net taxable income from the qualified business, or (ii) the combination of 25% of their allocable share of W-2 wages paid by the qualified trade or business plus their allocable share of 2.5% of the unadjusted basis of qualified property must exceed 20% of their net taxable income from the qualified business.
Other Provisions of New 20% Deduction
For the avoidance of doubt, qualified business income is specifically defined to exclude investment items such as capital gains and losses, dividends and dividend equivalents, and interest income not properly allocable to a trade or business.
Combined qualified business income does include 20% of a taxpayer’s qualified REIT dividends and qualified publicly traded partnership income (e.g., master limited partnerships), so these sources of income also qualify for the 20% deduction. In addition, a deduction is available for 20% of the aggregate amount of qualified cooperative dividends.
Impact of Pass-through Deduction on Choice of Entity
The simultaneous passage of the relatively low corporate income tax rate of 21%, together with the new 20% pass-through deduction, is forcing business owners and tax advisors to rethink the tax benefits and detriments of the available choices among business entities.
Tax advisors have often preferred pass-through entities for their domestic clients, especially entities treated as partnerships for federal income tax purposes, because they generally avoided the “double level of tax” imposed on C corporations, and typically provided more flexibility with respect to capital transactions such as sales of business assets and distributions of property in-kind. S corporations are generally tax-efficient with respect to operating income, but can trigger taxable gain on in-kind distributions of property, can be subject to a “built-in gains” tax and a passive income tax, and do not allow shareholders to efficiently share in debt-created basis as is available to partners in an entity treated as a partnership for tax purposes.
If a domestic taxpayer can fully utilize the new 20% pass-through deduction, given the related tax advantages of a pass-through entity for certain capital transactions, they may not wish to change to a C corporation, especially if they do not intend to leave significant excess cash in the business.
For domestic taxpayers who cannot utilize the 20% pass-through deduction, perhaps because they operate a specified service business, they may find that they are somewhat indifferent as to whether they operate through a C corporation or a pass-through entity. But they should carefully analyze the net tax effects to the equity holders of the choice of entities available, taking into account anticipated earnings, expectations regarding the extent to which profits would be distributed to the owners or reinvested in the business, state income tax rates at both the corporate and individual levels, the extent to which any long-term gains would be realized by the business or investment activity, and the effects of different entity choices on possible exit strategies and the tax effects of each approach.
Foreign holders of U.S. business or investment interests may find that with the new 21% income tax rate, investing through a C corporation may be an attractive alternative. The factors for such foreign investors to consider are still numerous – too numerous to be covered in this article.
Realize, however, before seriously considering using a C corporation, C corporations are still subject to the personal holding company tax of IRC Section 542 and the accumulated earnings tax of IRC Section 531. The personal holding company tax imposes a tax of 20% on the undistributed personal holding company income of a personal holding company, which means certain closely held corporations for which at least 60% of the gross income for the taxable year consists of passive types of income such as dividends, rents, royalties, and other types of passive income. The accumulated earnings tax is a 20% tax imposed on the accumulated taxable income of corporations formed or availed to avoid the individual shareholder tax by permitting earnings and profits to accumulate instead of being distributed.
The interaction of the new 20% pass-through deduction with other provisions of the Tax Code means that many business owners may well wish to reexamine their choice of entity to see if another structure might be more advantageous. Because this analysis needs to take into account numerous factors, as well as the interaction of various provisions of state and federal income tax law, taxpayers will want to work closely with their professional tax advisors.
If you have questions or concerns with how any of these provisions will impact you or your business, please do not hesitate to contact us.