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A Guide To The New 20% Pass-Through Tax Deduction

In December 2017, President Donald Trump signed the Tax Cuts and Jobs Act into law, ushering in the biggest changes to the tax code in more than 30 years.

Among the more significant changes made by the law is the creation of a new 20% deduction for certain pass-through business income. The deduction — sometimes referred to as the 199A deduction, after the section of the Internal Revenue Code in which it can be found — has the potential to reduce your taxable income by tens, if not hundreds of thousands of dollars.

CONFUSION ABOUNDS

 
Whenever there is a new tax law or regulation, it’s not uncommon for there to be confusion and/or different interpretations with respect to some of the provisions. Sometimes, in the rush to be “first to press,” there may even be some misinformation published by what are otherwise normally reliable sources. For whatever reason, however, there seems to be disproportional amounts of incorrect information being presented with respect to the new 20% pass-through deduction. So with that in mind, let’s cover some of the basics so you can be sure to relate the correct information to you.

THE DEDUCTION APPLIES TO MOST CORPORATE STRUCTURES

 
Depending upon the nature, size and type of business you engage in — as well as other factors — you may choose to structure your small business in a number of ways. Common small-business structures include sole proprietorships, partnerships, limited liability companies and S corporations. Business owners with companies in any of these ways may see benefits from the new 20% pass-through deduction.

That said, the precise benefit a you may receive could vary depending upon the type of corporate structure you employ. For instance, you may receive the deduction on all business income received from a sole proprietorship (net profits), but only on the profit distributions you receive from an S corporation (any salary earned from the S corporation is not eligible for the deduction).
 

BASIC MECHANICS OF THE DEDUCTION

 
The new 20% pass-through deduction will be applied to the lesser of your:

  1. Eligible (qualified) business income
  2. Taxable income (before application of the pass-through deduction), less any capital gains

Note: There are also certain adjustments that need to be made for so-called cooperative dividends. However, due to the fact that few people have such dividends, the impact on the pass-through deduction is being disregarded here for simplicity purposes.

A quick look at a couple of examples should make the basic mechanics of the deduction much easier to understand: 

Example 1: Jack, a single taxpayer, has a “regular” job where he earns a $100,000 salary as an employee. He also “moonlights” as a consultant and earns $50,000 of net profit via his Schedule C sole proprietorship. Now suppose that after accounting for deductions for self-employment taxes and the standard deduction, Jack’s taxable income is $133,500 (before application of the pass-through deduction).

Here, Jack’s business income of $50,000 is less than his taxable income of $133,500. As a result, the 20% pass-through deduction will be applied to Jack’s $50,000 of business income, resulting in a $10,000 ($50,000 x 20% = $10,000) deduction. 

Example 2: Jill, a single taxpayer, is a real estate agent who earns $100,000 of net profit via her Schedule C sole proprietorship. This is Jill’s only source of income. After factoring in Jill’s deductions for self-employment taxes and the standard deduction, her taxable income is $73,000 (before application of the pass-through deduction).

Contrary to our first example, here, Jill’s taxable income of $73,000 is less than her eligible business income of $100,000. Therefore, Jill’s 20% pass-through deduction will be applied to her $73,000 of taxable income. This results in a $14,600 (73,000 x 20% = $14,600) deduction.
 

A NEW CATEGORY OF DEDUCTION: “BETWEEN THE LINES”

 
One of the more interesting aspects of the 199A deduction is that it creates an entirely new type of deduction.Previously, deductions broadly fit into two categories on your return. One category of deductions, above-the-line deductions, helped you to lower your adjusted gross income (AGI) and was available to all filers, whether or not you itemized. The second category of deductions, below-the-line (itemized) deductions, was available only to those who itemized deductions, and did not reduce AGI, but did help reduce taxable income.

The 20% pass-through deduction does not fit neatly into either of these categories. It is not an above-the-line deduction, because it does reduce your AGI. Similarly, it is not a below-the-line deduction, because eligible individuals may claim the deduction regardless of whether they itemize. As such, the pass-through deduction is truly in a category in and of itself, and one that has been dubbed by many an “in between the line” deduction.
 

APPLICATION OF THE DEDUCTION FOR LOWER-INCOME INDIVIDUALS

 
A great deal of the coverage devoted to the new 199A deduction has focused on its complexity, and for good reason. It is clearly one of the more complicated provisions of the Tax Cuts and Jobs Act. There is, however, some good news. If your income is low enough, the deduction is actually quite simple. And the even better news is that “low income” here really isn’t that low!  

For single filers with taxable income below $157,500, and for joint filers with taxable income below $315,000, the only major wrinkle in the calculation of the 20% pass-through deduction is the aforementioned lesser-of-eligible-business-income-or taxable-income rule.

Note: Unlike most other thresholds in the tax code, which look at AGI (or modified AGI), the thresholds for the pass-through deduction are based on taxable income. This is actually more favorable, especially if you have large itemized deductions that can substantially drive down your taxable income to potentially receive a larger pass-through deduction than if the threshold were keyed to AGI. 

If your taxable income is below your applicable threshold, then your chosen profession has no impact on your ability to claim the pass-through deduction. That means that, contrary to what many believe, a reasonable number of doctors, lawyers, accountants, performers, athletes and, yes, even financial advisors are eligible for the 20% pass-through deduction.

Furthermore, if you are a “low income” filer, there is no need to evaluate the amount of W-2 wages their business has paid, nor the amount of depreciable assets your business owns. You simply get the deduction at the lesser of 20% of your eligible business income, or taxable income less capital gains.
 

APPLICATION OF THE DEDUCTION FOR HIGH-INCOME INDIVIDUALS ENGAGED IN A “SPECIALIZED SERVICE TRADE OR BUSINESS”

 
If you have taxable income above your applicable threshold, things begin to get more complicated and, in many cases, much less favorable. Nowhere is that more evident than for high earners with business income generated from a “specialized trade or business.”

If you fit into this category, then after a brief phase-out range ($157,500 – $207,500 for single filers, and $315,000 – $415,000 for joint filers) in which you receive a deduction for a prorated amount of your business income, the 20% pass-through deduction is completely eliminated. Specialized trade or business income includes income stemming from performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any business where the principal asset of the business is the reputation or skill of one or more of its employees.  

Bottom line: If you are a single filer with more than $207,500 of taxable income, or a joint filer with more than $415,000 of taxable income AND your business income stems from one of the above professions, you get no 20% pass-through deduction — for any of your business income.
 

APPLICATION OF THE DEDUCTION FOR HIGH INCOME INDIVIDUALS NOT ENGAGED IN A “SPECIALIZED SERVICE TRADE OR BUSINESS”

 
If you have high income from a business engaged in an activity that is not specialized service trade or business, it gets even more complicated. Once your income exceeds the same thresholds noted above, the 20% pass-through deduction is further limited. In such situations, the deduction available to you may not exceed the greater of:

  1. 50% of the W-2 wages paid by the business, or
  2. 25% of the W-2 wages paid by the business, plus 2.5% of the unadjusted basis of depreciable property owned by the business

Example 3: Bob works as an executive with a large company and earns a W-2 salary of $500,000. In addition, he is the sole owner of an LLC that owns rental real estate. Bob reports net profit from the LLC of $300,000 and has total taxable income of $720,000 (before application of the pass-through deduction). The unadjusted basis of the LLC properties is $1,400,000, and the LLC pays W-2 wages to a property manager of $80,000.

Bob is well beyond the phase-out range, but since LLC is not a specialized service trade or business, he is not precluded from taking the 20% pass-through deduction. Rather, instead of simply applying the deduction to the lesser of eligible business income, or taxable income, less capital gains, we must now incorporate the third test noted above. As a result, Bob’s pass-through deduction will be $55,000, which is the lowest of the following amounts:

  1. $60,000, which is 20% of Bob’s eligible business income of $300,000
  2. $144,000, which is 20% of Bob’s taxable income of $720,000
  3. The greater of:
    • $40,000, which is 50% of the LLC’s W-2 wages of $80,000
    • $55,000 which is 25% of the LLC’s W-2 wages of $80,000 plus 2.5% of the $1,400,000 unadjusted basis of the LLC property

This is by no means a complete analysis of the 199A deduction, and there will be much written in the coming weeks, months and years about how to maximize the deduction. Armed with this information, though, you can begin to understand how the deduction may benefit you and your family.
 

Disclosure: This commentary on this website reflects the personal opinions, viewpoints and analyses of the BluePrint Wealth Alliance, LLC employees providing such comments, and should not be regarded as a description of advisory services provided by BluePrint Wealth Alliance, LLC or performance returns of any BluePrint Wealth Alliance, LLC Investments client. The views reflected in the commentary are subject to change at any time without notice. Nothing on this website constitutes investment advice, performance data or any recommendation that any particular security, portfolio of securities, transaction or investment strategy is suitable for any specific person. Any mention of a particular security and related performance data is not a recommendation to buy or sell that security. BluePrint Wealth Alliance, LLC manages its clients’ accounts using a variety of investment techniques and strategies, which are not necessarily discussed in the commentary. Investments in securities involve the risk of loss. Past performance is no guarantee of future results.