May 22, 2018
The New Game in Town: Maximizing the 20% Pass-Through Deduction
Please read important disclosures HERE.
May 22, 2018
Please read important disclosures HERE.
Each April I eagerly await the blossoming of my dogwood trees. The snow-white bract under the tiny flowers brings me joy in both the display and the knowledge that I can count on the bloom each year. Every year around the same time, I can also count on filing my income tax returns. But even though filing an annual tax return is required of all of us, our tax obligations don’t typically stay the same from year to year. Life events, such as marriage, divorce, children, or legislative changes will always be a cause for increasing or decreasing one’s income tax liabilities.
The recently enacted Tax Cuts and Jobs Act (TCJA) is one of the largest pieces of federal tax legislation since 1986. Many of the provisions in the act are not permanent and are scheduled to expire after December 31, 2025. For instance, the estate, gift, and generation-skipping transfer tax exemptions are temporarily doubled. However, this means the federal estate tax is now inapplicable to most Americans. It is in the income tax area that creative planning opportunities now exist.
The most popularized changes to the federal income tax laws include changes in individual income tax brackets and the $10,000 cap on the deduction for state and local income, property, and sales taxes. However, the most controversial income tax topic, and the one with the most potential impact, could be the new Internal Revenue Code Section 199A deduction, also referred to as the 20% pass-through deduction.
In an effort to keep the tax rates of pass-through businesses somewhat in line with corporate tax rates (which were reduced to 21% under the TCJA), individuals, trusts, and estates who are eligible owners of pass-through businesses can deduct 20% of qualified business income (QBI). Taxpayers who are eligible for the deduction are owners of sole proprietorships (Schedule C), sole owners or tenants in common owners of rental real estate (Schedule E), partnership or LLC owners (Form 1065), and S-Corporation owners (Form 1120S).
The term “qualified business income” means, for any taxable year, the net amount of items of income, gains, deductions, and loss with respect to any qualified trade or business of a taxpayer. The term “trade or business” is not defined by statute or regulations, but is rather a “facts and circumstances” test. In general, to qualify as a trade or business, an entity must show profit motive, continuous and regular activity that has begun, and the sale of goods or services.
To prevent abuse of the deduction, the new QBI rules include certain limitations. A limitation on the amount of the pass-through deduction is imposed on income derived from certain specified service businesses (including lawyers, doctors, accountants, consultants, and financial advisors but excluding engineering and architecture firms). The pass-through deduction for owners of these personal service businesses begins to be phased out when the owner’s taxable income (from all sources and not from just the personal service business) exceeds $315,000 for married taxpayers filing jointly ($157,500 for a single person) and is completely eliminated when taxable income reaches $415,000 married filing jointly ($207,500 for a single person). The deduction cannot exceed the taxpayer’s taxable income and is available even to taxpayers who take a standard deduction.
For non-specified service businesses, the QBI deduction may also be limited if the business does not employ a substantial number of employees or invest in a substantial amount of property (this limitation is referred to as the “wages and property” limitation).
Taxpayers who are able to take advantage of the full 20% QBI deduction will effectively be taxed on only 80% of each dollar. This savings could reduce their top marginal tax rate on income from pass-through entities from a 2018 top tax rate of 37% to a reduced rate of 29.6% (37% x 80%). This savings should effectually reduce the gap between the taxation of small businesses and corporations.
Given the substantial tax benefit available for those who are eligible taxpayers, there may be significant planning opportunities to explore to take advantage of the deduction. Appropriate strategies could include: (1) reducing income through pension contributions or expensing capital purchases to reduce the amount of income exceeding the threshold amounts and increase the deduction; (2) increasing business income by paying off debt or increasing W-2 wages in non-specified service businesses; or (3) adding qualified property or spinning out practice buildings or equipment into separate entities.
In addition, forming completed gift trusts that pay their own taxes and transferring business interests to the trusts could result in creating additional taxpayers who have their own qualified business income limitations. Spreading the income among multiple owners may enable each owner to receive a larger QBI deduction. Depending on the type of business and other facts and circumstances, one of these techniques could help a taxpayer maximize the QBI deduction.
Small business owners including sole proprietors who earn less than the phase-out income limits should be able to claim at least some of the QBI deduction. Large businesses with big payrolls may obtain bigger deductions. However, doctors, lawyers, and accountants or those businesses that have limited numbers of employees or capital investments and whose income is over the thresholds of $157,000 for individuals and $315,000 for married couples may not benefit from much of a deduction.
In my time as an estate planning attorney, I was often able to help clients achieve estate tax savings for their families by implementing strategies developed in response to ongoing changes in the estate and gift tax laws. In many cases, there were many years between the analysis and implementation of the planning techniques and the client’s death when the tax savings were realized.
With the QBI deduction set to expire on December 31, 2025, we do not have the same luxury of time to analyze, plan, and execute tax savings strategies. For those individuals who have rental real estate or own an interest in a business, now is the time to explore possible opportunities to maximize the 20% pass-through deduction and generate income tax savings over the next eight years.