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Pass-Through Deduction

The Tax Cuts and Jobs Act (TCJA), enacted late last year, is best known for slashing income tax rates paid by C corporations and temporarily reducing individual rates. It also created a new 20% deduction for certain entities, effective through 2025, to help them compete with lower-taxed corporations. The deduction — which is available to qualifying S corporations, partnerships, limited liability companies (LLCs) and sole proprietorships — creates opportunities to transfer business interests to your children or other loved ones in a tax-efficient manner.

Section 199A Basics

The “pass-through deduction” can be found in new Internal Revenue Code Sec. 199A. It allows eligible owners to deduct 20% of their allocable share of the entity’s qualifying business income (QBI). QBI generally refers to net business income earned in the United States, excluding investment income, such as capital gains, dividends and non-business-related interest. Also excluded is reasonable compensation received by S corporation shareholders and guaranteed payments received by partners.

Generally, an owner’s deduction is equal to 20% of QBI or 20% of the owner’s taxable income (less net capital gains) — whichever is less. The deduction is taken against adjusted gross income (AGI) in computing taxable income, but it’s not an itemized deduction.

The deduction may be reduced or even eliminated if an owner’s taxable income exceeds $157,500 ($315,000 for joint filers). Once this threshold is reached, two limitations are triggered:

• 1. For “specified service businesses,” the deduction is gradually reduced and then eliminated after an owner’s taxable income reaches $207,500 ($415,000 for joint filers). Covered businesses include health care providers, accounting and law firms, consulting firms, investment-related firms and certain other service providers (but not architecture or engineering firms).
• 2. For all businesses, the deduction is limited to the greater of 1) 50% of the owner’s allocable share of the entity’s W-2 wages, or 2) 25% of W-2 wages plus 2.5% of the original cost basis of qualified depreciable property. This limitation is phased in beginning at the threshold amount and applied at full force when taxable income reaches $207,500 ($415,000 for joint filers).

In other words, for high-income owners to benefit from the deduction, their businesses must be other than specified service businesses and they must either pay significant W-2 wages or have a significant investment in real estate or other depreciable property.

Estate Planning Opportunities

If you own a business structured as a partnership, S corporation or LLC, Sec. 199A may offer some attractive estate planning opportunities. For example, if your taxable income is above the threshold and your deduction is reduced or eliminated by one or both of the previously discussed provisions, you may be able to obtain the full benefit of the deduction. Do so by transferring interests in the business to family members at lower income levels or to properly structured trusts for their benefit. (Trusts are subject to the same $157,500 income threshold as individuals.)

Be aware that W-2 wages and the basis of depreciable property are apportioned between the trust and its beneficiaries in proportion to the amount of income retained by the trust and the amount passed through to the beneficiaries.

A Complex Provision

Bear in mind that this is a highly simplified summary of Sec. 199A. In fact, it’s one of the most complex provisions of the TCJA. Consult us to determine whether the pass-through deduction will benefit your business or your estate plan.

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